NE Energy: Mountain high

Valuations in the US power market have now recovered to such a degree that creative financing of pricey acquisitions is a premium commodity. Until recently, equity risk appetite was a much greater factor in assets changing hands, and lenders were careful to stick to the best cashflows and highest security position possible. Plentiful debt market liquidity, an improvement in market conditions in the north-east, and developments in the hedging market have contributed to a financing environment that recalls the exuberance of the late 1990s.

Probably the best example of this sentiment is the holding company financing for Energy Capital Partners' acquisition of Northeast Utilities' baseload merchant capacity in Massachusetts and Connecticut. The $1.34 acquisition included $855 million in first and second lien debt layered over $320 million in outstanding project bonds, and a substantial merchant exposure. It also marked the first acquisition for ECP, which features the core of executives that built up Goldman Sachs' power portfolio in the US.

The portfolio consists of 15 plants at 14 locations with a total capacity of 1,442MW, of which the core, and largest, is the 1,080MW Northfield Mountain pumped storage hydroelectric project. The highlight of the remaining capacity, which is predominantly hydro, is Mt. Tom Station, a 146MW coal-fired plant in Holyoke, Massachusetts.

The assets, with the exception of Mt. Tom, were spun off from Northeast Utilities into its own unregulated subsidiary, Northeast Gen, in 2000 (NRG took the fossil-fuelled capacity). Citigroup sold $430 million in bonds into the 144A market in September 2001, on the back of a power purchase agreement for the portfolio's capacity between Northeast Gen and sister company Select Energy.

This PPA ended in 2005, and as a result of adverse sentiment towards utilities making unregulated investments, NU decided to sell the assets, and retained JP Morgan as financial adviser for the sale. After a close-fought auction, ECP bested competition from Brookfield and TransCanada, the first of which already had a presence in the region. Northeast Utilities and ECP announced a preliminary agreement on 24 July.

ECP mandated JP Morgan, the adviser and provider of the assets' stapled financing package, and Goldman Sachs, where senior partner Doug Kimmelman previously worked, as joint lead arrangers and bookrunners, and Barclays and WestLB as joint leads, for the $855 million in financing.

The most important element of the financing was deciding how much of the output of the portfolio to hedge, and how much to lave exposed to spot prices. This decision is especially difficult because Northfield is a pumped storage facility that consumes more energy than it produces, and is designed to exploit the difference between peak and off peak prices by pumping water up into a reservoir when power prices are low and releasing water from this reservoir at moments when prices are higher.

Not only does the project need to make sure that the differences between prices is sufficient to overcome this net energy consumption, but also to help pay off the outstanding project bonds, service the acquisition financing and ultimately pay ECP a dividend. Still, while Northfield accounts for 75% of the portfolio's capacity, it only accounts for 50% of its revenue.

The remainder of the portfolio – Mt. Tom and the conventional hydro facilities – is hedged to 2011 with J. Aron, Goldman Sachs' commodity arm. This should produce roughly $80 million in revenue per year. According to Scott Helm, a partner at chief financial officer at ECP, "there's no question we could have hedged Northfield, as we did with the other assets, but it would not have been appropriate given our plans for the asset."

The portfolio also benefits from capacity payments from the New England Independent System Operator, which uses them to reward generators for making capacity available and thus increasing system reliability. The payments have been set at $3.05 per kW each month, and rise to $4.10 per kW each month over the next 3.5 years, and after that are set through an auction process, in which hydro producers will likely hold an advantage.

These have been a factor in the resurgent fortunes of such struggling project financings as MASSPOWER and Boston Generating, and represent real income streams for the owners. The hedging arrangements, plus capacity payments, should provide 65% of the portfolio's gross margins.

But while the cashflows are strong, the portfolio is extremely highly leveraged. Of the $1.34 billion purchase price, $320 million is outstanding project level debt, and $855 million is holding company debt. This breaks down into a $550 million first lien term loan due 2013, a $65 million first lien cash-collateralised letter of credit due 2013, a $70 million first lien revolving credit facility due 2011, and a $170 million second lien facility.

The pricing on the debt is solid – 250bp over Libor on the first lien, down from 275bp in initial marketing, and 450bp on the second, down from initial talk of 500bp. Roughly a quarter of the first lien's principal will amortise in quarterly instalments over its life, while the second lien has no scheduled amortisation.

The debt is structured so that most cashflow is directed towards debt repayment. Indeed under several, albeit fairly conservative, scenarios, ECP will not be able to withdraw cash from the assets for five years. Some observers have posited that this will encourage the sponsor to sell up before then, particularly if reserve margins in the Northeast continue to fall or at the very least opt for an early refinancing. But Helm stresses that ECP is in the power business long-term, saying "we didn't buy the plants and then start figuring out how to take money out of the assets. We want to grow this business."

NE Energy Inc
Status: Closed 10 October 2006
Size: $1.34 billion
Locations: Massachusetts and Connecticut.
Description: Acquisition of Northeast Utilities' coal and hydro assets.
Sponsor: NE Energy
Debt: $855 million
Rating: First lien B1/BB- and second lien B3/B- (Moody's/Fitch)
Lead arrangers: Barclays Capital, Goldman Sachs, JP Morgan, WestLB.
Financial adviser to NU: JP Morgan Securities
Independent engineer: Stone & Webster
Lenders' insurance adviser: Moore-McNeil
Lenders' market consultant: Navigant
Lender legal counsel: Shearman & Sterling with assistance from Gibson Dunn
Sponsor legal counsel: Latham & Watkins