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Crisis Capital

Volatile markets call for alternative financial models.

Fortnightly Magazine - September 2009

of merchant- power generators active in the United States include Dynegy, Mirant, NRG, Reliant, and Calpine; these companies can be considered pure-plays for this sector, because they all have a predominant focus on deregulated power generation; a significant exposure to merchant power risk; a wide range of customers; a U.S. base with significant geographic diversification; and significant economies of scale in both operations and fixed costs because of the size of their generation portfolio. (NRG recently expanded beyond this pure-play description by acquiring the Texas retail operations of Reliant Energy.)

All of these merchant-power companies are rated below investment grade or in the high-yield class. Merchant projects traditionally have been project financed and carry market risk, as their cash flows may be exposed to the vagaries of spot-power prices unless they have power-purchase agreements that mitigate such risk. Although most project finance deals involve leveraged loans from commercial lenders, the debt costs for merchants generally approaches the returns on publicly traded high-yield bonds. Financing on a pure merchant basis currently is extremely difficult and power-purchase agreements are now a pre-requisite rather than a unique selling point. Recent examples of major project-financed generation plants include Caithness Energy and Noble Environmental Power.

Many companies in the merchant-power business aren’t pure plays. For example, companies usually considered utilities, such as Constellation Energy, have substantial merchant generation as well as regulated utility assets, and companies generally thought of as merchants, such as AES, own regulated utilities. For those companies, it makes sense to look at a blending of the methodologies and approaches. However, in carrying out valuations, the financial community tends to regard the fundamental risk profiles of such firms as one type or another, rather than both.

In this regard, it’s important to understand the recent history of the leveraged loan and high-yield bond market. The high-yield bond market grew rapidly throughout the 1990s and well into 2007—starting at $200 million in 1995 and expanding to $1 billion by mid-2007. Such bonds were used for financing leveraged buyouts and exits from bankruptcy, and they fueled the explosive growth of the sector in 2005 and 2006. For example, Mirant emerged from bankruptcy in 2006 and 2008 through the issuance of high-yield bonds, while Calpine’s exit financing in 2008 was privately placed.

But things changed rapidly, particularly for merchant companies. Credit dramatically tightened in 2008 and early 2009 after a period of stable and relatively low bond spreads ( see Figure 1 ). The spread is an important indicator that shows the amount that companies pay for capital over a benchmark such as the Treasury bonds or LIBOR. Until late 2008, one of the reasons for the narrow spreads, low cost of debt, and rapid increase in debt placement in the power industry was securitization, the packaging of groups of investments into a pool and then sold as a single security. In the mortgage market, securitization enabled the redistribution of substantial credit risk from originating banks to non-bank investors, and the power industry witnessed a similar dynamic through the collateralization of leveraged loan and high-yield debt instruments.