Eli Katz |
Project financings in the U.S. relied heavily the last three years on stimulus grants and federal guarantees. Both are disappearing. The euro is in trouble with a Greek exit from the eurozone looking increasingly likely. European banks have pulled back from the project finance market. What assumptions should developers make about the future cost of capital when bidding to supply electricity? What new strategies are likely to emerge for raising debt and equity? In this week’s Industry Current, four veterans in the project finance market talked about the cost of capital at an event hosted by Chadbourne & Parke. Eli Katz, partner in New York, moderated the panel.
The Panel
Thomas Emmons, managing director and head of renewable energy and infrastructure finance at Rabobank, New York Branch
Duncan Scott, managing director and global head of private placements and project bonds at SG Americas Securities
Richard Randall, managing director and head of power and project finance at RBS Global Banking
Carl Morales, a director at Sumitomo Mitsui Banking Corporation.
KATZ: Carl Morales, there are declining subsidies and a lot of volatility in the bank markets. How should developers be evaluating this when they think of the future cost of capital for their projects?
MORALES: We are headed for a tightening of terms and maybe some higher costs. Finance is moving from the bank market to the institutional debt market as a result of the European debt crisis and Basel III. Export credit agencies are also playing a larger role.
Banks Versus Capital Markets
KATZ: Tom Emmons, what is going on with the banks in terms of funding and regulatory issues that is making it more difficult to get long-term debt?
Thomas Emmons |
EMMONS: The bank market is segmented. The segment that is under the most duress is, of course, the European banks. There are regulatory pressures: Basel III is requiring banks making project finance loans to set aside more capital. The economic crisis in Europe is eroding the capital base. There is a deleveraging of balance sheets. Basically, as a category, European banks are under a lot of pressure, so you see them shrink, if not totally withdraw, from the project finance market in the U.S. The good news, if you can see any good news in it, is that some other segments of the bank market are actually filling in fairly well. I would look at margins as an indication of supply and demand. Margins and fees have not increased significantly since mid-2009. The good news is that the banking market is somewhat resilient and the other categories of banks, U.S., Canadian and Japanese banks, seem to be filling the void.
KATZ: Most developers are looking for longer-term debt. As you think about the different banks, who is the best target for that and why?
EMMONS: Banks are intermediaries. They basically take deposits and lend them out again. Insurance companies and pension funds are really investors: they have a pool of capital that they need to invest. So per textbook corporate finance, long-term debt is better matched to institutions. Banks typically would do the shorter term or the part of project finance work where construction is involved meaning that there will be more complicated draws and repayments. Institutions like to put the money out all at once. They will do construction debt and take construction risk, but the sweet spot for institutions is long-term, low-risk chunky investments. The reason why institutions were not the main lenders to the sector in the past is that European banks over the last decade considered their cost of capital lower than it really was, so they began competing with institutions and lending up to18 years and that has basically come to a halt.
KATZ: Do you see that restarting anytime soon?
EMMONS: There are some non-European banks still making long-term loans. But no, I do not see that coming back. I see this as a fundamental shift mostly due to regulation and higher capital costs. I think the institutions are probably competitive again, and banks are coming down significantly in maturity.
KATZ: Duncan Scott and Rich Randall work more in the capital markets. Since the place to get long-term debt is now the capital markets, will you talk about what those markets look like, how many active players there are and whether they are healthy?
SCOTT: Those markets are obviously huge. Over the last five to 10 years, the capital markets have been a niche part of project finance lending. Renewable energy companies are less familiar with the capital markets. The role of these markets is growing. A number of the institutional lenders participated in loan guarantee transactions last year to the renewable energy sector. This has contributed to a widening of knowledge among institutions about renewables projects.
There has always been a very active handful of life insurance companies who have understood these projects and have been active in them. Of obvious interest to this audience is how we widen institutional participation in the sector. That is the ongoing challenge, and it has accelerated in the last 12 months with the withdrawal of many long-term lending banks. Many developers have no choice but to look to institutions and to begin to adapt their requirements, their returns and their structure expectations to an audience that is similar but different.
KATZ: Rich Randall, banks are notoriously inflexible. Do you have the same thing in the capital markets? Do you get more flexibility in terms of who your offtaker is? Do you get more flexibility in terms of tenor? What sorts of things do you get in the capital markets that make it a more advantageous place for developers to borrow?
