Ray Wood |
Ray Wood, managing director and head of U.S. power & renewables at Bank of America Merrill Lynch, caught up with Senior Reporter Holly Fletcher ahead of the American Wind Energy Association’s Wind Energy Finance & Investment Seminar. Wood, the program chair of the event, discussed the undercurrents behind wind activity, how institutional investors value tax equity and why there is a rise in direct investments.
PI: Can you speak a bit about the factors driving wind deals?
RW: Just taking a step back, it has been very active in the second half of this year and on both sides of the balance sheet if you will. Late stage development activity is surging as a consequence of several factors including the looming expiration of the PTC at year-end, improved wind capture technology, somewhat supportive commodity prices and ongoing demand by load serving entities for power purchase agreements. Anecdotally, we are hearing about several PPAs being awarded. It may be that these utilities and other load serving entities want to execute before year-end and thereby allow their customers to benefit from the PTC.
As a consequence of this surge in activity, financing transactions should mirror this growth. Construction debt and as a consequence tax equity commitments need to be in place to qualify for the commencement of construction.
PI: What’s behind the investment activity?
RW: There have been several private investment transactions announced and funded. Wind projects that have achieved all their development milestones, that have all the accoutrements—executed and approved PPA, proven equipment, fully permitted etc—these projects have incredible value in the market today. Obviously, the same is true for construction phase or operating projects as well.
These shovel-ready projects can be sold to a wide range of investor types who like the risk-return profile that contracted generation offers, either with or without the tax attributes. There has been renewed interest by both strategic investors and a broad range of financial investors including infrastructure funds, sovereign wealth funds, pension funds and insurance companies. Some of these market participants including developers are actively considering or in the advanced stages of establishing their own yield oriented vehicle to participate in this segment.
This investment activity is supported by the current liquidity in the debt markets. Bank sourced construction financing is readily available and tax equity continues to be invested at competitive terms. This liquidity and depth to the debt market provides more comfort in turn to the prospective equity owners. These equity investor classes are showing a renewed interest in contracted power. Given general market volatility, they like the 20-25 year contract life and the stable dividend streams where the results are not correlated to the overall equity market.
PI: What about equity investors’ assessment of tax equity? How does that fit into it?
RW: In the past, the need for tax equity has been a limiting factor for these investors. One of the benefits of a yieldco structure is that it allows these sponsors to highlight the value of the project by focusing on distributable cash flow after debt service. Excess tax attributes provide a shelter well into future years and allow investors to consider the pre tax yield efficiently. This approach, depending of course on the facts and circumstances of each project, can compete with the investor who utilizes tax equity and leverage and considers an after-tax equity IRR. It also may appeal to those investors who are looking for a more consistent cash flow profile. At the same time, more tax capacity is coming into the market and new entrants are entering the business. Public market commentary now focuses on free cash flow generation for contracted generation and less on EBITDA metrics.
PI: It seems there’s continuing activity encouraged by the need to meet the PTC timeline.
I am not in a position to comment when and if Congress addresses the PTC issue. Over the past 10 plus years, from my memory, the PTC extension has from time to time been extended immediately prior to the then approaching maturity and on other occasions the PTC was extended several months after maturity. Today, we have a PTC deadline not for C.O.D. projects but for commencement of construction projects, so it affords the industry more time to grapple with or respond to future congressional action, budget scoring and policy ideas.
We do not see activity falling off a cliff at year-end. Considerable financing and strategic work needs to be executed just to finance the advanced development and construction activity immediately in front of us, not to mention the large operating fleets that may change hands in the months to come. We expect ongoing consolidation in the sector as strategics and the financial institutions noted above seek scale in operating fleets at competitive rates of return.
PI: What happens if the PTC is not extended? I’ve heard some general chatter about R&D out there for new structures for wind.
