In the second installment of this Industry Current, four veterans in the project finance market talked about private equity and merchant risk in regards to the cost of capital at an event hosted by Chadbourne & Parke. Eli Katz, partner in New York, moderated the panel, which included:
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 and
Carl Morales, a director at Sumitomo Mitsui Banking Corporation.
Private Equity
KATZ: People would like to raise more money from infrastructure funds to fill in the equity portion of the capital structure. Yet a lot of private equity funds do not seem to match up well with renewable energy assets. Do you agree with that perception, and why is there a mismatch?
MORALES: The private equity funds have high hurdle rates to meet, and the perception is that they usually cannot make the numbers work.
SCOTT: Most of the infrastructure funds with whom I have dealt are most interested in assets with predictable cash flows. This is not what one finds in renewables projects. The infrastructure funds are used to looking at long-dated infrastructure assets, social infrastructure and transportation infrastructure. It takes time to get comfortable with resource risk.
RANDALL: These private pools of capital have had to adapt to the current phase of the market. Before 2008 when renewables were booming, there were opportunities for private equity shops to make money by investing in developers and benefiting from their growth. They could benefit from rollups that would, in many cases, be sold to European investors. Basically the cycle is now reversed. Now you have a number of European investors selling off their portfolios. Returns on capital of 30% or more are just not available in at least the volume that they used to be. We are seeing some private equity shops in a sense morphing into infrastructure funds. I think a lot of them may not admit that they are looking for high single-digit or low double-digit returns, but that is what is available these days with a maturing pool of assets. The big returns are just not available like they used to be.
KATZ: Carl Morales, Sumitomo does lease financing, which is a form of raising equity. Could you talk about the pricing of that product and whether you can combine it with other pieces of a traditional capital structure like debt?
MORALES: The bank has tax capacity and we are looking to deploy it. The returns are equivalent to returns in partnership flip transactions. Our focus is on single-investor leases where the lessor pays full value for the project using equity. We are not crazy about leveraged leases in project finance transactions because we are behind a lender in the capital structure.
KATZ: Switching gears, there is a perception that a lot of European investors or maybe even Asian investors have a preference for U.S.-dollar-denominated assets. Do you see that happening? How does that translate into pricing or tenor for any piece of the capital structure for power assets?
RANDALL: There was talk a couple of years ago that Asian investors were looking to invest in the U.S. We spent a lot of time in Japan and other parts of Asia looking for investors, but it became a very crowded field with many others also searching for such investors. It is hard to find Asians willing to lend. There is more interest in investing equity. Asian investors want contracted projects with long-term power contracts with creditworthy utilities. Returns for such projects have fallen to the high single digits. Infrastructure funds that had been funding highways and bridges have started looking at energy as well. This has put further downward pressure on returns. The price of debt has increased to 5% to 6%.
At the same time, equity returns have compressed to 8% to 9%, so you have a low spread between debt and equity, but you still have a huge difference in risk between the two positions. If you start to talk about merchant energy or anything that adds risk, a lot of that equity disappears pretty quickly. It is not just Asian investors, it is also infrastructure funds and sovereign wealth funds who disappear, so we see a lot of people cancelling the debt because they cannot find the equity, even for fully contracted projects. Consider in addition that there are not a lot of projects with long-term power contracts coming to market.
Merchant Risk
KATZ: Is it possible to get any form of financing on a merchant project? If not, what happens in a market where there are not a lot of contracted projects?
RANDALL: As the renewable energy market starts to tail off, we are starting to see new activity on the thermal side. We see some gas-fired projects with merchant components to them. We will not see a return to the period before Enron went bankrupt where banks were financing purely merchant projects. However, a quasi-merchant project may be finance- able in an established market with a good track record. The transaction will work only if there is low leverage and maybe some level of hedging. With $2 gas, it is inevitable we are going to build more gas-fired power plants. Only a subset of lenders will consider projects with merchant risk.
KATZ: Will the banks on this panel lend to a thermal project where not everything is fully contracted?
MORALES: To be perfectly honest with you, we will not. Although we have done it before, we do not have an appetite for merchant risk at this time. From a risk management perspective, our institution is not comfortable with the non-contracted risk. We are not willing to make a credit decision on a “story.” At least for now, we are looking only at fully contracted projects and no merchants.
