Chadbourne hosts an annual conference for top people in the independent power industry. The conference this year was in June in San Diego. One of the panel discussions focused on the market for distressed projects. Many people had thought early in the year that there would be opportunities to buy power plants at fire-sale prices, but there has been a smaller number of sales than expected. The question before the panel was, “A new popular wisdom is taking hold that there will be fewer opportunities to acquire distressed power projects than thought earlier because the banks are in no hurry to write off bad debts. What’s the truth?”

The speakers are Jay Beatty, a prominent investment banker with long experience in the utility sector and who is currently managing director of New Harbor in New York, Robert Cushman, who has been looking for distressed assets in his role as vice president for mergers, acquisitions and structured finance at Entergy Corporation, Glen Davis, who held various senior positions with The AES Corporation and was most recently group manager of a team that was working on selling assets, Karl Miller, a senior partner with Miller McConville Christen Hutchison & Waffel, LLC, a private power company that formed last year to buy distressed assets, and John Schuster, the chief business person at the US Export-Import Bank for lending to projects in the power sector. Mary Power, a vice president for project finance lending with the German bank DZ Bank in New York, and Mark Woodruff, president of the AES business unit with responsibility for the western part of North America, asked questions. Keith Martin, a Chadbourne partner and editor of the NewsWire, was the moderator for the session.

MR. MARTIN: Jay Beatty, it now looks like there will be fewer project sales this year in the power industry than people had thought earlier — perhaps as few as 10 or 12 large transactions. Do you share this perception of the market?

MR. BEATTY: There has been an extraordinary shift in the market just in the last three months. Both project-level debt and corporate debt are now trading at two to four times the levels in March.  That means that the liquidity crunch is essentially over for now, and companies can raise money in ways that were unimaginable earlier this year.

MR. MARTIN: So the pressure has eased to sell assets?

MR. BEATTY: Right. I had a meeting earlier this week with a client who had just finished a major strategic review of its assets with an eye to what can be sold to raise cash.  The goal when the review started had been to shed as much as possible. However, by the time the review was completed, the conclusion was that everything is now strategic. I think you are going to see a lot fewer asset sales as people are not forced to raise liquidity. It is hard to imagine a credit in the industry that cannot clear the debt market at 80%.

MR. MARTIN: Bob Cushman, do you agree?

MR. CUSHMAN: Jay is right. Things are changing. A lot of it has to do with the resistance of companies and banks to take losses. Many people figure that if they could just hang in two, three or four years, things will come back, and there will be no need to take a loss. Stock prices have already collapsed. For a company to lay a new set of surprises on the market — “Oh, by the way, we forgot to tell you that we have a large number of assets that should have been written off” — it is just not going to happen.

MR. MARTIN: Glen Davis, your view?

MR. DAVIS: That sounds right. However, keep in mind that there are two types of assets — contracted assets and merchant assets — and there is also a hybrid class of assets that are partly contracted. [Ed.: A “contracted” asset is a power plant whose electricity has been committed under contract to a purchaser, usually over a long term.] The hybrid class contains assets where the contract is with an entity that is no longer creditworthy or has made a strategic decision to get out of the business of tolling or trading power. The transactions you may see in the next year or so may be driven mainly by strategic decisions of purchasers who want out of the business or by the unwinding of contracts with electricity purchasers who are no longer creditworthy.

Merely Delayed?

MR. MARTIN: Karl Miller, you have been a critic of merchant power companies and banks who think they can avoid losses by riding out the business cycle. You have suggested that the merchant companies have unsustainable capital structures and that a day of reckoning will come — if not now, then two years from now. Jay Beatty said the market has turned around in the last few months to a point where most merchant power companies are again able to raise new money. Is it possible that any further huge selloff of assets has been not merely postponed, but also avoided?

MR. MILLER: I spoke recently at a conference in New York attended by bankers, and the theme was hope is not a strategy. A variation on that theme is hope is not your best friend. I agree with Jay that liquidity may have been easy to find within these irrational spreads fixed in the market. However, the long-term problem has not been cured.  The reality is this market is going to see other assets change hands. A rational person might put some additional capital into these companies, but any such capital would be short term.

MR. MARTIN: Jay Beatty, how long can the banks avoid taking losses? How long can they roll over debt in the hope that market conditions will improve?

