Mind the gap
?The pessimist complains about the wind; the optimist expects it to
change; the realist adjusts the sails? ? William Arthur Ward.
The power sector in the first half of 2003 has been characterized by a wave of financial re-engineering on the part of diversified energy companies and IPPs such as AES, Allegheny Energy, Dynegy, El Paso, Mirant, Reliant and Williams and Chapter 11 bankruptcy filings by NRG and PG&E National Energy Group. The focus has been on repairing battered balance sheets in an effort to avoid bankruptcy, where possible, by postponing near-term debt maturities, increasing liquidity and reducing excessive leverage.
These restructuring efforts have largely been successful. Within the last six months, each of the non-bankrupt companies has successfully completed some form of corporate restructuring or refinancing.
Each of the completed out-of-court consensual refinancing activity by the diversified energy companies and IPPs, and the pre-packaged Chapter 11 bankruptcy filing and accompanying reorganization plan by NRG have all been conditioned, either implicitly or explicitly on the rebound and recovery of wholesale power markets within a 3-5 year timeframe.
Investors have generally reacted positively to the good news of the completed restructurings by bidding up the values of traded corporate and project bonds, traded bank debt and stock prices of many of the IPPs. For example, year to date through 30 June, the stock prices of Dynegy, Williams, AES and Reliant, while off of their highs for the year, have increased by 226%, 181%, 96% and 82% respectively. In addition, bonds prices for many of the IPPs have also exhibited similar increases as investors have started to believe that the worst of the financial distress is over.
A rough road to recovery
The belief, that the worst may be behind us, while not misplaced, masks an uneven and bumpy road to recovery that bank lenders, bondholders, equity investors and regulators would do well not to ignore.
The question that faces the industry is whether this optimism is justified, or have bank lenders and bondholders simply delayed the inevitable shakeout in the industry. Some observers have likened the recent restructurings, which should be more accurately referred to as debt extensions as akin to simply rearranging the chairs on the proverbial deck of the Titanic while the vessel slowly sinks.
Despite the latest restructurings, concerns still remain that the IPPs may have too much debt and too little secured cash flow to effectively manage the volatility inherent in operating merchant power assets.
Pace Global believes that while regional power markets are poised for recovery, substantial execution risks remain. The revised business plans and the feasibility of the projections that have been a feature of the recent refinancing activity may be at risk as a result of:
? Continued short-term weakness in power prices,
? Volatile and increasing fuel prices, especially natural gas,
? A lack of liquidity in wholesale power markets,
? A limited universe of credit-worthy trading counter-parties,
? A thin, buyers' market for the tolling contracts necessary to stabilize revenue streams
? An uncertain regulatory environment, and
? The likelihood of less than optimal recoveries from the sale of power generation assets in a distressed market environment.
Against this backdrop, it is important for the diversified energy companies and IPPs, bank lenders and bondholders not to sit back and wait for the inevitable market rebound but to aggressively and proactively mitigate the risks to recovery, while focusing on maximizing gross margins and recoveries from asset sales in an effort to survive until the market recovers.
The bust in the market
The wholesale power market's current situation results from a confluence of events. Spot and forward power prices are low due to regional oversupply, a loss of liquidity brought on by the exit of trading organizations, and a regional retreat from restructuring that limits IPP market access. The nation's taste for power restructuring has soured, and while Ferc's Standard Market Design, recently renamed the wholesale power market platform, promises a level playing field for cash-strapped diversified energy companies and IPPs, determined resistance in some regional markets threatens its implementation. Complicating this condition, gas prices remain stubbornly high, primarily due to storage concerns and expectations of increased gas-fired power generation that will drive up the cost of marginal supplies.
Exhibit 1 which illustrates 12-month moving average spark spreads for a new F-Series gas-fired combined-cycle plant in selected regional wholesale power markets outlines the move from boom to bust in wholesale power markets from January 1999 to April 2003. Generally speaking a typical combined-cycle plant requires spark spreads of within a range of approximately $39 to $55/kW-year to meet debt service payments and approximately $80 to 90$/kW-year to meet typical equity return thresholds. Since 2000, the price of power in these markets has fallen relative to the price of gas to the point where it is difficult for even new, highly efficient power plants to cover their debt service obligations.
