Business & Money
Merchant plants now draw investors from three different worlds-each with its own agenda.
It's tempting to chalk up the recent bubble in merchant generation to just another industry cycle, but there's more to consider. Investment in the industry was far from even, leaving some regions teeming with unused peaking plants while other regions continue to struggle with a need for capital investment. Technology also has evolved, opening up a new suite of potential options like demand-side management, more efficient transmission and distribution, and localized generation.
The growing concern over energy security and the environmental impact of the current fleet of generation assets also has created further flux. Change is the only constant in today's world-and change brings opportunity.
How has this experience affected investment? Few if any who invested during the generation boom have escaped unscathed. Nonetheless, we see the ongoing potential of the power sector. New investors have moved quickly to raise or redeploy capital and invest in an industry that is far from dead. Current investment in the power market increasingly flows from three distinct sources: private equity, institutional debt, and venture capital.
At one end of the risk spectrum, many private-equity investors have sought to purchase and finance contracted power assets. Large equity funds, which have tended not to see power as a core investment focus, have been drawn into the market by the opportunity to fund significant amounts of capital into strong, cash-producing assets. This trend has progressed steadily from single-asset acquisitions to large generation-portfolio purchases.
While private-equity investors may have been drawn to the market initially by the potential to acquire contracted cash flows at attractive prices, these opportunities have been fleeting. The sheer number of interested financial sponsors, a general dearth of bargain investments in other industries, and the availability of attractively priced debt have resulted in fierce competition and pressure on prices. As a result, power producers have been able to divest non-core or distressed assets at attractive valuations.
At the other end of the risk spectrum, many power producers and financial institutions are holding poorly performing merchant assets. These assets have proved difficult to value and therefore difficult to sell, although some have begun to change hands. Private equity investors have started to purchase these assets under two broad scenarios. First, merchant assets with strong fundamental characteristics (, coal generation in a gas-margin market) have appeal. Second, deeply discounted assets with no obvious structural economic advantage have sold to investors who see the potential for asset-value appreciation. They intend to contract assets successfully off of a low-cost base. The clear differences in the merchant segment are significantly discounted valuations and higher-debt costs for the purchaser.
The entry of private equity investment has served the useful purpose of providing liquidity to support ongoing industry efforts to restructure and deleverage. This growing class of investor is looking to profit from a short-to-medium term market imbalance and likely will exit these initial investments once stability returns. Depending on their experience with this initial foray, private-equity investors could present a deep pool of risk-tolerant capital that will continue to provide broader funding options for corporate partners.
Almost in tandem with the entry of large-scale, private-equity investment in the power sector has been the emergence of a deep second-lien institutional term loan market. The "Term Loan B" market, as it is known colloquially, has provided the debt capital necessary to support leveraged acquisitions by private-equity investors. This growing investor class largely comprises high-yield mutual funds and other institutional investors seeking liquid debt investments with attractive rates of return.
This form of debt appeals to financial sponsors because it is abundant and flexible. Covenants are light. Penalties for prepayment are usually minimal, as are fixed repayment requirements that typically rely almost exclusively on cash sweeps. In effect, these structures provide interim financing for private-equity investors pursuing a short-term acquisition and medium-term exit strategy.
Similar to private-equity investors, Term Loan B lenders were drawn into the market by the promise of attractive rates of return for a given level of risk. Similar again is the resulting compression of pricing margins as investors have crowded the market. Yields are not particularly high relative to perceived levels of risk in the transactions they fund. The depth of the Term Loan B market has worked in tandem with the availability of private equity capital to provide liquidity for the power industry's necessary restructuring efforts. This type of debt is not an ideal form of long-term financing, but it provides the sort of risk capital required by the market today.
