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Q&A: Brian O’Connor & Paul Colatrella, Ares Management

Ares Capital Corp., which is externally managed by affiliates of Ares Management, is gaining momentum as a lender of choice for the sponsors of various renewable and gas-fired projects in the U.S. In a bid to boost its power and energy infrastructure private equity portfolio, the New York-based asset manager acquired Energy Investor Funds (PFR, 11/7) in November last year, just after EIF

had launched its $1.7 billion fund, EIF United States Power Fund IV (PFR, 11/2). More recently, Ares Capital was a co-lead arranger in a refinancing program backing Panda Power Funds’ 758 MW Temple 1 gas-fired project in Texas, rubbing shoulders with Goldman Sachs and Credit-Suisse (PFR, 3/9). Ares is currently in talks with Panda to finance its 1 GW Hummel combined-cycle gas-fired plant in Pennsylvania.

In this PFR exclusive, Brian O’Connor and Paul Colatrella, managing directors at Ares Management, talk to managing editor Nischinta Amarnath about strategies within the company’s direct lending group, their approach to borrowers, the Panda deals, the burgeoning market for mezzanine debt, and more.

PFR: Tell me about the direct lending group at Ares Management and more about your role there.

O’CONNOR: The direct lending group at Ares manages approximately $29 billion, as of March 31, 2015, primarily in the U.S. and Europe. In the U.S., the main vehicle that we invest through is Ares Capital Corp., a publicly traded business development company. Paul and I are part of that direct lending effort, and we head up the project finance team. We started the project finance group four years ago and have committed more than $1.1 billion to projects over that time, investing across the capital structure including first-lien, second-lien and mezzanine loans and preferred equity in power technologies, including gas-fired, solar and wind assets, and one LNG project. We operate a direct-origination strategy, investing in projects where we are the most dominant lender in our tranche. To a much lesser extent, we have been involved in syndicated transactions, where we are typically either an anchor investor or a joint arranger with an investment bank.

PFR: How has your role in the company and its strategy evolved over the years, since its inception?

COLATRELLA: Our role has remained the same—providing project finance and energy expertise to the Ares direct lending team as well as sourcing and managing those investments for Ares Capital Corp., and other fund vehicles managed by the Ares Direct Lending Group. From inception, our strategy has involved making credit investments in the sector where we can earn a material premium to commercial banking loans by providing more flexible capital, certainty of execution, etc. Our strategy is flexible, so that we can respond to market trends and seek the best projects and structures with the goal of achieving very attractive risk-adjusted returns.

PFR: What challenges did you face in terms of market climate and competition when the direct lending group was first started?

O’CONNOR: When we started the project finance group four years ago, there was less competition than there is today. We started the group to fill a gap in sources of capital for project risk between the first-lien debt provided either by commercial banks or the term loan B market and mezzanine funds being raised in the market that targeted mid-teens to high-teens returns. We believed there would be attractive risk-adjusted returns and a substantial demand for capital in the 8% to 12% return range, and we believe we have proved out our thesis. Despite the increased competition, our group has been productive due to the flexible nature of the investment vehicles that Ares manages, and our very strong origination capabilities through long-term relationships in the sector.

PFR: One would imagine that the strategy would change to factor in the increased competition we see today. What is your approach to managing the competition today?

O’CONNOR: We’ve been able to stay ahead of the market in a number of ways. We were one of the first major lenders to support gas-fired projects in Texas before that market got more competitive. We were also the first major lender investing in residential solar before banks and other competitors accepted the credit thesis. We continue to seek out opportunities where the competition hasn’t gotten so intense, and then invest by taking advantage of Ares’ market-leading position, underwriting and structuring capabilities, and strong balance sheet. We try to find creative solutions for borrowers in off-market opportunities that are just a little less crowded than regular financings.

PFR: I understand that Ares Capital Corp. became involved in Panda Power Funds’ term loan B refinancing program as a co-lead arranger much later, joining five other investment banks, including Goldman Sachs and Credit-Suisse. What was the story behind the arrangement there?

O’CONNOR: We have a great relationship with the Panda team, and have been involved in all of Panda’s gas-fired financings to date, both in Texas and PJM—first-lien in most cases, and mezzanine in one case. When the financing you mention unfolded, we were able to get involved in a meaningful way in the project and we were able to provide good value to Panda and our investors. We really like their management team. We have participated in every Panda deal to date, so it wasn’t much of a surprise that Ares was involved.

PFR: Panda Power Funds is currently in talks with potential lenders to tee up debt financing for its 1-GW Hummel combined-cycle gas-fired facility in Pennsylvania. I suspect the project development cost must be phenomenal. What is your perspective on this facility in terms of its construction risks, COD and general viability?

COLATRELLA: Panda has developed and built numerous large power plants of 800 MW to more than 1,000 MW in the past. We are confident of Panda’s ability to manage a project of this size. I think the market has confidence in its [Panda’s] ability to manage it as well.

PFR: How is the market for mezzanine debt shaping up today, given its intrinsic risk factors? Do you see more lenders foraying into the mezzanine space?

O’CONNOR: You are correct that there are a few more players in the mezzanine space than there were a few years ago. However, I don’t think the asset class has gotten as crowded as the market for senior capital, where there is a lot more capital flowing into the sector. There aren’t a lot of opportunities for traditional mezzanine in the power sector. So, some of the energy players are focused on energy, more broadly defined as a space that includes exploration and production, midstream assets and services. In addition, the returns on contracted projects don’t offer the mid-teen returns that traditional mezzanine investors require. We find gas-fired opportunities for mezzanine potentially attractive—there’s just a limited number of opportunities and, for now, they are concentrated in PJM. We will continue to pursue attractive mezzanine opportunities in that space and expect to be successful in the medium term.

