There's something very familiar about William Kriegel, the CEO of K Road Power. K Road, and its hedge fund partners now own the Boston Generating portfolio, the first time that hedge funds have taken formal control of generating assets outside of a bankruptcy process. Kriegel ran Sithe Energies at the height of the merchant power boom, sold out just before the crash, and sat out its worst two years.

Kriegel is very fond of talking about the returns available to investors in merchant assets. He still has faith in the power of deregulation to reduce electricity bills and keep his shareholders happy. He steers clear of talking about speculation – indeed he explicitly rejects it – but does stress the need to "optimise" and "market" power assets.

The tone will be familiar to readers of sponsor profiles from the late 1990s. But K Road has teamed up with a very twenty-first century group of partners. Hedge funds, once feared as asset strippers and short-termists are K Road's long-term partners.

Long-term is a slightly flexible way of describing their funds, since part of K Road's achievement in putting together the acquisition was in creating a structure that encompassed their participation, but allowed them to become owners relatively simply.

Key innovation

The development is not so important in terms of broadening hedge fund participation, since the funds have beencircling US power for several years, but in lengthening their return horizon and cutting out the use of middle-men in selling assets on to commercial buyers.

For Kriegel, this is the structure's key innovation. "The template for distressed asset sales so far is that hedge funds participate in a distressed project's debt, and they or the agent bank conduct a sale, usually to a private equity fund. The equity fund, using an investment bank to mitigate offtake risk, then puts in place a debt facility for the project, before selling it on to a strategic buyer."

Kriegel has two objections to this approach. "Using an investment bank as a tolling counterparty eliminates most of the upside available to the owner, and still involves a little downside." For K Road, the returns that were possible to a greenfield developer of power plants should still be available to an asset buyer.

The second is more important – flipping an asset to a private equity fund, means that the fund is much more likely to reap the advantage of a medium-term improvement in market conditions. "The strategic buyers are out, and the pool of available equity for merchant assets decreased by 80%," says Kreigel. "So what we are trying to do is extend the length of time that the funds can hold a power asset into the medium term."

To reap such returns (which are very possible, as the sellers of Texas Genco will agree), K Road needs to put together a financial and holding company structure that enables hedge funds to take control of a power asset comfortably and legally. But hedge funds are not natural managers of power plants, and certainly less so even than a project finance lender.

The obstacles to this approach are considerable, and range from hedge funds' natural aversion to taking such long equity positions, to the Federal Energy Regulatory Commission's reluctance to free such owners from the more stringent forms of oversight. However, the will is most likely there, as evidenced by the funds' willingness to take subordinated B loan positions in power financings – at the right price.

The most potential for a quick return lies in those assets with troubled histories rather than weak fundamentals. In this regard, the Boston Generating portfolio excels. Sithe Energies developed the projects, so they are assets that K Road knows intimately. But the portfolio has suffered at the hands of, broadly, three factors – regional overbuild, contractor difficulties and high leverage.

Boston Gen's troubled birth

Boston Generating consists of three projects – Mystic 8&9, a 1600MW gas-fired plant, Fore River, 800MW of dual-fired capacity and Mystic Station, a 1005MW oil- and gas-fired plant. The assets are located in a moderately constrained part of the northeastern US, close to major population centres, but in a market that, while dependent on gas, became overbuilt just as the projects came online.

The projects' engineering, procurement and construction contractor was Raytheon, which Washington Group took over, shortly before declaring bankruptcy. The contractor was successfully replaced, a stalled BNP and CSFB-led project financing was syndicated, and Sithe sold the projects on to Exelon in November 2002 (for more details of this process, see Project Finance's analysis of the restructuring in November 2005, and search "Mystic" at projectfinancemagazine.com).

Exelon owned the projects for roughly a year – by November 2003 it had decided to walk away and leave them in the hands of the bank lenders. The plants had another year to go of construction, but the downturn in credit quality in the sector, combined with the poor outlook for power prices in the region, as well as Exelon's decision to exit the business, forced it write off the $543 million it spent on the plants' equity.

Kriegel and the Sithe team, however, were sitting out the initial phase of the downturn since they were barred from working on generation projects as part of a noncompete agreement. Thus did K Road begin as a power technology venture capital fund. Asked if he regrets missing out on the early stage of the distressed asset sales, Kriegel says "there were some good opportunities there, but buying contracted assets – even the undervalued ones – was not the main part of our strategy."

The lenders on the $1.25 billion project finance facility, led by BNP Paribas, formally assumed ownership of the plants in April 2004, after Exelon paid Raytheon $31 million to settle disputes over the contracts, and $1.5 million to the banks. In November 2004, as soon as the projects were complete, the agent started looking for buyers.

