Whose market is it anyway?
The number and volume of jumbo US power deals hovering on the edge
of the market is staggering. Tractebel, Mirant, American National
Power, Enron, Sithe Energies, NRG, PSEG and TECO/Panda Energy all
have large portfolio deals near to, or in, the market.
The most prominent players without immediate plans to bring a massive hybrid copororate/project facility to the market ? Duke, Reliant and Calpine ? made significant raids in 2000.
The two orthodoxies of the US power market are that integrated players will be the major winners from the staggered deregulation lurching across the country, and that their enormous capital needs demand creative thinking on the part of bankers. This is a major feature of the reorganisations that have hit several of the top-tier project finance banks. Dresdner Kleinwort Wasserstein, Bank of America and JP Morgan Chase have all reorganised themselves into all-encompassing sectorial banks ? and several familiar faces have disappeared to private equity arms, relationship offices, or into the arms of publicly-held banks or captive finance arms, all of whom are on hiring spree right now.
Some of this turmoil has been positive, avoiding conflicting mandate pitches from different divisions and bringing members of niche financing departments (for instance leasing departments) into closer convergence with bank strategy and client needs. Sponsors have several times made clear their preference for an integrated bank response ? Calpine for one has gone on the record with its frustration at overbearing project financiers.
Calpine's success may be one reason for the growing proliferation of similar jumbo facilities, as well as the chilly reception that some of them have received. Calpine's chief significance was its enthusiastic take-up by non-US investors which has convinced arranging banks that similar facilities will garner an equally avid following. The bottom tier in syndication for the $2.5 billion Calpine Construction Finance II consisted of Bank of Montreal, Landesbank Schleswig Holstein, Berliner Bank, LBS Bank, Landesbank Sachsen, Erste Bank, Arab Banking Corporation, Chang Hwa, BCI, RLB, Farmers China, Siemens and IKB DIB. Do such Asian and German institutions as these have the appetite for more US power paper?
Calpine CFC II is a story of a sponsor growing in financial strength and moving away from the structures that are best suited to undercapitalised developers. It has managed to have some of the burdensome covenants that featured in the first Construction Finance deal loosened, and indeed has been trying to apply them to its predecessor. At least part of its success has been in maintaining a comforting financial profile with timely and frequent holding company fundraising exercises. In any event, Calpine's appeal to stock market investors has been one of looking at earnings rather than leverage when taking a punt.
It has been just under two years since the appearance of the construction revolver, and imitators have been slow to come forward. The process of finding a successor will have been lifted by the demonstrable success that Calpine has had in raising holding company debt and equity to retire ?project?-level debt. Credit Suisse First Boston and Scotia Capital, the prime movers in the structure's development, are close to getting additional clients interested.
The nearest two are the NRG Energy deal and a number of construction finance facilities prepared for Tractebel, both in the hands of CSFB. The NRG deal looks like the closest to coming to market, and clocks in at a hefty $2.5 billion. Initial reports had placed the size at nearer $1.5 billion ? but the sponsor has decided to supersize its plans as a result of a number of acquisition announcements, including that of LS Power. This decision is causing something of headache at several participant banks.
Two main criticisms have been levelled at the NRG deal, the first of which essentially boils down to the mechanics of syndication.
According to one source pitched on the deal, the arranger is looking for commitments of $200 million from co-arrangers and an eventual hold position of $75 million. The source adds ?there are very few corporates that I love enough to hold $75 million of their paper on my books?. Given the sluggish and illiquid state of the secondary market in project loans, only the banks with the deepest pockets can afford to join in.
The NRG revolver has already reportedly seen an upward tweak in its pricing, which was based upon a positive view of the credit of the parent. NRG Energy is currently rated at Baa3 by Moody's Investors Service (Calpine has not yet quite made it to investment grade, standing at Ba1), and believes that it can get more leeway over how it manages the projects within its portfolio. At least one participant bank has suggested that a sponsor better known for its acquisition activity might have a hard time persuading the banks that its development processes were up to a revolver of such a corporate nature.
Nevertheless, ambitious sponsors and arrangers can be forgiven for finding themselves in such a credit crunch ? a major part of this hard-nosed approach can be put down to the fact that participants can be far more choosy.
