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As creditworthiness among energy companies vulnerable to their
unregulated arms continues to take a thrashing, bankers predictably
tend to put the best face they can on the situation. But they
cannot deny the devastation and admit they are trying everything
possible to limit the damages to their portfolios underneath a
landslide of refinancings and worse. While new utility project
lending is off the agendas of project finance bankers, particularly
if merchant-related, selective lending for transactions that hone
to fundamentals remains feasible ? if few and far between.
?We tend to be more fortunate than others because we're not in every bad deal, we're only in a few,? says Bruno Mejan, head of structured finance at NordLB's New York branch, with a resigned laugh. A ?selective? approach toward energy deals helped, and ?we were not as aggressive as some of our competitors,? Mejan says. Most of the assets in NordLB's portfolio are completed or almost so, unlike projects that have to drum up financing for a plant that's 45% built, Mejan says.
To be sure, the gallows humor that prevails among bankers these days is based more on reality than whimsy. A Standard & Poor's report on the utilities industry dated October 2002 produced by credit analyst Barbara Eiseman says ?the number of companies rated ?A' and above has significantly declined? as the ranks of firms rated ?BBB' have swelled to nearly half of the industry compared with 40% at end-September 2001. Moreover, some 11% of firms in the sector are now rated sub-investment grade (five carrying ?D' ratings) compared with 5% at the end of the 2001 third quarter, the report says.
?This has been a good week because I haven't had a lot of bad news,? says Eric McCartney, Americas head of project finance at Belgium's KBC bank, adding that the challenge is working out the negative data already there. McCartney says he appreciates a day with ?no new bad news?. According to McCartney, his bank will likely be less badly affected than those banks with large pieces of transactions with potential problems.
?Anything outside of power is a blessing,? says McCartney, who says electricity and utility business has dried up and whatever is going on is distinctly atypical in terms of structures; ?people are working out their problems rather than looking at new deals,? he says.
Research from S&P's Eiseman corroborates bankers' harrowing tales. Across the board, utilities that have strayed from ?core competencies? have seen their market capitalizations weaken and their ratings dropped, while companies that stay in their bailiwick and hone to a ?vertically integrated structure? are managing to hold on to ratings in the ?A-' range, the reports adds.
Specific indications of utilities' health woes: dwindling bondholder protection in the face of a sector total debt/cap ratio of nearly 60% at the end of the second quarter against 55% at the end of 1998. In essence, most of the debt increase went into unregulated operations, the report says. Meanwhile, lack of stronger cash flows contributed to a lower FFO/total debt ratio ? down to 16% in June from 21% four years earlier, failing to counterbalance the ?material increase in leverage?. Based on the current trend of key credit quality elements, ?...the median rating for the utility industry may eventually slip out of the high ?BBB? category,? Eiseman says.
Like KBC's McCartney, HVB Global Project Finance managing director (New York) Andrew Mathews thinks the sector has not yet hit bottom and he anticipates negative surprises in energy markets and for banks well into 2003. Mathews sees banks as ?pretty much spooked? amid utility sector bloodletting related to unregulated businesses and points to big-time ?event risk?. Further, McCartney cites substantial regulatory risk that is likely to keep players sidelined on concerns that the FERC could effect changes, particularly with its Standard Market Design proposals, with an unpredictable impact on existing loans.
While NordLB may be less exposed to energy company messes than some of its competitors, Mejan admits that the bank is mulling the prospects of running a couple of plants related to troubled project loans in an attempt to pull off recoveries if lenders foreclose on them. Still, that scenario ?doesn't look very rosy at this particular time,? Mejan adds.
More encouraging is Reliant's Orion Power deal refinancing in regard to several syndicated credit facility extensions, Mejan says. The cooperation and success of syndicate members who managed to approve a three-year extension of a maturing mini-perm shows how refinancings can go right. ?We all felt that was the right kind of solution? allowing time to vet the options and, if need be, extend again. Mejan adds that the value of project assets and sponsor willingness to adjust pricing to market rates are axiomatic for enabling arrangements like this.
Mejan says unsecured deals are now ex-agenda and that the days of corporate lending to BBB- utilities are over. Still, the bank will give due consideration to projects, aside from merchants, with a solid old-fashioned tolling contract or PPA in place. He will bring particular scrutiny to bear on the offtaker as well as on the underlying market for those contracts, given the recent sudden tendency of single-A ratings to morph into sub-investment grades, he adds.
