Last week, we published the first part of an interview with MUFG's Matt Odette, director in project finance, and Frederick Echeverria, executive director on the private placement desk, in which they discussed the evolution of the project bond market in recent years, including the increased willingness of private placement investors to provide delayed draw features (click here to read part I).
In the second part of this exclusive interview, the bankers address the relative merits of the 4(a)(2) and 144A products, structuring considerations and the potential application of the project bond market to projects with merchant exposure and small-scale solar.
PFR: We’ve been talking about the 4(a)(2) private placement market. Project finance issuers also have the option of going out to the 144A project bond market. Are all of the deals for construction financing in the 4(a)(2) market? How is the 144A product involved?
ECHEVERRIA: I view it as a single market. If you do 144A documentation, that opens up a much broader universe of investors, call it 1,000 investors versus 100, but 900 of those 1,000 investors are not that savvy in project finance, so you’re really still probably focused on 100 investors. But it does provide you that backdrop of a $1 trillion public market if you need the liquidity. The way that those deals are structured, with banks acting as initial purchasers/underwriters, and the settlement period, there’s no scope for efficiency on the delayed draw. You’re going to take all your proceeds up front, and then you’re going to have that negative arbitrage of capital sitting in a low-interest-earning account while you’re paying interest to the bondholders. We wouldn’t have been able to achieve the delayed funding that we did for AES on the bond tranche if we did it as a 144A. They were able to get aggressive execution on their bond pricing and also take advantage of almost two years of delayed draws on the bond piece, with the bank commitments behind it that then funded the remainder of the construction.
PFR: Talking about the efficiencies of these various different markets, if you have a transaction that’s large enough to tap multiple markets at the same time, we’ve seen transactions structured where there will be a bank tranche that amortizes first and the institutional investor tranche does not begin amortizing until the bank tranche is gone, is that right?
ECHEVERRIA: That’s correct. By delaying the amortization on the bond tranche, your average life on the bond is synthetically greater than if the whole transaction was just a bond out of the gate, so you’re able to appeal to the deepest, most aggressive parts of each market.
PFR: We’ve talked about tenor and pricing and the delayed draw feature and the depth of these markets. Is there anything else that borrowers and even bankers should think about when structuring these kinds of deals?
ODETTE: From a basic terms and covenants standpoint, the two markets are similar, with one big exception, which is the repayment flexibility. Banks can be repaid at par but in the bond market investors can only be repaid with a make-whole premium, which, depending on where interest rates are, can be pretty expensive. That’s somewhat sacred to bondholders—it’s very difficult, if not impossible, to get a deal done without it in there. So that is what we see as a key consideration that sponsors look at. If there is more desired flexibility around the capital structure, then the bank product might be more appropriate. If it’s more permanent financing, and you like the price you get on it and you intend to leave it in place throughout the duration of the contract, then you’re happy with the make-whole being there because you never intend to refinance it.
PFR: Do you see project bond or private placement investors looking at financing merchant projects at all in the U.S.?
ECHEVERRIA: Define merchant.
PFR: Projects with some element of merchant cash flows?
ECHEVERRIA: Primarily, the investors that are drawn to these assets are investment grade investors. It’s very difficult to have something with volatility or uncertainty in the cash flows to receive an investment grade rating. That being said, given the lack of contracted paper, we have seen a subset of investors willing to entertain looking at what I’ll call quasi-merchant projects. They’re not fully merchant—there’s some form of hedge or revenue put that gives you a floor on cash flows—but you still have a lot of uncertainty. We’ve seen investors look at that. I wouldn’t say it’s a huge part of the market currently. I wouldn’t say we’ve gotten a lot of calls from investors to show them more merchant transactions.
ODETTE: I think that’s right and clearly those sub-investment grade profile-type projects price very differently from what we were saying earlier in terms of spreads for a long-term contracted project. So I think, more so than banks, there is a preference among institutional investors for contracted projects. But, just like banks, contracted projects are getting more and more difficult to find and these institutions still have large amounts of money to put to work, so we are seeing interest and in a few cases actually executed transactions that are outside of that traditional senior secured investment grade box. Quasi-merchant is one of them, although still a very small proportion of the market compared to the commercial bank market.
PFR: That’s really interesting, especially with several sponsors still trying to finance greenfield gas-fired projects in the PJM Interconnection region. We’ve seen them getting very creative and tapping every available pool of capital they can possibly find as the commercial banks have become slightly fatigued with that region and their existing exposure to it. What do you think are the prospects for sponsors still looking to finance projects in that region?
ODETTE: There is a financing availability element to it but there is clearly also a limit, from an equity standpoint, to what the market can bear as far as new greenfield projects go. Certainly, we have clients, sponsors, who are interested in continuing to develop projects, and we have other sponsors who would not like to see more development because they own projects in PJM and are concerned the continued development will flatten or even potentially push down the economics of the plants they already have. So it’s hard to handicap how many of these projects in the queue will go forward. It will be some, certainly, but it probably won’t be the full pipeline that you hear sponsors talking about, just because of the limited ability of the power markets to continue to absorb these assets.
PFR: Are you working on any of those at the moment?
ODETTE: I’m probably not best placed to comment on that.
PFR: I guess we’ll have to wait and see how many and on what terms they get financed. Speaking of different kinds of offtake or contract, some portfolios of distributed generation or residential solar have apparently been financed with private placements and project bonds, but that must present its own challenges.
ECHEVERRIA: I think that residential and C&I solar’s been around for a while, but trying to aggregate and bundle that up into something financeable is rather novel, and I think a lot of it hinges on the specifics of the nature of the contract or contracts and the nature of the customers. A contract which is homogeneous among the customers would be ideal, but what I’ve heard on other deals is that you’ve got a mismatch of different contracts with different terms. If it’s all residential, then you’re almost doing an ABS, like a credit card receivables transaction, where the credit quality of each consumer on the hook is part of your collateral pool, which is a little different than analyzing a utility-scale solar project with an investment grade investor-owned utility as the single offtaker with a single contract. We have heard of some of these transactions—and I’d say they’re all pretty unique and bespoke—getting placed in the private placement market, and I think we’re still in the early innings of seeing that grow.
ODETTE: I think they face the same challenges that they face getting financed in the bank market, which is that you have a very heterogeneous set of contracts that are still chunky enough that you have to analyze each one from a diligence standpoint. My personal view is that these types of projects make sense economically and as the market grows and the contracts can be standardized to a greater extent, that’s really when we’ll see growth take off. It’ll probably be similar to what we’ve seen in utility-scale markets, where a lot of things are constructed under bank facilities, with more flexibility around the draw schedule. Then, if these contracts are very long-term and high quality, they can be taken out in the bond market, but I don’t think we’ve seen that happen yet on a large scale. A lot of people are looking at it but we haven’t seen that really blossom.
ECHEVERRIA: MUFG is well placed to play a role in this. We’ve been a leader on the bank side and we’re now also a leader on the capital markets side.
ODETTE: We’re able to offer credible solutions across the capital structure from bank to bond and I think that’s something that sets us apart.