MR. BEATTY: I’m not sure. Right now, banks are rolling over debt, but they are rolling it over by taking better security. From the bank standpoint, this is a no-lose bet. If its borrower went into a bankruptcy proceeding today, the loan is non-accruing and the bank is stuck. If the bank takes better security and the borrower files for a bankruptcy a year from now, then the bank is in much better shape. So I don’t think the banks have decided that their borrowers might be able to ride out the business cycle.  The banks have concluded that if these loans are non-performing anyway, they are a lot better off if they are secured lenders than not secured lenders.

MR. MARTIN: John Schuster, does what we heard about the US market also sound true for foreign projects?

MR. SCHUSTER: There are two points. First, you are starting with a much smaller base of merchant assets in the emerging markets in which the US Export-Import Bank deals than in the US market. Second, the turnover of assets in these markets is likely to be even slower than in the US. Remember that you are often dealing with official lenders who are not going to be in a hurry to sell things off. There is less tendency to try to turn things over to new borrowers because part of what the lenders hoped they were getting was somebody with experience dealing with the government of Indonesia, for example. Turning the project over to a new, less experienced borrower is not a risk that the lenders will want to take.

Five Stages of Loss

MR. MARTIN: Before we got started this morning, you said that a banker goes through five stages before concluding that a borrower won’t be able to repay a loan. What are they?

MR. SCHUSTER:This picks up on something that Bob Cushman said earlier. He said both banks and borrowers are reluctant to write off assets. They must work first through the classic five stages of dealing with a loss – you know, denial, anger, bargaining, depression — where you realize this can’t go on forever — and finally acceptance. Eventually what happens is banks conclude they have no choice but to accept the new breakdown. I think that is eventually where the market is headed, but, as far as I can see, the banks are still in denial today.

MR. MARTIN: When it comes to projects in emerging markets, the banks are still in denial?

MR. SCHUSTER: I think the problems are less acute internationally than they are in the US market. Maybe I’m just an international banker who is in denial.

MR. CUSHMAN: Actually, I have had some personal experience going through the five steps.  There were several merchant plants in the UK in trouble. At the end of the day, there was a deep-seated belief by the bankers that if they didn’t take the assets or restructure the debt, then someone like Goldman Sachs would come pick their pockets and, three or four years from now, Goldman would get rich and the bankers would look foolish.  Therefore, the banks ended up taking a number of the assets. I am not sure that is how things will play out in the US. What we are seeing in the US is the rolling over of debt with the consequence that someone else is allowed to handle the problem. However, the banks are in a much more secure position with their US assets than they were in the UK.

Role for Private Equity?

MR. MARTIN: Thank you for that bridge back to the US market. In the US, many private equity funds are circling power industry assets like vultures. Is there a role for them if fewer assets than expected are put up for sale? Karl Miller?

MR. MILLER: There is a role for alternative capital in this market, irrespective of winning the collateral.  The reality is the power industry must find new sources of capital.  The capital will be in tiers. Some distressed asset funds might step into various pieces of the capital structure. Some might offer short-term financing in the worst cases. Others may come in with medium-term capital plus a moderate spread and with very solid asset security. And then you have the longer-term products. I will say this: they are not coming in for 30% rates of return. Return expectations are markedly down.  That number is not realistic.

MR. BEATTY: The problem with private equity funds as owners of merchant assets is: how does the private equity fund trade the power? The private equity funds may have lots and lots of cash, but they are really bad credits. Are the funds willing to post the collateral required by counterparties to trading contracts? Interestingly, when NRG went into this, the first thing it did was get $250 million in debtor-in-possession – or DIP — financing. It needed that much money solely to allow it to trade its portfolio. Notice, it had all these existing lenders and it needed another $250 million in cash simply to trade.  The cash does nothing except support trades. The private equity funds must ask how much additional collateral they are willing to post to be able to play in something other than the day-ahead market.

MR. CUSHMAN: Back to two distinct classes of assets: we have contracted assets that I think everybody recognizes are a game of competing discount rates, and we have merchant plants. Merchant plants are a much more difficult problem. There is no good solution to the merchant plant problem other than buying an option.