HVB's Mathews also emphasizes a back-to-basics approach in future transactions that focuses on offtake quality and aims to remedy past slackness. Of lessons learned in recent months, he says that lenders major faux pas was doing equity bridge loans that indulged sponsors with latitude to inject equity back-ended on project completion. Despite having corporate guarantees on these arrangements, ?where we have money at risk right now, this is the prime reason,? Mathews says.
The decline of power prices and concomitant deterioration in asset values mean that a project's equity ? whether past, future, guaranteed or otherwise ? now has zero value, according to Mathews. Hence, the proliferation of abandoned project construction by NRG, NEG and the like, he adds.
In hindsight, Mathews says structuring with front-end equity would have enhanced prospects for completion given lenders' preference for a built plant over an unfinished one. In addition, despite current conditions, a merchant-type structure with 40% equity would have helped preserve interest payments. As project finance lenders are more prone to restructure debt than other lenders, providing, say, interest-only for 2-3 years and then vetting ?whether to sell the assets or reschedule again to amortise principal,? a project's survival might hinge on up-front equity, he adds.
Being a day late and a dollar short amid lost opportunity can make a banker consider adjusting a strategy. With the prospects of substantial losses as a result of its flawed equity approach, a bank will insist on up-front or pro rata equity going forward, and only with top sponsors in tandem with fully contracted offtake or a fuel-matching agreement, Mathews says.
One seasoned player emphasizes the significance of increased equity participation. The non-recourse project financing of the 1,250MW, combined-cycle Tenaska plant in Oklahoma and its long-term PPA with Shell affiliate Coral Energy illustrates what not to do under current conditions, he says. ?If there's an economic hiccup, you don't have anything except your own loan? because the sponsors didn't put sufficient equity into the project, he adds. He sees sponsor equity in the range of 20-25% as a minimum for such an undertaking.
Still others suggest that they wouldn't touch a deal with 100% upfront debt and would spurn any deal with less than 12% equity. ?It's just not going to work for me, regardless of the strength of the PPA? even with Shell/Coral contracted for the production, is the verdict of one. Nor do high levels of sponsor equity alone provide a panacea.
Even with a strong PPA and a bank's willingness to provide 15-year financing, it is reasonable to ask who is going to provide the counterparty guarantee to justify going out that far. One answer to that conundrum could be monoline insurers that may be willing to ?play in the space? and upgrade BBB or BBB+ credits to AAA through wraps to enable a long-term market for bonds or banks.
Mejan at NordLB has examined this possibility, and says ?it's a pricing trade-off and we'd be very happy to participate as a lender in those securities?. He would consider buying those instruments in lieu of lending and considers the approach to be a feasible option for refinancing mini-perms.
While refinancing composes the locus of much utility sector discussion, Mathews actually doubts whether the need to refinance existing energy company debt is really that critical. The typical structures are 2-year construction loans and 5-year term loans mostly with construction winding up or finished in the last 12 months, so most are in the term-out phase that lasts 4-5 years, he says. While no developer wants to wait too long, its ?not like they need to [refinance] today or even next year?. While it's wise to consider methods and refinancing options ahead of time, most sponsors can afford to wait, vet market sentiment and see how the whole thing plays out before they force the issue, according to Mathews.
Still, limitations on the refinancing of energy debt should prompt diverse and creative approaches by HVB and other lenders. Matthews notes that with sponsors' access to debt capital markets essentially dried up and original plans to take out mini-perms with public bond issues unfeasible, his bank is looking at private debt placements. Matthews thinks the market has an appetite for the right credit structure to enable putting long-term fixed rate energy firm debt from an individual asset in the private institutional market.
Further, Mathews thinks bank markets will eventually reopen, at which point better deals will get refinanced, albeit not necessarily long-term. ?I have no problem rolling over a mini-perm for another 5-7 years for a good credit ? restructure the deal and do mark-to-market pricing on it ? he says. Mathews admits that for some restructurings he may have no choice other than rolling them over.
In addition, mergers and acquisitions should play a key role, with precedent already evident in the form of multi-billion-dollar German utility group Eon entering European markets and its acquisition of UK power producer Powergen. Mathews expects the big European utility players to move into the US market to acquire assets and bolster portfolios. ?Not that I have any early signs of it, but they're smart players who can value assets as well as anybody,? he adds.
