New Trends In The Market
Project lenders report they are so busy this year that they can afford to be more selective about what deals they finance. Rates are increasing for project loans at the same time that rates are alling for other lending. The following are excerpts from a discussion about new trends in the project finance market that took place in late June at a Chadbourne conference in Colorado.
The speakers are Andrew Jacobyansky, vice president and senior credit officer for Moody’s Investors Service, David L. Hauser, senior vice president and treasurer of Duke Energy Corporation, David H. Wasserman, vice president for development of Sithe Energies, John Cooper, senior vice president and chief financial officer of PG&E National Energy Group, Gail Nofsinger, vice president in the capital markets division of CoBank, Robert J. Munczinski, managing director of the BNP Paribas Group, Steven S. Greenwald, managing director of Credit Suisse First Boston, Andrew C. Coronios, a structured finance partner at Chadbourne in New York, Roy K. Meilman, a Chadbourne tax partner specializing in leasing transactions, and James S. Godry, senior vice president of Dresdner Kleinwort Wasserstein. The discussion was moderated by Keith Martin from the Chadbourne Washington office.
MR. MARTIN. Our focus today is new trends in the market. One recent trend has been that utility
holding companies are spinning off their unregulated businesses to shareholders in the hope that
the market will assign a higher value to shares in a standalone independent power company than if that business remained tied to a regulated utility. Andy Jacobyansky, how many spinoffs have there been and are more expected?
MR. JACOBYANSKY: The first major one was NRG, whose stock has held up fairly well, which I think encouraged other companies to follow suit. Mirant then did it. There were also Orion, Reliant and Aquila, and we expect more to follow.
MR. MARTIN: What do the companies expect to gain from this — why do it?
MR. JACOBYANSKY: Investment bankers visit and tell these companies that their stock prices would be a lot higher if investors looked at the value of the subsidiary as a standalone business.
The spinoff will lead to a much higher combined stock value.
MR. MARTIN: David Hauser, you have probably heard the pitch from these investment bankers. Is this an appealing concept to Duke?
MR. HAUSER: We have been visited by investment bankers who think we ought to spin off everything we own, whether it is above or below our average multiple. If we followed all this advice, we would manage the pension plan and that would be it. It would be a great job!
However, at the end of the day it is a multiples game. It depends on where your multiple is, whether this is a good idea or not.
MR. MARTIN: Have companies that have done spinoffs benefited as expected?
MR. HAUSER: The answers vary depending on the company. The ones that have spun off 100% I would say have been pretty successful as to the original shareholder. Our job is to optimize value for the existing Duke shareholder, not the new shareholder.
MR. WASSERMAN: Sithe was public a number of years ago and then ended up going private.
One of the big traps is liquidity. Unless you are willing to spin off at least several billion dollars worth of market cap, you have a problem. We had a problem where we spun off a small amount.
Sithe wasn’t a big company. We had 10 million shares. We had four institutions each owning
over a million or a million and a half shares.
Anytime one of them wanted to dump shares, the stock price came crashing down and so we weren’t getting proper credit from the market. We had all the disadvantages of being public and we didn’t have the liquidity, so it’s a real trap unless you have enough market cap to spin a lot of shares and keep liquidity.
MR. JACOBYANSKY: I agree with that. It is an all or a none game at the end of the day.
MR. COOPER: I think that another reason for it is the independent generators are growing rapidly and have large development portfolios. They are massive consumers of capital. They need to borrow large sums of money, which you can’t do unless you are also able to provide equity. If you see an independent generator that is trading at 25 times earnings and a utility that has an embedded independent generator and the utility is trading at 12, or at the best at 14, clearly the utility’s cost of capital is a lot higher to raise equity as a utility — if its regulators will even permit it to do so — than a Mirant or an NRG or an Orion or an AES, whose equity capital is a lot cheaper.
MR. JACOBYANSKY: An example would be NRG and Xcel Energy. If you look at Xcel, the holding company, it receives and pays dividends and has some financing in place. To the extent it wants to put more money into NRG, its only real choice, without compromising its credit quality, is to issue more stock, which is a fairly unattractive option. NRG has announced a very aggressive growth plan, and there is really no good way for money to come down from Excel.
