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PFR Private Placement Roundtable 2020

sponsored by fitch and mufg

For a PDF version of this roundtable report, click here.

Editor’s Note

The Covid-19 pandemic upended financial markets earlier this year, and project bonds were no exception. But for private placement investors, the disruption created opportunities as well as headaches. For some, a bonanza of corporate debt issuance by investment grade utilities looking to bolster liquidity drew their attention away from project finance altogether. For those that remained active in projects, this meant bigger allocations.

But as the market returns to something approaching normalcy, there are plenty of non-pandemic-related issues to discuss. How do debt investors and rating agencies view portfolios of distributed energy projects? When will Pacific Gas & Electric be upgraded back to investment grade, if ever? What structures can be put in place to achieve a triple-B rating on a solar project with a merchant tail? What value can be assigned to future revenues from renewable energy credits, and how certain can we be about those revenues?

To discuss all of these issues and more, Power Finance & Risk brought together a diverse panel with a range of different perspectives. Three private placement investors gave their unique views on the market. MUFG’s Matt Odette injected the institutional knowledge of the biggest project finance lender in North America, and also a very active private placement agent. The rating agencies were represented by Fitch RatingsAndy Joynt. The perspective of the borrower was laid out by recent private placement issuer Hull Street Energy’s Sarah Wright. Legal insights were provided by Skadden’s David Armstrong. And a view into the mezzanine or sub-investment grade private debt market was made possible with the participation of Hadley Peer Marshall from Brookfield Asset Management.

I think that’s all the bases covered!

Richard Metcalf

pfr uspp rt 2020 participants

PFR:           If the global financial crisis of ’08-‘09 is considered to have been the making of the private debt market, the Covid-19 pandemic of 2020 is its first real trial. What did project finance activity look like at the start of the year and then when the first wave of the pandemic crested in March?

Matt Odette, MUFG: Like all markets heading into Covid, the project bond market was pretty robust. Early in the year, we led a wind deal that had a merchant element and that went very well. The expectation prior to Covid was that there would be another strong year.

                   When Covid hit, a lot of markets across project finance, including the bank market and the term loan B market, if they didn’t shut down, they pulled back very far. And the private placement market was no exception. What we did see, though, was that the bank market came back pretty quickly, mostly due to the massive amounts of liquidity pumped into the system by the Fed. The public bond markets also came back pretty quickly once corporate issuers realized they could come out and obtain a ton of liquidity to tide them over during shutdown. We haven't seen as much of a resurgence in the private placement market. There are a variety of reasons for that. Part of it is just that there hasn't been a lot of M&A activity, which is a sweet spot for this type of product. There haven't been a lot of opportunities for refinancings, with spreads gapping out compared to the bank market. But most of the activity post-Covid, at least in the power sector, has been on greenfield renewables, which is a sweet spot for the commercial bank market in terms of their comfort with construction and their flexibility.

                   We're certainly starting to see things pick up and the pipeline is building for the fourth quarter. But in terms of what we've seen since March, issuance has been fairly light in the private placement market for project finance.

Bob Cantey, Nuveen:           I agree with Matt that at the beginning of the year, things were quite tight and it looked like it was going to be a good year. When Covid hit, we stayed in the market. Actually, in March and April, we did a couple of deals where we got good yields, and we noticed that there were few other shops in them, so we got strong allocations. We had probably the best two months in quite some time. Issuers weren't quite sure if things were going to get better, so they were willing to pay up a little bit. Since then, as Matt mentioned, we’ve seen the market slow down a bit. We've been passing on some deals with coupons a bit too tight, since we did OK in March and April.

Paul Aronson, Voya Investment Management:     Frankly, we did not participate in March and April in structured project debt. I don't disagree with the comments Bob made, but we made the determination that, since we were able to get a lot of pure utility paper and corporate paper with similar types of yields and spreads, we felt we were not necessarily being compensated for the potential lower credit quality on some of those project deals.

                   That said, if I look at some of the coupons and some of those deals today, I’d probably be ecstatic to be in them. You had 10-year A+ rated utilities trading at 275 bp, 300 bp over Treasurys back in March and April. They're now getting deals done in the private market 150 bp to 175 bp inside of that. It's pretty logical to conclude that there should be, and there always is, some premium for projects on top of that.

                   I agree with Bob, but the challenge is: Do I want to be doing project finance deals for 20-odd years at 3% coupons? I'm shocked there isn’t more issuance, given the absolute level of yields and spreads. Risk is on again. And a lot of these are great deals, contracted, good assets, etc. So I would expect that the next few months should be pretty robust. I’d be shocked if we don’t see significantly more issuance into the long-term capital markets.

PFR:           Sarah, from an issuer's perspective, when you're evaluating the best options for sourcing capital, what structures are you considering in the private debt market, and how do you see that evolving over the rest of the year?