Structure of refinancing plans
The common feature of each of the completed refinancing plans has been the willingness of bank lenders and bondholders to look beyond the problems of today towards a brighter tomorrow.
The willingness of bank lenders and bondholders to extend near-term debt maturities is predicated on the premise that, in time, operating cash flows will rebound to the level needed to meet reconfigured debt service milestones. The plan is that the combination of strong recurring operating cash flows and one time infusions from asset sales will restore health to balance sheets. Borrowers will then have access to the equity and capital markets and that bank lines of credit will be re-established.
Firm in the belief that tomorrow is likely to be better than today ? with the only question being when will tomorrow come?, bank lenders and bondholders have refrained from forcing defaulting borrowers into bankruptcy and have agreed to extend the near-term maturities into the future.
This forbearance, while magnanimous on the face, was grounded in a painful realization. As liquidity pressures deepened it became clear that in the current market environment recoveries in bankruptcy for unsecured creditors would be unacceptably low. Secured creditors also realized that the collateral supporting their debts was impaired to such a point that full recovery for secured bank lenders and bondholders could not be assured in a free-fall bankruptcy filing.
In exchange for refraining from exercising their ultimate remedy, creditors have extracted a series of concessions from defaulting borrowers. In many of the refinancing plans, borrowers have pledged all of their available security to support the refinanced bank loans and other debt securities. Previously unsecured creditors have been secured and secured lenders and bondholders have been over-collateralized through additional security and pledges of the stock of subsidiaries of the borrowers.
Lenders and bondholders have therefore put themselves in a more advantageous position to maximize recoveries in the case of an eventual bankruptcy filing, while borrowers have been left with little incremental credit capacity due to an inability to borrow on an unsecured basis and little if any collateral to provide to potential secured bank lenders or bondholders. In addition to receiving additional collateral, in certain situations, creditors have been given the opportunity to profit from the return to financial health of the borrower through the receipt warrants to purchase stock in the company.
An integral part of these restructurings has been a significant increase in the all-in cost of the refinanced debt. Pricing structures of LIBOR plus margins in excess of 5% and floors preventing pricing falling below predefined levels has been a common feature. Restructuring fees and increased commitment fees have also been extracted from borrowers.
Other noteworthy features of recent restructuring activity include:
? Restrictions on wholesale energy trading activity
? Prohibitions against proprietary trading
? Cancellation of development activities
? Limitations on capital expenditures ? maintenance and construction
? Reductions or suspensions of common stock dividends
? Limitations on permitted investments
? Mandatory repayments
? Assets sales dedicated to debt amortization
? Restrictive covenants ? maximum leverage ratios and minimum debt service coverage ratios, cash traps and distribution tests.
Execution risks
The key risks that bank lenders, bondholders and equity investors face as borrowers implement their restructuring plans lie in the ability of companies to generate the margins necessary to meet debt service targets and that recoveries from the sale of power generation assets will be lower than anticipated.
In recent weeks it has become clear that certain companies may have more difficulty than anticipated in meeting their projections.
On 10 June 2003, Allegheny Energy blaming tough market conditions and the effect of the company's weakened credit profile warned that earnings and cash flow results, when reported, would be substantially below the levels projected in February 2003 in conjunction with the company's bank refinancing.
In a filing of interim financial statements covering the first quarter of 2003 Orion Power Holdings (Orion Power), a subsidiary of Reliant Resources disclosed that as a result of the failure to meet certain debt service coverage ratio tests and other distribution tests, subsidiaries, Orion Power New York and Orion Power Midwest, were unable to make distributions to Orion Power in the first quarter of 2003.
As a result, Reliant Resources voluntarily elected to contribute $15 million to Orion Power in order to prevent a payment default on Orion Power's $400 million 12% senior notes. Reliant's contribution to Orion Power represented approximately 63% of the $24 million semi-annual interest payment due on 1 May 2003.
Supplier credit concerns
The lack of creditworthiness as a trading counter-party is one of the key risks factors that will hamper the recovery prospects of troubled diversified energy companies and IPPs.
While it appears at this stage that most of companies that have completed a consensual restructuring have removed the threat of imminent bankruptcy filings, the possibility of a filing at some later stage will limit the ability of troubled companies to enter into contracts with load-serving entities or trade in wholesale power markets.
