The $475 million refinancing of KGen's acquisition of the 5,325MW portfolio from Duke Energy highlights how far the US lending market for merchant risk has come. Not only is the deal an unusual way of structuring a power project financing – with lender support predominantly pinned on the successful sale of assets – but on a project-specific level, the refinancing illustrates just how shrewd a purchase it is.

The original $325 million B-loan was closed in August 2004 and the $475 million refinancing closed 15 March 2005. The borrower's savings justify the speed with which the second deal was put together. The $325 million tranche A, due 2011 is priced at 262.5bp over Libor pared down from 400bp. The $150 million tranche B was priced at 262.5bp for the cash portion and 637.5bp for the payment-in-kind (PIK) portion – this compares with the 400bp for the cash portion of the original deal and 700bp for the PIK part. Overall for tranche B, an all in of 900bp versus 1100bp.

The refinancing was originally to be split $225 million for the first lien and $250 million for the second, but was changed after advice from CSFB and negotiation with the ratings agencies. The final split was predicated on the far greater appetite for the first lien, with the second lien suitors largely comprising hedge funds – the result is lower average-weighted cost for the borrower.

The proceeds of the refinancing take out the $325 million facility and a $48 million seller note issued by Duke Energy North America, with the remainder, excepting fees, funding a debt service reserve and liquidity reserve totalling $88 million.

The acquisition comprises four combined-cycle and five simple-cycle plants located in the south-eastern US states of Arkansas, Georgia, Kentucky and Mississippi. The plants are: 620MW Hot Spring, Arkansas; 520MW Hinds Energy, Mississippi; 640MW Enterprise, Clarke County, Mississippi; 640MW Marshall County Energy, Kentucky; 640MW Sandersville, Washington County, Georgia; 640MW Southaven, in Mississippi; 385MW New Albany facility in Union County, Mississippi.

None of the plants – except for the 600MW Murray 1 and 2 units – have power purchse agreements (PPAs) and all have O&M contracts with Cinergy, which is also responsible for selling dispatch.

A seven-year PPA between the KGen Murray unit and Georgia Power almost entirely services the first lien debt. The agreement provides for fixed capacity payments regardless of the level of dispatch of Murray 1 – this equates to about $170 million through the lifetime of the debt.

Despite the PPA, a spokesperson at KGen says that the difference in pricing is less to do with the structure of the deal and more to do with the market warming to US power again in the seven months between the deals. Whereas the original financing was an unrated private deal, the refinancing is publicly rated – B2 for tranche A and B3 for tranche B by Moody's – which should help the sell-down by sole arranger CSFB. The bank's involvement as sole arranger for both transactions also gives lenders comfort due to its closer appreciation of the risks.

The deal could prove a very canny purchase by KGen and Matlin Patterson – KGen's sponsor. As distressed assets, the $475 million purchase price effectively gives KGen the simple-cycle peaker units for nothing, with their disposal acting as incremental liquidity injections. The strategy is to disassemble and sell-off the peakers at equipment cost, potentially to Middle Eastern and Korean turbine buyers – as the SERC pool in which the assets operate are in an oversupplied market.

With optimal timing of disposals there is likely to be a sizeable purchase price discount to net asset value, but equity and lenders bear disposal execution risk. The deal, particularly if the spark spread remains at current levels or deteriorates further, relies heavily on the liquidity reserve accounts and timely sales of assets to support internal cash flow. Nevertheless, Moody's notes that in a distress scenario recovery would be highly likely for tranche A and substantial recovery would be likely for tranche B.

On the upside, there is potential for a further arbitrage play if the spark spread improves, and in a period of prolonged cold weather for example, KGen could feasibly continue to operate most of the assets.

However, for the time being four peaker units (about 2,300MW of KGen's 2,945MW) are mothballed. It is KGen's strategy to keep the four combined-cycle plants into the medium-term and $55 million has been budgeted for major maintenance spending at these facilities for the first two to three years.

As well as the assets healthy residual value, lenders can take comfort from the funding and maintenance of a debt service reserve account equivalent to six months debt service – $85 million – and a fairly strict set of covenants. No dividends will be distributed until the debt is repaid, and an annual cash sweep mechanism is in place that directs the first $20 million over and above the liquidity account to pay tranche A, then payments-in-kind accrued in tranche B, and finally tranche A and B on a pro-rata basis.

For the combined-cycle assets beyond the medium-operating term, Matlin Patterson's strategy will be to exit through a trade sale, in order of likelihood, to either a local utility, independent power producer, or another private equity house.

KGen refinancing
Status: Closed 15 March 2005
Size: $475 million – $325 million tranche A; $150 million tranche B
Description: Refinancing of KGen's acquisition of Duke Energy's SERC assets
Project company: KGen
Sole arranger: CSFB
Project counsel: Millbank Tweed
Lender's counsel: Dewey Ballantine
Valuation consultant: Stone and Webster