Growing Demand for Capital
MR. MARTIN: John Cooper made the point that companies are driven to search for higher share price multiples by a voracious demand in this industry for capital. What is driving the demand for capital, in addition to the obvious point that we are building more power plants?
MR HAUSER. Electricity trading is a huge user of credit if not long-term capital. It is a huge consumer of credit because you have to post margins with your counterparties. Those margins move around in a very volatile manner. Ours can move around $500 million in a day pretty easily, and they have been as high as $2 1/2 billion that we have to post either in cash, or letters of credit, or in some cases surety bonds
MR. MARTIN: Two and a half billion in a single day. What is the credit line at Duke Energy
MR. HAUSER: We are up in total now to about eight billion. As the banks merge and consolidate, our ability to get credit from banks becomes harder. This is true even with our credit rating, which is higher than a lot of other companies’
MR. MARTIN: Many of us are developers or financiers of power plants and not that familiar with trading. My understanding is that mark-to market accounting — or the notion that trading positions must be reflected on your books at the end of each day at their market value — is what is creating a lot of this huge demand in the power industry for credit. John Cooper?
MR. COOPER: Yes. Trading companies typically enter into master agreements with counterparties with whom they would like to trade over time. For example, PG&E Energy Trading might enter into a master agreement with Duke Energy Trading. The master agreement would provide for various types of physical or financial trades of gas or power. The master agreement gives the green light to the trader to enter into individual transactions. These individual transactions are probably evidenced by slips of paper. At the end of each trading day, you mark all of your positions to market. This is basically the price at which you could liquidate that position within a 24-hour period in the market. Not all positions are liquid, so some of them are more difficult than others to mark.
With every single one of your counterparties, you basically balance what they owe you, and you owe them, and you also value your open positions. The net position at the end of the day remains within the credit limits you have established.
Let’s say Duke and PG&E established an open account for $50 million back and forth. That is with parent guarantees or with investment grade credit quality — triple B or better — $50 million. It sounds like a lot of money. Your traders enter into positions. Two things can change the value of those positions. One is the quantity of contracts that you have open, and the other is the daily volatility in the price of the commodity. The value of your trading positions bounces up and down.
What has happened over the last three or four months, is that even though volumes of trading have not really grown that much over the last year, the volatility has increased incredibly. When you see electricity trading for $3,500 for a megawatt hour in California, it is not just the guy who is selling that power who is affected, but everyone’s trading positions in electricity are marked at that price. Your position in electricity may have been valued yesterday at $100. Suddenly it is $3,800. People who are short and long rebalance their positions. It may be that my $40 million of exposure to you yesterday, and that was inside my limit, is suddenly $400 million.
MR. MARTIN: In one day?
MR. COOPER: In one hour. But you only do it every night. Then the phone calls go out. You have a $400 million margin call that you must cover within 24 hours. If you don’t, the positions can be selectively liquidated, which means that the guy who is liquidating can cherry-pick what is best for him, and it can totally disrupt your portfolio.
Even though we may have shown a $400 million net negative to Duke, we have someone from whom we bought the position who owes us $400 million. Our book has not moved at all. We are hedged. Someone owes us $400 million. We owe Duke $400 million. Duke probably owes someone else $400 million. You have this huge volume of credit that has been required and you must either post cash or a letter of credit overnight
MR. MARTIN: And the trading positions may represent just pennies of profit
MR. COOPER: They may not represent any profit at all
MR. MARTIN: But someone makes a margin call for $400 million
MR. COOPER: It is a big circle and often without any net loss if one considers the entire circle. The only time a loss would be created is if someone defaults and you have to liquidate, then the liquidation leads to a domino effect. The trading system is sound as long as you have creditworthy players who can cover their costs. Sometimes you can work out a deal. I tell the counterparty that I can’t get a $400 million letter of credit by tomorrow, but I can assign this position that I have. This is easier in other commodities than in electricity
MR. MARTIN: Why?
MR. COOPER: You can’t store electricity. You don’t have a bill of lading. It’s not like a cargo of crude oil. There is nothing physical except a piece of paper. The two positions may not match. There is no effective clearinghouse to be able to match up all the counterparties around the table and say everybody put in $5 because the billion dollar positions that each of us holds net into nothing, and so it is a — MR. MARTIN: Trading operations absorb an enormous amount of credit
MR. HAUSER: The other piece of this is markto-market accounting creates paper earnings that are not matched by cash. Trading becomes an earnings driver. You may have great earnings but no cash coming in from it at that point
MR. MARTIN: Or big losses on a daily basis
MR. HAUSER: It could go either way.
