Above par?
Distressed debt players generally fall into two categories - the buy and hold investor, and the short-term arbitrage player. The categories overlap, and the approaches taken are often determined by liquidity, but the difference in approach is crucial. Hot money and hedge funds drove the speculative frenzy of the later months of 2002, and secondary market movements were the product of sketchy (and often straight misleading) market rumour.
Nevertheless, the two approaches do work side by side. Farallon, one of the world's largest hedge funds, held on to the 144A bonds issued by the troubled Paiton project in Indonesia, through to a successful restructuring. Those running the process at lead sponsor Edison Mission said that they had relatively positive experiences of dealing with the fund, suggesting that Farallon had bought in at a healthy discount.
Are there players out in the market that are looking to buy in for the long term? While some funds do exist to take up slack in the secondary market, many exist to service distressed sellers, rather than buy up distressed debt. TCW's project fund, for instance, is more interested in solid projects whose lenders need to get out of the project finance business. Beal Bank, however, may be an exception.
Beal Bank is a privately-held wholesale bank devoted largely to secondary market debt, and, while insured by the Federal Deposit Insurance Corporation, shares the central attitude to debt of a hedge fund - buy in low. However, the hot money market appears to have slowed a little, and debt prices are edging up. According to Steven Harvey, senior underwriter at Beal Bank's investment advisory arm, CSG Investments, "it's almost astonishing how much it's been bid up, whether through the activity of hedge funds or money diverted from the stock market. There's a whole lot more money chasing the same deals, so it creates an extra challenge."
In theory, this would cause little worry to CSG, working on strictly asset-based transactions. "We try not to adjust our valuations, try to take a long-term view and not get caught up in short-term fluctuations. There is, however, a band of reasonableness around the value of the collateral that you would like to have given the overall structure of the deal," says Harvey. "A number of deals that we would have liked a while back are just priced too high now. They don't meet our return criteria."
Another area where Beal differs is in its interest in liquidity. "We're a buy and hold shop,"says Harvey, "and won't trade the debt that we acquire. We keep them to maturity." Moreover, the bank is not interested in buying unsecured debt in the hope of eventually ending up as the owner of a company. "We wouldn't go in unsecured, and want a first lien over any collateral. We've done mezzanine level financing, where we're in a second lien position, but we still have a perfected lien over the property. At the end of the day we very much want to own a piece of iron, to foreclose and possess it if necessary."
One area where Beal has been active is in the new rash of Term B secured corporate deals. This is one area where the bank will find itself in the company of the hedge funds. Recent financings for Aquila (see Deal Analysis this issue), Allegheny, Reliant and CentrePoint have relied heavily on the market. Beal has been a participant on CentrePoint, and was the sole provider of a $140 million loan to CMS Energy. This last deal is secured by utility subsidiary Consumers Energy's first mortgage bonds, and gained a Baa3 rating from Moody's.
This loan is close to Beal's limit of $150 million per borrower, one that Harvey says that Beal would be happy to get close to for the right client. Unlike, perhaps, the majority of hedge funds, relationships take on a key role in generating dealflow, "Sometimes you will do a transaction because it gets you involved and gives you a chance to do future business."
The Term B market, one where few corporates like to remain long, could provide a useful entry into longer-term business. Such debt, in the region of 10-12 years, corresponds roughly with outstanding project bonds with substantial remaining life that Beal has bought at a discount. Moreover, it would prefer such bonds not to be callable, at least in the immediate future.
"We will typically want some kind of lock-out period, so that we know that our money will be at work at least for a little while," he says. "Not ten years, but ideally three. But it is a risk you take when you do that and sometimes for a couple more years after that we'll have yield maintenance, so that we get the effect of having the money at work for a few years. We definitely don't get excited about transactions where we're out in under a year." CSG could look at deals such as Aquila, which, although accompanied by stiff prepayment penalties, is callable immediately. But the penalty schedule would need to be very attractive.