Debtors that file for bankruptcy have the ability under section 365(a) of the Bankruptcy Code to assume or reject executory contracts (contracts with performance obligations on each side) and therefore have the ability to ?cherry-pick? the contracts and assume those which are profitable, and reject those which are not.
In fact, NRG which is currently reorganizing under Chapter 11 of the Bankruptcy Code recently used this provision to try to reject an out-of-the money power supply contract with Connecticut Light & Power (CL&P). While claiming breach of the contract by CL&P for non-payment, NRG also claimed that the contract which supplied CL&P with 45% power needed to serve its 1.1 million customers was causing the company to loose $500,000 per day.
NRG stated that its poor credit quality limited its ability to contract with counter-parties and it was forced to purchase power from the wholesale power market at prices in excess of those received from CL&P and that the losses were jeopardizing its ability to access debtor-in-possession financing and implement its reorganization plan.
Realizing that debtors that reorganize under Chapter 11 will use their ability to reject unfavorable contracts, load-serving entities such as CL&P will become increasingly reluctant to transact with companies that may possibly file for bankruptcy. This stance may limit the universe of potential purchasers for the output of merchant facilities.
Faced with the inability of counter-parties to post acceptable collateral, a limited universe of creditworthy power marketers have continued to acquire power supplies from energy merchants though the use of master netting arrangements and cross-commodity netting to limit their exposures in the event of a default. While these arrangements allow credit-constrained power sellers to market a proportion of their output, a buyers' market limits the opportunity of the sellers to optimize their margins, while providing a less than perfect risk mitigation strategy for the power purchaser.
In the event that a power supplier fails to perform or otherwise defaults under a contract, some power purchase contracts allow a non-defaulting party to terminate a contract and walk away without the payment of termination fees. However many power sales contracts call for the calculation of settlement payments at termination using mark-to-market valuation methodologies. In the case of above-market contracts, where the contract price is higher than current market prices, and the defaulting party is the power supplier, the non-defaulting party may be faced with making substantial termination payment, even when no product is being received.
In addition, dealers in swap agreements, commodity contracts and forward contracts, defined as forward contract merchants may mitigate their exposure to counter-parties with weakened credit profiles. Power market participants that fit the definition of forward contract merchants may take advantage of the ?safe-harbor? protections of sections 556 and 560 of the Bankruptcy Code.
These provisions allow the non-defaulting counter-party to terminate, net and liquidate collateral supporting these contracts as a result of a bankruptcy filing, notwithstanding the automatic stay, and executory contract provisions of the Bankruptcy Code. However, the current definition of forward contract merchants does not apply to the over 2,000 public power associations such as municipal utilities, rural electric cooperatives and public utility districts, further limiting the willingness of these load-serving entities to transact with credit challenged diversified energy companies and IPPs.
Distressed Assets Gap
The sale of power generation assets to reduce leverage is a central feature of the recovery plans of the diversified energy companies and IPPs.
The flood of power generation asset sales that market participants had expected to hit the market has turned into a trickle as a wide bid/ask spread has developed between the offering price of buyers and the target price of sellers.
We have dubbed this bid/ask spread the ?distressed asset gap?. Sellers such as IPPs and their lenders are looking to maximize the liquidity generated from asset disposals, while opportunistic buyers are looking to capitalize on industry dislocation to acquire assets for a fraction of their original build or financing costs.
Until this gap closes, transactions will not be prevalent and IPPs will face increasing pressure to meet the liquidity targets mandated in the recent round of restructurings.
Most of the power generation assets listed for sale are merchant assets. Our view is that the pricing of merchant risk by new money equity investors, such as private equity and hedge funds, and the desire of lenders to reduce their merchant exposure, has led to the distressed asset gap.
On the one hand, lenders have inked restructuring plans which incorporate the sale of power generation assets at target prices which minimize the write-down by creditors. This same group of lenders however through their reluctance to support the acquisition of merchant assets is limiting the value that can be realized through these sales and possibly damaging the recovery prospects of the IPPs.
The merchant exposure of power generation assets is reflected in the IRR expectations of equity investors and in the debt-to-equity ratios they can expect to achieve from bank lenders. In order to compensate for merchant risk, potential equity investors have established hurdle rates of return in excess of 20%, while bank lenders, given recent events, have understandably demonstrated little appetite in financing the acquisition of an asset with merchant exposure.