Sarah Wright, Hull Street Energy:  We are a middle-market, power-focused investor.  As power decentralizes due to the addition of renewables, we expect to see more middle-market deal flow, and an important component of our plan is aggregating assets in order to access larger, more efficient capital markets. In most acquisitions, we tend to fund with conventional bank loans or, in some cases, all equity, so we're not looking to the private placement markets until we get a given portfolio to scale by aggregating with other investments or improving the cash flow profile.  Once we have demonstrated improved earning capability, then we can go to the debt markets and/or rating agencies to evaluate refinancing options. We recently used a private placement in association with the acquisition of a larger, long-lived, well-established hydroelectric asset portfolio. And in that case, it made sense to use the private placement market. The duration of the debt facilities that are available in the US private placement market makes it a really nice fit for some our portfolio companies, given that we are a private, long-term infrastructure equity investor.

                   There are often advantages to using the private debt markets – which offer bespoke, customized terms – to provide permanent capital for our portfolio companies.  We have found that, as the whole world has gotten better at dealing with big data problems, it has become easier to underwrite some of the risks inherent in power related credit facilities, particularly for power plants that are not contracted. We were pleasantly surprised by the degree of sophistication and rigorous analytical capability we saw on the part of investors, underwriters and rating agencies in that particular process.

PFR:           Are issuers or investors using creative strategies to capitalize on or cope with market dislocations?

Charles-Henry Lecointe, Legal & General:            There has been a flight to quality. I’ve seen quite a few transactions where there was pushback from debt investors because of Covid-19 uncertainty. It's probably the opposite to last year, when there was a lot of innovation. The appetite for BBB- is more limited, because you don't want to be in a situation where your transactions are downgraded to non-investment grade a few months after closing. I was happy to see pushback on some aggressive structures. For instance, there was a gas pipeline transaction whose structure was significantly strengthened during negotiations with lenders.

Matt Odette, MUFG: I agree that tighter structures are more necessary for execution now than they were nine or 12 months ago. One thing we are seeing a lot is issuers looking at pre-hedging. Project finance deals take some time to put together, between preparing all the diligence and getting them rated. Investors remain sensitive to all-in coupons, which causes spreads to widen when Treasurys rally abruptly. When Treasurys are at 50 bps, 60 bps, even a low coupon implies a wider spread than issuers might want to pay. Some issuers have taken the view that they'll hedge Treasurys and at least lock in that portion of the cost. If Treasurys do rise, spreads may come in and they can benefit.

David Armstrong, Skadden:            Since March, more so in the bank market than the private placement market, we've been seeing greater focus on very clear diligence items, such as force majeure and schedule and the like in construction risk. Generally, we've been seeing heightened focus from credit committees. For example, structural matters and diligence points that might have flown through the bank market six months ago are now being scrutinized more closely and structured in ways that address issues that lenders might have lived with in the past because the market was so competitive.

                  We also witnessed this in a 144A bond deal we worked  on in May. A seasoned issuer had its bonds fly through without any questions for a few years, and then in May, there was a lot more scrutiny. They had a successful deal — oversubscribed and priced well — but there was greater scrutiny.

PFR:           What has been the impact of the pandemic on existing portfolios? Has there been any portfolio positioning to withstand potential downgrades?

Cantey, Nuveen:        From Nuveen’s perspective, we haven't made changes to holdings. But we have seen some downgrades as the power prices in PJM, compared to when we bought a lot of these deals, based on the original forecast, have just gotten weaker. We've had some issues there, for sure. I don't think there will be going-concern issues, but we've had some downgrades. We're working with the issuers on how we're going to rectify things going forward, as they ask for modifications and waivers. That gives us the ability to ask for things we may not have gotten in the past, but hopefully will stabilize the ratings going forward.

Andy Joynt, Fitch Ratings:  In demand-based infrastructure, it's been ugly. It's been a bloodbath across toll roads, airports, seaports. But PPA-backed energy projects have been a port in a storm, and our ratings have mostly been stable because these are essential businesses. They're insulated from volume risk, and we haven’t seen many operational hiccups. Maybe some spare parts or replacement parts are somewhat delayed in arriving, but for most of these projects, especially on the renewable side, you don't need that much staff on site to operate them. And the counterparties have held up quite well, since they're mostly utilities.

                   We've had some downgrades linked to a midstream counterparty or maybe a corporate. It's that counterparty linkage that can cause some issues. And then, as Bob mentioned, if you're exposed to merchant prices, there has been some downward pressure there, which is not necessarily just Covid-related. That goes back to the maneuvers of OPEC pre-Covid, that were already impacting gas and power prices.

Cantey, Nuveen:       To clarify, I was talking about merchant hydro, mainly in PJM, with the lower prices you already had before. But Covid has made the prices drop more and that has caused rating issues.

Aronson, Voya:         Andy, that was very helpful. When you look across the broad infrastructure space, you're absolutely right. Power, for the most part, has been insulated. Some of the offtakers will definitely see weaker credit profiles. That's true with respect to utilities, because we are seeing a drop on the demand side. That's, ultimately, what's flowing into pricing when we're talking about merchant stuff.

