B loans now account for the majority of debt issuance for power plant assets. Most of the large thermal power financings are pitched to B lenders, which have built up a presence in the market as substantial as they have elsewhere in the US leveraged loan market. Roughly 90% of US leveraged loans are now sold to institutional investors in the form of a B loan. There are roughly 500 B loan investors in the US power market, 100 of which are very active, compared to 50 or 60 banks.

Amongst the many deals that have been done in the B loan market recently are the Astoria Generating acquisition, LS Power's DENA acquisition, and the Coleto Creek coal power facility. But a slight push back from the B loan market has occurred over the last few months. Tom Murray, global head of energy at WestLB, says "the market became very aggressive; leverage was going up, pricing coming down, deal sizes increasing and still deals were oversubscribed. Price talks at 225bp over Libor closed at 200bp over Libor because investor interest was so intense and leverage could be used to reduce the price." So appetite may be subsiding slightly – Coleto Creek's financing was recently restructured to include a second lien because it could not be done in its original form.

B loan deals have certain characteristics: they are rated by Moody's or S&P, have 1% scheduled amortization, have pricing commensurate with the rating and are sold to institutional investors. In addition, B loans are relatively liquid instruments.

In general, leveraged B loans used to consist of senior secured first-lien paper, but have evolved. Arrangers of an acquisition financing tended to maximise the proceeds within a certain ratings band, then also raise unsecured high-yield bond debt, which would be subordinated to the position of the secured investors. The investors that used to buy this high yield piece are now buying second-lien B loan paper. This is one of the reasons the high-yield bond market has not kept pace with the B loan market; high-yield debt is now structured as second-lien B loan debt. These buyers prefer the B loan's floating rate interest to the fixed coupon on high yield bonds.

Hedges: secure enclosure or prickly?

The majority of B loan investors are hedge funds. The common perception is that banks tend to build relationships with developers while hedge funds may not necessarily have a project's best interests at heart when they enter a deal – that they would as soon put the company in bankruptcy as try to work out any difficult situations that arise.

One developer in the US power industry is among those who harbour such concerns. "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. So it is a very uncomfortable position to be in unless you're very confident you as an issuer are in a very strong position. If I thought a deal would involve renegotiation of debt, I would never do a term B. I would take it to my four favourite banks instead."

The benefit of using B loan debt is that no investor holds a big chunk of an issuer's paper and so cannot hold the issuer hostage. The downside is that trying to get a decision out of the numerous investors is difficult; there may be 120 investors, of which 75 have to say yes.

Murray says "B loan buyers can be just as good providers of capital as banks, and have better features in some ways. If you have a secondary market for your paper and something happens, you as an investor can go out and sell it to someone else. You also have the option to oppose a decision made by management if you dislike it, and sell your exposure to someone else who does like it. In a bank deal if investors don't like it they can cause big problems for the issuer".

The end of the bank market?

Nevertheless, such investors have a huge demand for capital, particularly in the power and ethanol markets, which have been partly responsible for the huge jump in B loan issuance. The broad perspective taken by B loan investors is that the power sector is solid; it has hard assets as collateral, it is a relatively stable industry, and at present the dynamics are good. In addition, the previous period of overcapacity in gas-fired generation is being worked out – at least in some regions – and there is a need for more generation in the near term.
WestLB's Murray says "it's still on the up but the rate of increase has slowed. We don't see it going down, but at some point it will plateau. Pricing is not going to be lower than a certain level and the market has become very aggressive very quickly. You're seeing BB deals getting done at 175bp over Libor and below on the energy side, and the guys that used to be yield hogs are prepared to deal with it at levels commercial banks don't find attractive. That can only go on for so long".

Many deals now go directly to the B loan market, leaving a lot of banks with limited deal flow. One banker says "If you ask a bank's opinion, they would love to see the B loan market disappear so that the deals come back to them again".

"The problem with the commercial bank market" says another source involved in the market "is that it is highly inefficient and carries huge staffing costs. Investors are now putting their money in CLOs, which are more efficient at managing portfolios, with fewer people involved. That said, there is also insufficient infrastructure at these companies, which may blow up and come back to haunt them. That could cause the B loan market to dry up, there's not the same oversight as there is at a bank. Ideally a happy medium of efficiency plus oversight would be the perfect combination; banks are bloated, bureaucratic and inefficient, while institutional investors are too small and don't have enough meat in the organisation to limit potentials of disaster."

