The “End Game” For Merchant Power
By Rohit Chaudhry and Adam Wenner
Many merchant power companies in the United States appeared to be barely hanging on financially early in the year. Three are currently in bankruptcy. However, conditions improved enough by early summer for companies in the sector to be able to resume borrowing and to raise additional equity.
The outlook remains cloudy. The companies are highly leveraged with billions of dollars in loans coming due in the next three years. Almost all regions of the United States have more electric generating capacity than they need. This condition is expected to persist in many parts of the US until as late as 2010 to 2014, according to the latest forecasts from industry experts. Private equity funds are circling the power industry like vultures hoping to pick up projects at fire-sale prices. There have been fewer sales than expected. The banks — in no hurry to write off loans — have been allowing loans coming due this year to be refinanced, but the rollovers are short term and often come at a cost to the merchant power companies of having to put up better security, leaving less room for maneuver the next time. Meanwhile, the US economy as a whole is starting to improve.
Chadbourne hosted a debate in San Diego in June on the question, “What is the ‘end game’ for the merchant power industry?”
The following are excerpts from that debate. There were eight debaters, four to a side. Four spoke for the lending community. They are Leanne Bell, a managing director of GE Structured Finance, Gail Nofsinger, vice president in the capital markets division of CoBank, a cooperative bank based in Denver that has been a lender to many merchant power projects, Larry Kellerman, a managing director with Goldman Sachs & Co., and William Chew, a managing director of Standard & Poor’s.
The four debaters opposite were Tom Kilgore, vice president-structured finance with El Paso Energy Corporation, J. Stuart Ryan, until recently executive vice president and a chief operating officer of The AES Corporation, Donald R. Kendall, a leading investment banker in the 1980s who now manages a portfolio in the power sector for hedge funds at Carlson Capital, and Andrew Schroeder, vice president of the EIF Group, formerly known as the Energy Investors Funds.
The debaters alternated in laying out their views of the future and in prodding the other side. Other speakers include Mark Woodruff, president of the AES business unit with responsibility for the western part of North America, Kenneth Seplow, vice president of United American Energy, Adam Wenner, a regulatory lawyer with Chadbourne in Washington, and Michael Polsky, president of Invenergy, an independent power company in Chicago. The moderator was Rohit Chaudhry, a project finance lawyer in the Chadbourne office in Washington.
MS. BELL: In order to set the stage for my response to the end game, I thought it wise to tell you what we had in mind at GE Capital for the game at large.
GE Capital has an energy portfolio totaling almost $8 billion. We have called on many of you in the room looking for partners who share our view of long-term capacity and energy margins, partners who can manage day-to-day operations including dispatch, and partners who are attracted to our well-priced money. We look to invest equity in plants with long-term tolling agreements with investment-grade counterparties. As a structured equity provider, we rationalize giving away upside for downside protection.
Just as with most QFs we invested in long ago, we knew we were dependent on tollers. Our models suggested way too many plants were being built for the capacity values in the near term. Fortunately, we and many others in the room were aware of the mighty big difference between an integrated utility offtaker and a power marketing company.
You may recall the experts once said that Exxon Mobil was a dinosaur that would cease to exist. Exxon Mobil lives on. However, our view internally is that the dinosaur appears to have been the framework around which we did business over the past few years.
Where do we go from here? With respect to us, we’ve made a business of buying QF equity in the nine to 10% after-tax range from sellers looking for liquidity — terms that we hope work only for us.
With respect to the market at large, I’ve come up with this hypothesis, and many of you may disagree with it, but here goes.
For the next year, most of us would probably agree that many gencos will continue to obtain 30-day default waivers and some will die. In time, those gencos that obtained the waivers will decide it is not worth working for lenders without the prospect of the near-term payoff and effectively turn the assets over to their lenders. Lenders secured by distressed assets will hold out for as long as possible hoping for relief in the capacity markets. Relief won’t come and certainly won’t come quickly. Reserve margins and gas prices will stay high, nukes will stay on, and the weather will stay rainy in New York.
