More than 2,000 people listened in January when Keith Martin, partner at Chadbourne & Parke, hosted a conference call with a group of project finance industry veterans to discuss the cost of capital in the tax equity, bank debt, term loan B and project bond markets and what they foresee for the year ahead.
Last week, we published the second part, in which Martin discussed bank debt with Rabobank’s Thomas Emmons. In the third and final instalment, the veteran project finance attorney talks with Jean-Pierre Boudrias, managing director and head of project finance at Goldman Sachs, about the term loan B market, and Jerry Hanrahan, m.d. and head of power and infrastructure at John Hancock, about the project bond market.
TERM LOAN B
MARTIN: Jean-Pierre Boudrias, what was the term loan B volume in the North American power sector in 2015, and how did that volume compare to 2014?
BOUDRIAS: In 2015, there were 10 transactions for a total borrowing of $3.3 billion. That was down from 2014 when the deal volume was around $9 billion, and down from 2013 when the deal volume was around $11 billion.
The market tends to be a good place finance acquisitions. The market also has had in the past couple years a large number of refinancings. There were few of either type of transaction last year. There was also strong competition from banks to finance new projects. These factors help explain the drop in volume.
MARTIN: That is almost a 50% drop from last year. It sounds like Tom Emmons is stealing your lunch.
BOUDRIAS: The drop is due to a number of things. On the M&A side, acquirers have been using more corporate balance sheet finance, so that has removed some volume from the market. We saw the bulk of refinancings in 2013 and early 2014. In terms of new assets, the banks have financed the quasi-merchant gas plants to the tune of about $1.6 billion last year with only one deal in the term loan B market, which was a bank and term loan B deal for Panda Hummel, of which only $460 million was raised in the term loan B market.
MARTIN: What percentage of the 2015 deals were merchant gas-fired power projects? You mentioned one.
BOUDRIAS: It looks like approximately 60% of deals had a significant merchant component.
MARTIN: They were all gas-fired power plants?
BOUDRIAS: Yes.
MARTIN: Were all of those projects in PJM or ERCOT? There was talk last year about merchant deals in New England.
BOUDRIAS: The only new-build project that was financed in our market was in PJM. One project in New England was financed last year in the bank market.
MARTIN: Has the market basically closed at this point to more PJM merchant gas deals? Are people feeling flush with that risk?
BOUDRIAS: It requires a case-by-case determination. Obviously the investor community has a lot of exposure to certain sponsors. There may be more appetite for new sponsors at this point.
The broader theme across the market has been the continued retreat from energy stocks as oil prices fall and gas prices remain low. That has affected the fundamentals of certain power markets, ERCOT in particular. If we look at a sample of deals in ERCOT, for instance, a year ago all these loans were quoted around 99% or 99.75% of face value. The same transactions today are quoted in the low 80s — for example, 82 — so that is an increase of 500 basis points in terms of yield to worst. Loan value is moving in the same direction in PJM, but not by as much. For example, the same portfolio around the same bid level of 99.75 in PJM is down to 95, which is about 75 bps more in yield equivalent, which is a little bit more in line with the broader market.
MARTIN: Pricing a year ago for strong BB credits was around 350 bps over Libor with a 1% Libor floor and 1% original issue discount, and single B credits were 500 bps over Libor. Where do you see rates today?
BOUDRIAS: We are probably 75 to 100 bps higher than these levels. Some of it just reflects the broader malaise that we have seen across the leveraged finance markets overall. Some of it has been energy driven, like the aversion to exploration and production companies that are directly affected by the downturn in oil and gas prices. It was widespread across most sectors of the market in 2015, so borrowing costs are higher than they were a year ago.
MARTIN: So rates are continuing to go up. Are tenors and required coverage ratios the same as in the bank market?
BOUDRIAS: Coverage has never been a good metric for term loan B debt because most term loan Bs sweep excess cash to pay debt service. As a result, people will try to understand under a variety of scenarios how certain the loan is to be repaid by the end of the term. You would expect a base case to show the loan being paid off and, in the downside cases, 50% of the principal, or perhaps less, paid off. As far as tenor goes, the market has been pretty consistent. B loans tend to have a seven-year tenor. We do not expect that to change.
MARTIN: How large a transaction must one have to make it worth the trouble to do a B loan?
BOUDRIAS: Anything less than $250 million is probably not worth the trouble. Obviously some slightly smaller transactions were done last year. There were two transactions that were done in the low $200 million range, but it is difficult to justify the expenses for a loan of less than $250 million.
MARTIN: How long should a transaction take?