EMMONS: We only do renewable energy projects and, within the renewables category, we avoid market price risk, which is the same thing as saying we will only lend against contracted revenues.
KATZ: There are times in the cycle when banks are willing to finance merchant projects. What happens that changes their minds? Is it that you run out of contracted projects to finance or your funding sources loosen up? What would have to happen to change your minds?
EMMONS: The last time banks lent against merchant projects was more than 10 years ago and there was a lot of blood on the floor as a result. The reason for the last foray into merchant was there were a lot of fully-staffed banking groups with nothing else to do coupled with a lot of irrational exuberance. A lot of money was lost. The banks have not forgotten that. There are very few banks who will lend merchant.
KATZ: Dan Reicher wrote an op-ed piece in the New York Times recently pointing out that renewable energy is at disadvantage because it does not have access to retail investors like the oil and gas industry has with master limited partnerships and the real estate industry has with real estate investment trusts. Are a lot of people talking about opening renewable energy to retail investors? What would that do to pricing if those markets could open up?
RANDALL: There has been talk for several years now about using MLPs or REITs. However, use of MLPs requires a statutory change by Congress and people see such a change as an uphill battle, especially in an election year. For quite a while, people in the industry have said if you can get those tax credits in the hands of retail investors, then the market would become much more efficient. I believe that, too. The efficiency will drive down the cost of tax equity. MLPs would simplify a lot of the capital structure.
KATZ: Putting aside the tax piece, if you could raise money against the cash flows using MLP or REIT structures, do you think that would be a game changer for the industry? Would it bring down the cost of capital significantly?
RANDALL: If you are planning to use such a structure to finance a single asset, I do not think it will have a big impact. You sell the first loss layer to a tax equity investor. The MLP equity is behind other pieces of the capital structure. This will not affect the cost. Where I think you get some effective pricing is when you start to do stuff on a corporate basis. You put a bunch of assets together in an MLP and go leverage them on a corporate basis. That is where you get some real efficiencies by moving out of single asset nonrecourse structures.
KATZ: Let me ask a general tax equity question because tax equity remains an important piece of the capital structure. Do you think pricing will move up or down over the next year or two?
RANDALL: I think we are going to see some new entrants, including ourselves. Some regional banks are looking at investing tax equity. Developers have been trying to tap the corporates and I think with the right structure, you might see some more of them entering the market. Yield is the main driver for people.
New Trends
KATZ: Where do you think you will be spending your time over the next 18 months? What new trends do you see in the market?
RANDALL: In terms of lending, I think we will be spending a lot of time on M&A. I expect M&A will be where we spend most of our time on the advisory side, too. With so much equity chasing projects, we are starting to see more M&A activity. A lot of European companies are going home and liquidating assets. If you own assets, it is not a bad time to sell. I also expect to see more new construction of thermal power plants. There are going to be some interesting structures around quasi-merchant risk.
SCOTT: I might echo the gas build situation in the U.S. I expect to see continued activity in the wind sector, especially in the south, but at a lower level than in the past. Sponsors, certainly some of the European sponsors, who have amassed critical mass of assets in the U.S., will be beginning to look to refinance those on a portfolio basis or in quasi-corporate transactions. There will be much more activity in mid-stream gas assets. There has been a fundamental change in the direction in which liquids and gas move around the US. There is growing activity in selected countries in Latin America.
EMMONS: There is no one category that is going to be a big growth area, but if production tax credits are not renewed by Congress, then on-shore wind will wane. If the tax credits are renewed, then I think on-shore wind will remain a major area of focus. Mid-size, commercial and industrial solar will be a growth area because that market will continue to benefit from tax subsidies and the market penetration of PV is still low. Offshore wind will never be a huge sector, but hopefully there will be a few large deals over the next few years. We hope to be active there, but it will not be a huge segment of the market.
MORALES: We will continue to push our core debt business on the project finance side and try to grow the tax equity business. We have a strong interest in doing export credit agency transactions. We have a very strong Latin American presence, so that will be an area where we also expect to see growth.