Relationship pull becomes less important further down, and California has led to credit committees frantically rushing to re-evaluate their exposure levels and try to factor in, or make more prominent, some sort of market risk analysis. Some of the genco financings have put a greater emphasis on the marketing abilities of corporate energy trading arms, and test out various scenarios based on developments in diverse and discrete markets.
Although most banks now have the capacity to analyse these changes, the debt market has failed to follow the equity market in the flight to quality that the energy companies represent. Since there is much less willingness on the part of sponsors to pay up for the long-term contracts and performance guarantees that would gain a decent tenor, and with the uncertainty of deregulation (now an intensely political process) biting in several markets neither side wants to go out further.
In this respect the mini-perm has come into its own, and its true purpose is now revealed. Much like the synthetic lease, the mini-perm has a loose antecedent in the real estate industry, where loans of this length were typically used in periods of extreme interest rate uncertainty. The power finance community has claimed several benefits for the structure, including the ability to refinance in the bond market as and when these become opportune, and its critics have noted that the mini-perm is as far as the financiers want to commit their capital.
As Jay Worenklein, SG's global project finance head notes, ?Mini-perms are a response to the banks' appetite for shorter-term deals, based in large part on RAROC (return on risk adjusted capital) models the banks have put into place to determine their ?real' returns on capital, which penalize longer maturities.
They also reflect the desire to re-examine the economic performance of merchant facilities at a relatively early stage after completion, rather than being locked in for long periods.?
In its new regulations on how banks account for assets, the Basel Accord has reached into yet another corner of the power lending business.
Creating liquidity
A vibrant secondary loan market would open things up, but needs to be accompanied by some form of ratings process to allow participants and buyers to set their capital treatment properly. Some of the larger deals, in particular AES' Drax transaction in the UK, have used a bank loan rating to deal with a genuinely shallow primary loan market in a particular currency. However, the need for disclosure and the fees associated with the process mean that loan rating will take off more and more only when sponsors lose faith in the syndication abilities of the banks.
Portfolio facilities offer some comfort, provided that they are not accompanied by burdensome hold requirements. Bruno Mejean, senior vice-president in structured finance at NordLB, says that ?in this environment people are more interested in portfolio facilities, typically coming in with a reasonably high level of equity, in the 35% range. Where people get worried is in terms of concentration of assets by area, particularly in Nepool and Ercot, and in where sponsors ask for too much in terms of flexibility of operation. In the aftermath of the California energy debacle, banks are less and less tolerant of aggressive structures and more difficult syndications are proof of that?.
Mejean has noted the trend in pricing ? upwards. ?What we've seen of late is pricing firming up, not so much because of a more risky profile, but simply because of how these assets are priced relative to project bonds and leveraged loans. Of course, the California crisis has helped this trend. Without an explicit investment grade rating, under Basel II these assets will probably attract a higher capital treatment, so participant banks have decided to be more selective?.
This premium will probably increase liquidity in the long term, since it will persuade UK and other mortgage banks that the returns in US power are still there. Another bright spot, for the fortunate few sponsors, is that focussed second-tier banks will look for arranging opportunities with the small number of sponsors that their teams can handle. KBC has already had some success in this regard, with Dexia and NordLB hoping to follow. Asking for high hold positions may work in these cases, though rarely. ?Even the toughest of these guys wants to be in on the next headline deal, so they have to be able to churn commitments?, explains one banker with an Asian institution not in the market for arranging roles.
Most are sympathetic with the sponsors' wishes for greater operational flexibility, and whilst tolling agreements are attractive, the long-term PPA is seen as the near-exclusive preserve of the undercapitalised, often privately-held, developer. Sponsors who believe that a guarantee from a captive marketing arm will suffice as a form of corporate recourse will also be penalised on the pricing. Lenders have started to express a reluctance to put too much faith in agreements with marketing arms below the A- creditworthiness level. This has ugly ramifications for energy groups whose spun-off unregulated subsidiaries rarely reach this level.
The best prospects for market liquidity may come from what some players see as a long-overdue pricing correction. If pricing keeps inching up, then the institutional investors, who have not yet reached the potential they have offered for the last few years, could start talking to sponsors more regularly.
Worenklein at SG says that the impact of the instiutions has so far been limited because, ?at the moment few US-based banks are prepared to hold long-dated project paper (such as the classic 17-18 year maturities), and for US deals, the practical limit of the bank market for such deals is probably in the $250 million area. Institutional debt from insurance companies and other such players is an important source of long-term financing, but the amount of capital available for projects is also limited?. This comes from a bank that placed several deals, including RS Cogen and Oxy Taft, to long-dated investors in 2000.