While the Term Loan B market has seen an explosion in participation, the traditional long-term, fixed-rate institutional debt market, which has typically played a significant role in the power sector, has been conspicuous in its lack of activity. This certainly does not imply a lack of interest or investment appetite. The current lull in the long-term, fixed-rate market is best understood as a result of the rise in Term Loan B financing. Private-equity investors, who must look ahead to an exit or refinancing strategy, are not well served by long-term fixed-rate loans that carry prepayment penalties. As investment activity shifts back to strategic corporate investors, who are more concerned with showing consistent earnings, balance is likely to return. Long-term, fixed-rate institutional debt has not disappeared, but, for the moment, the transactions in which it makes sense disappeared.
Venture capital in the power industry has been dominated in the past by early-stage development equity for large-scale generation projects. This activity continues at a reduced scale while a new wave of technology-driven investors becomes more active. Revolutionary power technology has long been a marginal curiosity in the industry. However, recent developments in advanced technologies have presented promising opportunities to venture-capital investors. Some of these technologies, such as load curtailment systems, are commercially deployable today. Others, like solar, wind, and fuel-cell generation, still require some level of subsidy but are demonstrating steady advances in cost reduction. Clean coal, waste-to-energy, and emissions curtailment technologies also hold great promise as this country seeks to limit its dependence on foreign sources of fuel, while reducing the environmental impact of combustion-based generation.
Deep pools of capital for investment in advanced power technologies already have been raised, and interest is growing. Focused power-technology funds first emerged in the late 1990s but were lost among the larger and more numerous IT-focused funds. These early funds are expanding, and new entrants are emerging as new opportunities surface. One key issue for these funds is access to project finance. Many of the emerging technologies are deployed in smaller projects that have proven inefficient to finance individually. As these efforts gain critical mass, there will be opportunities to finance these projects as off-credit portfolios and to overcome the cost inefficiencies that have stood in the way of growth and deployment. A number of lenders are working on this type of product and dealing with some of its inherent challenges. Much as the Term Loan B markets support private-equity investment, venture capitalists will see their investments succeed with the emergence of portfolio-based financing for smaller projects. Patient venture-capital investors who have chosen the right technology, management team, and financing partner could earn significant returns on their deployed capital.
A Robust Financing Market
Investors have not made a wholesale exit from power finance. It is true that many have taken significant losses. It is also true that some remain wary. Despite all this, investors continue to enter the market and address the needs of the industry today.
The Next Big Investment?
Renewables and energy trading may be the next hotbed of investment activity.
Many bankers and investors have spent the greater parts of their careers waiting for renewable power generation to become mainstream. While rates of deployment have grown significantly, renewables remain highly dependent upon tax-based subsidies and government rebate programs. Nonetheless, legislators and regulators are focused increasingly on larger social and technological trends and will continue to support renewable generation. Concern over the environmental impact of current power generation technologies is growing. While our power needs will never be fully serviced by large-scale wind generation, there is an array of increasingly cost-effective renewable generation technology available for deployment. Current renewable technology requires some form of subsidy, but it isn't unreasonable to predict that this cost disadvantage will diminish over time.
In the meantime, the current system of production tax credits (PTC) will support significant development of renewable generation. Wind-power development is an excellent example. There are approximately 5 GW of planned wind projects that alone will move forward now that PTCs have been extended. Renewable project development has grown significantly in Europe and other regions. Lenders familiar with those projects are active in the U.S. market as well. Given investor comfort with the risks inherent in wind production, rates and terms on wind portfolio loans are very attractive from the sponsor's perspective. The PTC model also requires a base of tax-driven investors who could make use of the incentives allowed. While some sponsors can make use of the benefits, others will rely on passive financial investors who have an interest in the tax incentives. The bottom line: significant pools of debt and equity capital are available to support the development of renewable projects.
While not a direct source of capital, the slow re-emergence of energy trading is worth consideration. Industry trading operations have been replaced and acquired by financial institutions that recognize the continuing need for liquidity and risk mitigation. Assuming these efforts are successful, merchant risk eventually will lose some of its stigma as investors regain confidence in the ability to hedge off-take price and fuel risk. It's still unlikely that a fully merchant power project with 80-percent leverage will be financed in the near future. However, carefully structured projects with a good fundamental story will be able to carry some element of merchant risk. A broad and reliable trading market will help accelerate this process.-R.P.
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