The La Paloma project is a longstanding veteran of the project B loan market. Its experience goes back to its construction financing, but its refinancing sets a new benchmark in B loan pricing and terms. With the right structuring, many power sponsors could achieve comparable results, and it sets an aggressive pace that traditional lenders will find difficult to match.

La Paloma is 1022MW of combined-cycle natural gas-fired capacity located in Kern County, near Bakersfield, in southern California. It is located close to the end of the Kern River gas pipeline (another multiple Project Finance award-winner), and dispatches power into the growing regional power market. It was developed at the same time as the state was experiencing growing power shortages in 2000.

The four-unit project's original sponsor was PG&E National Energy Group (NEG), the unregulated merchant energy affiliate of Pacific Gas & Electric, the northern Californian utility. The NEG put together a $730 million financing in March 2000 for the project, one that optimized the tax and accounting position for its corporate parent.

That deal consisted of $374 million of commercial paper guaranteed by PG&E Corp, the parent of the NEG and the utility, $295 million B loan, $25 million debt service reserve facility, $15 million working capital, and $21 million in certificates. The commercial paper was to be replaced at completion with sponsor equity, and the whole deal was structured as a synthetic lease. This lease governed the structure of the debt and commercial paper, and was designed to allow the sponsor to report different tax and accounting treatments on the project.

The plant, however, had to deal with the bankruptcy of Pacific Gas & Electric, which filed for Chapter 11 bankruptcy protection a year later. The bankruptcy did not affect the process directly, since PG&E Corp did not file. The NEG was recapitalized using a financing structure that protected it from events at the corporate parent.

This structure, unfortunately, made NEG's solvency dependent on its rating, and in the aftermath of Enron, NEG found it harder and harder to conserve cash, and maintain an investment grade rating. The synthetic lease structure was unwound, and by August 2002, the NEG was said to be looking at a second B loan to fund its equity commitment. By November that year, with the plant largely complete, NEG said that it would not contribute the remaining equity, claiming that its corporate credit facilities prohibited it from doing so.

SG and Citigroup, as agents for the plant's lenders, became the owners of the project. Citigroup, which created the lease structure (and pioneered it on the earlier Lake Road project), was lead agent, while SG took on NEG's other large defaulted deal, the GenHoldings portfolio. At the same time, much of La Paloma's debt changed hands on the secondary market.

Probably the project's main stroke of fortune was signing a power purchase agreement with Southern California Edison, part of Edison International and the utility for the south of the state. This contract, signed because of the same power market crisis that drove its northern counterpart into bankruptcy, runs until 2007.

The project is well located, close to demand centres, and NEG had planned at first to run it without any contracts. But finding a buyer for a project without any contracts would have been difficult, so Lehman Brothers, hired in late 2004 to sell the asset, found the assignment a little easier than it could have been. NEG declared bankruptcy in July 2003, although its slide was slow and signaled well in advance.

Complete Energy, which entered into exclusive negotiations with the lenders in March 2005, is a start-up formed by former personnel at Allegheny Energy and Dynegy. Hugh Tarpley, one of its managing directors, was head of M&A at Dynegy when it almost bought Enron, and left Dynegy in December 2002. Its other two managing directors – Lori Cuervo, former head of strategic planning, and Peter Dailey, head of mergers and acquisitions, were at Allegheny. A fourth, Milton Scott, formerly of Dynegy, has since left Complete.

Complete persuaded Morgan Stanley Capital Group to buy power from the third unit from 2005 through 2012, and to use the two units from which Edison buys power from 2008 to 2012. Morgan Stanley is A-rated, and has an experienced power marketing operation. Moreover, Morgan Stanley, by signing a PPA with a company before it bought the asset, underwriting additional equity (since taken by CIT), and arranging the debt, played a crucial role in allowing the deal to close.

On the back of this contract, WestLB, which advised the buyers, and Morgan Stanley put together a package that consisted of a $244 million seven-year term loan B, a $21 million delayed-draw seven-year loan, a $40 million synthetic letter of credit and a $65 million working capital revolver, all first priority, and a second lien piece of $155 million with a maturity of 2013.

The most impressive aspect of the deal was the pricing. The first lien piece, which was 1.5x oversubscribed, is priced at 174bp over Libor and the second lien, which was 3x oversubscribed, priced at 375bp. The leads managed to get the pricing in at 25bp below the price talk for each piece, although the reception of the second lien suggests that there might have been a little more room. Nevertheless, the pricing compares favourably with conventional project finance credits, even though the deal was rated at Ba3/BB- (Moody's/S&P) for the first lien and B2/B for the second lien.

Since the financing closed, WestLB has gone on to complete a similar financing for the Wolf Hollow project. Certainly, the deal formed a central part of its re-entry into the power finance market. Buyers of assets with troubled histories but solid and certain fundamentals would to well to give this type of financing a look.

La Paloma Generating Co
Status: Closed 16 August 2005
Size: $643 million
Location: California
Description: Financing for the purchase of 1,022MW gas-fired plant from its creditors
Sponsor: Complete Energy
Debt: $523 million
Equity: $120 million
Lead arrangers: WestLB, Morgan Stanley
Seller financial adviser: Lehman Brothers
Equity funding: TCW and CIT
Sponsor legal: Vinson & Elkins
Arranger legal: Latham & Watkins
Seller legal: Milbank, Tweed, Hadley & McCloy
Equity funding legal: O'Melveny & Myers
Operations: Fulcrum

Independent engineer: Harris Group