Many of the original lenders had already sold on their commitments to third-party buyers – primarily hedge funds and other institutional buyers. As such, the potential for a unanimous agreement lessened, since different debt holders had bought in at different fractions of par. K Road's strategy for taking over the assets hinged as much on bringing key debt-holders on board, as on wooing the agent bank, a task that Kriegel admits had to be performed with a great deal of delicacy.

Enter K Road

In this K Road received assistance from Credit Suisse First Boston, once the bookrunner on the original financing, now putting together a recapitalisation that reduced the level of leverage on the assets. Of the roughly $1.25 billion in outstanding debt, $550 million was converted to equity, and $800 million restated as B loan debt.

This package consisted of a $500 million first lien loan (which breaks down into a $370 million term loan, a $70 million working capital facility, a $30 million debt service reserve facility and a $30 million letter of credit facility) and a $300 million second lien piece. The difference between the two is simply their relative recovery position.

Such B loans usually have at least one piece rated in the double-B range. But this presupposes an offtake contract for the plants' output. The first lien piece gained a rating of B from S&P and B2 from Moody's, while the second lien piece is unrated. The first lien priced at 325bp and the second at 630bp over Libor.

Here, the advantages of working with hedge funds are clear – the current debt owners could make a quick and informed decision about the plant's credit. The rating likely cleared out some of the more conservative B loan investors, but does show that a restructuring of this sort is not absolutely dependent upon a contracted solution. In fact, Kriegel asserts that even a partially contracted asset dampens the return available to a sponsor considerably.

Thus, K Road pitched the hedge funds with the idea that superior returns were available over the 5 to 7-year period. To do this, however, it had to persuade them that their money would not be locked in over this entire period. This involved converting the funds' debt investment into a liquid equity position.

And in this regard, the deal had to confront an interesting regulatory kink. The Federal Energy Regulatory Commission screens potential asset transfers to confirm that potential buyers do not exercise market power. The process is not likely to result in a refusal, but does require time and effort. The BostonGen acquisition rested in large part on creating a holding company structure that would exempt buyers from this oversight requirement.

The solution is to create two classes of shareholders – A and B class shareholders – in EBG Holdings, which owns the portfolio. A shareholders, which carry voting rights and involve operational control, are more closely regulated. B shareholders have fewer rights, and can transfer their interests more easily. FERC approved this structure in September, but imposed restrictions on the transfer of A units.

A second decision, in December 2005, eased those restrictions. The decision was made easier by means of a further holding company, called Custodial Company, and using a C-Corp (taxable) structure. Shares in this company can be transferred to existing or outside owners, subject to FERC-mandated restrictions on the new owners' activities. Kriegel declined to go into details of the structure (some of which is detailed in FERC's decision on the acquisition), saying simply "we brought good enough advisers together to make it happen."

Still some uncertainties

FERC's influence over Boston Generating's future remains immense. The portfolio benefits from reliability-must-run contracts with the New England Independent System Operator. FERC has yet to approve these, and the extent to which the portfolio's economics are dependent on these is of intense interest to the commission. Kriegel will not give an indication, although published ratings reports do mention these as a key credit positive.

The portfolio would also benefit, as Kriegel concedes, from the implementation of Locational Installed Capacity markets, which would pay generators more if they were located close to areas of high demand. Finally, it would also benefit from the importation of greater quantities of LNG to the Boston area, since these would likely ease the portfolio's fuel costs. Still, as Barry Sullivan, K Road's chief operating officer notes, "PJM is probably the most well-developed market, but NEPOOL is certainly a known quantity."

The structure of the recapitalization would travel well to other markets, provided these offer the promise of a tangible improvement in conditions. In particular, K Road has frequently mentioned as a possible bidder for the MachGen (formerly PG&E Genholdings) and Entegra (formerly TECO/Panda) merchant portfolios. If K Road's clients can reap the returns of a direct sale to strategic buyers, its principals will have a second chance at reshaping the power market.

Boston Generating
Status: Closed October 2005, awaiting equity transfer approvals
Size: $1.2 billion
Location: Massachusetts
Description: Portfolio of roughly 3405MW of oil and gas-fired merchant capacity
Sponsors: group of hedge funds led by K Road Power (10%)
Debt: $800 million, split into $500 million first lien piece and $300 second lien
Arranger and adviser: CSFB
Maturity: 2010
Lender legal counsel: Milbank Tweed Hadley & McCloy
Sponsor legal counsel: Reed Smith
Market consultant: Pace Global
Independent engineer: Black & Veatch