Lenders will be forced by the regulators or managements to write down the assets. Sick of managing the power plants, these discounted assets will be offered for sale to aggregators of distressed assets looking for a 15% return. Money will pour in. More and more aggregators will enter the fray, margins will be driven to dismal levels, driving the aggregators to sell their portfolios to investor-owned utilities. It will be cheaper to buy the assets and put them back into rate base than to remain subject to the volatility of the wholesale market. Reintegration will lead to fewer financially-healthy utilities. They will have a very highly efficient gas fleet but in all the wrong locations. These utilities will eventually be eliminated and power will become a fungible commodity across the United States.
This statement is somewhat controversial, but I’d be interested in my colleagues’ responses to it.
MR. KILGORE: Thank you, Leanne. It is indeed refreshing to hear such happy optimism. The merchant model is dead. Long live the merchant model.
Let me address where we are, how we got here and where we’re going to go. This paradigm lasted, what, five years?
Why did the paradigm arise? It arose out of several things. First, we are talking about a business that has a fundamental interaction between politics and the marketplace. And whenever the government enters business in a regulated environment, you find mass inefficiency. That mass inefficiency still characterizes the investor-owned utilities today, which is why the merchant model arose, why it died, and why it will come back again in a slightly reformed framework.
The underlying fuel for all this work on our part was firms from 1980 on engaged in a 20-year bull market propelled to grow at all costs and propelled by lenders desperate to put their capital to work at egregious premiums. These combined to erode the independent power industry. The non-regulated subsidiary companies and energy merchants all scrambled to grow and to claim a market share.
A whole paradigm developed around iron in the ground and megawatts under your control, a paradigm no less bankrupt than looking at internet companies and page views. We succumbed to that, too. How many of you still have dot com companies in your portfolio wondering when they will come back?
What we see in the future for the merchant energy sector is that we will have a new merchant sector, not in the manner described by my esteemed colleague, but rather because there is an inefficiency, and because the regulated markets and their regulators have, in effect, outsourced to the merchant companies the bundling of services and the management of risk. That function has been lost from the investor-owned utilities.
As we go forward, as the companies involved today restructure, as we replace our managements and bring in management that understands VAR and how to apply it properly, as we apply proper credit policies and margining factors, and as we become more astute political players, you will see a new energy merchant arise, one that is able to function in this market. It will be a private rather than a public entity. It will be very well connected with the local regulatory system. It will arise on a regional as opposed to a national or global basis. That is the future of merchant energy.
MS. NOFSINGER: I’m surprised to hear you admit that there were things that you didn’t tell us up front — like politics. Did I hear you say management didn’t know what it was doing?
I think we will still have a merchant market. It is not a market to which the banks are eager to lend, but they will continue lending because they want to be repaid what was lent before.
We relied on everything you told us: your plans for the future, your plans to have the most megawatts in the ground, competitive power for everyone, and electricity prices that will remain high enough to allow you to repay your debts to us. It should probably have been obvious that one consequence of deregulation is prices fall. Where are all the consultants today whose forecasts suggested otherwise just two and three years ago?
One key assumption made by the banks is that if prices fell, eventually demand for electricity would increase. Plants would be dispatched with greater frequency. That has not happened, either.
At the end of the day, we remain committed to the merchant market. Painful lessons lead to greater understanding of how not to do things the next time. And we are going to get back the money we have already lent.
MR. RYAN: The merchant power companies will be here for some period of time, notwithstanding the severe liquidity crisis that all these companies faced about a year ago. What we now realize is that it wasn’t a liquidity problem but a solvency problem for the most part.
Many people are predicting that the real crunch will come in 2006 or 2007, and merchant companies that refinanced today will be staring bankruptcy again in the face then. I do not believe the merchant companies will end up in bankruptcy. They were all tailored to be super-high-growth engines, but the same engines still work in coasting mode. There are plenty of places where the companies can find efficiencies within. In addition, the current interest rate environment is a strong wind at the back of those companies that will allow them to restructure and avoid bankruptcy.
Share prices for many of the companies have recovered to a point where they are again able to raise equity. The more equity they can raise, the farther the threat of bankruptcy recedes.