Some of the more seasoned investors ? Teachers, Allstate, John Hancock and Travellers ? have tentatively returned to the market since the mid-90s to find the landscape drastically changed. Of the institutions, only MetLife has shown any interest in encroaching upon tenors typically offered by banks. The payment flexibility offered by banks is also unlikely to be forthcoming ? with sponsors locked into long-term amortization schedules and with hefty penalties for prepayment if interest rates drop substantially. The variable volume of business going through project funds, many of which have seen themselves turn into repositories for lease debt and other corporate deals, is another manifestation of this trend.
The best way to raise a laugh from the increasingly harassed participant banks is to ask them how many of the deals mentioned above will make it to close over the next three months. Some deals, like the Sithe and American National Power deals, are suffering from other, exogenous factors. Sithe is having to clear up the mess caused by the near-bankruptcy of its contractor, Washington Group, and ANP is suffering from tightened exposure levels for the troubled Alstom turbines that it plans to install in Texas.
Sithe waits for a resolution of legal proceedings and ANP hopes that a pricing tweak and a positive story from the sponsor with restart its syndication.
A lot of the debt will disappear into conduits and short-term bridge loans, which would require a far lower market presence. Cinergy is waiting for the completion of what it says will be a unique and accounting-geared facility and has taken out a bridge for the purpose. These sub-one-year deals may also fall victim to changing capital treatment rules, but until a better convergence of interest is forged in the US power market, sponsors should grow increasingly accustomed to such fixes.
EPC contractions also causing problems...
Two power deals ? one of which closed last year and one which is in syndication ? could be victims of an unseemly row and litigation between one of the US' larger contractors and the firm from which it bought much of its business. At stake is the reliance placed by lenders on contracts with firms which are enjoying booming order books but ever-decreasing margins on power plant deals. The two deals ? Sithe Boston and AES Red Oak ? have different exposure levels but critical milestones depending on the situation's outcomeThe business of contracting has been slightly declining in importance recently, as part of the recent drift in the balance of power towards. Many sponsors are taking over a larger share of the development process, including Calpine, which now regularly centralises parts and turbines for speedy installation of power plants. At the same time the usual power balance of project finance have been turned on its head as integrated energy and generation companies see their market capitalisations swell.
In the past, a sponsor had far less leverage when dealing with the contractor. James O'Brien, partner at Baker & McKenzie, recently examined the changing nature of the Engineering Procurement and Construction (EPC) contract. He noted that: ?Single asset project financings by under-capitalized sponsors needed lump sum EPC Contracts. Large, creditworthy EPC contractors stepped in to take the risk of construction delay, performance and cost overruns because the sponsor's completion guarantee was not enough. Sponsors paid a 10% to 20% premium over the estimated construction costs, but investors demanded coverage for the construction risk.
Now, the sponsor is almost always larger and more creditworthy than the contractor, and lump sum EPC contracts are not used as often.
Instead, the sponsor purchases the combustion turbine generators, heat recovery steam generators, and steam turbine generators directly from one or more vendors. Even the engineering and balance of plant procurement may come in to the project directly and not through the construction contract?.
These trends have been amply demonstrated by events at some of the contracting firms.
Whilst some, such as Black & Veatch, have managed to maintain a healthy order backlog, several in the industry have experienced a very volatile operating environment. Foster Wheeler has seen its share price buffeted and has been forced to make strenuous efforts to shore up its finances. Stone & Webster went bankrupt and was acquired by the shore group at auction.
The most recent rumbling concerns Washington Group's acquisition of Raytheon Engineers & Constructors, after the latter's parent decided to focus more on its defence-related activities. Washington bought Raytheon Engineers & Constructors in July 2000 for $53 million plus $450 million in assumed liability. Washington Group has estimated its liabilities from the Raytheon unit to rise by $400 million to as much as $700 million above original estimates, and it wants a revision to the price to be paid. Meanwhile, Raytheon has said it doesn't believe a ?material? adjustment to the purchase price is required.