RW: Certainly in the absence of the PTC and for projects that did not qualify by year-end, losing that $20 per MWh escalating by CPI does create some headwinds for new development activity that would have to be made up by ongoing equipment efficiencies, by higher power purchase agreement prices or through other innovations either supported by Washington or created on Wall Street. There has been talk of master limited partnership eligibility or real estate investment trust eligibility or other ways the federal government could show support for renewable energy. I think Wall Street and developers are focused on all of those approaches.
PI: Do you think that seeing no sale in the instance of BP Wind has had a broader impact on people thinking about how to value or thinking about options for their larger wind fleets?
RW: We were not involved in the process so cannot comment as to what happened or why it happened. That said, we do not believe the market should draw negative conclusions as to values that can be achieved in the market. That deal is not a measuring rod for interest in the space. Investors continue to focus on cash flow stability, equipment reliability and tax structure.
PI: You alluded to infrastructure funds and pension funds. You talked about how they are playing a heightened role in the space—what is driving their appetite and how long do you think their interest is going to be sustained?
RW: There is an incredible amount of institutional liquidity lined up with sovereign wealth funds, infrastructure funds, pension funds, insurance companies and there is a desire to match the duration of the asset against the duration of liabilities. That’s kind of portfolio management 101. We continue to see several asset classes that fit this broad profile including contracted generation, transmission and/or other regulated businesses.
As long as we’re talking about building up renewable generation with renewable generation being a long-term contracted play it will continue to be in the wheelhouse of that investor class. And that investor class is not going away. It’s getting bigger every year. More institutional funds line up and more growth equity funds are being asked by their limited partners to create an infrastructure vehicle. We think there continues to be a proliferation of players and more capital being allocated to the space. Part of that is the risk adjusted returns appear attractive.
PI: There have also been an increased number of pension funds, such as CalPERS and Borealis, looking to make direct investments either themselves or alongside a partner fund like Harbert Capital Management. What do you think is behind the emergence of confidence in doing something on their own?
RW: That’s a very astute comment. We see increasing interest in direct investments by pension funds and other institutional players that in the past directed almost the entirety of their investment in this asset class through an infrastructure fund or other fund player. There is disintermediation going on in the space and we think that has to do with their years of diligence, their comfort in the asset class and the scale of the industry today versus 10 years ago. It’s now big enough for the biggest players to have direct opportunities.
PI: That dovetails with some of the conversations I’ve had with some of the investors. They just seem to be more comfortable with the assets themselves and they don’t seem to need that third party between them and asset.
RW: While that’s true, we do think that those portfolios that are being managed by strategic players or proven players in the industry will give these institutional investors more comfort. They are often coming in to back a management team that is operating the fleet as opposed to buying, controlling the asset and finding their own management to run it.
PI: With the proliferation of the longer term players, where does that leave the more traditional private equity players? What opportunities are they seeing and how are they looking to transact?
RW: We think this is a market that supports all those players. The growth equity players tend to spend more time deploying capital behind developers—whether its transmission development, wind development, solar development, gas development, you name it. To drive their returns they tend to buy into situations that have more organic growth so as to use their expertise to advance those businesses to the point where they can be valued differently in the market. Often that catalyst for value creation is development milestones, as well as other milestones, so we continue to see active interest in solar and wind and other development businesses by the growth equity players.
PI: There have been several successes in initial public offerings. NRG Yield was terrific. TransAlta Renewables, while not quite the same structure as NRG Yield, has done quite well. However, some companies have pulled or postponed. So what do you think characterizes the story that investors are willing to buy right now?
RW: We at Bank of America Merrill Lynch have a strong point of view on what it takes to be successful in the public markets. We believe success in the markets can be summarized into three key features: sponsorship, growth and portfolio size and stability.
Of course the portfolio must be of sufficient scale to attract efficient capital in the market. However, what really drives investor interest is couple that initial portfolio with the knowledge that the capable sponsor will continue to be motivated to create value and grow the business. This creates a superior return expectation and the growth in the portfolio in turn creates more liquidity in the market.
We believe the most successful deals will highlight those three elements.
Check www.powerfinancerisk.com for coverage of AWEA’s Wind Energy Finance & Investment Seminar Sept. 9-10 in New York.
