The Distressed Projects Market
By Neil Golden
One topic this year at a conference Chadbourne hosts annually for leaders in the energy industry was the state of the distressed projects markets in the United States. The conference took place in June.
Standard & Poor’s issued a gloomy report about the outlook for the remaining merchant power companies early in the year, but by June, the rating agency had updated its outlook and was sounding somewhat less pessimistic.
Electricity prices remain low in many parts of the United States. Private equity funds and other players continue to circle independent power companies in the hope of being able to acquire projects at reasonable prices. Several large portfolios of projects have been sold this year to financial players. A group
of panelists at the Chadbourne conference discussed the latest developments in the market, including the Standard & Poor’s reports, what assumptions the winners are making to win bids, and if Goldman Sachs and other bulge bracket players on Wall Street are really just ‘buying up paper,’ what happens to all the plants.
The speakers are Thomas Plagemann, managing directorglobal energy for GE Energy Financial Services, Jacob J. Worenklein, president and chief executive officer of US Power Generating Co., William H. Chew, managing director of Standard & Poor’s, Mary Power, vice president of DZ Bank, Merrick Kerr, chief financial officer of PPM Energy, Steven S. Greenwald, managing director of Credit Suisse First Boston,
two independent consultants — Joseph Lane, formerly with ABN-Amro Bank, and David Wasserman, formerly with Sithe Energies — John Burges, a partner with MMC Energy, and Anadi Jauhari, head of project finance, Americas with Natexis Banques Populaires. Neil Golden, a Chadbourne partner in
Washington, acted as moderator.
MR. GOLDEN: One question we will be debating this morning is whether there has been any change in the market since Standard and Poor’s issued a gloomy report on the merchant power sector in February
called “The Worse Case Scenario Has Become the Base Case.”
The report focused on 12 companies and said that approximately $65 billion of the total $125 billion in debt of these 12 companies will come due by 2010 at the latest. It suggested this is a substantial debt burden. The report characterized the events of the last few years as involving fewer retirements of coal and nuclear plants than had been anticipated and smaller growth in demand for electric power because of a decline in the manufacturing sector. It said there is still substantial excess generating capacity. It said the merchant
power companies will have to attract more private equity because there is no identifiable “end game.”
By June, S&P was somewhat less gloomy but still had a negative outlook on 15 of 23 companies in the merchant power sector. It said there may not be improvements in the ratings until there is more clarity as to what is a sustainable cash flow for these companies.
Let me start with Thomas Plagemann. Where do you see the distressed projects market going? Will more projects be put up for sale in the near term or does the fact that a lot of these companies rolled over their bank debt recently mean there will be few additional sales until the refinanced debt comes due later in the decade?
MR. PLAGEMANN: I would not go so far as to say there is euphoria in the market, but there is certainly a sense that things have turned.
A lot of new capital has come into the market in the last 18 months looking for assets. When you look at what assets have sold during that time period, they are largely contracted or regulated assets. These are not distressed assets. The merchant plants are the distressed assets. There have not been many sales of
them. There was one recent notable transaction where the Duke North America assets were sold but, other than the efforts by a few utilities to bring a few merchant plants into the rate base, there has not been a lot of activity.
The real question is whether there are going to be many more transactions like the Duke sale. We as an investor are income driven. We have an inherent problem with merchant assets because most such plants are not generating enough revenue to cover their fixed costs. This is a problem for any buyer looking for
income. The challenge for us when bidding is to look for ways to bridge a 5- or 6-year period — maybe longer in some regions — before electricity prices are projected to recover.
The banks today own many of the assets that have been the subject of the most distress. It is hard to figure out what is going on with the banks. They have a dilemma. They look at the value of these assets like the rest of us do and see a recovery in the market in the long term, perhaps even by the time their loans come due. But they are facing the problem of having to put additional money into these projects and,
depending on which part of the bank is managing the plants, they may not be willing to do that.
