Update: M&A Market
The past year was a difficult one for project developers looking to raise capital by selling projects or whole companies, but 2010 looks more promising. The following is an edited transcript from a discussion at an Infocast conference on “Projects and Money” in New Orleans in January about the state of the market. The panelists are Jon Fouts, a managing director in the power and utility group at Morgan Stanley, Ted Brandt, CEO of Marathon Capital, which has auctioned off several prominent wind companies in the last few years, and Alex Darden, director of EQT Partners, Inc., the US arm of a northern European-based private equity fund with 12 offices in 10 countries and approximately €13Êbillion raised through five investment strategies, including €1.2Êbillion in a new infrastructure fund that closed in late 2008. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Jon Fouts, was there much M&A activity in 2009, and did it vary by sector?
MR. FOUTS: Obviously 2009 was a tough year. We saw overall M&A volumes drop by about 60%. Volumes in the power and utility sector were probably down even more than that. M&A has usually accounted for between 15% and 20% of overall deal volume in that sector. Deals last year were primarily distress sales; the sellers needed cash.
MR. MARTIN: Ted Brandt, there was a wide bid-ask spread last year. Sellers thought their assets were worth more than buyers were prepared to pay. This was a barrier to sales, except in cases where sellers had no choice. Are the bid-ask spreads narrowing as we head into 2010?
MR. BRANDT: I remember sitting on this panel this time last year. We were just launching the sale of the Babcock & Brown wind assets and my position at the time was that cash flow would still sell. It was an interesting year. Congress was just about to enact a program of 30% cash grants for new renewable energy projects. The next six months after that were a period of great uncertainty about how the new program would work, and whatever life there was in the market ground to a halt until people began to feel more comfortable they understood how the rules work. As we head into 2010, I think we are at a point of departure. The distress is done. We are seeing a lot of money returning to the market. I think the cost of capital will come down. We are running an auction now for the Infigen wind portfolio. I am optimistic about M&A deal volume.
MR. MARTIN: Jon Fouts, are you also optimistic about deal volume, and what will be the main drivers behind M&A deals in 2010?
MR. FOUTS: I am. We saw deal volume pick up considerably in the last quarter of 2009. I see five main drivers behind sales in 2010. One is portfolio rationalization: if a business is not strategic, move on and get out of it. We will see fewer distress sales and more sales by companies rethinking where it makes sense to deploy their resources. Another big driver will be the continued interest in clean tech, with even the big utilities seeking outside capital to develop their clean tech portfolios. We are seeing growing interest in the transmission side of the business; there are more people looking for partners to undertake transmission projects. We are seeing some interest in going-private transactions. And, finally, there will be some smaller companies put up for sale after their owners do a sober analysis and conclude, from the market cap perspective, “We are just not big enough to make it.” All of that said, deals will be smaller, and they will be conservatively financed.
MR. MARTIN: Ted Brandt, to what extent will deadlines in the 2009 stimulus bill drive M&A in 2010?
MR. BRANDT: They could be a significant driver. We focus on wind and solar. Both types of projects must be under construction by the end of this year to qualify for 30% cash grants from the US Treasury. Everyone is operating like that is a real deadline, even though everyone remains hopeful that Congress will extend it. There will be companies who will be looking for partners or buyers for projects this year that they have concluded they lack the wherewithal to get underway in time.
If you have a late-stage contracted project, this is a wonderful time to sell. We have a couple large portfolios of projects in the market for sale, and we are seeing lots of interest and heavy bidding.
If you have a development project that will not be ripe to start construction until past 2011, we think that market is still pretty lackadaisical, but I tell potential buyers it is where the bargains are. We are seeing some high valuations for solar PV companies, but potential bidders in wind companies appear to assign almost no value to pipeline projects after 2011 because developers claim impressive numbers of projects under development but few such projects are actually built. We are not seeing anywhere near the valuations for project pipelines that we saw even a couple years ago.