Tight Bank Market
MR. MARTIN: Let me move on to a related point. We have this demand for capital created by trading operations. Gail Nofsinger, you mentioned that interest rates are increasing in the project finance market in marked contrast to the trend in the rest of the economy. Bankers are working overtime, and they are becoming much more fussy about what they are willing to finance. Explain this.
MS. NOFSINGER: I think a lot of that is driven by the large number of new power plants under development. There is a huge need for capital. There are many more deals coming to market seeking financing in the domestic market this year than three or four years ago.
The deals are also getting larger. We used to look at $200 million transactions. Five banks could get together, and the deal would be done. Now we are seeing $1 and $2 billion deals. To do one of these, you need every bank in the market to participate in the syndicate, so the larger deals must be priced higher in order to attract everyone in the room. Higher prices in large deals translate into higher prices also for small deals, because no one wants to look at a small deal that pays less. The bottom line is that prices are going up across the board
MR. MARTIN: We heard yesterday the European banks are reluctant to lend to projects — perhaps even borrowers — with significant California exposure. Are the domestic banks in the same position? MS. NOFSINGER: Definitely. It is not only the European banks, but I think they are probably in a more difficult position because their parent companies in Europe read the newspaper articles and call back to the States to ask, “What does this mean?” No one really has the answer yet to what it means. People find their time eaten up having to answer questions about what is happening in California. This, in turn, makes people nervous about bringing a deal that has anything to do with California, whether it is ownership or whether the deal is located in California. It is easier just to say no to such deals because you don’t have to spend a lot of time answering questions
MR. MUNCZINSKI: I take exception to the generalization that European banks are backing away from this market. We are certainly not backing away. We have multiple tiers of exposures in California from utilities to QFs, and our job has been to manage that process and provide infor mation to people in Paris, and we have spent a lot of time since November or December last year doing that.
I think that the general concern conveyed by credit committees at European institutions is the issue of contagion. Is the problem in California likely to spread to other parts of the United States? We have spent a lot of time on this, and I think we have been able convince our credit people in Paris that it is a WSCC problem for now, one that we are unlikely to find spreading across the country.
Search for Equity
MR. MARTIN: Let me come back to the topic of rapidly growing demand for capital. Trading operations force companies to have larger credit lines. Projects are getting larger. This, too, requires more borrowing. A company can’t add indefinitely to the debt side of its balance sheet without also periodically raising equity. What new approaches are companies using to raise equity
MR. HAUSER: We are doing a couple different things. We think convertibles are — MR. MARTIN: A convertible is
MR. HAUSER: A convertible is a debt security that gives the holder a right to convert into common stock. There are a thousand different ways to structure them, but the one we just issued is mandatorily convertible in three years into common stock and, from the viewpoint of — well, I’ll let Andy speak from the viewpoint of the rating agencies — we thought we had a positive reaction from the rating agencies on treatment of these instruments as equity or we would not have issued them
MR. JACOBYANSKY: We see an awful lot of these instruments — MR. MARTIN: These are instruments that are initially debt with a mandatory conversion to equity in three years?
MR. JACOBYANSKY: There is every single variant that you can imagine, and the one thing that is consistent across them all is the investment bankers tell their clients that Moody’s sees them as equity. Quite often we don’t
MR. MARTIN: How do such rumors start
MR. HAUSER: They saw them as equity until there were too many of them
MR. JACOBYANSKY: Well, not really. Take, for instance, something NRG did about a half a year ago where they basically issued preferred stock that paid dividends for five years. There was a second feature that required anyone owning the preferred stock at the end of year three to buy some NRG common shares and, at the same time, NRG had to sell the common shares. NRG was told we would put some equity treatment on this. I look at NRG’s coverages and I take into consideration that NRG has an extra fixed charge that the company will have to cover over the five years. Our rating assumes that NRG can make it to the equity markets in three years anyway. It is nice that the company guaranteed it. At the end of the day, the reaction of the rating agency is, “So what?” This is simply a fixed-charge financing. The company will get equity at the same time that we thought it would anyway. The company is hoping we will look at the fixed-charged financing as equity
MR. HAUSER: That’s a really key piece of advice. We are told things about how a product works, but it is important to go back to our friends at the rating agency before issuing something like this and get the straight story
MR. MARTIN: Do you have any leverage over a person like Andy
MR. HAUSER: Well, we sat down with Moody’s on the one we issued. They have a scale of A to E on the equity, and it’s a D. It was that straightforward
MR. MARTIN: Failing grade?