Washington's financial situation is now looking distinctly sickly, and management says that it will delay filing its annual report until it can resolve its current liquidity crunch. It says that its business, apart from the Raytheon contracts, is strong, and that Raytheon misrepresented the condition of two contracts for Sithe Energies for plants in Massachusetts. The two power plants covered by contract are a 1600M gas-fired plant in Everett, with a contract worth roughly $700 million, whilst the second is an 800MW gas-fired plant in North Weymouth whose contract is worth around $411 million. Both plants were scheduled to be completed in the spring of 2002. The Everett plant is billed as the largest merchant power plant currently under construction in the US.
Washington stopped work on the plants on 8 March, and a week later its contracts with Sithe were terminated. The terms of the sale to Washington carries a performance guarantee from Raytheon (few sponsors like changing horses mid-project), which has now been called upon. Sithe forced Raytheon to carry out the work in a New York court ruling: since it does not have any of the right engineers on its payroll, Duke/Fluor Daniel has been hired to finish the job.
It is possible that Raytheon will be able to in turn sue Washington Group to recover some of the money it has spent. It plans, however, to take a charge of $275-325 million to cover the costs of completing the plants. Standard industry practice for contractors that take over projects half way through is to complete them on a cost plus basis.
Washington is also working on the AES Red Oak deal, which was funded in March 2000 via a $384 million bond issue managed by Lehman Brothers. Work on the plant, located at Sayreville, New Jersey, is 52% complete and is still on schedule. Moreover, Raytheon backs Washington's obligations, the contract is prepaid and the contractor is backed by a letter of credit provided by Bank of America.
However, Standard & Poor's has placed the bonds on Creditwatch, because it believes that further litigation could delay construction.
If this were to happen then it is conceivable that the plant could miss its acceptance date, and thus be in breach of its tolling agreement with Williams Energy Marketing & Trading. It is unlikely that Williams would want to repudiate the deal, especially after it has agreed a large energy services contract with Allegheny Energy. It simply means that AES will have to move fast if work on the Red Oak is contaminated by troubles elsewhere.
It is a sign of how little sponsors have come to expect of contractors that AES has not been seriously perturbed by the incident. What appears more probable is that further consolidation within the industry is likely, although Washington itself was formed by the combination of Raytheon and Morrison Knudsen.
Meanwhile further syndication on Sithe Boston, a $1.25 billion deal led by Credit Suisse First Boston and BNP Paribas, has been shelved. The deal would have been an interesting addition to the slew of portfolio deals close to market, but will probably not see the retail stage of syndication for some months.
The most prominent players without immediate plans to bring a massive hybrid copororate/project facility to the market ? Duke, Reliant and Calpine ? made significant raids in 2000.
The two orthodoxies of the US power market are that integrated players will be the major winners from the staggered deregulation lurching across the country, and that their enormous capital needs demand creative thinking on the part of bankers. This is a major feature of the reorganisations that have hit several of the top-tier project finance banks. Dresdner Kleinwort Wasserstein, Bank of America and JP Morgan Chase have all reorganised themselves into all-encompassing sectorial banks ? and several familiar faces have disappeared to private equity arms, relationship offices, or into the arms of publicly-held banks or captive finance arms, all of whom are on hiring spree right now.
Some of this turmoil has been positive, avoiding conflicting mandate pitches from different divisions and bringing members of niche financing departments (for instance leasing departments) into closer convergence with bank strategy and client needs. Sponsors have several times made clear their preference for an integrated bank response ? Calpine for one has gone on the record with its frustration at overbearing project financiers.
Calpine's success may be one reason for the growing proliferation of similar jumbo facilities, as well as the chilly reception that some of them have received. Calpine's chief significance was its enthusiastic take-up by non-US investors which has convinced arranging banks that similar facilities will garner an equally avid following. The bottom tier in syndication for the $2.5 billion Calpine Construction Finance II consisted of Bank of Montreal, Landesbank Schleswig Holstein, Berliner Bank, LBS Bank, Landesbank Sachsen, Erste Bank, Arab Banking Corporation, Chang Hwa, BCI, RLB, Farmers China, Siemens and IKB DIB. Do such Asian and German institutions as these have the appetite for more US power paper?
Calpine CFC II is a story of a sponsor growing in financial strength and moving away from the structures that are best suited to undercapitalised developers. It has managed to have some of the burdensome covenants that featured in the first Construction Finance deal loosened, and indeed has been trying to apply them to its predecessor. At least part of its success has been in maintaining a comforting financial profile with timely and frequent holding company fundraising exercises. In any event, Calpine's appeal to stock market investors has been one of looking at earnings rather than leverage when taking a punt.