It would be interesting to hear from some of the bankers in the audience about the current bank view of how best to deal with these plants. Will they simply sit on the plants until the market recovers and are they interested in selling? The Duke sale is a new data point for assessing comparable value.
Ripe for Consolidation?
MR. GOLDEN: We will get to the banks, but I would like to hear first from Jay Worenklein. What is the end game for the merchant power market?
MR. WORENKLEIN: In my mind, the end game is not a magic moment when things get suddenly better, but it is a process. The process is a rational consolidation of the merchant industry.
I see an industry that is ripe for consolidation. We have companies or lenders with large portfolios of plants with huge expenses that are not economic on a current basis. There is not enough critical mass in some portfolios. The portfolios are not on a large enough scale to have diversification of risk.
What I see is not so much a strategy of buying individual merchant assets because the asset is a great asset and is going to make a lot of money, but a strategy of trying rationally to build a portfolio, manage the portfolio, contract it at appropriate stages, at different times and different values and, at the end of the day, recognize that the load-serving entities are the core market.
We will never have a merchant power industry built up again in the US. It is not that people will have long
memories. The problem was a fundamental flaw in the thinking that merchant power made sense. The flaw is we failed to see the enormous volatility that comes with electricity because of the lack of storage and because of the inadequacy of transmission. That volatility was amply demonstrated in California when one of the Duke plants went off line. A 50,000-megawatt system was brought down by the sudden loss of a mere 500 megawatts of capacity. Power prices that day and for some time after were up about 33%. That is enormous volatility for a minute shortage, but the larger point is that a similarly small excess destroys
There is no point in buying individual assets in the hope of a merchant recovery. The load-serving entities still have the duty to serve, and they have a responsibility to contract for a supply of power. Auctions have been taking place around the country — in Arizona, New York City and elsewhere — as load-serving
entities look at the highly-depressed state of the market. The regulators are saying to the load-serving entities that if they do not take advantage of the current market by locking in capacity when capacity prices are extremely low, then they should not expect permission during future shortages to get cost recovery for higher-priced capacity.
There is a logic to trying to build the right kind of portfolio to be able to serve that demand — to find assets for which contacts are possible, and to combine them in a rational portfolio. These individual asset acquisitions that we are talking about only make sense in the context of building a sensible portfolio. It makes no sense to own a standalone plant in Connecticut.
Moving to Tom Plagemann’s point about what is happening with the banks, the banks are divided. What happened with the hedge fund entry — where hedge funds were able to buy pieces of loans before they became off limits and agents said they would not permit transfers — is that you have a three part division among banks.
First, a sizable portion of the banks have a workout mentality, which is what we saw happen before in real
estate:“We don’t have to sell.”The banks are not under a macro pressure to reduce their exposure to the merchant power sector. From a bank-wide point of view, there is no crisis here at all. Even the individual institutions do not have crises. They do not have to liquefy assets in order to clean up their balance sheets. In fact, what we are seeing today is the reversal of provisions taken earlier. The major provisions taken in 2003 are being to some extent reversed as loan maturities are extended and people decide there is more
value in their portfolios than they thought earlier. Many of the major banks and securities houses are feeling this way.
That it means if you have a workout mentality is your workout guys are leading the deal. They saw what happened in the last real estate bust. The basic motto is: why sell at the lowest point of the market? They think the whole game is reserve margins, so they might as well hold until reserve margins get a little bit better. If you have that point of view, then you are not feeling any compulsion to sell. A deal must
make very strong sense before you sell. There is another point of view among bank steering committees that I call the project finance point of view.
Holders of this viewpoint would say these assets are very complex; they are not office buildings. You have to manage them. You have to lobby regulatory commissions, participate actively in court proceedings, and make sure that what you perceive to be anticompetitive behavior gets called so that the markets remain open to independent producers. The project finance point of view is we ought to sell because the
unexpected happens and ownership of plants require hands-on management.