                   Most of the projects in the private market, in our portfolio anyway, do not have significant construction or merchant risk at this point. We have been asked, over the last few years, to do contracted deals where you're ending up taking merchant risk years down the road. But hopefully, that'll be relatively stable at that point in time.

                   Relative to other things, in the context of Covid, the demand for energy is stable. When I think about going into any recession, I would think energy might drop off 5% or 10%. But it had a period from March to April where it dropped off probably more than that, and you won't recover that. But over time, that will come back. Relative to some of the other assets that we view as infrastructure, it has been our port in the storm. So we feel pretty good about that.

PFR:           Have there been any changes in the structures of project bonds or subordinated debt packages because of the pandemic?

Armstrong, Skadden:           In the context of private placements, I have not seen a lot of language changing or pandemic-specific language. On the relatively mundane side, there are investors out there who cannot access their vaults, and they do not want physical notes. We have had to tinker with the delivery language that allows investors to take a PDF at closing and then demand physical notes when they have their vault up and running. That's a pretty uninteresting example, but the one documentation point we've seen in private placements. I haven't done a construction-related private placement since the pandemic began, but in bank transactions there is additional language being added specifically around notice requirements, building out the notice of force majeure to specifically say anything COVID-related has to go to the lenders. From January through March, construction contractors and suppliers sent out a quasi-force majeure notice that basically said, “Just letting you know there's a pandemic going on, in case you're not watching the news.” This may at some point ripen into a force majeure. We've seen very few actual force majeure notices, but we have seen a lot of cover-your-butt future notices. We've tweaked language in bank loans that captures those types of notices, because they wouldn't necessarily be captured in standard force majeure language.

PFR:           Has the pandemic affected the relative attractiveness of the project bond market versus the bank market?

Odette, MUFG:          Yes, I think it has. We saw a delayed impact where early in the pandemic, a lot of large corporates, to preserve liquidity, started drawing down on their revolving credit facilities, which really impacted bank liquidity costs, particularly for foreign banks. So bank capital got more expensive at the same time that all capital got more expensive.

                   But as the Fed intervened with their various programs supporting capital markets, and the public markets opened up, those revolver balances were paid down as companies accessed liquidity in the public bond markets. With liquidity costs having fallen, the bank market is probably back to where it was pricing-wise pre-Covid. We're back to seeing spreads in the mid-100s for clean, contracted transactions, and even tighter for construction-only deals, where the equivalent spread on a private placement is probably in the mid-200s. A lot of that is due to investor sensitivity to minimum coupons, since folks are putting money out for 15, 20 years. It's a very understandable impulse that has impacted the relative attractiveness.

                  The bank market does not offer the tenor and match of assets and liabilities that the bond market does. But ignoring those considerations, if you're putting them next to each other, spreads are significantly tighter in the bank market now than in the private placement market.

Lecointe, Legal & General:              Matt, I've seen banks being very active in the renewables sector. Is this because banks really like the sector and are happy to offer competitive pricing because there’s an ESG aspect?

Odette, MUFG:          There's an element of that, particularly with European banks, some of which have more defined mandates to support the development of renewables. But frankly, the vast bulk of activity in the US over the last couple years, particularly over the last 12 months, has been renewables. It's a matter of just chasing the deals that are there for the taking. Gas-fired deals, to the extent you can find one with a contract, will price very tightly too. Maybe there’s somewhat of a premium over contracted renewables, but there's really not a big distinction.

Cantey, Nuveen:        As Covid goes on, I would assume that throughout the rest of 2020 to 2021, we're going to have low growth throughout the world. From a banker’s perspective, do you think there's going to be pressure as loans from other areas of the bank may have issues? Is that going to cause banks to be a bit more careful in these investments and demand more return, or is that separated somehow?

Odette, MUFG:          It depends almost entirely on the path forward on the economy. Banks, particularly US-regulated banks, have already set aside quite a lot of reserves, which have already hit the earnings. It's just a matter of whether things deteriorate further. You could make the argument that because this sector is somewhat of a port in a storm, and there's a very strong ESG and policy bias towards the sector, that you'll continue to see banks be enthusiastic about funding renewables. But if a bank’s balance sheet becomes significantly weaker because other parts of the economy suffer and that causes loan losses, I think that could impact activity in this sector.

PFR:           Hadley, you focus on subordinated debt. How would you describe sponsors’ appetite for subordinated debt right now?

Hadley Peer Marshall, Brookfield Asset Management:   Leading up to Covid, the pace was normal. Covid obviously brought about some dislocation in the market, which created opportunities. During that time, we financed a residential solar portfolio and invested in some other asset classes as well. However, there was a short window before the Fed support brought back most liquidity. Currently, it does feel like most of the markets are pretty attractive from a borrower’s perspective. From a sponsor’s appetite perspective, it's really back to M&A-type financing to offset equity check sizes, or the accretion value, or funding capex needs.