Against this backdrop, potential acquirers of power generation assets are faced with the real potential of financing the acquisition of a merchant asset with 100% equity financing.
Exhibit 2 illustrates the distressed asset gap and outlines a road map for shrinking the bid/ask spread. The chart in Exhibit 2 illustrates the maximum price that a bidder could pay for a merchant asset given a hurdle IRR of 21 % with leverage which varies from 0% to 100% equity.
Assuming in the first instance that bank lenders would be unwilling to finance the acquisition of a merchant asset, a potential acquirer assuming 100% equity financing would be able to bid a maximum of $194/kW and still reach their target IRR of 21%. Conversely, if a lender were willing to provide 80% leverage, the bidder would be able to offer $390/kW. This difference of approximately $196/kW lies at the heart of the distressed asset gap.
If 80% leverage can be achieved, the resulting risk profile of the structure is now inconsistent with a 21% IRR and takes on the characteristics of a relatively secure utility-like investment opportunity where 10% returns may be considered the typical hurdle return.
One way to increase the leverage in the structure is to materially change the risk profile of the asset through removing the merchant exposure. If a secure, contracted revenue stream can be put in place, an acquisition lender will be encouraged to increase the leverage in the transaction commensurate with the reduced risk profile.
However, given the current oversupply in most power markets, and the limited universe of credit-worthy power purchasers, many IPPs will be unable to materially reduce their merchant exposure. Lenders will therefore have to retain some merchant exposure in order to maximize recoveries from these asset sales.
Conclusion
The darkest days may indeed be behind for most diversified energy companies and IPPs. The successful deferral of near-term debt maturities has bought many borrowers valuable breathing room, as market fundamentals point towards a recovery in wholesale power markets within a 3-5 year period.
However, in the short-term, substantial execution risks remain, which require diversified energy companies and IPPs, bank lenders and bondholders to proactively monitor and mitigate the risks to recovery to focus on optimizing gross margins.
Additionally, to maximize the proceeds from the sale of merchant power generation assets, equity investors and bank lenders must consider creative, well-structured solutions to bridge the distressed asset gap. Such innovative approaches may well smooth the road to recovery.
The power sector in the first half of 2003 has been characterized by a wave of financial re-engineering on the part of diversified energy companies and IPPs such as AES, Allegheny Energy, Dynegy, El Paso, Mirant, Reliant and Williams and Chapter 11 bankruptcy filings by NRG and PG&E National Energy Group. The focus has been on repairing battered balance sheets in an effort to avoid bankruptcy, where possible, by postponing near-term debt maturities, increasing liquidity and reducing excessive leverage.
These restructuring efforts have largely been successful. Within the last six months, each of the non-bankrupt companies has successfully completed some form of corporate restructuring or refinancing.
Each of the completed out-of-court consensual refinancing activity by the diversified energy companies and IPPs, and the pre-packaged Chapter 11 bankruptcy filing and accompanying reorganization plan by NRG have all been conditioned, either implicitly or explicitly on the rebound and recovery of wholesale power markets within a 3-5 year timeframe.
Investors have generally reacted positively to the good news of the completed restructurings by bidding up the values of traded corporate and project bonds, traded bank debt and stock prices of many of the IPPs. For example, year to date through 30 June, the stock prices of Dynegy, Williams, AES and Reliant, while off of their highs for the year, have increased by 226%, 181%, 96% and 82% respectively. In addition, bonds prices for many of the IPPs have also exhibited similar increases as investors have started to believe that the worst of the financial distress is over.
A rough road to recovery
The belief, that the worst may be behind us, while not misplaced, masks an uneven and bumpy road to recovery that bank lenders, bondholders, equity investors and regulators would do well not to ignore.
The question that faces the industry is whether this optimism is justified, or have bank lenders and bondholders simply delayed the inevitable shakeout in the industry. Some observers have likened the recent restructurings, which should be more accurately referred to as debt extensions as akin to simply rearranging the chairs on the proverbial deck of the Titanic while the vessel slowly sinks.
Despite the latest restructurings, concerns still remain that the IPPs may have too much debt and too little secured cash flow to effectively manage the volatility inherent in operating merchant power assets.