What will the future bring? I think we will have something other than a merchant energy business. I say that because “merchant” has become a loaded word. We will have a competitive power market principally because, at the end of day, it doesn’t make sense to sell electricity to each member of a large varied group of customers at exactly the same price and terms. Each customer is different and deserves different terms.
What will happen to all the debt encumbering the merchant power companies? We will obviously see a lot less debt in the future. The mistake made was too much leverage. It doesn’t require any sophisticated change in structure to fix — just less of it.
On the equity side, I see today many new entities looking for an opportunity to play. The equity money will be there, but there will be much more sophisticated analyses of commodity price risks, credit risks and regulatory risk. The hybrid model or partial deregulation is a dangerous cocktail. Regulatory risk is a huge problem when regulators are allowed to second guess capital investment decisions on an hourly basis. I do not see the muddled model or the model where everything goes back into rate base as at all likely given the preference in this country for competitive wholesale markets.
MS. BELL: I think Stu Ryan just called me a muddle. Now I’m feeling a little cranky. I took exception to a lot of what you said, but the question that falls out, given the popularity of this concept of aggregators — these hedge funds and other companies that are forming with the intention of buying up assets at distressed prices over time — is how do you see those companies interacting with the El Pasos and maybe one or two others that might still be around after the year passes? Do you see any conflict between the two types of companies? Or do you see them working together?
MR. RYAN: I don’t see the aggregators establishing a significant presence, to tell the truth, and I am someone who is spending most of his time in that space right now. My theory is that most of these companies — the would-be sellers of these assets — are not going to be major asset sellers. This leaves little room for aggregators. I do not think you will see the equity selling out like that.
MS. BELL: Think about this added twist to my theory. I was a lender for a very long time. The banks will hang on to these assets for as long as they possibly can. But the regulators will move in at some point and ask, “What the hell happened here? You’re calling this a par investment? Your statements are suggesting that condition might hold for a while.” At some point, the regulators will push the numbers down and the assets will end up with the aggregators or somebody else.
MR. RYAN: Depends on size, right? If it is a big enough lender problem, that may be right. If the problem does not rise to the level of $30 billion or so, then I don’t see the regulators stepping in and forcing the banks’ hands.
MR. KILGORE: A question for Gail Nofsinger: wouldn’t you agree with me that there is demand for a unique service and that there is a need for merchant power companies or someone else performing the same role to provide that unique service? It may be an aggregator who provides the service. It may be a Goldman Sachs. I think you would have to agree there is no better evidence of a new merchant model emerging than seeing Larry Kellerman, the quintessential developer, now working as an investment banker and employing money in the sector. Would you not have to agree with me that that is proof positive that the merchant model survives and that there is an ongoing need for management of electricity?
MS. NOFSINGER: Isn’t the fact that Larry Kellerman is on the money side a sign that the lenders are now the owners and they are merely trying to bring good talent to their side in the hope of getting out of the situation?
MR. KILGORE: But that doesn’t answer the question. You may be owners now, but this is a marriage that is still intact. It may be an ugly and long divorce for so many parties involved, but it is still an intact union. And wouldn’t you say that that union will survive in one form or another?
MS. NOFSINGER: Maybe we will stay together, but the question I have for you is: what will your motivation be when we are getting all the money out of it?
MR. KILGORE: You get to ask me questions later.
MR. RYAN: Would the fine and proper Miss Bell please act out for the group just how she would explain to her credit committee that the assets will end up inevitably back in rate base where the potential returns are limited by regulation?
MS. BELL: We invest against contracted cash flows, so at the end of the day we will be making our —
MR. RYAN:You are supposed to be talking to your credit committee.
MS. BELL: I am talking to my credit committee. We invest against contracted cash flows. In round two, we will be a lot smarter about that counterparty with whom we are dealing. In round one, we bought a whole lot of bunk with respect to risk management procedures, and we bought a whole lot of bunk about limits and controls that will not, I think, stand the test of time.
