Southwest Generation: Black hold

Power finance lenders and sponsors spent the first part of 2008 adapting to the new realities of acquisition financing. Some sponsors, most notoriously IFM, had to cope with complications external to the bank market. But cleanly closing acquisitions for portfolios, with leveraged finance characteristics, was not impossible then, especially where sponsors were prepared to acquiesce quickly to banks' demands.

The financing for the acquisition of Black Hills Corporation's southwestern gas-fired generation portfolio is the best example from the period. It closed without a flex to either pricing or terms, syndicated without difficulties, and married some of the flexibility of the leveraged loan market to the demands of project lenders and offtakers.

It also highlights the increasing presence of generalist infrastructure funds in the US power market. The sponsors of Southwest Gen are funds managed by Hastings Fund Management and JP Morgan Asset Management.

Black Hills Corporation, a utility serving South Dakota, northeastern Wyoming and southeastern Montana, wanted to buy five utilities from the dismembered Aquila. It proposed selling the portfolio of unregulated power projects, which it had acquired with Indeck Capital, to pay for them. In October 2007 it engaged Credit Suisse and Morgan Lewis to run an auction of the plants.

The winning bidder, with a price of $810 million, was the consortium of several Hastings-managed funds and the JP Morgan-managed IIF BH Investment. The portfolio, which had a total net capacity of 974MW, was located in California, Colorado, Nevada and New Mexico. The projects dated, with one Californian exception, back to the mid-1990s, run on natural gas, and sell power to local utilities.
                                                          Capacity
Asset (State)                                     (net MW)          Offtaker
Fountain Valley (Colorado)                  240              Public Service Company of Colorado/Xcel
Las Vegas II (Nevada)                         224              Nevada Power/NV Energy
Valencia (New Mexico)                       149              Public Service Co of New Mexico/PNM
Arapahoe (Colorado)                           130              Public Service Company of Colorado/Xcel
Harbor Cogeneration (California)            98             Merchant
Valmont (Colorado)                               80              Public Service Company of Colorado/Xcel
Las Vegas I (Nevada)                            53              Nevada Power/NV Energy
                                                   Total 974

Southwest Gen has three major customers: Public Service Company of Colorado (rated BBB+/Baa1, part of Xcel Energy), Public Service Company of New Mexico (rated BB-/Baa3, part of PNM Resources) and Nevada Power, (rated BB/Ba3, part of NV Energy, formerly Sierra Pacific Resources). The three serve growing parts of the country.

Two of the three present a straightforward challenge to the portfolio's lenders, since they are below investment grade, or partly below, in the case of PSCNM. Lenders, however, which have been happy to finance single-asset construction financings for projects with junk-rated offtakers, can usually look to a project's importance to its customers, and regulators' willingness to allow generators to recover their costs if a utility defaults. Offtakers with a higher cost of capital than their peers will find it harder to build or buy competing generation facilities.

Lenders are more concerned that the projects will be able to sign new power purchase agreements when their existing contracts expire. Utility and regulator willingness to renew these is key, and the debt has been sized and structured to account for this recontracting risk. One of the projects – Harbor Cogen – is already merchant, but is a small part of the portfolio, is slightly older than the other plants, and operates near the Port of Long Beach.

The ports sector inspired some of the acquisition financing structures that infrastructure funds hoped to use in the power sector. These financings typically enjoyed low pricing, often linked to debt-to-Ebitda ratios, and limited restrictions on sponsors' ability to withdraw dividends and expand their business. By the time that the sale was announced, in April 2008, the New York bank market had reasserted its priorities. Lenders were looking for stricter covenants, stronger security packages, higher pricing and lower underwriting commitments.

Lenders first had to learn to live with some pre-existing liens on the portfolio held by the offtakers, but managed to receive a pricing level for the portfolio debt – roughly 325bp over Libor – that fairly reflected the circumstances of early 2008. And the two sides settled on a measure of the portfolio's leverage, debt per kW, that reflected the state of the market, and the recontracting risk, most fairly.

Neither sponsor nor lenders viewed the portfolio as something that should be operated on a merchant basis for a protracted period of time. Harbor Cogen, for instance, is now the subject of some hedging. The debt per kW ratio is designed to give lenders a floor value for the portfolio that is substantially less than the cost of replacing its plants. But it also allows the sponsors to operate the portfolio, which includes several expansion opportunities, flexibly. According to Mike Hamilton, investment director at Hastings, "this is an attractive generation business, that serves tightening power markets, and one that we'd like to operate, and potentially expand, with a degree of freedom."

The sale closed on 11 July, to meet Black Hills' tax requirements, and was funded with equity until the bank financing closed a week later. The bank financing consisted of a seven-year $460 million term loan with a partial bullet payment at maturity, a five-year $80 million revolving loan and working capital letter of credit and a seven-year $20 million debt service reserve letter of credit. Joining Royal Bank of Scotland, which led the financing process, as mandated lead arrangers were GE Capital, Calyon, Natixis, Union Bank of California, and WestLB.

The Southwest Gen deal is, inevitably, a snapshot rather than a template, a product of a specific time in the market when limited concessions and creative compromise could produce a clean and flex-free close. Sponsors may, in the current market, need to offer up more for even stronger sets of assets. But Southwest Gen was a moment of calm before the market's later storm.

Southwest Generation LLC
Status: Closed 18 July 2008
Size: $810 million
Location: Southwestern US
Description: 974MW contracted power portfolio acquisition
Sponsors: Hastings Funds Management, JP Morgan Asset Management
Debt: $560 million
Lead arrangers: Royal Bank of Scotland, GE Capital, Calyon, Natixis, Union Bank of California, and WestLB
Buyer financial adviser: Lehman Brothers
Seller financial adviser: Credit Suisse
Seller legal adviser: Morgan Lewis
Insurance adviser: Moore-McNeil
Independent engineer and market consultant: Black & Veatch
Legal counsel to lenders: Latham & Watkins
Legal counsel to sponsors: Linklaters (transaction and Hastings), Stroock (JP Morgan), Hogan & Hartson (regulatory)