It has been just under two years since the appearance of the construction revolver, and imitators have been slow to come forward. The process of finding a successor will have been lifted by the demonstrable success that Calpine has had in raising holding company debt and equity to retire ?project?-level debt. Credit Suisse First Boston and Scotia Capital, the prime movers in the structure's development, are close to getting additional clients interested.
The nearest two are the NRG Energy deal and a number of construction finance facilities prepared for Tractebel, both in the hands of CSFB. The NRG deal looks like the closest to coming to market, and clocks in at a hefty $2.5 billion. Initial reports had placed the size at nearer $1.5 billion ? but the sponsor has decided to supersize its plans as a result of a number of acquisition announcements, including that of LS Power. This decision is causing something of headache at several participant banks.
Two main criticisms have been levelled at the NRG deal, the first of which essentially boils down to the mechanics of syndication.
According to one source pitched on the deal, the arranger is looking for commitments of $200 million from co-arrangers and an eventual hold position of $75 million. The source adds ?there are very few corporates that I love enough to hold $75 million of their paper on my books?. Given the sluggish and illiquid state of the secondary market in project loans, only the banks with the deepest pockets can afford to join in.
The NRG revolver has already reportedly seen an upward tweak in its pricing, which was based upon a positive view of the credit of the parent. NRG Energy is currently rated at Baa3 by Moody's Investors Service (Calpine has not yet quite made it to investment grade, standing at Ba1), and believes that it can get more leeway over how it manages the projects within its portfolio. At least one participant bank has suggested that a sponsor better known for its acquisition activity might have a hard time persuading the banks that its development processes were up to a revolver of such a corporate nature.
Nevertheless, ambitious sponsors and arrangers can be forgiven for finding themselves in such a credit crunch ? a major part of this hard-nosed approach can be put down to the fact that participants can be far more choosy.
Relationship pull becomes less important further down, and California has led to credit committees frantically rushing to re-evaluate their exposure levels and try to factor in, or make more prominent, some sort of market risk analysis. Some of the genco financings have put a greater emphasis on the marketing abilities of corporate energy trading arms, and test out various scenarios based on developments in diverse and discrete markets.
Although most banks now have the capacity to analyse these changes, the debt market has failed to follow the equity market in the flight to quality that the energy companies represent. Since there is much less willingness on the part of sponsors to pay up for the long-term contracts and performance guarantees that would gain a decent tenor, and with the uncertainty of deregulation (now an intensely political process) biting in several markets neither side wants to go out further.
In this respect the mini-perm has come into its own, and its true purpose is now revealed. Much like the synthetic lease, the mini-perm has a loose antecedent in the real estate industry, where loans of this length were typically used in periods of extreme interest rate uncertainty. The power finance community has claimed several benefits for the structure, including the ability to refinance in the bond market as and when these become opportune, and its critics have noted that the mini-perm is as far as the financiers want to commit their capital.
As Jay Worenklein, SG's global project finance head notes, ?Mini-perms are a response to the banks' appetite for shorter-term deals, based in large part on RAROC (return on risk adjusted capital) models the banks have put into place to determine their ?real' returns on capital, which penalize longer maturities.
They also reflect the desire to re-examine the economic performance of merchant facilities at a relatively early stage after completion, rather than being locked in for long periods.?
In its new regulations on how banks account for assets, the Basel Accord has reached into yet another corner of the power lending business.
Creating liquidity
A vibrant secondary loan market would open things up, but needs to be accompanied by some form of ratings process to allow participants and buyers to set their capital treatment properly. Some of the larger deals, in particular AES' Drax transaction in the UK, have used a bank loan rating to deal with a genuinely shallow primary loan market in a particular currency. However, the need for disclosure and the fees associated with the process mean that loan rating will take off more and more only when sponsors lose faith in the syndication abilities of the banks.
Portfolio facilities offer some comfort, provided that they are not accompanied by burdensome hold requirements. Bruno Mejean, senior vice-president in structured finance at NordLB, says that ?in this environment people are more interested in portfolio facilities, typically coming in with a reasonably high level of equity, in the 35% range. Where people get worried is in terms of concentration of assets by area, particularly in Nepool and Ercot, and in where sponsors ask for too much in terms of flexibility of operation. In the aftermath of the California energy debacle, banks are less and less tolerant of aggressive structures and more difficult syndications are proof of that?.