MR. RYAN: How are you going to get to a contract risk as opposed to a regulatory risk in the market you see developing in the future?
MS. BELL: Let me be very clear about the answer here. We are going to our credit committee and we are saying we know the future — I am the creditor, and you are the credit committee — we know the future. The future is expected to be X, and it is a controlled environment but one in which we can make a return over time. It will not be a high return, but it is a stable return.
MS. NOFSINGER: Mr. Kilgore, before we make a decision about separation, what is it you are planning to bring to the table that will allow the marriage to remain intact?
MR. KILGORE: Well, flowers and chocolate have always worked well for me. [Laughter.]
MS. NOFSINGER: That worked the first time around, but the banks are not buying it.
MR. KILGORE: I’m tempted to think about jewelry, but —
MS. NOFSINGER: You are limited to a $500 gift.
MR. KILGORE: We’ll have to work backwards, then. I think the answer is rather simple. We will bring to the table, as current developers, enough expertise to be able to try recovering some return of our equity and return on our equity. It is unlikely for any developer to stay with a project once he determines that he cannot get either a return of or return on equity. And he will return the project rightfully to the lenders. That leaves the lenders in the merchant energy business. And a group of lenders that apparently failed in its original due diligence — having made an issue of it with us — now gets not only to repeat the mistake of that due diligence, but now has to operate that facility in the absence of people with historical background and expertise to help. That’s the foreseeable outcome. It is really a transfer one project at a time or one small project company at a time of the merchant model from the original developers and entrepreneurs to the lending community.
MR. KELLERMAN: On behalf of the lending community, I want to start off by saying mea culpa. We on the lending side have created an egregious error and a major sin by being too lenient, by being too tolerant of the wayward paths of the developer community.
Thus far in this debate, we have heard much about the destabilizing effects of hubris and benign tolerance for an unsustainable business model that has brought this industry to the precipice of ruin. What we have to do is point out and reconcile ourselves to, perhaps, the role that the parties most culpable had in the creation and perpetuation of this sad state of affairs in our industry. Unfortunately, I have to point to ourselves in the commercial lending community as being the perpetuator of the problem.
In the criminal justice system in this fine country of ours, the purveyors of elicit drugs are meted out much, much harsher punishments than the hapless and wayward drug abusers. I point out to you in the audience, the hapless and wayward drug abusers [Ed. The speaker is pointing at the opposing debaters who are representing project developers] who have been on the side of the street unfortunately being given the crack cocaine of liberally-granted funds by ourselves on the lending community. [Laughter.] That must stop. In the halls of this industry, we should likewise be placing due blame and opprobrium where it belongs on the parties who have lavishly dolled out the funds that have been responsible for this industry’s demise.
Thinly-capitalized developers and larger merchant energy firms have become this sector’s junkies. Junkies motivated and, yes, actually rewarded by weak lenders via the cocaine of liberally-available project financing against assets that have no power contracts and very little chance of ever getting a power contract.
Just listen to these numbers: 45, 44, 41, 40. No, these are not the respective IQs of the poor hapless debaters opposite. [Laughter.] No, these are the projected 2004 summer reserve margins in the SPP, ERCOT, SERC and MAIN respectively. On the hottest day next year, verily, there will be more than 40% more metal in the ground in these regions than could possibly be used. And nationally that figure is a bloated 34%.
The fundamental cause of this great waste of capital and destruction of value in our industry is that somebody gave these misguided souls a weapon of mass economic destruction, and that weapon was cheap, highly available capital without a disciplined diligence process effectively to constrain these poor souls from misapplying that capital. That is our fault, and it is something that we on the lending side should stop. [Laughter.]
But alas, now it is 2003, the morning after the big party. Drained kegs and empty Dorito bags litter the floor of our collective house. [Laughter.]
The lenders have woken up and discovered that their homes are filled with marginally conscious, blurry-eyed developer revelers from the night before. They don’t smell very good, and you have to watch where you step. [Laughter.]
What should a responsible lender do in a circumstance like this? You clean up the mess, and you send the junkies packing.