MR. MARTIN: Let’s fill in a little background information. Of the 62 project sales or sets of sales last year, 60 were contracted assets, or plants that come with long-term contracts to sell the output. Bob Cushman, your point is that all you are doing when you buy one of those is purchasing an annuity or income stream. Only two of the projects sold last year were merchant plants.

Jay Beatty, your point is that private equity funds will find it hard to own merchant plants because one needs credit as well as cash to trade electricity. The funds have cash, but they lack credit.

MR. BEATTY: That’s exactly right.

MR. MILLER: There is a hard question whether the credit required to do this business is justified, regardless of whether it is private equity or anybody else. It may turn out that the regulatory outcome is what is most important here. Before deregulation, credit resided in the public utility commissions. People did deals because they knew that public utility commissions would allow them to cover all the costs in the end.

If the credit pressure on non-regulated entities is so great that the only way to keep this going is to return to a situation where only the regulated utilities can bring credit to the deal, then merchant plants — whether by contract or through ownership — are going to end up back in the regulated system. For the regulated utilities part, they prefer to buy the asset rather than do a contract. The assets will gravitate ultimately toward the regulated utilities.

The End Game

MR. MARTIN: Do you think that is the end game for merchant power – all the assets will end up back in the rate base?

MR. MILLER: I don’t think you can make a broad statement like that. You can’t even make a broad statement about the direction in which regulation will take in this country. It varies from state to state. But I think you will see a move in the direction where assets end up back in the rate base.

MR. MARTIN: Come back to the issue of whether the merchant power companies are fooling themselves.  The banks are letting them ride along for a few years. Are the current debt restructurings merely postponing the real day of reckoning two years from now when the merchant power companies will have to face up to their unsustainable capital structures?

MR. DAVIS: I think the first step for the banks that have made loans at the holding company or corporate level is to gain better security over the underlying assets of their borrowers.  That is what you are seeing happening today. Second time around starting a year and a half, two years, three years from now, depending on the particular company, when these debts that have been rolled over come due again, the companies will again face the question whether they can pay their debts. If you don’t see a future recovery of the market, the second time around the banks will exercise their security more than they have done to date. At the project level, it’s probably a similar pattern.  The banks will probably wait a year or two years, but probably not longer than that.

MR. BEATTY: I see the banks facing the same problem the companies face when they take over the assets. If the banks take the assets, what do they do with them? You see this question today with PG&E National Energy Group, which has turned over the keys to some of its power plants to its lenders. Will the banks sell the assets? If they hold on them, how do they manage these merchant assets? That will be the interesting test for a whole series of companies whose debts are coming due over the next 18 to 24 months.

On the other hand, given this capital market, I would not be surprised if merchant power companies are able to raise enough money to clear out this bank debt by replacing it with capital markets debt on three, five or seven year terms.

MR. MARTIN: Bob Cushman, you said something interesting before we started the session today. Entergy is both selling and buying assets at the same time. It is not the case that we have distressed companies shedding assets and a separate group of private equity funds and healthier companies looking to buy.

MR. CUSHMAN: But to a great degree, Entergy is always the buyer and seller on everything. It is just a matter of where we are and where we would like to be.  We sell in markets that we believe have reached their potential, and we buy in markets where we think we have a better future. This is a matter of repositioning the company to focus on certain markets.

MR. MARTIN: And how is Entergy trying to reposition itself?

MR. CUSHMAN: Obviously, we have a nuclear strategy. We have been buying up nuclear assets. We also have a fairly aggressive trading arm, and in regional markets where our traders would like to trade, we will look at buying assets. But will we buy merchant assets? I really don’t think so.  We are in the same position as everybody else. No want wants to repeat the same mistakes the industry made in the recent past. Looking for contracted assets is probably the name of the game, but if you can’t find something that works from a discounted return basis, then you move on.

MR. MARTIN: Karl Miller, how do you win a bid for contracted assets? What is the key?

MR. MILLER: We are not really interested in contracted assets; we are not going to compete on discount rate. That is just not our strategy.

Let me return to a point that I think Jay Beatty made. I think smart capital will always attract itself to the right deal. It is an integrated process. This is not a black-and-white market in which merchant power companies try to survive the business cycle for the next two or three years and then, all of a sudden, the market has to face up to the problem with capital structures.  This will be an ongoing process.  To date, the main opportunities for people to put capital into the sector have been at the holding company level rather than at the asset level. In the longer term, the assets will be up for grabs. You have seen a lot of contracted assets move but you have just not seen merchant plants.