Pace Global believes that while regional power markets are poised for recovery, substantial execution risks remain. The revised business plans and the feasibility of the projections that have been a feature of the recent refinancing activity may be at risk as a result of:
? Continued short-term weakness in power prices,
? Volatile and increasing fuel prices, especially natural gas,
? A lack of liquidity in wholesale power markets,
? A limited universe of credit-worthy trading counter-parties,
? A thin, buyers' market for the tolling contracts necessary to stabilize revenue streams
? An uncertain regulatory environment, and
? The likelihood of less than optimal recoveries from the sale of power generation assets in a distressed market environment.
Against this backdrop, it is important for the diversified energy companies and IPPs, bank lenders and bondholders not to sit back and wait for the inevitable market rebound but to aggressively and proactively mitigate the risks to recovery, while focusing on maximizing gross margins and recoveries from asset sales in an effort to survive until the market recovers.
The bust in the market
The wholesale power market's current situation results from a confluence of events. Spot and forward power prices are low due to regional oversupply, a loss of liquidity brought on by the exit of trading organizations, and a regional retreat from restructuring that limits IPP market access. The nation's taste for power restructuring has soured, and while Ferc's Standard Market Design, recently renamed the wholesale power market platform, promises a level playing field for cash-strapped diversified energy companies and IPPs, determined resistance in some regional markets threatens its implementation. Complicating this condition, gas prices remain stubbornly high, primarily due to storage concerns and expectations of increased gas-fired power generation that will drive up the cost of marginal supplies.
Exhibit 1 which illustrates 12-month moving average spark spreads for a new F-Series gas-fired combined-cycle plant in selected regional wholesale power markets outlines the move from boom to bust in wholesale power markets from January 1999 to April 2003. Generally speaking a typical combined-cycle plant requires spark spreads of within a range of approximately $39 to $55/kW-year to meet debt service payments and approximately $80 to 90$/kW-year to meet typical equity return thresholds. Since 2000, the price of power in these markets has fallen relative to the price of gas to the point where it is difficult for even new, highly efficient power plants to cover their debt service obligations.
Structure of refinancing plans
The common feature of each of the completed refinancing plans has been the willingness of bank lenders and bondholders to look beyond the problems of today towards a brighter tomorrow.
The willingness of bank lenders and bondholders to extend near-term debt maturities is predicated on the premise that, in time, operating cash flows will rebound to the level needed to meet reconfigured debt service milestones. The plan is that the combination of strong recurring operating cash flows and one time infusions from asset sales will restore health to balance sheets. Borrowers will then have access to the equity and capital markets and that bank lines of credit will be re-established.
Firm in the belief that tomorrow is likely to be better than today ? with the only question being when will tomorrow come?, bank lenders and bondholders have refrained from forcing defaulting borrowers into bankruptcy and have agreed to extend the near-term maturities into the future.
This forbearance, while magnanimous on the face, was grounded in a painful realization. As liquidity pressures deepened it became clear that in the current market environment recoveries in bankruptcy for unsecured creditors would be unacceptably low. Secured creditors also realized that the collateral supporting their debts was impaired to such a point that full recovery for secured bank lenders and bondholders could not be assured in a free-fall bankruptcy filing.
In exchange for refraining from exercising their ultimate remedy, creditors have extracted a series of concessions from defaulting borrowers. In many of the refinancing plans, borrowers have pledged all of their available security to support the refinanced bank loans and other debt securities. Previously unsecured creditors have been secured and secured lenders and bondholders have been over-collateralized through additional security and pledges of the stock of subsidiaries of the borrowers.
Lenders and bondholders have therefore put themselves in a more advantageous position to maximize recoveries in the case of an eventual bankruptcy filing, while borrowers have been left with little incremental credit capacity due to an inability to borrow on an unsecured basis and little if any collateral to provide to potential secured bank lenders or bondholders. In addition to receiving additional collateral, in certain situations, creditors have been given the opportunity to profit from the return to financial health of the borrower through the receipt warrants to purchase stock in the company.
An integral part of these restructurings has been a significant increase in the all-in cost of the refinanced debt. Pricing structures of LIBOR plus margins in excess of 5% and floors preventing pricing falling below predefined levels has been a common feature. Restructuring fees and increased commitment fees have also been extracted from borrowers.