MR. HAUSER: But we heard it from Moody’s
MR. JACOBYANSKY: Yes, but the point is how you apply the D. We don’t look at capital struc ture. We look at cash coverage. We are no different than all the other project people in here. On a GAAP basis, projects have negative equity for years after finishing construction. So when people are told an instrument is going to look like equity, perhaps it looks like equity on the balance sheet, but we don’t look at balance sheets. We look at cash coverage
MR. HAUSER: That’s exactly right. We have been told directly by the rating agencies that they don’t care if our equity is 10% or 80% of our balance sheet. It is cash coverage that matters. That’s the right approach on which to base ratings
MR. COOPER: Let me add one thing. The major equity driver is not so much to support trading. The amount of credit that is there to support trading is still a very small fraction of what it takes to actually to build assets. One power plant of $500, $600 or $700 million would provide a lot of margin for trading. So the capital requirements are really driven by assets, new construction, acquisitions and things like that.
MR. MARTIN: Other trends? Gail Nofsinger, you mentioned mini-perms. These are short-term loans of, say, five years that require payment of interest only during the term — and perhaps some cash sweeps as the end of the term approaches — and then a balloon payment of principal. It is almost as if the banks are becoming merely transition lenders. The project takes a mini-perm loan as a bridge until it can get into the capital markets. What is behind this?
MS. NOFSINGER: The fact that most deals have some element of merchant risk to them. The banks are less willing to lend long term on a transaction that has an uncertain cash-flow stream. With a mini-perm structure — whether the ultimate financing ends up being bank debt or bond debt — the bank has shorter exposure to the merchant risk — usually construction plus two, although I have seen as long as construction plus eight. You have sweeps to start paying down the principal automatically after the second or third year. The debt is being paid down quickly. If it turns out to be a bank financing in the end, there will be less debt to finance over the remaining period of 10 or 15 years and, therefore, less exposure on the long-term debt to the lender
MR. MARTIN: If a mini-perm is a bridge to the capital markets, why not go to the capital markets directly?
MS. NOFSINGER: I think part of it is timing. When you are going into the bond market, you have to see if the price is what you want to pay. A bridge loan gives you more time to play the market. Historically, when banks underwrote the transaction, they gave you a firm price and you knew what it was. When you went to the bond market, you didn’t really know the price until the day the loan closed. I think we have seen some erosion of this on the bank side. Banks are more likely today to say they were wrong three months ago when the deal was priced and to invoke flex pricing, or the right to reprice
MR. COOPER: The mini-perm is a sign of the maturity of the industry. We did IPP deals initially with long-term contracts and project financing in which everything was locked up and fixed. The deals were hard to structure, but they were nobrainers. Those financings were also fairly unique. No other industry, except for the regulated utilities, can raise 25-year debt from banks. What you are seeing now is banks are moving toward a more traditional position, which is providing mediumterm financing or backstop for credit support. At the same time, we have gotten access to the capital markets — the long-term debt markets — which we didn’t have three or four or five years ago. Therefore, you use a bank as an interim source of finance if the timing isn’t right to go into the capital markets. Each of the banks and the bond markets has probably moved into the position it wanted from the start
MR. MARTIN: Why borrow short-term when rates are at an historic low
MR. COOPER: We are in an unusual situation, so I can’t comment on the bond markets, but the banks are still a lot cheaper
MR. HAUSER: What Duke is doing is accessing the capital markets for long-term floating-rate debt, normally 10 years. We are also doing a fair number of swaps. We are not borrowing much short term
MR. JACOBYANSKY: I think there is sort of a myth and a bet going on here with developers. I think the myth is the capital markets are not comfortable with construction risk, but our risk profile for construction is exactly the same as the bank’s. We tend to look past construction if there is a good construction scheme and focus on the operating phase. I think the bet is that someday the rating agencies will get religion and all of a sudden become easier on the merchant markets
MR. GREENWALD: Two points. We all learned that you don’t finance long-term assets, fixed assets with short-term liability. Look at companies that just went belly-up in the past and that is probably the reason why it happened. Number two, the argument of the negative arbitrage is spurious because most of these projects have short construction periods. What rate are you thinking you are going to get a year or two years from now in the capital market? People are checking the interest rate when they go into the bank market to fund these projects, and they are keeping their fingers crossed that things are going to be great a year or two years from now when they decide to do the long-term takeout in the capital market. If you look into the cost of implementing the forward interest rate swap — and that is the key — you will see the swap adds 80 to 90 basis points to the cost of a deal for one year and 130 to 140 basis points for two years. What the guy does is decide against doing the forward rate swap. This puts him back in the position of betting on where interest rates will be a year or two from now and that he will, in fact, have access then to the capital market
MR. HAUSER: Just one more comment. We do not look at debt on a project-by-project basis, but rather put all our debt into one view and determine how much of it we are going to allow to be floating, and how much as we are going to allow to be fixed because this can have a big effect on earnings. How much you allow to be fixed affects the volatility of your earnings.