PFR: So, you’re saying it will continue to be a niche area.

O’CONNOR: Yes, I think so.

PFR: Borrowers are scrambling to come to market ahead of an anticipated rise in the Federal fund rate that could occur as soon as September this year. What rate hike implications do you foresee?

COLATRELLA: The futures markets currently reflect that interest rate hikes in the near future are anticipated to be relatively small and we believe that’s not likely to have a major effect on the project finance market, especially considering that loans in our industry tend to be long-term. They’re also geared toward floating-rate debt. In the event that there is a major hike in interest rates, power purchase agreement prices will need to be adjusted to compensate for the higher cost of capital, which will translate into higher costs of projects—or there will be a limited number of equity investors who would be willing to invest in project finance assets. However, we anticipate that rate hikes will be sufficiently small and/or gradual enough that they will not cause any sudden and/or major changes in the market.

PFR: I understand that Ares Capital is the first port of call for a large number of borrowers. What approaches do you follow to not only keep that momentum but also retain existing clients? Also, what qualities are you looking for in the borrowers that approach you?

O’CONNOR: Our goal is to provide borrowers with flexible capital solutions and one-stop financing solutions up and down the capital structure. We can invest with small developers in transactions as low as $20 million and we have the ability to make very large commitments of $200 million or more. We are well-known for our ability to move fast and provide execution certainty for borrowers. We take a relationship-driven approach. We’re also known throughout the industry as a constructive partner in projects, if there are bumps in the road.

As far as what kinds of borrowers we look for, we seek to back quality management teams that have deep experience in the sector, especially with a focus on construction-ready or operating projects. We tend to stay away from borrowers who are taking technology risks and development risks within Ares Capital Corp.

PFR: Could that include shovel-ready solar projects?

O’CONNOR: Absolutely. A large portion of the investments we have made have been shovel-ready construction projects in the gas-fired and renewable sectors.

PFR: What is your most memorable deal, to date?

COLATRELLA: The first financing for Panda. I won’t go into too much detail, but there are definitely some good stories and challenges in that deal, and we were able to generate a successful outcome for Panda and our investors.

O’CONNOR: The SunRun transaction was memorable [for me] because it was residential solar. Residential solar financing was a new frontier in the sector. It was a really interesting opportunity for us to learn a new part of the business and make a nice return by being ahead of the curve, relative to the rest of the market.

PFR: Paul, could you describe what aspects of Panda’s Temple I project particularly captivated you during the course of that deal?

COLATRELLA: It was the first large merchant project that had been done in the market in a long time, and getting the structuring right and finding the market players was challenging at the time.

PFR: What sorts of project finance deals is Ares Capital Corp. looking at?

O’CONNOR: In the project sector that Paul and I focus on, we are looking at transactions across all proven technologies. We are focused on gas-fired, wind and solar primarily, however we are also looking at technologies like biomass, geothermal and other power technologies where there is lesser deal flow, but interesting opportunities. Right now, the pipeline is a pretty good mix of solar, wind and gas-fired projects.

PFR: Are merchant projects back in vogue in terms of gaining a buy-in from investors who are willing shoulder merchant risks? Also, are merchant project power hedges sufficient in terms of compensating for the lack of offtake agreements?

COLATRELLA: We are noticing that merchant and semi-contracted deals are driving the project finance market in the energy and term loan B markets right now. While there are exceptions, we think the current market is underpricing the merchant risk in general, compared to fully-contracted deals. We believe that this trend exposes equity investors and debt financiers to a great deal of risk and volatility from a price standpoint.

PFR: What about hydro, biomass, land-fill gas or even offshore wind?

O’CONNOR: Yes, we’d be very interested in all of those opportunities; there’s just less of them than the other types of transactions. We have looked at a lot of biomass projects and some hydro—which, we don’t see a lot of, and we’ve looked at landfill gas too. Generally, we’re happy to evaluate any of these technologies; there are just fewer opportunities. We anticipate that we may see more deal flow in all those types of projects in the coming years.

PFR: What is Ares’ geographical focus in terms of its plans for expansion?

O’CONNOR: Right now, the project finance team is focused on the U.S., since we primarily work through Ares Capital Corp. At some point, we would like to make our investing ability broader.

PFR: What are the areas to watch out for in 2015 and 2016 in terms of lending activity and project finance trends?

COLATRELLA: One of the new trends you may see in the market is the first of a few energy-storage deals that might pop up later this year and in 2016. However, we both feel that the market will continue to be driven by semi-contracted deals in PJM and other similar markets that we talked about. Lastly, we believe that there are going to many more large renewable deals such as wind farms in the U.S. and utility-scale and commercial and industrial solar activity in the Southwest and along the East Coast.

O’CONNOR: I agree with Paul. I also think we’ll see a lot of activity in yieldco-related transactions, whether it is construction financing on renewables for dropdowns into yieldcos or warehouse facility-type financings.

PFR: Do you plan to make additions to your team in the year ahead? If so, what types of roles do you see opening up in your group?

O’CONNOR: We are well-positioned at this point both in terms of deal flow and staffing. However, we are part of a growing platform. If we require more resources, we may look to grow the team, as needed.