Not to ignore refinancing arcana, Mathews asserts that a few ?sophisticated lenders will look at the tail end of a loan? where there's a contract to buy down the debt and then on expiration there will be a 2-3 year ?merchant tail? but with meager amounts of debt on the project at that level so it can withstand volatility in the merchant market. But in general, Mathews says the sense among lenders is ?
?We tend to be more fortunate than others because we're not in every bad deal, we're only in a few,? says Bruno Mejan, head of structured finance at NordLB's New York branch, with a resigned laugh. A ?selective? approach toward energy deals helped, and ?we were not as aggressive as some of our competitors,? Mejan says. Most of the assets in NordLB's portfolio are completed or almost so, unlike projects that have to drum up financing for a plant that's 45% built, Mejan says.
To be sure, the gallows humor that prevails among bankers these days is based more on reality than whimsy. A Standard & Poor's report on the utilities industry dated October 2002 produced by credit analyst Barbara Eiseman says ?the number of companies rated ?A' and above has significantly declined? as the ranks of firms rated ?BBB' have swelled to nearly half of the industry compared with 40% at end-September 2001. Moreover, some 11% of firms in the sector are now rated sub-investment grade (five carrying ?D' ratings) compared with 5% at the end of the 2001 third quarter, the report says.
?This has been a good week because I haven't had a lot of bad news,? says Eric McCartney, Americas head of project finance at Belgium's KBC bank, adding that the challenge is working out the negative data already there. McCartney says he appreciates a day with ?no new bad news?. According to McCartney, his bank will likely be less badly affected than those banks with large pieces of transactions with potential problems.
?Anything outside of power is a blessing,? says McCartney, who says electricity and utility business has dried up and whatever is going on is distinctly atypical in terms of structures; ?people are working out their problems rather than looking at new deals,? he says.
Research from S&P's Eiseman corroborates bankers' harrowing tales. Across the board, utilities that have strayed from ?core competencies? have seen their market capitalizations weaken and their ratings dropped, while companies that stay in their bailiwick and hone to a ?vertically integrated structure? are managing to hold on to ratings in the ?A-' range, the reports adds.
Specific indications of utilities' health woes: dwindling bondholder protection in the face of a sector total debt/cap ratio of nearly 60% at the end of the second quarter against 55% at the end of 1998. In essence, most of the debt increase went into unregulated operations, the report says. Meanwhile, lack of stronger cash flows contributed to a lower FFO/total debt ratio ? down to 16% in June from 21% four years earlier, failing to counterbalance the ?material increase in leverage?. Based on the current trend of key credit quality elements, ?...the median rating for the utility industry may eventually slip out of the high ?BBB? category,? Eiseman says.
Like KBC's McCartney, HVB Global Project Finance managing director (New York) Andrew Mathews thinks the sector has not yet hit bottom and he anticipates negative surprises in energy markets and for banks well into 2003. Mathews sees banks as ?pretty much spooked? amid utility sector bloodletting related to unregulated businesses and points to big-time ?event risk?. Further, McCartney cites substantial regulatory risk that is likely to keep players sidelined on concerns that the FERC could effect changes, particularly with its Standard Market Design proposals, with an unpredictable impact on existing loans.
While NordLB may be less exposed to energy company messes than some of its competitors, Mejan admits that the bank is mulling the prospects of running a couple of plants related to troubled project loans in an attempt to pull off recoveries if lenders foreclose on them. Still, that scenario ?doesn't look very rosy at this particular time,? Mejan adds.
More encouraging is Reliant's Orion Power deal refinancing in regard to several syndicated credit facility extensions, Mejan says. The cooperation and success of syndicate members who managed to approve a three-year extension of a maturing mini-perm shows how refinancings can go right. ?We all felt that was the right kind of solution? allowing time to vet the options and, if need be, extend again. Mejan adds that the value of project assets and sponsor willingness to adjust pricing to market rates are axiomatic for enabling arrangements like this.
Mejan says unsecured deals are now ex-agenda and that the days of corporate lending to BBB- utilities are over. Still, the bank will give due consideration to projects, aside from merchants, with a solid old-fashioned tolling contract or PPA in place. He will bring particular scrutiny to bear on the offtaker as well as on the underlying market for those contracts, given the recent sudden tendency of single-A ratings to morph into sub-investment grades, he adds.
HVB's Mathews also emphasizes a back-to-basics approach in future transactions that focuses on offtake quality and aims to remedy past slackness. Of lessons learned in recent months, he says that lenders major faux pas was doing equity bridge loans that indulged sponsors with latitude to inject equity back-ended on project completion. Despite having corporate guarantees on these arrangements, ?where we have money at risk right now, this is the prime reason,? Mathews says.