The area that is most exciting to players such as CSG is the transmission sector, where attractively-collateralised packages are increasingly on offer. The mix of small start-up companies left holding valuable assets and striving for operational flexibility is a good fit. "We're talking to some of the transmission players that are looking at them, and would love to be involved," says Harvey. The difficulty for a player such as Beal is that the yields would not be attractive enough at issue, and such debt should not trade substantially below par outside of extreme circumstances.
The same principles apply to private equity players that might be looking at buying power plants at a steep discount. Several former power bankers and executives are looking at setting up companies to buy out their former clients or assets. "There are a number of parties out there that will eventually succeed in buying a distressed asset, and we'd be pleased to work with them as a lender. In general, however, it is harder to make a primary financing work given the yields to which Beal is committed. We're looking for the rarer transactions with good quality collateral and better yields."
Moreover, so far, banks involved in project finance have proved reluctant to liquidate their portfolios. While unwilling to go into detail as to the possible reasons why this is the case, Harvey does say, "we haven't seen much secondary market activity in power project debt - less than we might have predicted at this point in time. My sense is that at present many banks are at least delaying decisions, perhaps hoping to ride it out." It suggests that investment banks looking to boost their loan trading desks are not the only ones disappointed with the bunker mentality at project lenders.
Project bonds provide a better source of debt for this distressed asset buyer, despite recent decreases in yields. CSG likes to make an entrance into a market through buying up publicly-traded securities, because, as Harvey puts is "those are things that both give you a handle on market pricing, give you price signals, and also because they're the low-hanging fruit." It has positions in several generation company issues, both corporate and leveraged lease.
Indeed, Harvey still believes in the value of portfolio debt, saying that "a portfolio always gives you the comfort that you can spread risks like unexpected outages. Some of what we're in are portfolios and some are single assets, although we don't have systematic preferences." This thinking is at variance with the attitude of primary lenders, who have suffered among their heaviest losses on portfolio deals.
CSG, however, does have an attitude to deals that favours a merchant type analysis. Here, credit-based principles act as icing, and little more. "We like plants that are fundamental to the market in which they operate, so we have a higher number of coal plants in our portfolio than gas plants," says Harvey. "We like tolling agreements and contracts just fine but we much prefer it if they are in market, or at least close to current market values. We feel like the intrinsic value of the asset lies in its merchant value, and the PPA is credit support, smoothing cashflows and sometimes adding value in its own right."
Harvey's attitude to valuing plants (an important part of his previous role at NRG Energy) rests on three supports. "The first, and most important is location, and also, on a lot of the assets that we particularly like, our gas price assumption is a huge factor. If you're looking at a coal-fired plant, and you happen to believe in a high gas price scenario, then you're going to have a lot of buying opportunities. Then the next critical element, setting aside other issues like environmental and structural due diligence, is to pick a market consultant and really understand how they generate their results."
As with many participants, Harvey agrees that prices went up to unsustainable levels, and that most players were caught off guard. One theory, that several plant announcements made at the height of the power boom were not entirely serious, does not find favour with him, however. "A lot of the bigger sponsors were publicly traded and both wanted to announce and had to announce anything material. I think you got a lot of it, although the privates did not announce. I don't think there was any gaming, there was just tremendous pressure, particularly on the publicly traded companies to maintain high growth rates, show they were a growth stock, get big P/E ratios. To abandon a project was a very hard thing to do."
This exuberance does, however, have one important impact on valuations in the market - the turbine backlog. "Our next challenge in estimating is how many turbines are sitting out there in turbine warehouses that from the view of a project sponsor are already sunk costs. The next round of combined-cycle gas turbines may be built at an incremental cost of $300-350/kW." Recovery, he adds, will be region by region, at any point between 2006 and 2012, according to the data he has seen.
Harvey, like many lenders, does not have a firm blueprint for the sort of market framework that should prevail in the US, but welcomes diversity in offtake arrangements. "I see a strong impetus back towards contracted deals. Most people I talk to are mostly interested in deals with contracts. I think that that's a short-term phenomenon, and going forward I'd like to see a healthy mix. The value of a spot market is you get some transparency and price feedback. When you're going to contract long it's helpful for the financial community that prices bear a reasonable relationship to the market. The contracts that are most troublesome are those that are out of market and those outcomes are problematic."