BOUDRIAS: Generally speaking, three months from beginning to end. Most of it goes into producing the material required to go through rating agencies. Once the loan is in the market, things move quickly. There is usually a two-week period to closing after the rating is received.
PROJECT BONDS
MARTIN: Jerry Hanrahan, the project bond market does not do well when the bank and term loan B markets are wide open and looking for product. We have heard the bank market is alive and well, and the term loan B was down last year.
There were no large syndicated project bond transactions in 2014. You and others did a few transactions on a direct, relationship basis. How many deals were there in 2015?
HANRAHAN: There were probably a half a dozen or so deals last year in the investment grade project bond market. There was one gas-fired deal early in the year that was well received, and the remaining deals were renewables, primarily solar, brought by corporate sponsors to the private placement or 144A market.
MARTIN: How many active institutional investors were there?
HANRAHAN: That is always difficult to gauge, but there is no shortage of liquidity. Everybody who can participate is participating.
There are probably somewhere around 25 institutional investors like ourselves who participate in these deals. The market is probably led by a group of eight or 10 of us who tend to be the anchor investors with larger teams and resources to bring to bear on a transaction.
MARTIN: Last year at this time, you said there was one deal in the pipeline. How many are there in the pipeline today?
HANRAHAN: Not many. It is hard to get visibility at this time of year as to what is coming, but there is one deal about which we are aware that went out as a request for proposals in the fourth quarter last year with the sponsor indicating that it prefers a bond structure. I expect that deal, if it ends up as a bond structure, to come to market in the first quarter this year.
Beyond that, we do not have a lot of visibility. Given what has just been said about the bank and term loan B markets, we will probably see a similar year this year to what we did last year.
MARTIN: Project bonds are fixed-rate debt, and they tend to be longer term than bank loans and term loan B debt. Both of those products are floating rate debt. Project bonds need a spark, like a fear of rising interest rates, before that market gets traction. Are we at such a point today?
HANRAHAN: It is possible. It all depends on one’s view of inflation and how much interest rates might increase. The advantages that we can offer are the longer tenor and the fixed-rate nature, and there tend to be little or no fees associated with bonds. So those are the pluses that we can use to attract borrowers.
If we are in a rising rate environment, then bonds will look more attractive. We do well then. We also do well when there is some dislocation in the market that people can arbitrage against; for example, if there is a larger spread than normal between the Libor swap spreads used to price bank debt and Treasuries.
MARTIN: What is the current spread above treasuries, and what does that translate into as a coupon rate?
HANRAHAN: It is a range like everyone else has answered. A typical investment grade project could expect to pay a rate in the mid-200 bp level above average life Treasuries, plus or minus depending upon the particular features and quality of the deal. It could be anywhere from the low 200s to high 200s or even 300 bps above average-life Treasuries. We tend to do longer-term deals, so we are usually pricing off something in the area of a 10-year Treasury, which today is around 215 bps, so you end up with coupons in the low-to-mid 4%, maybe 4.5%, range.
MARTIN: That is not much different than the current rate on bank debt.
HANRAHAN: Not much.
MARTIN: Shouldn’t this market start to get traction when people think we are at the bottom of the interest rate cycle; it is a chance to lock in an historically low rate.
HANRAHAN: Right.
MARTIN: Another key difference between project bonds and term loan B debt is project bonds generally have the same tenor as the power purchase agreement, correct?
HANRAHAN: Yes.
MARTIN: There is no upfront fee like these other two products because the economics are fully baked into the spread. When are ratings required?
HANRAHAN: Ratings are generally not required, at least by us and the other large insurance companies. Sponsors tend to get ratings if they are worried about execution or they want to attract some of the smaller players who are more comfortable in rated deals, or if they opt to go the 144A route, in which case ratings would be required.
We don’t require them ourselves, but we will structure a deal to a BBB investment grade rating internally.
MARTIN: Of course, the big difference between bank and term loan B debt and project bonds is project bonds require a make-whole payment if the bonds are repaid ahead of schedule. How is such a payment calculated?
HANRAHAN: It is calculated off a spread to Treasuries when the bond is repaid. It is less likely in a rising rate environment that there will be a make-whole payment if rates are higher on the early payment date than at time of original issuance. You probably have no incentive to refinance in such a case in any event. You locked in a lower rate than you can get by refinancing.
MARTIN: How long does it take to do a project bond deal?
HANRAHAN: If the deal comes to us in the syndicated private placement market, then you are usually talking two to four weeks. A direct placement deal requires a couple months to complete the due diligence and documentation.
MARTIN: How large a transaction does one need to make it worthwhile?
HANRAHAN: For the direct placement deals that we do, the transaction size is usually $30 to $50 million. A syndicated deal should be $100 million.