Mejean has noted the trend in pricing ? upwards. ?What we've seen of late is pricing firming up, not so much because of a more risky profile, but simply because of how these assets are priced relative to project bonds and leveraged loans. Of course, the California crisis has helped this trend. Without an explicit investment grade rating, under Basel II these assets will probably attract a higher capital treatment, so participant banks have decided to be more selective?.
This premium will probably increase liquidity in the long term, since it will persuade UK and other mortgage banks that the returns in US power are still there. Another bright spot, for the fortunate few sponsors, is that focussed second-tier banks will look for arranging opportunities with the small number of sponsors that their teams can handle. KBC has already had some success in this regard, with Dexia and NordLB hoping to follow. Asking for high hold positions may work in these cases, though rarely. ?Even the toughest of these guys wants to be in on the next headline deal, so they have to be able to churn commitments?, explains one banker with an Asian institution not in the market for arranging roles.
Most are sympathetic with the sponsors' wishes for greater operational flexibility, and whilst tolling agreements are attractive, the long-term PPA is seen as the near-exclusive preserve of the undercapitalised, often privately-held, developer. Sponsors who believe that a guarantee from a captive marketing arm will suffice as a form of corporate recourse will also be penalised on the pricing. Lenders have started to express a reluctance to put too much faith in agreements with marketing arms below the A- creditworthiness level. This has ugly ramifications for energy groups whose spun-off unregulated subsidiaries rarely reach this level.
The best prospects for market liquidity may come from what some players see as a long-overdue pricing correction. If pricing keeps inching up, then the institutional investors, who have not yet reached the potential they have offered for the last few years, could start talking to sponsors more regularly.
Worenklein at SG says that the impact of the instiutions has so far been limited because, ?at the moment few US-based banks are prepared to hold long-dated project paper (such as the classic 17-18 year maturities), and for US deals, the practical limit of the bank market for such deals is probably in the $250 million area. Institutional debt from insurance companies and other such players is an important source of long-term financing, but the amount of capital available for projects is also limited?. This comes from a bank that placed several deals, including RS Cogen and Oxy Taft, to long-dated investors in 2000.
Some of the more seasoned investors ? Teachers, Allstate, John Hancock and Travellers ? have tentatively returned to the market since the mid-90s to find the landscape drastically changed. Of the institutions, only MetLife has shown any interest in encroaching upon tenors typically offered by banks. The payment flexibility offered by banks is also unlikely to be forthcoming ? with sponsors locked into long-term amortization schedules and with hefty penalties for prepayment if interest rates drop substantially. The variable volume of business going through project funds, many of which have seen themselves turn into repositories for lease debt and other corporate deals, is another manifestation of this trend.
The best way to raise a laugh from the increasingly harassed participant banks is to ask them how many of the deals mentioned above will make it to close over the next three months. Some deals, like the Sithe and American National Power deals, are suffering from other, exogenous factors. Sithe is having to clear up the mess caused by the near-bankruptcy of its contractor, Washington Group, and ANP is suffering from tightened exposure levels for the troubled Alstom turbines that it plans to install in Texas.
Sithe waits for a resolution of legal proceedings and ANP hopes that a pricing tweak and a positive story from the sponsor with restart its syndication.
A lot of the debt will disappear into conduits and short-term bridge loans, which would require a far lower market presence. Cinergy is waiting for the completion of what it says will be a unique and accounting-geared facility and has taken out a bridge for the purpose. These sub-one-year deals may also fall victim to changing capital treatment rules, but until a better convergence of interest is forged in the US power market, sponsors should grow increasingly accustomed to such fixes.
EPC contractions also causing problems...
Two power deals ? one of which closed last year and one which is in syndication ? could be victims of an unseemly row and litigation between one of the US' larger contractors and the firm from which it bought much of its business. At stake is the reliance placed by lenders on contracts with firms which are enjoying booming order books but ever-decreasing margins on power plant deals. The two deals ? Sithe Boston and AES Red Oak ? have different exposure levels but critical milestones depending on the situation's outcomeThe business of contracting has been slightly declining in importance recently, as part of the recent drift in the balance of power towards. Many sponsors are taking over a larger share of the development process, including Calpine, which now regularly centralises parts and turbines for speedy installation of power plants. At the same time the usual power balance of project finance have been turned on its head as integrated energy and generation companies see their market capitalisations swell.