But what are we in the lending community doing? This is the dilemma facing my colleagues today. The lending world by and large continues to funnel money, resources, and most of all, benign tolerance for an unsustainable business model. By not forcing a radical set of changes on this merchant energy sector, what we are doing is condoning and perpetuating a folly that spark spreads will rebound, and that the good old frat house days will return once again. They are not coming back. And by not forcing a fundamental change in perspective, we are lengthening the time during which we do not have the three R’s that need to take place in this industry: restructuring, recapitalization and renewal. By putting that day off, we are perpetuating the problem.
This industry is mired in malaise and plagued by procrastination. Poorly-capitalized, non-investment-grade credits cannot prosper in the merchant sector. Lenders need to reconcile themselves to the fact that a poor credit cannot perform adequate risk management, cannot properly hedge its positions, and cannot optimize its assets.
Lenders to this industry, I call upon you to realize the gravity of our collective problem and to transition troubled assets in your portfolios out of the hands of those misguided souls in the marketplace who have misapplied the funds and so fool-heartedly taken those assets and suboptimized them even to this day. [Applause.]
MR. KENDALL: Thanks for ruining my talk. [Laughter.] I wanted to say first that I’m really on both sides or neither side. As a relatively new entity, Carlson Capital fortunately does not have the past baggage of problems that almost everybody else here has. I also want to review some of the history. This is a relatively new industry. We really didn’t get started until the Public Utility Regulatory Policies Act, or PURPA, was enacted in 1978. We really didn’t have a merchant business until the 1990’s. So the industry is still in its infancy.
Also, the amount of value destruction that has occurred is just gigantic. If you go back to January 2001, the market capitalization of the top 10 players was a little over $200 billion. If you go back a little bit earlier this year, the combined market capitalization of the same top 10 players was about $25 billion. The market destruction on the debt side is probably more significant than on the equity side. So, clearly, many, many mistakes have been made.
Very few bankruptcies have occurred so far, but also very few problems have been solved. I think we are merely deferring the problem until 2005, 2006 or 2007. It will be a fun and interesting world when we get up to that point in time.
We are in a new world. This is a commodity business. We have moved from a regulated framework where you did not have the risk we have today to a world where you have part deregulation, part regulation, and you are subject to ups and downs and the supply and demand issues of the normal commodity business. We do have very high fixed costs. We do have many technical issues. It is not easy to store electricity. Transmission requires a lot more technical expertise than is required to deliver groceries and other similar services. Add to this the fact that companies in this business have operated with very high leverage.
We have had a huge number of bad business models. Some of those I think can be changed. Some will have to be destroyed and the companies start over again. I agree with Larry Kellerman that there was far too much cheap capital. I have talked to a number of developers who said lenders forced them to take money. In my view, both sides are to blame because, yes, the developers are taking what is cheap, but they did not identify something rational to do with it.
We are about to see some major changes with the entry of new players. There are probably as many ex-El Paso people here as Chadbourne people, but probably only two or three of them are still with El Paso. This is typical of the shift in the industry. In the future, attendees at these types of meetings will be from a host of new entrants.
A couple things are worth noting about the new world. We will have dramatically modified behavior. A few years ago, generating growth and trading volume was the focus. Today, the focus is much more substance over form. By that, I mean let’s do trading where it is profitable and not just to create volume so that the company can be ranked number one.
You are also going to see a huge decrease in the attempts at manipulation. Handcuffs work. We will see more prosecutions in other areas where there has been fraud. We will see major migration toward trading platforms. There will be improved price transparency. There will be better ways to understand where the risks are and are not in the business. There will be much more attention paid to price and credit risks. Many painful lessons have been learned from the current debacle.
History should be studied because it can repeat itself. Fortunately I wasn’t involved in it, but one of the early failures in this industry that hit a number of players in this room was the AES Deepwater project. It was done as a very high-capital-cost-project because of a relatively low-cost petroleum coke fuel. The contracts did not match. Their base was dependent on gas prices remaining high. My recollection is that GE Capital’s gas forecast at that time said gas would never fall below $4 again. Before the project completed construction, I believe gas was under $2. And before GE funded its lease equity commitment, the project was in default.
