Power Contract Securitizations
The Enron bankruptcy has made it more difficult — but not impossible — to “monetize” the revenues an electricity generator expects to receive over time from a long-term power sales contract by borrowing against the revenue stream in the capital markets.
Yields have increased, investor appetite has decreased and rating agency scrutiny has intensified. Even bonds that were intended to be carbon copies of previously successful offerings, which otherwise should have been relatively straightforward transactions, became both more complex and harder to close than the parent deal.
Investor demand for bonds backed by revenue streams from power sales and other energy service agreements is down. Investment banks have shared in some of the pain as their bond sales commissions have decreased, but the greatest impact is on the issuers who now must pay more over time to borrow less money.
Extended Sales Process
Road shows are more arduous than before. Questions from potential investors are more pointed, more cities and presentations must be included on itineraries and, in general, investors are signing up for fewer bonds than in more normal times. The practical impact of these developments is to make it more difficult to close parallel transactions (for example, paying down an existing financing with the proceeds of the new bonds) as it is now more difficult to predict the ultimate closing dates of offerings. In addition, the number of days that elapse between distribution of the final offering circular and actual receipt of funds — “T+x days”— has tended to increase in the aftermath of the Enron bankruptcy as the investment banks need more time to line up buyers for the bonds.
In a number of instances, material changes have been made to transaction terms after the red herring was printed in response to investor or rating agency concerns. Issuers then face the added expense and delay associated with “stickering” the offering circular to draw to investors’ attention the differences between the preliminary and final offering circulars. Even if the structural changes are not so significant as to be “material” for disclosure purposes, offering circulars and the corresponding transaction documents often require reworking, adding to transaction costs and occasionally delaying the offering.
Rating agencies are also paying closer attention to debt offerings. For example, in the past, the rating agencies tended to rely primarily on the ratings of the offtaker and the sponsor when formulating ratings on receivables-backed securities. Since the Enron bankruptcy, the rating agencies have become more involved in the minutiae of transactions and have required more changes than ever to significant and ancillary deal terms. This increased scrutiny means longer review periods and sometimes extensive revisions of payment terms, collateral packages and operational covenants to achieve the targeted ratings, even when the offtaker and sponsor are themselves unaffected by Enron’s collapse.
Outside accountants and other advisers have also become more careful — even skittish. Audited financials must be included in offering circulars and the reports of experts and consultants give comfort to investors that the issuer’s revenue and cost projections are reasonable. All of these third parties are potential targets for investors seeking recourse if an issuer defaults on its bonds and all are now more careful in their analyses and precise in their written work products. The practical impact is that comfort letters and consents are not given as freely or quickly as they once may have been.
Issuers have been taking home fewer proceeds from offerings than originally projected — in some cases, the discrepancy can approach 20% of the pre-Enron expectation.
Even after aggressive road shows, fewer investors have been willing to purchase energy-oriented bonds and, when they do, they often do so in a reduced aggregate amount that effectively results in higher-than-required coverage ratios. For example, bonds might require, and be priced for, a 1.03-to-1 coverage ratio but the smaller offering amount results in an effective 1.07-to-1 coverage ratio.
The impact on issuers can extend to the closing process as documents and offering circulars are revised to take into account the gap between the bonds that will actually be sold at closing and the aggregate amount of bonds that could otherwise be issued based on the contractual revenues. In such cases, the parties either reduce the offering to match the amount of bonds sold or revise the transaction documents to enable the issuer to sell additional bonds when investor appetite recovers.
Many energy-oriented bonds issued recently have been sold at a discount from the face value (meaning that investors paid, for example, 97¢ for each dollar of principal amount). The discounted purchase price increases the effective yield of the bonds above the stated yield, which increases the attractiveness of the bonds to investors but reduces the proceeds to the issuer.
However, too much of a discount can be burdensome for holders of the bonds since the discount is treated as accruing over time for tax purposes and must be reported as taxable income even though no cash is paid to the holder until the bond reaches maturity. Issuers need to be aware, both for disclosure purposes and for general marketability of the bonds, of the impact of a significantly discounted purchase price.
“Market Out” Provisions
Each of the factors discussed so far is an impediment to closing a transaction on the terms initially proposed and at the time originally planned. However, the events of September 11 also precipitated a change in the traditional documentation between issuer and investment bank that, however unlikely, may prevent an offering from closing at all.
Specifically, after the September 11 attacks, many investment banks revised the “market-out” provisions in their standard purchase agreements — the agreement entered into a few days before the closing of the offering pursuant to which the investment bank agrees to purchase the bonds from the issuer — to provide that the bank will have no obligation to purchase an issuer’s bonds in the event of a terrorist attack against the United States.
Previously, “market-out” provisions were generally limited to declarations of war and other upheavals with which market participants were more familiar prior to the September attacks. Now, given their new familiarity with attacks that take place on US soil and may cause the financial markets to close for a period of time, the investment banks have expanded their ability to walk away from a transaction if they do not believe they will be able promptly to resell the bonds into the larger market. The capital markets remain open to securitization transactions involving power companies. However, issuers will need to remain flexible with respect to their timing, economic expectations and relations with third parties until the market as a whole regains its comfort with the energy sector.