RANDALL: Our developer clients would probably say the capital markets are less flexible than the banks. I think the only flexibility you get is on tenor. Essentially the two markets are almost identical in structure and in creditor arrangements. There are still tranche deals. They are still very similar.
The disconnect comes as the bank markets fade and focus more on the short-term aspects of projects like getting through construction and we start to fund these projects as 25- to 30-year assets in the institutional debt market. There is a bit of a breakdown in the market right now as developers want to retain flexibility to refinance long-term debt while insurance companies and pension funds want a truly long-term instrument. We have seen a lot of flow in the last two years compared to the recent past. I would have expected to see more.
Banks tend to be gravitating to a five- to seven-year structure. Insurance companies want 20-year debt. There is a void in the market for a 10-year type of instrument and it will be interesting to see whether institutional money fills that gap. Pricing has crept up, and we are now looking at pricing in the institutional debt market that is more akin to bank loan-type pricing. The low rates that the European banks were offering in the last five years are starting to move upward. There is an opening for institutional money to fill that gap.
SCOTT: Renewable energy developers are looking for long-term money to match their assets and talking to both institutions and banks. The fundamental difference between the two markets is the institutional debt market is interested in lending long-term at fixed rates. It is potentially a game-changing perspective for developers. The insurance companies and pension funds do not have the same long-term experience with performance of these assets that the banks have. They have not been tracking the technology changes. They end up looking through the prism of the rating agencies. The rating agencies color the views of a lot of institutions.
The rating agencies have been skeptical about wind projects and wind resources. They remember one high-profile project that they rated several years ago that did not perform as expected. They are unaware that 95% of the transactions turn out well. It is a chicken-and-egg problem to kickstart the market.
Term B Loans
KATZ: Rich Randall, what is a term B loan and where does it fit in the capital structure?
RANDALL: It is essentially the same as bank debt. It has a floating rate that is LIBOR based and a tenor of seven years. It can be prepaid easily. There may be some call restrictions in the first couple of years, but it is a very flexible financing. It is distributed primarily to holders of collateralized loan obligations. Some insurance companies and hedge funds buy term B loans as well. They are sub-investment grade, around BB. The term B loan market was very active before the economy crashed in the fall 2008. It has come back quite a bit since then. It is very similar to the high-yield bond market: a floating-rate instrument but senior secured debt.
Term B loans are a good barometer for the true cost of capital. The reason we see bank pricing gravitating more towards the terms in the institutional debt market is because banks, for lack of a better word, were lying to themselves about their true cost of capital, and reality has caught up. You see bank pricing gravitating to where the B loan market is.
KATZ: What is the pricing difference between a B loan and a senior secured term loan from a bank?
RANDALL: A BB credit probably has to pay 350 to 450 basis points over LIBOR in the B loan market. A project finance bank loan, which is usually a BB+ finance credit, is gravitating around 300 basis points over LIBOR right now. There are also upfront fees.
EMMONS: We have seen B loans often applied to holding companies. If a developer has a long-term power contract, it can generally get full leverage at the project level, so there is no room for another mezzanine debt tranche. However, developers borrowing against portfolios of projects borrow at the level of a holding company one tier up from the project companies and secure the B loan by pledging the equity interests in the project companies.
RANDALL: Three years ago, we had 40 or 50 banks to whom we syndicated debt. Last year, 25 banks did four or more deals. That was our definition of active. This year the list is about 15. We are seeing the bank market shrink. Usually, when you see that amount of liquidity leaving the market, you would see pricing increase dramatically. I think what offset that is that we have some Japanese and Canadian players and a couple of regional U.S. banks coming in.
Demand is down at the same time. It is hard for developers to persuade utilities to sign long-term power contracts. We are not seeing the volume in projects that we usually do. North American project finance is around a $30-to-$40 billion-a-year market. This year, it will probably be around $20 billion.
I think demand will recover for project finance debt in a couple years. That demand will have to be filled from some other pool of capital that needs to form. Times like these see new pools of capital form, so it will be interesting to see whether the additional capital will come from the B loan market. There has been resistance to single asset financing from that market.