                   On the bank market, there is a little bit more of a flight to quality in terms of the opportunities that the banks are looking to finance, and the types of sponsors and assets. That creates some opportunities for the other markets.

                   As a borrower, Brookfield used the private placement market back in May. We are accustomed to that type of long-term financing and find it quite attractive.

                   Subordinated private debt shouldn't ever compete with the private placement market or the bank market, because it's additive. If there's conservative underwriting, then subordinated debt can add a little bit more and fill in that gap, if the lender sees the value. The subordinated private debt market provides, similarly to the private placement and bank market, delayed draws. It can hold pricings. That's always competitive in the M&A environment. Our specific type of capital is more junior capital-like, but you see others that are more equity-like, and so borrowers can customize more so than you would typically see at the senior debt level.

PFR:           Sarah, you touched previously on Hull Street’s private placement financing of its acquisition of 31 hydro plants. Did Hull Street also obtain proposals for bank loans and compare the terms on offer?

Wright, Hull Street:   Whenever we are looking at refinancing a portfolio company, we evaluate all of our options. Having said that, given the fact that many USPP investors are seeking long-term yield, the USPP market is a good fit for hydro as an asset class (a) because it is so long-lived and (b) because of the nature of the diverse portfolio of energy, reliability and renewable attribute products that it produces across the revenue stream. As equity investors, if we are looking to deploy capital in the US right now, given what might happen politically, we want to own assets that earn a variety of different revenue components so that we are protected from value migration across products.  For example, we like assets that might earn incremental revenue if, for example, carbon starts to matter more. In terms of the experience we had underwriting that hydro portfolio, I think of capacity and energy revenues as the classic components. Those are the generation services that most people are familiar with. On the other hand, the market is less familiar with REC value and ancillary services. As we move forward in the grid transition, we expect to see less value in the energy market and more value in products like the ancillary services and RECs. So we were pleased to find that the rating agencies and our debt investors were pretty fluent in REC markets and able to think about how they might deliver under various scenarios and stresses. It is a very promising trend in the industry, that ability to tackle increasingly complex revenue profiles, given the ongoing evolution of the power industry, wherein long-term public utility QF contracts are getting replaced with shorter-term, more syndicated power purchase agreements from corporate and merchant electricity supply counterparties. 

                   On the other hand, we also encountered some glitches. For example, if you’re looking at weather data and you're saying, ‘I want to understand what a P99 weather scenario is for the purposes of stress testing this prospective credit facility,’ that, in any given year, is a valid test. But when you look at tests that make the assumption that a very low probability event occurs every year over the term of a very long-lived facility, that's an irrational assumption. There's still room to improve the analysis around the rating and pricing of these types of project financings. And, if the analytical capabilities of the buyers and the agencies and the underwriters does continue to improve, the market will probably grow.  I think there are many issuers who would prefer the USPP market over some of the other shorter-term, and/or subordinate corporate debt markets, and the number of USPP issuances could increase, because there does seem to be an element of excessive conservatism in some of the underwriting, so investors are, perhaps, missing some attractive risk-adjusted return opportunities.

Odette, MUFG:          The hydro market, really for the last several years, has been very well suited to the bond market. We haven't seen a lot of bank deals just because it is, as a quasi-perpetual asset, well suited to long-term liabilities. The biggest gap that we've encountered when we've gone out to structure a rate and market these deals is just what Sarah pointed to, which is RECs.

                   The renewable value of these assets over time is high. If you compare hydro to wind and solar, with the capacity factors, resource stability and asset life, they’re phenomenal assets. But we've encountered resistance to giving a lot of credit to RECs and renewable values mainly because these tend to be small, state-based programs, without a lot of historical data. That's probably the next frontier, as you're looking at merchant renewables and merchant hydro in particular, of convincing the market of the value of the “green” element of the revenue stream.

Aronson, Voya:         I do wonder what those REC payments will be like in seven and 10 and 12 years, and how much credit we are supposed to give them. What are your thoughts around the extent to which those revenues, which are perhaps a little less certain, end up being less than projected, or less than the consultants project they're going to be? Could traps and triggers be inserted into the transaction such that at that point, either equity is reducing distributions, reducing debt or kicking in more equity?

Joynt, Fitch:   We've historically dealt with RECs bundled into the PPA. Now that there are bilateral contracts and uncertainty beyond that particular contract, it introduces a market risk that is not too dissimilar from power price risk. On top of that, there's an element of political risk, in terms of what US policy is going to be on carbon. That starts to sound less like investing and more like gambling. Thinking about the whole premise of the REC market, why do they exist? Because they incentivize the development of renewables. And if pricing gets elevated, the idea is that it incentivizes development, which should then pull those prices back down.

                   Our stance has generally been, where we feel that there's visibility over the medium term as to what the pricing could be, we'll be a little more comfortable accepting it as quasi-contracted. Beyond that, there'd be a point in time where we have to treat this essentially as merchant and maybe even a little worse than merchant, where some level of coverage cushion is sufficient and can get you there. But we've been quite conservative on that point.