This year's headline B loan was the $1.69 billion in debt arranged by Credit Suisse, Goldman Sachs, Morgan Stanley and WestLB for LS Power's acquisition of the bulk of Duke Energy's generating portfolio. The portfolio includes a large element of merchant risk, which does not interest the commercial banks, since they were hit hard in 2001/2002 after the market collapsed.

Where possible however, construction financing has traditionally been better suited to the bank market. Plum Point is a greenfield construction project in which the developer – again LS Power, chose the B loan route. Credit Suisse, Goldman Sachs, Merrill Lynch and WestLB led the $750 million loan portion of the deal. LS needed, therefore, to pay an incremental premium to cover construction risk, and because the project would not initially be generating Ebidta. A more efficient structure mights have been a combination of a bank and second-lien B loan structure, since banks are willing to price construction risk more favourably for their clients. Banks are also better placed to grant the necessary waivers or otherwise deal with problems during construction.

Murray says "The credit quality of B loan transactions range from BB to CCC with many falling in the single B category. Also, second lien B loans have become more prevalent. All of this equates to more risk."

Another banker close to the market notes "People are accepting more risk for less return now. There's some crazy stuff out there that investment banks wouldn't touch, they wouldn't put a dime into these deals".

Astoria – a fast, one-time shot

Astoria Generating's acquisition of Reliant Energy's New York-based power assets closed earlier this year. The $975 million purchase price involved $730 million in acquisition debt, $430 million of which was term B, and $300 term C. The assets comprise 2200MW – or roughly 23% of New York's generating capacity. The deal was 5 times oversubscribed and the B loan involved 150 institutions, a large amount, averaging at less than $5 million dollars per institution. Morgan Stanley was lead underwriter, while Goldman Sachs, Merril Lynch and BNP Paribas were lead arrangers.

The investor briefing took place on 17 January and the deal closed on 23 February, says Jay Worenklein, president and CEO of USPowerGen, one of the project's sponsors. Market sources indicate that if a bank were to underwrite and syndicate a $950 million credit facility for a merchant power portfolio in New York City or elsewhere, it would likely have taken around four months from start to closing.

Worenklein adds that in a B loan deal, the borrower retains greater control over timing and terms of the deal than in a typical bank financing. "B loan deals in their execution represent a public-style debt financing," Worenklein said. "The timing between deal launch and closing is far more rapid and the documentation is less restrictive from the borrower's perspective." Worenklein adds "however, the documentation must be within accepted market norms on all key provisions, and the rating agencies and their counsel review the documentation to make sure the security and other key provisions are acceptable to them."

The sponsors felt confident – the NY market is the single most constrained marketplace in the US; it is more difficult to build a plant there due to a scarcity of sites, and so the prospect of buying plants that made up 23% of state capacity looked appetising to them. In addition, notes Worenklein, New York has a very stable environment for merchant power deals.

While USPowerGen was able to improve the deal's execution and terms through the B Loan structure, this benefit came at the cost of an unavoidable reduction in control over who its lenders would be. "In contrast to a typical bank deal, in which we would have had twenty or so relationship banks in a deal of this size" Worenklein said, "in the New York City deal, we had over 160 money managers, hedge funds and other financial institutions come into our deal, each of which can trade its position at will to other institutions we may have no relationship with. We felt this cost, which is a significant one, was outweighed by the improved terms and speed of execution."

Rated and elated

Moody's and Standard & Poor's have seen a big boom in B loan ratings. "Some deals either wouldn't get done or would get done in the bank market, but now a huge source of financing has opened up." says Arleen Spangler, director in S&P's global utilities and project finance group.

Notes Scott Taylor, a director in the same group at S&P, "A big concern of ours is the refinancing risk, since the loans are relatively short-term for a long-life asset; they typically have seven- to eight-year terms and no scheduled amortization except the 1%. There has been a big shift from when we started rating project finance loans. Back then, if an issuer had a long-life asset it would also have debt to mirror that life and amortized during a contractual period. B loans are set up with minimal amortization so that funds can buy them and sweep excess cash-flows. We've seen amounts ranging from 40% up to 100%. This is then used to pay down principal."

"There's still a large amount of interest to be paid" says Art Simonson, a managing director at S&P, "and that's really what we're looking at. But when you look at coverages for B loans compared to old style bank deals, old deals had interest and principal repayment, and were being covered at 1.4/1.5 at two times, but B loans are just covering interest with this ratio. The principal is missing, but the interest is about the same."

Spangler believes the popularity of the B loan market will continue: "I believe it will increase and take over bank lending. Banks will lend to deals that can't get done in the B loan market, smaller deals such as wind projects." And bank interest will lie in what happens when the refinancing bubble will hit, in three or four years time.