MR. MARTIN: Glen Davis, what is the best way to win a bid for contracted assets?

MR. DAVIS: Some people say the way to win when you are bidding for contracted assets is not to come in first.

MR. MARTIN: Why is that?

MR. DAVIS: The winner always loses.

MR. MARTIN: Cambridge Energy Research Associates did an exercise several years ago where it put a jar of pennies on a table and asked the audience to guess how many pennies were in the jar. There may have been $15 worth, but of course the winning bidder guessed $17 or $18. It is the person who buys the next time around — after the jar has been opened and the pennies counted — who does better. But one would think a bidder can already tell the number of pennies in the jar when it comes to a contracted asset.

If the bidding on contracted assets comes down to the cost of capital and competing discount rates, then what about merchant assets? Many people have ascribed little value to them. Jay Beatty said in an earlier session that owning a merchant asset is the economic equivalent of SARS. Is there a sensible strategy for pursuing these?

MR. DAVIS: It is a case-by-case situation.  The value turns on the region where the merchant plant is located, the local supply and demand outlook for electricity, the availability of transmission and how locational marginal pricing works on the regional grid for relieving congestion.

MR. MARTIN: Stop there for a moment. Explain locational marginal pricing and why it is important.

MR. DAVIS: It adjusts the price that a generator will receive for its electricity depending on whether the generator is supplying power into a regional grid at a point where the electricity is needed.

MR. MARTIN: What does this mean for a power plant that is, say, in northern Maine far away from consumers who use the electricity?

MR. DAVIS: What locational pricing does is it rewards the generator in Boston so that the Boston power plant is more likely to run.  The Maine plant will shut down.  The effect is to relieve some congestion on the transmission grid. Relieving congestion is worth money to the system, and that money goes to the Boston generator.

Rectangles v. Triangles

MR. MARTIN: Jay Beatty, you made the point at our last roundtable that the trouble with the merchant power companies is they are all making rectangles when the market wants triangles and this provides an opening for new players in the merchant power market. Explain this please.

MR. BEATTY: The notion is that a merchant power company is looking for someone ideally to buy 100 kilowatts every hour of the year from its plant. But what the market really wants is shaped power. What any load-serving entity that might buy from a merchant power company wants is a peak load, a minimum load, and mobility within the peak periods. Clearly the way to make money is to be the person selling that shaped power, the power the load-serving entities want and not simply offering a unit power contract for a 150-megawatt gas plant.

The problem for the merchant power companies is becoming more acute now that the rating agencies are taking the position that load-serving entities that have committed to long-term power purchases must put a good portion of the obligation — in some cases 7% of the present value of the contract, which is a big number — on their balance sheets as if it were a debt.

This creates two problems. One is it may hurt the ratings of the electricity purchaser.  This, in turn, hurts the merchant power company because a tumbling rating for the offtaker hurts the project. This has the effect of pushing load-serving entities — at least those who face the capital markets — to shorter-term purchase contracts — not of the 10- or 15-year variety, but of the 3-, 5- or 7-year variety. You are going to find load-serving entities pushing harder to buy shaped power rather than signing on to bulk contracts.

MR. MILLER: Let me put this discussion about shaped power into another context. What the merchant power company should be trying to do is to enhance or create value in the asset.  The power company is focusing in restructuring talks in how it can come up with the funds to do this. I hope that the banks are thinking exactly the opposite.  They are thinking about how they can do it.  They see a hole in the revenue needed to support the debt. They are thinking about how to plug that gap.

MR. CUSHMAN: You know, the more we believe the banks are going to become operators and traders in this industry, the more I’m looking forward to the 2008 conference when we will be talking once again about distressed assets.

MS. POWER: I would just like to say something on behalf of the banks. First, in connection with the refinancing of unsecured assets by taking collateral, in most of those instances it been done on the basis that it gives the company time to make asset sales and repay the loan. One of the first companies to restructure has already paid 50% of the debt down and will eventually get to the point where the loan is manageable.