Other noteworthy features of recent restructuring activity include:
? Restrictions on wholesale energy trading activity
? Prohibitions against proprietary trading
? Cancellation of development activities
? Limitations on capital expenditures ? maintenance and construction
? Reductions or suspensions of common stock dividends
? Limitations on permitted investments
? Mandatory repayments
? Assets sales dedicated to debt amortization
? Restrictive covenants ? maximum leverage ratios and minimum debt service coverage ratios, cash traps and distribution tests.
Execution risks
The key risks that bank lenders, bondholders and equity investors face as borrowers implement their restructuring plans lie in the ability of companies to generate the margins necessary to meet debt service targets and that recoveries from the sale of power generation assets will be lower than anticipated.
In recent weeks it has become clear that certain companies may have more difficulty than anticipated in meeting their projections.
On 10 June 2003, Allegheny Energy blaming tough market conditions and the effect of the company's weakened credit profile warned that earnings and cash flow results, when reported, would be substantially below the levels projected in February 2003 in conjunction with the company's bank refinancing.
In a filing of interim financial statements covering the first quarter of 2003 Orion Power Holdings (Orion Power), a subsidiary of Reliant Resources disclosed that as a result of the failure to meet certain debt service coverage ratio tests and other distribution tests, subsidiaries, Orion Power New York and Orion Power Midwest, were unable to make distributions to Orion Power in the first quarter of 2003.
As a result, Reliant Resources voluntarily elected to contribute $15 million to Orion Power in order to prevent a payment default on Orion Power's $400 million 12% senior notes. Reliant's contribution to Orion Power represented approximately 63% of the $24 million semi-annual interest payment due on 1 May 2003.
Supplier credit concerns
The lack of creditworthiness as a trading counter-party is one of the key risks factors that will hamper the recovery prospects of troubled diversified energy companies and IPPs.
While it appears at this stage that most of companies that have completed a consensual restructuring have removed the threat of imminent bankruptcy filings, the possibility of a filing at some later stage will limit the ability of troubled companies to enter into contracts with load-serving entities or trade in wholesale power markets.
Debtors that file for bankruptcy have the ability under section 365(a) of the Bankruptcy Code to assume or reject executory contracts (contracts with performance obligations on each side) and therefore have the ability to ?cherry-pick? the contracts and assume those which are profitable, and reject those which are not.
In fact, NRG which is currently reorganizing under Chapter 11 of the Bankruptcy Code recently used this provision to try to reject an out-of-the money power supply contract with Connecticut Light & Power (CL&P). While claiming breach of the contract by CL&P for non-payment, NRG also claimed that the contract which supplied CL&P with 45% power needed to serve its 1.1 million customers was causing the company to loose $500,000 per day.
NRG stated that its poor credit quality limited its ability to contract with counter-parties and it was forced to purchase power from the wholesale power market at prices in excess of those received from CL&P and that the losses were jeopardizing its ability to access debtor-in-possession financing and implement its reorganization plan.
Realizing that debtors that reorganize under Chapter 11 will use their ability to reject unfavorable contracts, load-serving entities such as CL&P will become increasingly reluctant to transact with companies that may possibly file for bankruptcy. This stance may limit the universe of potential purchasers for the output of merchant facilities.
Faced with the inability of counter-parties to post acceptable collateral, a limited universe of creditworthy power marketers have continued to acquire power supplies from energy merchants though the use of master netting arrangements and cross-commodity netting to limit their exposures in the event of a default. While these arrangements allow credit-constrained power sellers to market a proportion of their output, a buyers' market limits the opportunity of the sellers to optimize their margins, while providing a less than perfect risk mitigation strategy for the power purchaser.
In the event that a power supplier fails to perform or otherwise defaults under a contract, some power purchase contracts allow a non-defaulting party to terminate a contract and walk away without the payment of termination fees. However many power sales contracts call for the calculation of settlement payments at termination using mark-to-market valuation methodologies. In the case of above-market contracts, where the contract price is higher than current market prices, and the defaulting party is the power supplier, the non-defaulting party may be faced with making substantial termination payment, even when no product is being received.
In addition, dealers in swap agreements, commodity contracts and forward contracts, defined as forward contract merchants may mitigate their exposure to counter-parties with weakened credit profiles. Power market participants that fit the definition of forward contract merchants may take advantage of the ?safe-harbor? protections of sections 556 and 560 of the Bankruptcy Code.