The third point of view is held by some smaller players. They may be hedge funds that bought debt in secondary trading. Say you just paid 70¢ on the dollar for an asset that really should not be worth more than 50¢, and now a workout plan is being proposed. There is no way you are voluntarily agreeing to sell. The presence of these smaller players means the voluntary workouts that we saw in 2003 will be much more difficult to arrange in the future. Every deal that is sold will have a prepackaged bankruptcy associated with it. The point is deals will not sell in 2004 in a way that some bidders have been bidding. Many bids to date have been DIP financing kinds of bids, which is,“We will put in equity, but we want our equity to come out first,” or “We will allow a little bit of debt to come out first, but then the bulk of our
equity comes out before the remaining debt.”The banks think to themselves,“If we want debtor-in-possession financing, we can arrange that ourselves and, if we do that with you, we will pay you only a debtor-in-possession kind of interest rate.”
At the end of the day, there will be sales, but those sales will require that a fair amount of equity be put in and the debt be restructured in a way that the banks feel fundamentally makes sense. It could involve a write-off. It could involve deferrals. It could involve more back-ended payments.
Reaching agreement in some cases will require a clamp down on any holdout banks through a repackaged bankruptcy.
MR. GOLDEN: Bill Chew, where does Standard & Poor’s see the distressed debt market headed and what kind of recovery are you seeing in the merchant power sector?
MR. CHEW: I am not an expert on the distressed debt market, but one thing we see happening in the larger merchant power sector is a remorseless refocus on the quaint old-fashioned notion of fundamental credit, something that we would argue was lost earlier. I recall a paper in late 1996 or early 1997 that one of my colleagues wrote that said there is no doubt the merchant plants being proposed at the time can be built, but if you want investment-grade credit, it will require capital structures that include equity layers that go well beyond anything that was being contemplated at the time. The paper was greeted with total disbelief. We proceeded to rate only two or three real merchant plants. Others in this business rated 40
or 50. We know what happened, and here we are today talking about distressed assets.
We think there is a fairly rudimentary drill you can do at the asset level. A discounted-cash-flow analysis looks at the entire range of possible scenarios. That is where we earn our stripes by being the most difficult guys at the table, but we think that type of rigorous analysis is a necessary part of the end game.
I agree with much of what Jay Worenklein said, but his scenario has the assets being handed to intermediate owners. The real question is: who are the long-term natural owners of these assets? We are talking about a major US industry and a major portion of the US economy.
Private Equity Role?
MR. GOLDEN: We have seen a rush in the last 18 months to two years by private equity firms to go after assets. Tom Plagemann, do private equity funds with short- to mediumterm horizons have a role to play in helping this sector to recover?
MR. PLAGEMANN: That’s an interesting question. I was about to agree with Jay Worenklein that a rational portfolio roll-up strategy is definitely the right approach. However, what Bill Chew said is correct. Who is going to do it? I do not see the hedge funds pursuing such a strategy. I see them chasing yield. They are not builders of businesses from scratch. Maybe stepping into industries where they have some expertise, fixing things up, creating more efficiency and then reselling at a nice return is something to do, but they are not the right people to build a business from scratch.
We are a long-term investor. The long-term strategy would potentially be of interest to us provided we can solve the income issue that we have. I see the hedge funds taking a buy-low sell-high perspective. They think,“We are paying a rock-bottom price, this is an essential industry, at some point demand will strengthen, and we will sell at a profit.” I would like to know what Jay Worenklein thinks.
MR. WORENKLEIN: A number of hedge funds have pockets of long-term capital. Such funds could form a pool by investing $50 million or so each for the purpose of acquiring a rational portfolio. Another part of the equation is wealthy family offices. We have been able to identify some of the families that are long-term investors and who like the strategy. However, third-party equity must also be part of the mix. Private equity does have a time horizon, but it is long enough in some cases to tolerate the build-up of a portfolio
and then to allow time to exit in a rational way.