Wright, Hull Street:   In evaluating power credit, the market customarily looks at the top of the cycle dynamic, where a given market gets constrained, prices rise temporarily, new entrants pile in and then prices come back down. What people are not sufficiently focused on yet is the other side of that coin, which is when the market gets long.

                   If you are evaluating downside for investors who are underwriting long-term debt, there is a resistance level across a basket of commodities that can be identified by looking at the market as a whole.  Let's say you are looking at a scenario where energy prices are low and capacity prices are low and REC prices are low. This power plant is in trouble. But does the rest of the market exist in this scenario? If the answer is no, all plants are in distress, and NERC reliability standards are unable to be met, then that scenario is too extreme. If you find a point at which the rest of the market continues to exist, but your plant fails, that is a reasonable stress test. We see people do a better job of limiting the upside of the cycle than the downside. But as I have said before, debt market analytics are improving.

                   I would say to Paul that, as a borrower, of course, we don't like traps and triggers! But having said that, given the nature of these private placement processes and lenders who will consider bespoke customized structured transactions, we should, theoretically, be able to allocate risk between debt and equity holders in a manner that optimizes the credit for both parties. However, this only works if both parties price risk the same way, and when you have a rating agency or other underwriter at the table, it can be very difficult to get all parties to agree on risk pricing. So, in practice it is harder to achieve an optimal outcome. On the other hand, one of the other attractive characteristics of the USPP market is that if and when borrowers run into trouble, you often don't see foreclosure because they have an asset that's going to last 100 years. Borrowers seem to wind up renegotiating with their small group of sophisticated investors. Those negotiations sometimes create an opportunity for everybody to reallocate risk and carry on with some measure of success, enabling the investors to maintain their credit quality and the issuers to maintain their ownership interests.

Aronson, Voya:         The vast majority of our clients are insurance company money, and they are very sensitive to ratings and capital charges. Sarah, I agree with you that these are 100-year assets, and we have run into difficulties in the past and, guess what, we've not lost money on them, because people are going to see the long-term value of those assets from an equity perspective. They might be short-term impaired, but over the next 30, 40 years, they're still there. The amount of debt that's on the assets is not a problem. The issue is that in the short term, we're faced with capital charge downgrades and a lot of our clients get very frustrated by that.

                   One of the things that's unique about project finance vis-à-vis corporate transactions is that usually, the project deals are structured to BBB-, and that's about as high as that credit quality will ever go. If something does get a little dicey, they get downgraded pretty quickly. With respect to corporate transactions, there are usually bells and whistles and triggers and covenants built in that allow the lender to ensure that it stays investment grade without having that same capital implication. That's one of the challenges. We're willing to do that. We get paid, frankly, an extra premium, in my opinion, for the structure and the lower liquidity relative to corporates, but the stability of that rating is very important to a lot of our lenders. There have been times that we end up passing if we feel that it's a good deal, but we're going to end up renegotiating the structure in two years.

                   We haven't talked about California yet. It's a little different, but those are examples of perfectly decent projects that were out there and all of a sudden, PG&E's in bankruptcy, so everything that they're an offtaker on is immediately downgraded. Clearly it weakened the credit, but those contracts and coverages are still pretty good. That's why I asked the question about traps and triggers, because I think you could actually raise more capital if you were willing to put them in and take the equity risk and keep us at that BBB- threshold.

PFR:           With PG&E emerging from bankruptcy on July 1, will that relieve pressure on some of the existing project finance private placements on insurance company books? Will we see any pent-up issuance coming down the pipeline?

Cantey, Nuveen:       It hasn't yet. For our existing holdings with exposure to PG&E we have not been upgraded to reflect their emergence from bankruptcy. The rating agencies are saying they’re not going to upgrade to the PG&E opco level until we get past the fire season. It's been very frustrating, from our point of view. They performed like they were supposed to and they're still performing, and we have credits where 14% to 20% of the revenue comes from PG&E and we are still deep in BB territory, and the agency’s saying, ‘No, we're not going to upgrade yet.’ It makes me wary of PG&E and it makes me wary of what happens if other California utilities experience a bad fire season.

Aronson, Voya:         I understand that the agencies have their structures in place and I'm sensitive to that and we're thankful for it. On the other hand, for renewable assets in California, is it really PG&E who’s the offtaker or is it the entire state of California? The contracts have been blessed by the Public Utilities Commission. They're going to be paid. To me, that does not seem like a below-investment-grade risk.

Joynt, Fitch: Our utilities team came to the view – and the other agencies did as well – that PG&E’s track record is not good. The wildfire fund is there, a structure that was not in place previously, but there is some question as to whether or not that fund is sufficient if you get hit with another wildfire season. How long is it till you get comfortable that that wildfire fund is sufficient? Is it three, four wildfire seasons? What's to say that the fifth isn't then going to be the one that breaks the camel's back? That's a very tough prediction. There's a lot of headwinds to PG&E getting back to investment grade. And it raises the question: Are these ratings going to be held down permanently?