MR. MARTIN: That’s a perfect bridge to our next topic. Some of the other people at this table work on products that help with earnings. Synthetic leasing is one. Andrew Coronios, what is a synthetic lease
MR. CORONIOS: A synthetic lease is a form of off-balance sheet financing. It is treated like an operating lease on the balance sheet, which means the company shows neither a debt nor a corresponding asset. Because there is no asset on the balance sheet, there is no depreciation. Depreciation reduces earnings
MR. COOPER: But the company remains the owner for tax purposes
MR. MARTIN: Let me give a tax lawyer’s perspective. A synthetic lease is a short-term loan, but it is drafted to look like the lender is leasing the asset to the borrower
MR. CORONIOS: You tax people keep looking at substance. The accountants focus on the form of the transaction. It is the perfect disintermediation to create a product
MR. MARTIN: And the reason this helps with earnings is . .
MR. CORONIOS: Because the borrower does not own the asset for book purposes and has no book depreciation to reduce earnings
MR. MARTIN. What about the rent payments on the lease? Aren’t these the equivalent of depreciation
MR. CORONIOS. If you think of a synthetic lease as a short-term loan, the lease requires payment of interest only. The rent payments are a small fraction of the book depreciation the company would have had if it had to put the asset on its books
MR. COOPER: It is a form of 100% debt financing. It helps you leverage up earnings without having to raise true equity capital
MR. MARTIN: Synthetic leasing is appropriate only in limited situations in the power business. What are they
MR. CORONIOS: The accountants have taken the position that a power plant is real estate for accounting purposes. This means, in turn, that a company cannot do a synthetic lease of an asset that it already owns
MR. MARTIN: The company cannot own the asset before the lease financing is put in place
MR. CORONIOS: That’s right. And that is the major challenge in these transactions. Others at this table will talk about leveraged leases, which are basically a way to take assets that a company already owns off the balance sheet. But the cost of a leveraged lease is you give up tax ownership. In a synthetic lease, the company keeps the tax ownership of the asset, but a synthetic lease can only be done on an asset that the company does not already own
MR. MARTIN: Let me stop you there. A company planning to build a power plant normally goes about setting up contracts, obtaining a site, ordering turbines — things like that. You say the company cannot own the asset if it wants to do a synthetic lease. At what point in the development process does it cross this line
MR. CORONIOS: The synthetic lease turbine deals that everyone reads about are set up exactly to address this problem. The synthetic lease must be in place before the company gets to the point of making irrevocable payments on the turbines. Such payments would put the turbine on balance sheet and taint the entire project
MR. COOPER: The turbines have become the driver because they have the longest lead time. However, the point is a company cannot spend money on any hard costs to develop the project and still do a synthetic lease
MR. CORONIOS: That’s right. No spending on hard costs. People think when they hear this that it means putting a shovel in the ground. It doesn’t. It means ordering and starting to pay for key equipment like turbines
MR. COOPER: It could also be paying for an interconnect. It could be paying in advance to build the waterline. There are myriad things that can cause developers to trip over this rule if they aren’t careful
MR. MARTIN: David Hauser, you have not done any synthetic leasing. Why
MR. HAUSER: We have certainly looked at the product, but we have a serious tainting problem because our own construction subsidiary builds all our power plants, making them tainted from the very beginning. The other thing that has pushed us away from it is we believe in asset optimization in the sense that we are buyers, builders and sellers of assets. If you have a power plant that you may decide to sell in a year or two, it is questionable whether it is worth the effort to structure a synthetic lease
MR. MARTIN: Andrew Jacobyansky, are synthetic leases off-balance sheet for rating purposes
MR. JACOBYANSKY: If a company must make cash payments, they are part of the coverage ratio
MR. COOPER: Well, he doesn’t look at debt to capitalization. The other rating agency looks at debt to cap as well as coverages and so, from their perspective, synthetic leases are not debt
MR. MARTIN. John Cooper, your company was one of the first to use a synthetic lease