The income issue that Tom Plagemann mentions — the potential earnings dilution — is obviously a very critical issue for any public company. However, if you have a big portfolio, you will always have some cash flow. The thing to do is what Tom and his colleagues and others here have done in a very smart way, which is basically to tier the returns so that you have preferential returns for those who need current income
and something else for the private investors with longerterm horizons who don’t need current returns. As people become more comfortable that the strategy overall makes sense, funds will come together and it becomes a problem of execution. The key is to have a clear strategy and then have the patience and ability to execute it deal by deal.
MR. GOLDEN: One of the questions asked this morning is: when will the banks be ready to sell? Mary Power, you and I spoke about this at the break. You are with DZ Bank. What is your bank’s strategy for
dealing with distressed assets?
MS. POWER: It is as Jay Worenklein said. We are not looking to sell in a belowmarket environment. We
solicit opinions from the experts about whether we would do better by selling now — what a sale would fetch, what offers are there on the table at this moment — or whether we would do better to hold the assets for two or three years, wait for a market recovery and then fetch a higher price. In some instances, that has meant putting in a little extra money on a priority basis.
The bank groups have been fractured. I agree with the three different viewpoints that Jay said are found in bank groups. However, I am not sure that I agree with him on the makeup of those groups. We have seen large banks determine that they want to get out of the market, and they have sold off their positions — sometimes merely on a participation basis — because they have a general mandate to get out.
Most of the bank groups in the truly large distressed facilities are still trying to determine whether they should sell, and what the offer really is from the few people who are there bidding. Those offers are still being negotiated. The analysis of whether the banks would do better to hold the assets is ongoing, and the consultants keep revising the numbers. Jay is right when he says that no decision has been made yet, but we are in no hurry to sell.
Mr. GOLDEN: Bill Chew, there are many merchant power companies that still have fairly poor credit, yet we are not seeing a lot of asset sales this year. Why not? One would think some of these companies would be selling more readily in an effort to improve their credit ratings.
MR. CHEW: It may not be commercially attractive for them to do. There is just too big a spread between bid and ask prices. It depends to some extent on who the holder is, but there seems to be a basic impasse that has prevented the sales. The Duke sale is the most visible. There have been other deals that are less visible — short sales, secondary market transactions and synthetics — but this is a classic situation where there is too much distance between what the banks who hold the bulk of these assets want and what
the buyers are prepared at the moment to pay. Sales may accelerate. Some are predicting such an acceleration within the next six to 12 months.
MR. GOLDEN: Are there any comments from the audience? Merrick Kerr.
MR. KERR: I have a question about Mary Power’s observation that the banks are reluctant to sell because the asset prices are below market. The market price is a function of supply and demand. The banks are looking for a price that is a product of the paper that they hold plus a make whole. My question is: do the banks reach a point in time when they have to take impairment because of the spread between what they need and the current market price, and might the taking of such an impairment break the impasse?
MS. POWER: There are accounting rules that require a bank, when a project or sponsor has come out of bankruptcy, to reset the debt to fair market value and to adjust the financing structure, but not always. In one case I have in mind, it was not required. There was a revaluation for GAAP purposes, but we retained the debt at the full level. There are other instances for tax purposes where you may have to write down some of the equity. However, just because you write it down does not force a sale if you believe the market price of electricity will recover sufficiently in the next two or three years that you could ultimately recover
your outstanding debt and a portion of your equity. Those are the sorts of issues with which we are trying to come to grips.
MR. KERR: So the reluctance to take a writedown is not what is motivating the banks to hold on to assets?
MS. POWER: Right. In fact, most banks have already made provisions for their bad loans, as Jay Worenklein intimated.
MR. GREENWALD: One of our workout guys at Credit Suisse made a comment to me along the lines of what Groucho Marx said about not wanting to be a member of any club that would have him as a member. His comment was something like,“I would not want to sell any asset that Blackstone is interested in buying.”