                   We try to take a thoughtful view on the projects that are being supported by PG&E. Say PG&E is your sole offtaker on a single project. It’s hard for us to justify getting around the risk that PG&E falls back into bankruptcy and you're once again presented with this risk of contract rejection. That risk of rejection is going to be more prevalent. Even though they're baked into the rate base, it's going to be more prevalent for the projects that have the $150/MWh to $200/MWh PPAs. When PPAs are more competitively priced, and then you run an analysis to see what happens if you lose that contract, the impact doesn't seem so great, because you've already got a reasonably-priced PPA. In those cases, we have been able to rate above PG&E’s rating.

PFR:           In Texas, there are merchant solar projects that have been financed in the bank market on the basis of hedges. Can insulating mechanisms also be used to attract investment grade debt for these types of projects?

Odette, MUFG:          This gets back to the question Paul was asking earlier about structural enhancements that can mitigate ratings pressure or credit quality with respect to merchant prices. Where we've seen it most prominently is not so much in merchant hydro, because there's already a pretty well-established structure there. Where we have seen some innovative structuring is what I’d characterize as merchant tail transactions. We were involved in a couple earlier this year, which a lot of the people in this discussion were involved in as well. One was a large portfolio with a number of PPAs rolling off, so that merchant exposure slowly increases. In another case, it was a single asset where the PPA expired prior to the bond maturity. In both cases, with a combination of structural enhancements and conservative assumptions around prices, they were successfully marketed and oversubscribed. The key structural feature is cash traps or reserves that are contingent, and come into place to the extent that power prices or RECs substantially underperform the original forecast. If so, then cash is trapped and it helps bolster liquidity to cover some of the debt that is no longer supported by the weaker merchant cash flows. These features have been necessary to get these kinds of deals done.

PFR:           Has Fitch been asked to rate any merchant solar projects in Texas?

Joynt, Fitch: We've looked at a couple of those deals. There’s a lot of Texas solar happening right now. The bells and whistles on top of not over-leveraging the merchant tail are always better than just coverage alone, because you don't know what the prices are going to be at the time when the merchant exposure is there. But the structural features differ, too, in how beneficial they are. You have to look at the terms. For example, if there's a forward-looking price trigger that will cause a cash sweep, is it based on a market consultant’s view? Right then and there, you're maybe once again faced with the same consultant that you were doubting in the first place. What are they going to be saying 15 years from now? Are they even going to be around? Or is it based more on a forward-looking price or an index price that you can actually point to more firmly? Is the trigger a one time test, where you just have to pass it once and then that provision is gone? Or is it a test that you have to pass on a go-forward basis? That helps to ensure that the structure gets preserved. If you do have a sweep or feature that might get triggered, is there going to be enough cash to actually sweep down and then keep you whole?

PFR:           Toward the end of last year, Goldman Sachs Renewable Power financed the largest commercial and industrial solar portfolio seen by bond buyers, clocking in at 600 MW. It was also the first to obtain a BBB rating. Is this an indication that private debt investors are looking into the residential solar and C&I solar subsectors with more interest?

Peer Marshall, Brookfield:   On our end, for sure. For our type of capital, we have already been looking at C&I opportunities.

Odette, MUFG:          The GSRP deal is certainly the biggest one that we have seen, and we were lucky enough to be involved in that. One thing that's really opened that market up is rating agencies and investors being more willing to look at offtakers from a portfolio perspective. The challenge has always been that if you have 50 offtakers and 50 projects, how do you evaluate each and every one of them? But the rating agencies have been pretty flexible in terms of looking at things on a portfolio basis, even including unrated counterparties to the extent that they’re a small portion of the total. That makes it possible to take these very large portfolios and market them effectively. We'll continue to see a lot of this, because there is a lot of activity in distributed solar.

Cantey, Nuveen:       I have to agree with that. We participated in the Goldman deal, although it had to have some changes. We thought they were too optimistic on the merchant side. But I don't think we'll see a lot of residential. All the residential deals I'm seeing are more in the asset-backed space. We have not done any at Nuveen on the residential side, except via the asset-backed securities. We would like to see more C&I. But the issue we’ll continue to run into is people using consulting reports 20 years out and believing that power prices are really going to be that high. We're comfortable with putting the PPAs together, just not sizing debt based on long term forecasted power prices.

Lecointe, Legal & General:              I did spend a lot of time looking at GSRP. Andy may remember that we spoke quite a bit about this transaction. The structure was interesting with this merchant period. We know that whether it's in Europe or in the US, additional merchant risk is where the renewables market is moving. We're seeing more and more transactions with merchant tail. As an investor keen to invest more in ESG, we're spending a lot of time trying to get more comfortable with this merchant risk. But it's not an easy one, especially if you want to keep your investment grade rating over time. There are less concerns about whether you are going to lose money. The question is really about whether your rating is going to remain at BBB- for 15, 20 years.