Second, in regard to taking title to assets, I am personally involved, on behalf of DZ Bank, in taking title to five merchant plants. This has been done in each instance on a very thought-out and careful basis.  We have independent market studies of what the asset is worth and what we can recover. We have looked at putting people in to manage the assets, and we have one of the top companies managing those energy sales. The point is the banks are not going to be selling energy.  They are putting people in to do it and run these projects until the time comes when we can sell and recoup our debt. Maybe we won’t recover 100% of our debt, but we will recover more of it than we could have recovered had there been a sale now. And that’s all we are trying to do.  We have so much exposure in this industry.  We have to maximize our recovery.  We are moving as cautiously as possible.

MR. MARTIN: John Schuster, at which the five stages of loss is she?

MR. SCHUSTER: I’m impressed that this is actually getting beyond the anger and everything else and moving to the acceptance stage. Kudos.

MR. MARTIN: So the story here is that with the debt markets reopening to merchant power companies and the banks not in a hurry to push assets on to the market at fire-sale prices, the huge asset sales that were expected will not occur, at least in the short term?

MR. MILLER: Let me comment on what Mary Power just said. It is not the most efficient approach to deal with the assets one at a time by hiring experts to handle fuel procurement, power marketing, operations and maintenance, engineering.  You can probably put somebody on top of all the outside experts as a bankers’ representative, but the model is not ideal. It leads to value deprivation.  The better way to create value is to bring together portfolios of assets.

Asset sales will occur. I think portfolio sales will occur, and I don’t believe that we will  see a big gap for two or three years during which there are relatively few asset sales. These assets will change hands.

MR. MARTIN: Glen Davis?

MR. DAVIS: I agree with the point that what is being transacted isn’t really assets. It is businesses. And whether a standalone merchant asset can constitute a business is a key question. It can’t be. One needs the ability to manage power sales as part of an integrated business.

Can a merchant asset, without being part of a portfolio and without being part of a trading platform, really be spun into some kind of business? One of the reasons the transactions in merchant assets haven’t happened yet in volume is people are not able to define what the business is in many instances.  Why buy such an asset? It is not a standalone business.  And with so many people fleeing the trading business, it takes special courage for someone to move toward setting up the integrated model required to own such assets.

MR. BEATTY: That’s exactly right. The contracted and the non-contracted assets are two very different businesses. With contracted power plants, it’s a financial game with discount rates and financial engineering.  With a merchant power plant, you are in the business of selling power. The fact of the matter is your business is selling electricity and you own assets simply to support that business. You must figure out your business model first, who your customers are, what business you want to be in, and then go in search of assets to support that business.

One of the more interesting shifts in the market in the past month or two is that, with merchant power companies able to borrow again, people are dropping strategic planning. Every asset they have fits. Now, that can’t be right. It is like everybody being above average. If you really have a business plan, you are like Entergy. You have some plants do no longer fit the business plan, and other holes where you want to buy them.

I am not suggesting that one business is better than the other. I understand that some people may find the greatest attraction simply in earning a three or three-and-a-half percent or whatever compounded return on invested capital.  That is a perfectly acceptable business model. But the fact of the matter is someone who buys contracted assets is getting into a very different business than someone who buys a merchant asset. One is a financing business and the other is a power business, and the two businesses require very different capital structures. The capital structure has to match whichever business model has been chosen.

MR. WOODRUFF: I have a question for Karl Miller about the value of the portfolio. Do you see a greater value of a portfolio of assets within a given regional transmission organization, or do you see greater value of a portfolio of assets that cuts across multiple markets? And why?

MR. MILLER: We’re looking at both. We tend to individualize assets and then look at how can we, from a cost structure, optimize around those assets. We would argue that you could probably do a distressed portfolio and start a strategy in ERCOT and even in California. Outside of those two areas, I would say you’re going to have to take a stand on geographic disbursement by having assets spread across markets to diversify risk.

MR. MARTIN: Let me leave this group with a quote.  This is from the current issue of Power Finance & Risk. It seems particularly appropriate given that we started off this session with an observation that things have started looking up for merchant power companies in the last month or two — at least some of them are in a position once again to borrow. “Executives at US gas and electric companies off-loaded four times as much of their companies’stock over the past three months as in previous quarters, suggesting that talk of an industry recovery may be a little premature. Between March and May, the insiders sold some $128 million in stock compared to $33.1 million between December and February.”

MR. CUSHMAN:Those options were in the money, and we had to do what we had to do. [Laughter]