Nevertheless, the two approaches do work side by side. Farallon, one of the world's largest hedge funds, held on to the 144A bonds issued by the troubled Paiton project in Indonesia, through to a successful restructuring. Those running the process at lead sponsor Edison Mission said that they had relatively positive experiences of dealing with the fund, suggesting that Farallon had bought in at a healthy discount.
Are there players out in the market that are looking to buy in for the long term? While some funds do exist to take up slack in the secondary market, many exist to service distressed sellers, rather than buy up distressed debt. TCW's project fund, for instance, is more interested in solid projects whose lenders need to get out of the project finance business. Beal Bank, however, may be an exception.
Beal Bank is a privately-held wholesale bank devoted largely to secondary market debt, and, while insured by the Federal Deposit Insurance Corporation, shares the central attitude to debt of a hedge fund - buy in low. However, the hot money market appears to have slowed a little, and debt prices are edging up. According to Steven Harvey, senior underwriter at Beal Bank's investment advisory arm, CSG Investments, "it's almost astonishing how much it's been bid up, whether through the activity of hedge funds or money diverted from the stock market. There's a whole lot more money chasing the same deals, so it creates an extra challenge."
In theory, this would cause little worry to CSG, working on strictly asset-based transactions. "We try not to adjust our valuations, try to take a long-term view and not get caught up in short-term fluctuations. There is, however, a band of reasonableness around the value of the collateral that you would like to have given the overall structure of the deal," says Harvey. "A number of deals that we would have liked a while back are just priced too high now. They don't meet our return criteria."
Another area where Beal differs is in its interest in liquidity. "We're a buy and hold shop,"says Harvey, "and won't trade the debt that we acquire. We keep them to maturity." Moreover, the bank is not interested in buying unsecured debt in the hope of eventually ending up as the owner of a company. "We wouldn't go in unsecured, and want a first lien over any collateral. We've done mezzanine level financing, where we're in a second lien position, but we still have a perfected lien over the property. At the end of the day we very much want to own a piece of iron, to foreclose and possess it if necessary."
One area where Beal has been active is in the new rash of Term B secured corporate deals. This is one area where the bank will find itself in the company of the hedge funds. Recent financings for Aquila (see Deal Analysis this issue), Allegheny, Reliant and CentrePoint have relied heavily on the market. Beal has been a participant on CentrePoint, and was the sole provider of a $140 million loan to CMS Energy. This last deal is secured by utility subsidiary Consumers Energy's first mortgage bonds, and gained a Baa3 rating from Moody's.
This loan is close to Beal's limit of $150 million per borrower, one that Harvey says that Beal would be happy to get close to for the right client. Unlike, perhaps, the majority of hedge funds, relationships take on a key role in generating dealflow, "Sometimes you will do a transaction because it gets you involved and gives you a chance to do future business."
The Term B market, one where few corporates like to remain long, could provide a useful entry into longer-term business. Such debt, in the region of 10-12 years, corresponds roughly with outstanding project bonds with substantial remaining life that Beal has bought at a discount. Moreover, it would prefer such bonds not to be callable, at least in the immediate future.
"We will typically want some kind of lock-out period, so that we know that our money will be at work at least for a little while," he says. "Not ten years, but ideally three. But it is a risk you take when you do that and sometimes for a couple more years after that we'll have yield maintenance, so that we get the effect of having the money at work for a few years. We definitely don't get excited about transactions where we're out in under a year." CSG could look at deals such as Aquila, which, although accompanied by stiff prepayment penalties, is callable immediately. But the penalty schedule would need to be very attractive.
The area that is most exciting to players such as CSG is the transmission sector, where attractively-collateralised packages are increasingly on offer. The mix of small start-up companies left holding valuable assets and striving for operational flexibility is a good fit. "We're talking to some of the transmission players that are looking at them, and would love to be involved," says Harvey. The difficulty for a player such as Beal is that the yields would not be attractive enough at issue, and such debt should not trade substantially below par outside of extreme circumstances.