Those things will happen time and time again. It is a simple lesson in project finance 101. You need to make sure that the revenue and expenses match and that people work to mitigate risks.
MR. CHEW: It seems I’m in the midst of role reversals. My colleague has said all the lenders are wrong. It sounds to me like my opponent just said that the developers are wrong.
At the risk of muddling the issue further, let me go back to at least a couple of the questions that were asked and give a perspective from Standard & Poor’s.
What is the end game? I agree with what Mr. Kilgore said: the merchant model is dead. Where I disagree is whether the lessons have been learned. There are two issues we see in particular. First, what was the problem? A lot of it has been the failure of the business model. However, we believe that the business model is only part of the failure. The real wreckage — the real source of value destruction — is the matching of a weak and, in fact, very risky business model with very high-risk finance strategy. There was an increase in leverage at exactly the point that the business risk was increasing. Look, we moved from franchise monopoly markets to competitive markets. Business risk automatically increases when that occurs and, somehow, we have leverage increasing sharply at the same time.
I am not sure from listening to the comments from the chastened developers on the other side and from my lending colleagues that this lesson has been learned. Yes, you have heard the call for lower leverage. I think the real lesson is that the leverage must match the specific business risk that is still contained in some of the reconstructed business models we have seen.
Second, another lesson that remains to be learned is the big challenge is dealing with some of the compound credit risks that are embedded in the merchant model even today in the firms that remain in trouble. The problem is there is a basic conflict in the trading model that is embedded in these firms. Trading requires enormous capital. At the same time, it creates additional exposure to credit risk.
It has been unclear to us for some time how the aggressive trading models can be maintained while the credit ratings at best for some of these operators are low investment grade. We look at the financial derivatives market, which is the closest thing to the financial trading that is taking place here. In that market, the counterparty credit for transactions is high investment grade or else the trades involve a structured derivatives product operation that protects against losses when the market turns sour.
Just to finish addressing all the questions, I think this sector will be able to attract new capital, but it will be on a risk adjusted basis. There will be a true risk adjustment on the pure merchant model. The debt component needs to be de minimus in order to continue to attract equity investors. The problem with enthusiastic lenders will remain. The animal keeps choosing to play, as we heard in the discussion yesterday about the debt market reopening to further borrowing by merchant companies that were in distress just three months ago. That may indeed occur, but to be sustained over the long term, the companies will require much higher equity.
Finally, we have the question of whether the industry will remain plagued by asymmetric returns. I think the problem is excess capacity. It is not simply the return that is the problem. It is driven by the phenomenon that we have a lot of springing potential additional capacity that will come into play at exactly the wrong time. When we move from a regulated model to a competitive model, we often forget that the constraints on additional capacity that were supplied by certificates of need were supposedly replaced by the economics of the marginal cost barriers to entry. The difficulty here is that the marginal entry is off of a rate-based utility that does not respond in any sense to market incentives. Indeed, the utilities have the incentive to run additional rate base just at the level sufficient to drive the merchants down to very difficult prices. So over the long term, we expect there will be a real problem in avoiding boom and bust in this sector as long as we have a hybrid arrangement.
MR. SCHROEDER: As a current equity investor in this space and a recovering lender, I have reached step three in the five stages of working through loss. I see a bleak future for the merchant power business and merchant lenders.
I think that a false optimism has set in recently after some of the energy merchants and independent power producers restructured their debts. The restructurings were nothing more than a full employment act for the lenders and for others involved in our business. Sweeping the problems under the rug for the next three or four years is not going to solve this crisis. It will only put it off.
The industry has more than $80 billion in debt that must be refinanced in the next six years. You have higher rating agency thresholds, some of which are egregious. You have deals that are coming into the market today with ultraconservative structures. This is a hard way to finance future growth of this business. The energy merchants have given up their flexibility by pledging all their remaining collateral to get the recent refinancings accomplished.
As we heard yesterday, the companies and the banks are reluctant to take writedowns of assets. That will only hurt them down the road. You are not going to see many sal