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Watch the Cycle
Can the upward swing in global power infrastructure investment be sustained?
highly liquid secondary markets. Term-B loans are quick to market and are less restrictive from the borrowers’ perspective than bank loans. Term-B lenders often make opportunistic investments that are potentially at odds with long-term industry objectives.
A U.S. power-project developer recently said, “The very thing some hedge funds are praying for is that we fail and they can take over our assets. In a way, their debt is an option for equity if a loan defaults. If I thought a deal would involve renegotiation of debt, I would never do a Term-B. I would take it to my four favorite banks instead.” 1
Cyclicality in Price Margins
In the late 1990s, a greenfield gas-fired merchant-power plant in the United States could raise leveraged equity at a pretax internal rate of return of 15 percent, and strong sponsors could obtain senior debt financing at spreads no higher than 250 basis points above the risk-free rate. By 2002, financing for greenfield projects had disappeared. And for fully contracted plants, where some liquidity remained, lending margins had widened to more than 500 basis points and required equity returns were better than 20 percent in many cases.
In the current aggressive lending market, margins on similarly rated projects now are below 200 basis points, and accepted equity returns have dropped into the low teens on average. Reports indicate that equity returns even have dropped into the single digits in recent infrastructure fund investments in the UK power sector.
Given wide variances in company specific and regional risk profiles, fuel sources, plant designs, and marketing arrangements and consequent corporate and project credit ratings, it is not a simple task to discern distinct trends in sector-wide asset valuations over time. Financial investors during 2003 and 2004 picked up U.S. gas-fired assets at prices as low as $250/kW of capacity. Recently closed agreements to buy into new coal-fired generation in Texas, on the other hand, were rumored to be priced at as high as $2,800/kW. In the UK, assets that were purchased at roughly £600/kW in 1999 were exchanged at slightly better than £100/kW in early 2004. Coal plant proposals currently under consideration in the UK are expected to cost in the range of £900/kW to£1,600/kW. Clearly, these are not apples-to-apples comparisons. However, it is plain to see that in the current environment, asset valuations are approaching prior peak levels.
The current recovery in the power sector clearly is global in its reach. Yet the recovery is showing distinct characteristics in each of the major regions of the world, and the implications of a downturn in the current cycle and the potential market development impacts likely will vary on a regional basis.
Europe. The European power sector has seen the highest levels of M&A and project financing, relative to other regions of the world, during the past few years. This has been spurred in large part by EU-mandated deregulation efforts, which have induced utilities to solidify market positions by acquiring their peers. M&A transactions valued at roughly $90 billion in 2005 tripled those of 2004. Average deal