The decline of power prices and concomitant deterioration in asset values mean that a project's equity ? whether past, future, guaranteed or otherwise ? now has zero value, according to Mathews. Hence, the proliferation of abandoned project construction by NRG, NEG and the like, he adds.
In hindsight, Mathews says structuring with front-end equity would have enhanced prospects for completion given lenders' preference for a built plant over an unfinished one. In addition, despite current conditions, a merchant-type structure with 40% equity would have helped preserve interest payments. As project finance lenders are more prone to restructure debt than other lenders, providing, say, interest-only for 2-3 years and then vetting ?whether to sell the assets or reschedule again to amortise principal,? a project's survival might hinge on up-front equity, he adds.
Being a day late and a dollar short amid lost opportunity can make a banker consider adjusting a strategy. With the prospects of substantial losses as a result of its flawed equity approach, a bank will insist on up-front or pro rata equity going forward, and only with top sponsors in tandem with fully contracted offtake or a fuel-matching agreement, Mathews says.
One seasoned player emphasizes the significance of increased equity participation. The non-recourse project financing of the 1,250MW, combined-cycle Tenaska plant in Oklahoma and its long-term PPA with Shell affiliate Coral Energy illustrates what not to do under current conditions, he says. ?If there's an economic hiccup, you don't have anything except your own loan? because the sponsors didn't put sufficient equity into the project, he adds. He sees sponsor equity in the range of 20-25% as a minimum for such an undertaking.
Still others suggest that they wouldn't touch a deal with 100% upfront debt and would spurn any deal with less than 12% equity. ?It's just not going to work for me, regardless of the strength of the PPA? even with Shell/Coral contracted for the production, is the verdict of one. Nor do high levels of sponsor equity alone provide a panacea.
Even with a strong PPA and a bank's willingness to provide 15-year financing, it is reasonable to ask who is going to provide the counterparty guarantee to justify going out that far. One answer to that conundrum could be monoline insurers that may be willing to ?play in the space? and upgrade BBB or BBB+ credits to AAA through wraps to enable a long-term market for bonds or banks.
Mejan at NordLB has examined this possibility, and says ?it's a pricing trade-off and we'd be very happy to participate as a lender in those securities?. He would consider buying those instruments in lieu of lending and considers the approach to be a feasible option for refinancing mini-perms.
While refinancing composes the locus of much utility sector discussion, Mathews actually doubts whether the need to refinance existing energy company debt is really that critical. The typical structures are 2-year construction loans and 5-year term loans mostly with construction winding up or finished in the last 12 months, so most are in the term-out phase that lasts 4-5 years, he says. While no developer wants to wait too long, its ?not like they need to [refinance] today or even next year?. While it's wise to consider methods and refinancing options ahead of time, most sponsors can afford to wait, vet market sentiment and see how the whole thing plays out before they force the issue, according to Mathews.
Still, limitations on the refinancing of energy debt should prompt diverse and creative approaches by HVB and other lenders. Matthews notes that with sponsors' access to debt capital markets essentially dried up and original plans to take out mini-perms with public bond issues unfeasible, his bank is looking at private debt placements. Matthews thinks the market has an appetite for the right credit structure to enable putting long-term fixed rate energy firm debt from an individual asset in the private institutional market.
Further, Mathews thinks bank markets will eventually reopen, at which point better deals will get refinanced, albeit not necessarily long-term. ?I have no problem rolling over a mini-perm for another 5-7 years for a good credit ? restructure the deal and do mark-to-market pricing on it ? he says. Mathews admits that for some restructurings he may have no choice other than rolling them over.
In addition, mergers and acquisitions should play a key role, with precedent already evident in the form of multi-billion-dollar German utility group Eon entering European markets and its acquisition of UK power producer Powergen. Mathews expects the big European utility players to move into the US market to acquire assets and bolster portfolios. ?Not that I have any early signs of it, but they're smart players who can value assets as well as anybody,? he adds.
Not to ignore refinancing arcana, Mathews asserts that a few ?sophisticated lenders will look at the tail end of a loan? where there's a contract to buy down the debt and then on expiration there will be a 2-3 year ?merchant tail? but with meager amounts of debt on the project at that level so it can withstand volatility in the merchant market. But in general, Mathews says the sense among lenders is ?
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