We have a couple clients who are actively working on roll ups of pipeline projects that are still under development. They buy a small portfolio here, a medium-sized portfolio there, and none them is having to put out a lot of cash because the transactions are done typically with heavily contingent earnout structures.
Opportunities and Buyers
MR. MARTIN: Alex Darden, what are the areas of greatest interest for a private equity firm like yours?
MR. DARDEN: Picking up on what Jon and Ted said, the main driver for the private equity firms is finding places where they can deploy capital that offer an appropriate return in relation to risk. We see plenty of such opportunities, not just in renewables, but also transmission lines, midstream oil and gas and utility projects generally.
MR. MARTIN: Jon Fouts, a strategic player or private equity fund asks you for the two best places to deploy capital in 2010. What are they?
MR. FOUTS: That’s a tough question because the answer turns on the strategic objectives of the person asking the question.
From a value perspective, we still see a lot of opportunity in the development side of the business for investors who are willing to take development risk. A contracted, well-structured project with a good management team can generate returns in the high teens to low 20% range. We see a lot of interest in that. There is $500 billion in capital sitting on the sidelines, and that doesn’t include the dedicated infrastructure funds. If you leverage that, you get to some pretty big numbers very quickly.
MR. MARTIN: Ted Brandt, you have been running auctions of large portfolios of wind projects, including the Infigen portfolio of 18 wind farms that is out in the market currently. Have you seen any change in the last year or two in the mix of companies bidding to acquire US renewable energy developers and project portfolios?
MR. BRANDT: Yes. Before the crash, there was a clear advantage to incumbent utilities. FPL is probably the best example. It had a competitive advantage in wind and solar because it did not need to engage in complicated tax equity transactions to take advantage of the large tax subsidies the US government throws at renewable energy projects. We have now moved into a cash grant world after the stimulus. Certainly for wind farms with capacity factors below 37%, which are something like two thirds of the market, there is a much more level playing field. The private equity-backed firms and the infrastructure funds are much more competitive, and we see that across both wind and solar.
The other thing worth noting is there is a new class of investors — infrastructure funds of which Alex’s company is an example — that are looking for long-term cash flow. They appear willing to live with very low double-digit returns and, as a consequence, they have been putting in very competitive bids in auctions lately. They are also willing to live with minority positions in companies; they don’t insist on control.
MR. DARDEN: There are some funds that are willing to invest during the development phase, but there are also plenty of funds who are returning to the basic private equity model of buying operating projects or companies with such projects and then trying to create value. They look for ways to improve the operating performance.
MR. MARTIN: I know your fund bought Midland Cogeneration Venture, a huge gas-fired power plant in Michigan, recently. That project has been around for a while. How you do you add value in a case like it?
MR. DARDEN: The plant is 20 years old, and you may think there are not many operating efficiencies that haven’t already been found, but the truth is there can be tremendous unrealized value in an older plant. With our industrial heritage, we focus on using former industry executives who have specific industry expertise, including in the case of Midland, former ABB executives who built the facility and knew the plant and technology intimately. The plant is built on a former nuclear site. Its interconnection to the grid can support a lot more capacity. It has extra land where we might be able to build a renewable energy facility. There are some technical packages that can be added to the plant. And further operational enhancements can be achieved through simple changes in processes and procedures. An older power plant may actually confer a fair number of advantages not found in a newer plant.
MR. MARTIN: How visible have the Chinese become in the US market?
MR. BRANDT: They are visible and they will become even more so. CIC made a large investment in AES. Chinese money went into Cielo in Texas. It is clear from the dialogue we have been having not only with CIC, but also with other state-owned enterprises in China, that they are making a big push into the US because they like the regulatory climate.
MR. MARTIN: Are European buyers showing more or less interest in the US market?
MR. FOUTS: Our people have had lots of conversations in the last two to three years with companies that have successfully developed renewable energy businesses in Europe — for example, in Spain and Germany — and want to apply that expertise in the United States. I think there is still a growing interest in the US market in Europe. It goes back to the rationalization point. They are picking spots that make strategic sense.