There is a lot of truth behind the comment. The buyers of these assets are smart guys. They want 25 to 30% returns. We as a lender do not need a 25% return. We just need a plus 2% return to make back our money. Our analysis of the value of debt on that asset is very different than what the equity buyers are looking to pay for the asset. That is why you have such a large gap at the moment between the bid and ask prices. The banks really believe that they can get out much closer to par than guys like Blackstone are willing to pay for the assets.
MR. WORENKLEIN: Some of the banks are starting to advocate sales structures that address this problem. The way to bridge the gap is to have a sale take place with some cash and a very large chunk of assumed debt. The assumed debt gets restructured. Depending on how troubled the project is and in what part of the country it is, you may have the debt being payable only on a cash-flow basis for some period of
years. This is a way to bring the equity investors and the banks together on the proposition that when the markets recover, the banks will get their money back and yet, in the meantime, you can have somebody who knows the business actually managing the property. That is where it starts coming together for a potential deal.
MR. GOLDEN: Let me throw out another question. Does anyone think we are going to see more offtake contracts from financial players? Jay Worenklein mentioned buying projects and turning them into contracted assets. Does anyone think that financial players have a major role to play on the other side of those contracts?
MR. WORENKLEIN: One thing we are seeing is a disconnect between the near-term view and long-term view so that you have players who are prepared to enter into tolling agreements on a near-term basis. Such agreements give the plant owners enough cash flow to cover their fixed O&M costs. Such short-term tolling agreements are a guarantee against being forced to put your hand in your pocket to pay for fixed O&M. There may be other players who can then take the risk in terms of terminable value.
MR. GOLDEN: Bill Chew, you have a comment?
MR. CHEW: The fundamental issue — not just for merchant power, but for the power sector generally — is
who are the long term sources of financing? The basic problem is we have in the power business a commodity business that requires large amounts of capital. It is a particularly tough commodity that we all know cannot be stored. The transmission and regulatory issues and lumpiness of capital are particularly tough. That means long-term credit is absolutely paramount
MR. LANE: I just want to remind people that we do not have to generalize. There have been some discrete events.
ABN-Amro took over a merchant plant from NRG and, after some work with the assistance of Lehman Brothers, it managed to sell the plant to Calpine and got out, I believe, at 85 or 90¢ on the dollar.
MR. WASSERMAN: I think the problem with the merchant market is with independent system operators and the fact that the traders are looking to trade against a price that is set by the ISOs. In a volatile commodity market like this, you are going to make all your profit in a given year probably over the course of a few weeks if not just a few days. However, when the market tightens, the ISO says the electricity price is not a true market price — it is due to transmission congestion — so it limits the price. The result is that traders are robbed of an entire year’s profit. There is full downside risk but only limited upside. Until this problem is corrected, it will not be profitable to own merchant assets.
MR. BURGES: The Duke sale earlier this year was 6,000 megawatts at $90 a kilowatt. I am very interested to know whether the bankers are actually taking the provisioning levels down to that kind of number. That is a market-clearing price.
MR. GOLDEN: Are there any bankers who want to respond?
MS. POWER: We do not think one transaction makes a market. We do not believe there have been enough transactions yet to say what is market. Each transaction is a little different. We base our provisions individually in each instance on what we expect to receive back from the sale based on the price of electricity rather than the price of an individual transaction. Provisions have varied in transactions based on expected recoveries.
MR. JAUHARI: We are also a bank with merchant exposure. The banks that I have spoken to are willing to wait until the market recovers over the next three to five years and electricity prices improve. No one wants to sell at a value that is less than par. I can think of two or three transactions where incremental equity has been put into deals to buy more time until the market recovers. Turning to the question of provisioning for loans, banks are not required to take any loss, but if a bank sells a portion of its exposure, then it will
be under pressure to mark its entire exposure to market. That is one reason banks are unwilling to sell a portion at 60¢ on the dollar.