Sowood Commodity Partners Fund II has completed a $312 million financing for the Thermal North America (TNA) portfolio. TNA consists of a number of district heating and cooling systems (DHCS) and a cogeneration project. The financing provides a rare chance for lenders to gain exposure to revenues from monopoly DHCS assets. It also marries a strongly-performing asset with one that has experienced some operating difficulties, rather than two with different contractual profiles.

Sowood's ultimate manager is Harvard Capital Management, which runs Harvard University's endowment. Sowood had made several energy-related investments, particularly in smaller scale exploration plays. The presence of a hedge fund as owner of such solid contracted assets, rather than a dedicated power fund with institutional backing, makes little sense, however, unless the current condition of the assets is accounted for.

Most of the portfolio was owned by Trigen, which was acquired by Elyo, part of Suez, and transferred to Tractebel Electricity & Gas International in 2002. Trigen, once a listed corporation, was sold in October 2004 to TNA. TNA was formed to pursue the acquisition, but its owner wants to expand the business. At present, however, its assets encompass systems in Baltimore, Maryland; Boston, Massachusetts; Kansas City, Missouri; Oklahoma City, Oklahoma; Philadelphia, Pennsylvania; St. Louis, Missouri; Trenton, New Jersey; and Tulsa, Oklahoma.

The portfolio, however, also includes a 175MW cogeneration project – Gray's Ferry, in which Trigen held 50%, and Calpine the remainder. The Trigen stake in Gray's Ferry was transferred to TNA with the sale of Trigen. Calpine, which had owned its stake since 1999, announced on 14 June that it was in negotiations with Tenaska Power Fund to sell the stake for $37 million.

TNA ultimately offered $37.4 million, or 475 per kW, for the stake, as well as the opportunity to control the asset. Calpine said that the sale of the non-core asset was at an attractive price, although it booked a $20 million loss on the sale. Gray's Ferry, located in Philadelphia, sells power to PECO, part of Exelon Corporation, and steam to the local Trigen operation. However, according to the Moody's report into the debt issue, Gray's Ferry has underperformed under its previous ownership.

At least part of the money raised through the new financing will be put into changing the dispatch profile of the plant, and allow it to operate in the liquid PJM power market more effectively. Getting this asset up to speed, as well as growing the DHCS business, is where the Sowood management hopes to add value.

The financial adviser to Sowood was Lehman Brothers (Banc of America Securities advised Suez), which now has the mandate to arrange the debt. The financing breaks down into a $247 million term loan with an eight-year tenor, a $30 million synthetic letter of credit due 2013, and an eight-year $35 million revolver.

The loan is an effective bridge between the typical B loan structure that has emerged for power assets, and a more traditional project loan. In particular, the eight-year tenor is slightly beyond what a B loan borrower might expect. Norms in the market usually reach to about seven years. The cashflows from the business support this length, but the borrower evidently preferred the operational freedom that usually accompanies a B loan.

The debt features a light amortization schedule for the first six years of the loan (roughly $35 million a year), with a cash sweep thereafter. Recent B loans have usually featured very little amortization, followed by a cash sweep slightly earlier than this point. The fact that Sowood intends to stay as owner of the assets for an extended period, as well as spend a fair amount of money on upgrading them, encouraged this structuring. Nevertheless, using TNA's projections, $200 million in debt will likely remain outstanding at maturity.

The loan proved popular in syndication, and attracted a strong set of buyers, ending up 5x oversubscribed, according to sources at the arranger. Among the buyers were a small number of project banks, and institutional buyers such as collateralized debt obligations, prime rate funds and other structured vehicles. Hedge funds were a smaller presence than normal, partly because the spread was so low – it priced at 175bp over Libor after a flex downwards.

The loan gained a rating from Moody's of Ba3, and one of BB- from S&P. Moody's noted that the vast majority of the revenues of the portfolio – 70% – comes from sales of steam, with 14% coming from electricity, 9% from chilled water and 5% from hot water sales. The advantages of the DHCS assets having a monopoly position, as well as the high upfront capex required to create a rival operation, are immense.

Nevertheless, maintaining a strong operational profile and good condition at the assets will be the key to keeping coverages at a healthy 1.7x. The sponsor has hired Johnson Control (which in turn has hired back most of the former Trigen staff) to operate the assets, and ThermalSource to provide management and consulting services to TNA. Operating the Gray's Ferry plant in a more optimal fashion, according to sources close to the arranger, will in part simply come from the retirement of its project level debt, "which saddled the asset with dispatch restrictions that were not optimal."

The TNA financing might represent a bridge between B loan and project structures but its ease of replication, however, remains an open question. Funds such as those of Macquarie have been actively scouting for utility services opportunities, and Goldman Sachs' bond issue backing DTE Energy's purchase of DaimlerChrysler's utility assets was popular. Building a growth business on the back of such plays would be more doubtful.

Thermal North America
Status: Closed September 2005
Size:
Location: several US states
Description: Portfolio of district heating and cooling systems and one cogeneration project
Sponsor: Sowood Commodity Partners Fund II
Arranger and financial adviser to the sponsor: Lehman Brothers
Maturity: 2013
Margin: 175bp over Libor
Sponsor legal: Foley & Lardner
Lender legal: Simpson Thacher & Bartlett
Independent engineer: Stone & Webster
Seller financial adviser: Banc of America Securities