Joynt, Fitch: We're still trying to figure out what's the right way to assess and approach that risk. There's often a number of behind-the-meter assets, and there, you really are reliant on a single customer. You often don't have interconnection rights. You have to make an assumption around how much you would have to reduce the price to incentivize the customer to re-sign, or if there's going to be customer attrition because those sites end up vacant for some reason. What's an appropriate assumption for how many of those sites go away? You're less concerned if it's a rooftop installation on a school building. But if it’s a warehouse, there’s more concern that that might not be occupied. We feel that we can come up with a reasonable downside and that's what we try to rate to. The other difficult aspect of these distributed generation portfolios is that there is necessarily going to be some level of asset sales or additions that come into and out of the portfolio. It benefits the lenders, in some ways, to have a sponsor that is able to be proactive in getting rid of assets that are not serving the portfolio well and using the net proceeds to bring in new assets, but there have to be controls around that, at least on the agency side. We've got to be able to take a view that we know what this portfolio is going to look like 20 years from now. It can’t just wholesale change. If so, then it’s not really a project financing. We spend a lot of time looking at what kinds of permitted asset sales exist. Are there traps on that, or are there triggers to have a rating agency affirm the rating before those are executed?

PFR:           Gas-fired peakers are not usually seen in the US private placement market, but the bond market responded to Rockland Capital’s refinancing of its Gridflex peaker portfolio with a twice oversubscribed book. The structure included a capacity reserve account to help sweeten the deal. Are these the kinds of features that private debt investors want to see for these assets?

Aronson, Voya:         Yes.

Cantey, Nuveen:       Yes!

Odette, MUFG:          The capacity reserve has been around and utilized on a couple of different transactions going back a few years, and it is very much ratings-driven. While these deals have been well received and oversubscribed, they have priced relatively wide to what you would see on even a merchant hydro deal and certainly compared to a fully contracted transaction. So while they do have investment grade ratings, I think the market views them as more aggressive than some other investment grade transactions.

Cantey, Nuveen:        Internally, we have been rating them as BB. The one that you mentioned, Gridflex, we thought that over that time period, given how PJM is evolving, there's a high probability you'd go to high yield. We went ahead and decided to rate at high yield to begin with.

Aronson, Voya:         We participated in and co-led both Gridflex and Gridiron. We absolutely agree. When Gridflex first came, it did not have the capacity traps that we were talking about, and we refused to do the transaction. We only ended up participating once we got that structure in place. Ironically, the external rating did not change, which we were surprised by, because we felt that by putting in the appropriate protections, that made a significant difference for us.

                   We were approached on the Gridflex transaction, and the idea was: ‘Do you think we could do this without a cash trap?’ And our response was, ‘No – but you can try if you want to.’ The agents listened and ended up modeling Gridflex like Gridiron, and the transaction was smoothly executed. I agree with Bob. We did get paid more than we would on a lot of other BBB- type projects. But the sponsors benefited themselves by listening to the advice and putting the structure in place. It's a hybrid, but with those protections in place, the rating stability is going to be maintained.

PFR:           One of the limitations of the US private placement market has been the size of the deals you can do. But we're seeing increasingly large deals, like the recent $3 billion Vanguard Group transaction, the largest ever recorded in the USPP market. This suggests greater depth, meaning more investors able to deploy more capital in each deal. What does that mean for project bonds? Does it, for instance, open the door to financings of larger portfolios of wind and solar projects in the USPP market?

Aronson, Voya:         For several years, there have been a number of transactions financed in the private Reg D 4(a)(2) market that have been at or around or in excess of a billion dollars. $3 billion is not, in my opinion, doable. But doing a billion-dollar transaction for project finance assets would not be a problem. Charles and Bob and I can routinely write checks for nine digits, and there are a lot of other people out there who can do that as well. But a lot of the things that we're interested in, and it is a struggle, is when you have some of these more unique, special transactions that might only need $250 million or $300 million.

Lecointe, Legal & General:        I agree. In terms of size, the appetite has increased. For instance, Legal & General was not investing in the US private placement market four or five years ago. We've come here. We've seen a lot of US investors being very active in Europe and we're just doing the opposite, crossing the Atlantic. But I would tend to agree. I think $3 billion is probably too much for the market. But more than a billion? Yes, definitely.

PFR:           Last year, Calpine was trying to refinance its Geysers geothermal portfolio in California. It initially started off as a $2 billion quadruple-tranche hybrid bank loan and bond offering. But after the Kincade fires, it was reduced to a $1 billion bank loan. What are the prospects for geothermal assets in the private debt market?

Cantey, Nuveen:       In geothermal, we've had issues with the plants not working properly. In my opinion, and I'm sure this will differ, we're seeing some deals at BBB-. For the length they want to go to, I think we need a little bit more protection. Maybe a BBB rating with some major maintenance reserve accounts. But when we give that feedback, the possible borrower is not interested.