In the past, a sponsor had far less leverage when dealing with the contractor. James O'Brien, partner at Baker & McKenzie, recently examined the changing nature of the Engineering Procurement and Construction (EPC) contract. He noted that: ?Single asset project financings by under-capitalized sponsors needed lump sum EPC Contracts. Large, creditworthy EPC contractors stepped in to take the risk of construction delay, performance and cost overruns because the sponsor's completion guarantee was not enough. Sponsors paid a 10% to 20% premium over the estimated construction costs, but investors demanded coverage for the construction risk.
Now, the sponsor is almost always larger and more creditworthy than the contractor, and lump sum EPC contracts are not used as often.
Instead, the sponsor purchases the combustion turbine generators, heat recovery steam generators, and steam turbine generators directly from one or more vendors. Even the engineering and balance of plant procurement may come in to the project directly and not through the construction contract?.
These trends have been amply demonstrated by events at some of the contracting firms.
Whilst some, such as Black & Veatch, have managed to maintain a healthy order backlog, several in the industry have experienced a very volatile operating environment. Foster Wheeler has seen its share price buffeted and has been forced to make strenuous efforts to shore up its finances. Stone & Webster went bankrupt and was acquired by the shore group at auction.
The most recent rumbling concerns Washington Group's acquisition of Raytheon Engineers & Constructors, after the latter's parent decided to focus more on its defence-related activities. Washington bought Raytheon Engineers & Constructors in July 2000 for $53 million plus $450 million in assumed liability. Washington Group has estimated its liabilities from the Raytheon unit to rise by $400 million to as much as $700 million above original estimates, and it wants a revision to the price to be paid. Meanwhile, Raytheon has said it doesn't believe a ?material? adjustment to the purchase price is required.
Washington's financial situation is now looking distinctly sickly, and management says that it will delay filing its annual report until it can resolve its current liquidity crunch. It says that its business, apart from the Raytheon contracts, is strong, and that Raytheon misrepresented the condition of two contracts for Sithe Energies for plants in Massachusetts. The two power plants covered by contract are a 1600M gas-fired plant in Everett, with a contract worth roughly $700 million, whilst the second is an 800MW gas-fired plant in North Weymouth whose contract is worth around $411 million. Both plants were scheduled to be completed in the spring of 2002. The Everett plant is billed as the largest merchant power plant currently under construction in the US.
Washington stopped work on the plants on 8 March, and a week later its contracts with Sithe were terminated. The terms of the sale to Washington carries a performance guarantee from Raytheon (few sponsors like changing horses mid-project), which has now been called upon. Sithe forced Raytheon to carry out the work in a New York court ruling: since it does not have any of the right engineers on its payroll, Duke/Fluor Daniel has been hired to finish the job.
It is possible that Raytheon will be able to in turn sue Washington Group to recover some of the money it has spent. It plans, however, to take a charge of $275-325 million to cover the costs of completing the plants. Standard industry practice for contractors that take over projects half way through is to complete them on a cost plus basis.
Washington is also working on the AES Red Oak deal, which was funded in March 2000 via a $384 million bond issue managed by Lehman Brothers. Work on the plant, located at Sayreville, New Jersey, is 52% complete and is still on schedule. Moreover, Raytheon backs Washington's obligations, the contract is prepaid and the contractor is backed by a letter of credit provided by Bank of America.
However, Standard & Poor's has placed the bonds on Creditwatch, because it believes that further litigation could delay construction.
If this were to happen then it is conceivable that the plant could miss its acceptance date, and thus be in breach of its tolling agreement with Williams Energy Marketing & Trading. It is unlikely that Williams would want to repudiate the deal, especially after it has agreed a large energy services contract with Allegheny Energy. It simply means that AES will have to move fast if work on the Red Oak is contaminated by troubles elsewhere.
It is a sign of how little sponsors have come to expect of contractors that AES has not been seriously perturbed by the incident. What appears more probable is that further consolidation within the industry is likely, although Washington itself was formed by the combination of Raytheon and Morrison Knudsen.
Meanwhile further syndication on Sithe Boston, a $1.25 billion deal led by Credit Suisse First Boston and BNP Paribas, has been shelved. The deal would have been an interesting addition to the slew of portfolio deals close to market, but will probably not see the retail stage of syndication for some months.
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