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Q&A: Frank Napolitano, Credit Suisse - Part I

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Frank Napolitano joined Credit Suisse in June as global head of power and utilities. He leads a team that has seen a wave of departures as it moves into an era of deals that are being dominated by a host of new players. Napolitano called Manag­ing Editor Holly Fletcher from the road to talk about who is active in M&A and why hedge funds are making a return as asset owners.

PFR: You are pretty new to Credit Suisse. Tell me a bit about what goals you have for the team.

Napolitano: Being the newest member of a very established team with a great track record, and some current deals in the market like the Dynegy transaction, I’ve had the pleasure of meeting quite a capable team. It is a great opportunity to come into a leadership position to take what we have—which is in fine shape—and grow it back into what people may remember the broader Credit Suisse Power and Utilities franchise to be.

PFR: How are you going to do that?

Napolitano: This is going to be an evolution, not a revolution, of our approach to the market. There are three or four major items that we are focusing on currently and that we will continue to focus on. The first important thing is clients first.

The firm has clearly come through the financial crisis in good stead, and in the market cycle, and in the client cycle, we are absolutely back in client aggregation mode and back into client service as it relates to the value-added aspects of client needs. In this market, that’s largely M&A and structured financing execution. These are two things that suit my historical skill set very well, that suit the firm’s existing product areas well, and that suit the deal experience and the training of the bankers that are now senior bankers on a team that has grown up here.

PFR: Who do you work with and is that changing?

In the client base, we have regulated utilities and independent power producers. But we, like other financial service firms and investment banks, are now focused on the growing alternative asset manager community. That includes pure play private equity funds, both the global macro-type and the power and energy type, as well as the infrastructure types. Those infrastructure types could include direct invest pension funds and insurance companies.

Increasingly, we have a new entrant, back into the space—the hedge fund component. It’s focused not just on securities trading but the re-emergence also includes a private equity strategy. They are integrating the securities activities, the commodities activities, and the private equities activities on an industry vertical basis. We’re seeing activities with those clients trend more toward power plants more than say with regulated utilities.

I go to the trouble of mentioning it because I think it is going to continue. There are some forces at work pushing banks and financial services firms out of the commodity intermediation role that they have been playing over the last decade.

PFR: And how are hedge funds stepping in?

Napolitano: A few of the banks are saying they will stay in the commodities product lines but others have exited the commodities product line in a complete fashion. That has created, according to my clients on the consuming and producing side of physical commodities, such as power and natural gas, a gap in the market place that needs to get filled at some point to provide market-making liquidity. It does appear that alternative asset managers are stepping into that role.

So if they’re going to see these commodity flows, which they are, which is very good information for them, I think they are going to be able to make some informed decisions around their desires to physically own assets in the space. We see that as a very interesting call it “renewed entrance” since this was a strategy back in the early 2000s. It certainly has some legs for going forward.

PFR: Are you seeing hedge funds look at the space that haven’t played a lot in the downstream power or are these alternative asset managers who already have sophistication in the power space? What’s the learning curve?

Napolitano: I’d say the majority, 99% of the market participants that are looking at the space today, either have talented teams that have spent time in the space and/or those talented teams have been with those exact firms while they’ve spent time in the space, so it’s a very sophisticated audience. As a result, the friction cost of doing business, meaning the startup time, learning curve, etc, are done.

PFR: Done?

Napolitano: These are actual parties that are able to and ready to, and already have been transactors in the current state of the market. Some of it is around complete growth stories. Some of it is around restructuring stories. The large EFH situation has clearly got many different types of investors in many different places in the capital structure and ultimately there may be two businesses there. There may be a wires business on the regulated side suiting one investor base, and there may be a genco with a large retailer involved on the other side.

Bottom line, plenty of clients, never enough bankers on any given platform, so we have to find the places where we can focus and produce results. In terms of the kinds of business that we’re doing, it varies by client type. For investment grade utilities, it is lending and capital markets, it is interest rate derivatives, and it is strategic positioning, so whether that’s corporate M&A, asset buy-sides, or asset sell-sides. Folks are still growing their strategies and harvesting existing assets that are no longer as core to the new strategy as they used to be, and that is creating a lot of flow in the physical asset, M&A market.

PFR: Renewables are coveted by yieldcos and make up a swath of the financing arena. What’s the outlook for where the activity will be on this side?

Napolitano: We’re seeing impacts from activity on utility holding company and independent power producers spill over into the renewables area. Tax policy in this country is still a key part of financing a renewable capital structure. The industries are evolving to a point where some day they may not depend on subsidies of that nature, but be that as it may, where we are today in the cycle, tax equity is extremely important. Credit Suisse does have a tax equity business and does serve clients in that regard, as do other banks. So we are spending a good amount of time with regulated utility companies who want to let their holding company level participate in renewables, both for public policy as well as for financial benefits. That’s typically been solar as of late, but we’re still seeing a fair amount of wind activity.