These provisions allow the non-defaulting counter-party to terminate, net and liquidate collateral supporting these contracts as a result of a bankruptcy filing, notwithstanding the automatic stay, and executory contract provisions of the Bankruptcy Code. However, the current definition of forward contract merchants does not apply to the over 2,000 public power associations such as municipal utilities, rural electric cooperatives and public utility districts, further limiting the willingness of these load-serving entities to transact with credit challenged diversified energy companies and IPPs.
Distressed Assets Gap
The sale of power generation assets to reduce leverage is a central feature of the recovery plans of the diversified energy companies and IPPs.
The flood of power generation asset sales that market participants had expected to hit the market has turned into a trickle as a wide bid/ask spread has developed between the offering price of buyers and the target price of sellers.
We have dubbed this bid/ask spread the ?distressed asset gap?. Sellers such as IPPs and their lenders are looking to maximize the liquidity generated from asset disposals, while opportunistic buyers are looking to capitalize on industry dislocation to acquire assets for a fraction of their original build or financing costs.
Until this gap closes, transactions will not be prevalent and IPPs will face increasing pressure to meet the liquidity targets mandated in the recent round of restructurings.
Most of the power generation assets listed for sale are merchant assets. Our view is that the pricing of merchant risk by new money equity investors, such as private equity and hedge funds, and the desire of lenders to reduce their merchant exposure, has led to the distressed asset gap.
On the one hand, lenders have inked restructuring plans which incorporate the sale of power generation assets at target prices which minimize the write-down by creditors. This same group of lenders however through their reluctance to support the acquisition of merchant assets is limiting the value that can be realized through these sales and possibly damaging the recovery prospects of the IPPs.
The merchant exposure of power generation assets is reflected in the IRR expectations of equity investors and in the debt-to-equity ratios they can expect to achieve from bank lenders. In order to compensate for merchant risk, potential equity investors have established hurdle rates of return in excess of 20%, while bank lenders, given recent events, have understandably demonstrated little appetite in financing the acquisition of an asset with merchant exposure.
Against this backdrop, potential acquirers of power generation assets are faced with the real potential of financing the acquisition of a merchant asset with 100% equity financing.
Exhibit 2 illustrates the distressed asset gap and outlines a road map for shrinking the bid/ask spread. The chart in Exhibit 2 illustrates the maximum price that a bidder could pay for a merchant asset given a hurdle IRR of 21 % with leverage which varies from 0% to 100% equity.
Assuming in the first instance that bank lenders would be unwilling to finance the acquisition of a merchant asset, a potential acquirer assuming 100% equity financing would be able to bid a maximum of $194/kW and still reach their target IRR of 21%. Conversely, if a lender were willing to provide 80% leverage, the bidder would be able to offer $390/kW. This difference of approximately $196/kW lies at the heart of the distressed asset gap.
If 80% leverage can be achieved, the resulting risk profile of the structure is now inconsistent with a 21% IRR and takes on the characteristics of a relatively secure utility-like investment opportunity where 10% returns may be considered the typical hurdle return.
One way to increase the leverage in the structure is to materially change the risk profile of the asset through removing the merchant exposure. If a secure, contracted revenue stream can be put in place, an acquisition lender will be encouraged to increase the leverage in the transaction commensurate with the reduced risk profile.
However, given the current oversupply in most power markets, and the limited universe of credit-worthy power purchasers, many IPPs will be unable to materially reduce their merchant exposure. Lenders will therefore have to retain some merchant exposure in order to maximize recoveries from these asset sales.
Conclusion
The darkest days may indeed be behind for most diversified energy companies and IPPs. The successful deferral of near-term debt maturities has bought many borrowers valuable breathing room, as market fundamentals point towards a recovery in wholesale power markets within a 3-5 year period.
However, in the short-term, substantial execution risks remain, which require diversified energy companies and IPPs, bank lenders and bondholders to proactively monitor and mitigate the risks to recovery to focus on optimizing gross margins.
Additionally, to maximize the proceeds from the sale of merchant power generation assets, equity investors and bank lenders must consider creative, well-structured solutions to bridge the distressed asset gap. Such innovative approaches may well smooth the road to recovery.
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