MR. COOPER: It was the flavor-of-the-month last year, but we are no longer doing them for a variety of reasons
MR. MARTIN: What is the major reason
MR. COOPER: Well, these things are driven by a forward equity commitment or a forward takeout in three to five years after the power plant commences operating. Since the creditworthiness of our parent has deteriorated, banks are no longer comfortable with lending us a five-year forward commitment. We still have two existing synthetic leases we put in place, which we have restructured, but we are not really doing any new ones
MR. MARTIN: Andrew Coronios, how does synthetic leasing compare in terms of cost of capital to straight borrowing or a leveraged lease
MR. CORONIOS: It depends on how the synthetic lease is structured. John Cooper’s company did a variation on the theme. A basic synthetic lease requires an investment-grade company that puts its full faith and credit behind the deal — to the extent the accountants permit it — so that you are basically looking at the company’s corporate borrowing rate plus a slight premium for a structured deal. The deals that John Cooper did were hybrids. Basically, a portion of the deal was financed on a project finance basis — let’s say 50% — and this part was assigned a nonrecourse debt rate
MR. COOPER: Traditional synthetic leases are 85% guaranteed, and ours was 40% or 50%. Leveraged Leases MR. MARTIN: Let’s move to leveraged leasing. Roy Meilman and Jim Godry, it seems like there has been a resurgence of interest in leveraged leasing for power plants. Why
MR. MEILMAN: To me, it’s a little like David Hauser’s comment about convertible debt. Leveraged leases have been around for a long time. There were a lot of leverage leases of power facilities in the 1980s. They were less common in the 1990’s — until the last couple of years
MR. MARTIN: Why the renewed interest
MR. MEILMAN: The two drivers are tax and accounting. On the tax side, one way to look at a leveraged lease is it is a tax-advantaged loan where the tax advantage reduces your interest rate. There have been some developments that add to the tax profile of power plants. That helps. Companies that cannot use the tax benefits that come with ownership may be better off having someone else own who can use the tax benefits and then share in them indirectly in the form of lower rent. Many power companies cannot use foreign tax credits. Such companies are better off paying rent than interest. Additional interest payments will make their foreign tax credit positions worse. As for accounting reasons, perhaps Jim can address that
MR. MARTIN: Jim Godry, what else explains the renewed interest in leveraged leasing for power plants
MR. GODRY: Earnings management, but just to stick with the tax side for a moment, there are a couple of power plants being financed this year in the lease market because they are on Indian land and qualify for 12-year MACRS depreciation rather than the normal 20-year. The developers cannot use the tax depreciation on a current basis. That is the primary reason for them to lease — the desire to give them to someone else who can use them in exchange for better terms on the financing. Turning to the earnings game, a company can boost its earnings per share by doing a long-term lease. Take the cash rent and divide it by the number of years in the lease term. That determines you annual rental expense. Many people are doing extraordinarily long-term leases to stretch out that rental expense and reduce it on an annual basis and, therefore, increase earnings per share
MR. MARTIN: People used to do a lease-buy analysis to determine whether it made sense to do a lease or straight borrowing. The breakpoint was leasing made more sense if the tax benefits were at least 10-year MACRS depreciation or perhaps longer depreciation but with a tax credit. Does that analysis still hold
MR. GODRY: You know, we never looked at it that way. People are looking at a conventional lease-versus-own analysis in some cases, but I think what drives many people to leasing is the cost of capital. If the developer or IPP’s cost of capital is significantly higher than the lease equity investor’s cost of capital, then leasing will make sense from purely an economic standpoint
MR. MARTIN: John Cooper, your views on leasing
MR. COOPER: We’ve done a bunch of them. Ours have been purely earnings driven. Bear Swamp is a pumped storage project with a very long useful life — over 60 years. We got a 43-year lease with 20-year debt. The rents during the last 23 years of the lease after the debt is repaid are very low. As Jim Godry said, if you levelize the rent over the entire 43 years, you end up with a much lower rent expense profile in the first 20 years than if you had borrowed to purchase the asset. These are accounting earnings, so they don’t really count in your ratios and things like that. You still have to pay cash rent. You may be paying $40 million a year in cash rent to service the lessor’s 20-year debt, but the accounting charge for that may be only $15 million a year