Odette, MUFG:          The Geysers are a really unique geothermal asset in that they’ve been operating for 50 years and it's one of the most stable geothermal resources you're ever going to find. When we were marketing the Geysers transaction last fall, folks generally got comfortable with the resource. It's a very different story with greenfield or newer geothermal resources, where there's a lot more potential for variability or decline in the wellfield. But for big, stable geothermal assets, there's a lot of appetite. Geysers was a victim of bad timing, with a major wildfire starting in the vicinity as the deal was being marketed. But we successfully led a bank financing for the Geysers last spring, one of the first big post-Covid deals to be closed.

Cantey, Nuveen:        I agree with Matt. It's more of a greenfield issue for us. That asset he speaks of is a good asset. But we were closed for California at the time, so we couldn't even look at it.

Joynt, Fitch:  There's also a degree of recontracting risk baked into some of these deals which you have to wrap your head around. Right now, geothermal does price at a premium, typically, when you see these contracts come in, because there's a premium put on baseload renewables. Is that going to exist forever? That’s a big question. And it depends on how pervasive and quickly storage develops as another way to get at baseload renewables. You have that tension there. And the more premium you assume that geothermal is going to command at the point of recontracting, it's essentially a bet against the rapid development of storage. I would say it's more likely going to be the opposite. Storage is probably going to develop more quickly than we expect. And when you're pairing geothermal resource risk with some recontracting risk, that becomes a hard argument at the investment grade.

PFR:           Since the USPP market prefers proven operating projects with certainty of cash flows, are the technological risks associated with battery storage too big a hurdle right now from an investment grade financing perspective?

Cantey, Nuveen:        Nobody showed us one yet. We have a project where there's a battery that doesn't flow into our cash flows, but we haven't had anybody approach us with a structure. We’d be interested to see. One of the issues would be how long these batteries last and how do we handle issues if the batteries don't perform as well as we think. And of course, they may perform better. What could be put out there? Do we put a wrap on it, or is there another way to do it, in case there are issues with the equipment? But I do believe it’s the future. Battery storage will probably come quicker than we thought, especially in the western states, with all the solar being put out there.

Odette, MUFG:          As Bob said, there isn't really a long-term track record as to how this equipment will perform over time. If you’re putting 15-, 20-year financing on something, people are naturally going to be conservative. There haven't been a lot of standalone battery financings, but the ones that we have seen have gone to the bank market. The more prevalent form of batteries being introduced to the market is in combination with renewables: solar-plus-storage, wind-plus-storage. That has predominantly been in the bank market, but we're going to start to see it increasingly across all markets.

PFR:           What are the latest issues that the NAIC is focusing on which could affect the market? Are there any points to note on their capital charge regime or private letter ratings? Or do we not want to talk about the NAIC – touchy subject?

Cantey, Nuveen:        They rate the project finance sector more conservatively than most of the rating agencies. And it's a problem for a lot of deals because if you do not have a rating, then you risk getting a NAIC 3 designation. I’m not going to argue whether they're right or they're wrong, but they just differ, say, from a Fitch or a Kroll who might rate solar deal IG at 1.25x coverage and the NAIC would likely give it a 3. That's something we've always had to deal with, because the NAIC rating affects our capital charges.

Aronson, Voya:         Almost a bigger concern is that the NAIC has been making a run at suggesting that transactions that only have one private letter rating will still be subject to their review and purview. That causes a bit of uncertainty in the market, which causes uncertainty in the ability to get a transaction completed because all of a sudden, we have an incremental wild card in the deal. I agree with Bob that they don't rightly or wrongly always rate the same way as some of the agencies. But it's causing uncertainty.

Lecointe, Legal & General:              I'm investing mostly UK money, so I don't have to focus too much on NAIC but Solvency II regulation, which can also be challenging. We have the ability to rate transactions internally, which can be useful as well. It's one of the advantages of Solvency II compared to the NAIC. But we've had a US transaction that we rated internally and then the NAIC had a different view. So I can share the same concerns about the way they rate these transactions.

PFR:           What does the pipeline look like for the rest of the year? Could it be impacted by the outcome of the US presidential elections?

Odette, MUFG:          The pipeline definitely has been building, and we expect more activity in the third quarter and early fourth quarter. Given the inherent uncertainty introduced by the election and potential volatility as we get closer to it, there is a bias among sponsors to be in and out of the market by early October. I would expect to see a flurry of activity in the next six to eight weeks, and then, depending on what happens in the election and the market's reaction to it, there's a pretty good long-term pipeline after that.

Lecointe, Legal & General:              I’m getting a lot more calls. It’s going to get busier. With the elections, people will try not to price transactions too close to the big date to avoid any volatility. For transactions with construction risk, where we are being asked to hold spreads, it's going to be difficult around that time – for obvious reasons. It's going to be an interesting period.

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