The same principles apply to private equity players that might be looking at buying power plants at a steep discount. Several former power bankers and executives are looking at setting up companies to buy out their former clients or assets. "There are a number of parties out there that will eventually succeed in buying a distressed asset, and we'd be pleased to work with them as a lender. In general, however, it is harder to make a primary financing work given the yields to which Beal is committed. We're looking for the rarer transactions with good quality collateral and better yields."
Moreover, so far, banks involved in project finance have proved reluctant to liquidate their portfolios. While unwilling to go into detail as to the possible reasons why this is the case, Harvey does say, "we haven't seen much secondary market activity in power project debt - less than we might have predicted at this point in time. My sense is that at present many banks are at least delaying decisions, perhaps hoping to ride it out." It suggests that investment banks looking to boost their loan trading desks are not the only ones disappointed with the bunker mentality at project lenders.
Project bonds provide a better source of debt for this distressed asset buyer, despite recent decreases in yields. CSG likes to make an entrance into a market through buying up publicly-traded securities, because, as Harvey puts is "those are things that both give you a handle on market pricing, give you price signals, and also because they're the low-hanging fruit." It has positions in several generation company issues, both corporate and leveraged lease.
Indeed, Harvey still believes in the value of portfolio debt, saying that "a portfolio always gives you the comfort that you can spread risks like unexpected outages. Some of what we're in are portfolios and some are single assets, although we don't have systematic preferences." This thinking is at variance with the attitude of primary lenders, who have suffered among their heaviest losses on portfolio deals.
CSG, however, does have an attitude to deals that favours a merchant type analysis. Here, credit-based principles act as icing, and little more. "We like plants that are fundamental to the market in which they operate, so we have a higher number of coal plants in our portfolio than gas plants," says Harvey. "We like tolling agreements and contracts just fine but we much prefer it if they are in market, or at least close to current market values. We feel like the intrinsic value of the asset lies in its merchant value, and the PPA is credit support, smoothing cashflows and sometimes adding value in its own right."
Harvey's attitude to valuing plants (an important part of his previous role at NRG Energy) rests on three supports. "The first, and most important is location, and also, on a lot of the assets that we particularly like, our gas price assumption is a huge factor. If you're looking at a coal-fired plant, and you happen to believe in a high gas price scenario, then you're going to have a lot of buying opportunities. Then the next critical element, setting aside other issues like environmental and structural due diligence, is to pick a market consultant and really understand how they generate their results."
As with many participants, Harvey agrees that prices went up to unsustainable levels, and that most players were caught off guard. One theory, that several plant announcements made at the height of the power boom were not entirely serious, does not find favour with him, however. "A lot of the bigger sponsors were publicly traded and both wanted to announce and had to announce anything material. I think you got a lot of it, although the privates did not announce. I don't think there was any gaming, there was just tremendous pressure, particularly on the publicly traded companies to maintain high growth rates, show they were a growth stock, get big P/E ratios. To abandon a project was a very hard thing to do."
This exuberance does, however, have one important impact on valuations in the market - the turbine backlog. "Our next challenge in estimating is how many turbines are sitting out there in turbine warehouses that from the view of a project sponsor are already sunk costs. The next round of combined-cycle gas turbines may be built at an incremental cost of $300-350/kW." Recovery, he adds, will be region by region, at any point between 2006 and 2012, according to the data he has seen.
Harvey, like many lenders, does not have a firm blueprint for the sort of market framework that should prevail in the US, but welcomes diversity in offtake arrangements. "I see a strong impetus back towards contracted deals. Most people I talk to are mostly interested in deals with contracts. I think that that's a short-term phenomenon, and going forward I'd like to see a healthy mix. The value of a spot market is you get some transparency and price feedback. When you're going to contract long it's helpful for the financial community that prices bear a reasonable relationship to the market. The contracts that are most troublesome are those that are out of market and those outcomes are problematic."
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