MR. HAUSER: We have done a fair amount of leasing, although not so much in power plants as in other assets, like buildings. We have leased one power plant — actually in California. We have done synthetic leases on airplanes. We have done a lot of different things. You need to be looking at your total arsenal of weapons all the time. I don’t think it is as simple as a lease-buy analysis like it used to be. If you are looking at a lease, you better be figuring out where you are with foreign tax credits, where you are with the alternative minimum tax. All these factors play into the decision. You are going to reach a different decision at different points in time
MR. MARTIN. One more leasing question — can one do a lease on a project credit or must one have a creditworthy parent standing behind the lease rentals
MR. GODRY: It really is only doable with creditworthy entities. Having said that, you can do a project backed by power purchase agreement or tolling agreement with a creditworthy party. I can think of three or four projects that have been done on that basis this year. The creditworthy entity must be a triple B or better. Merchant Ratings MR. MARTIN: Let me ask a series of rapid-fire questions in the time we have left. Andy Jacobyansky, is there a trend in ratings for merchant power plants? Are the rating agencies getting more comfortable with merchant risk
MR. JACOBYANSKY: We get investors asking us if we are loosening our standards because recent ratings have been higher than in the past. However, the reason for the higher ratings is recent ratings have been on assets that are moving over from one part of the company to another with no real debt. These are not assets that were bought at an auction where somebody paid more than anyone else wanted to pay and had to put a lot of equity in and lever up as much as he could. An example is where a utility has $550 million in coal-fired power plants on its books. It has owned them for a long time. It moved them recently to a sister Genco and took back an extremely subordinated note. The transfer was blessed by the public service commission. The subordinated note is essentially equity. It is a significant coal-fired portfolio of 2,500 megawatts that is essentially being moved over with no debt on it
MR. MARTIN: What about ratings for greenfield merchant plants — are they improving
MR. JACOBYANSKY: No. If we looked at a project today that is identical to a project two years ago, we would come to the same rating
MR. MARTIN: What about a California-type risk? Are companies with California exposure under pressure from the rating agencies
MR. JACOBYANSKY: There are many companies with California exposure. We looked at all the corporates — like Calpine and Mirant and Duke and Reliant — and decided they did not have enough California exposure to warrant bringing down their ratings. We took all the projects in California down to Caa2, which is the unsecured rate for utilities, but just two days ago, recognizing what is going on in California, we put all except one on a list for possible positive upgrade and said the upgrade could be more than one notch. So I think we may start to see some of them move up.
MR. MARTIN: What effect has California had on the ability to get financing for projects outside California
MR. HAUSER: We have had moments when it was very difficult to get financing for merchant power plants. We are all having these peaks and valleys. Things will settle down and then someone like Gray Davis will say something or FERC will do something and the banks pull back to assess what it means. The markets get tough for a little while. Our biggest challenge this fall will be refinancing a portfolio of assets, including in the portfolio some assets in California, but I expect this will get done on schedule
MR. COOPER: There is what several people said is a headline premium. The bankers must go back to their credit committees and explain after every headline why the latest news story has nothing to do with this deal. It’s kind of the aggravation premium. It means that deals are taking a lot longer to syndicate because the bankers have to explain a lot more. When an international monetary crisis hits in an emerging market, the entire country is hit and dries up. It is that sort of phenomenon that we are seeing in the United States