These conversations then help us make some introductions among our developer client base, independent power client base, which is now evolving into the yieldco client base as they continue to grow or aggregate pools of renewable assets. So for a number of the recent equity research calls held by large utility holding companies, the Q&A that they’re hearing is concerns their intentions for these renewable assets. Are they going to leave them in the C-corp as they are, or are they going to carve them out in some form of yieldco IPO, or in the case of midstream assets an MLP IPO? Or if the company is fortunate enough to have both business lines working on their behalf—meaning growing—are they going to put it all together for a super yieldco?

Right now the equity markets are supporting the momentum by voting with higher stock prices for any and all of those quality carve out strategies. It is a very beneficial time for CFOs and CEOs to be considering matching capital structure with strategy, simply because it seems to be a value creating exercise.

PFR: It strikes me that with all the funds publicly listed companies the competition to buy a power plant is really steep.

Napolitano: There is absolutely well-funded and robust competition on the buy-side. In short, at this moment in the financial cycle, there is no lack of money, both debt and equity, to accommodate cash acquisitions of properties of a spectrum of varying quality. The issue is deal flow. It is why the pressure on owners of assets is coming from bilateral overtures. These are not necessarily bankers trying to create transactions, but buyers and sellers going directly to each other, which is a threat to the investment banking business model—but that’s something bankers will deal with as the market conditions evolve.

We are seeing those who have the better cost of capital and/or the better funded balance sheet making those calls directly to try to pry the assets out of the hands of the existing owners. So then you deal with a reality of life, which is that there are only so many assets that can transact. Not every owner is a seller. And so that fixed set of an addressable universe is fairly well touched at this point.

PFR: To your point, I’m hearing from different types of lenders these days that they are routinely being called up by potential buyers engaged in a bilateral transaction. Do you as an investment banker think that sellers are more comfortable in that type of deal, or do they have questions about whether they are getting a good value for their assets?

Napolitano: I think you framed the question very nicely. The reality is that there are quite a lot of capable transactors or deal people all around the space, whether they’re on the banking side, investment bank or commercial bank, or the industry side. The acumen to do deals is well-populated. Since we are at a point where values are good, certainly with the yieldco IPOs, etc., it’s clear that there is a cost of capital advantage on the buy-side. But returns are still tight.

We are still in a fundamental commodity supply-demand market in power where demand is not growing leaps and bounds, so we’re still dealing with somewhat of a head-room-constrained market. Returns are tight, and so the costs of doing a deal are important to keep low. In a bilateral transaction, there are unique circumstances. People entering into these deals are influenced by what they know. What people know what people? What unique characteristic of this asset might uniquely fit the one particular buyer who’s made the bilateral call? And does the seller acknowledge that? You can get to a whole host of reasons why people would or would not want to do something other than an auction.

If they do openly get down the road together and get to the point of an actual transaction—terms, conditions, price that seem to make sense—there is always the thought on the back of a seller’s mind, could I have done better if I’d run an auction.

Sellers are now sophisticated and have a pretty good view of the value of their assets. It’s rare that someone does not know completely, within reasonable bounds, what something might be worth. If that’s true that they do not know then I encourage those sellers to give me a call, we’ll help them out.

The situation is that are you better off using the bilateral market to be more direct, more certain of your outcome with a given counterparty that you’ve spent time with. If your asset has certain characteristics, such as size, complexity or attractiveness to a broad group of buyers then it may make more sense to come through the auction process. We have seen large deals go bilateral. We have seen small deals go bilateral. We have typically seen the majority of large deals be auction processes simply because of what we said before, plenty of money on the buy-side in all different forms and needing to get employed.

If it is a somewhat homogenous business that truly doesn’t have unique characteristics to operation, in this market you’re probably best served trying to find the best buyer via an auction.

PFR: With bilateral deals taking a larger piece of the M&A pie and large turnouts for competitive auctions, where are folks looking to spend their money?

Napolitano: New assets need to be created to satiate the employment of the capital that is floating around in the system. That really gets to the development game, which can consume book-value dollars. When you build an asset you’re paying full price for it because you’re building it. The book-value development game is more around renewables, and hopefully contracted renewables at this point in that cycle because contracts are still available. There are some thermal PPAs for new assets are available in certain markets. We’ve seen California being one of those markets; from time to time they let out 10-year contracts for reliability purposes, on gas plants. We may see some of that activity, but by and large the industry is not expecting a whole lot of that activity.

The lack of PPAs is what led us to green field merchant plant financing. We’ve seen a number of markets supporting capital structures and assets of that type. Take PJM and Texas, for instance. We’re taking an awful lot of meetings here in the second half of 2014 on those two markets in particular.

There additional markets, too, where folks see potential within the next five years. They see signals that new capacity would be required, either due to relative load growth and/or accelerated retirements of coal plants as an example, and/or transmission solutions that people are depending upon not getting built fast enough and that power plants would be required. So the debt markets are very supportive of these greenfield type situations if the fundamentals are correct. We are also seeing private equity returns being available to the funders of developments of this type.

Check back next week for the second installment when Napolitano discusses the financing markets and corporate M&A.