MR. BRANDT: I agree. You have a lot of conversations. Some of the companies are slow to make a move.
How to Win Bids
MR. MARTIN: Ted Brandt, what is the key to winning a bid? Say you are advising a buyer who is trying to stand out in this market.
AUDIENCE MEMBER: Pay a high price. [Laughter]
AUDIENCE MEMBER: Pay all cash. [More laughter]
MR. BRANDT: Those are certainly keys, but we have had two examples in the last year of strategic buyers — Keith, you can appreciate this, and I can say that you were not representing either of these — strategic buyers that absolutely screwed up in the red zone on the document issues. At the same time, we have watched private equity-backed companies very dexterously manage the legal issues and get to the finish line. Obviously paying more is the easy answer, but I think there is an under-appreciated amount of execution ability that we have seen. I will say out loud and in public that one of the greatest displays of this was a couple of years ago when we sold development assets that are now the CHiPs wind project in California to Terra-Gen and ArcLight, and those guys were magnificent in the red zone and they won the deal over a consortium that offered a higher price and manages more money. They won the deal [with Chadbourne as counsel] because they executed better.
MR. MARTIN: So good counsel is third after pay a high price and pay cash. Jon Fouts, are asset values going up or down?
MR. FOUTS: I think they are going up, but valuations have been driven for the past six months by liquidity rather than fundamentals. Liquidity is getting better, so valuations are going up. The next phase will be when people resume focusing on fundamentals, but for now, they are going up because the financial markets are improving.
MR. MARTIN: Alex Darden, do you agree?
MR. DARDEN: Absolutely. There were plenty of potential sellers who sat on the sidelines last year because they thought asset values would recover, and they will feel vindicated to some extent. I don’t know whether values will return all the way to where they were a few years ago.
MR. MARTIN: Ted Brandt, you said during our prep call that “financing is one of the main drivers for whether bidders win deals.” What is an example of financing that helps win a bid?
MR. BRANDT: The best way to answer that question is this. Two or three years ago when the Europeans were coming here with bags of Euros and trying to acquire development companies, they all pretty quickly coalesced around a view that the weighted average cost of capital to finance a fully-built contracted project was 8%. Since the meltdown in late 2008, people are less sure of what capital costs. It depends on who you are and where you sit, whether you choose a 30% Treasury cash grant on a project instead of tax credits, and a host of other variables. It is pretty clear after the stimulus bill last February and the passage of time that the cost of funds is again in single digits, unleveraged, after taxes. The cost is still a little above what it was before, but it is approaching where it was before.
Now, relate that to an M&A deal. If Alex Darden and his fund decide to buy a project, Alex will have to take the proposition to his credit committee, and he will have to make an assumption about how much it will cost to finance the acquisition.
A couple years ago, there was a general view about how different types of projects are best financed. There is less certainty today. M&A is driven by certainty. If there is a gap between what you can develop a project for — say around 10 1/2 or 11% — and what capital costs, which is still somewhat of a question mark, projects don’t tend to sell. They sell when people feel they have nailed down the capital cost, and the lower the cost of capital to a buyer, the more value he is likely to see in a project.
MR. MARTIN: Jon Fouts, you said during our prep call that a Chinese wind company had sold recently for 13 times EBITDA. What are the current multiples in the US market?
MR. FOUTS: It was a public market deal. It can be difficult to compare multiples in an initial public offering to multiples when selling assets to a private equity fund or strategic buyer. Prices in the US renewables sector are still very much driven by discounted cash flow analyses. That said, I think we will see a number of clean tech and renewables companies come to market here in the next 12 to 18 months, and we could see numbers in the double-digit EBITDA range.
MR. MARTIN: Ted Brandt, how far along does a project have to be before it is ripe for sale?
MR. BRANDT: I can tell you at our shop, we like to know that the developer has a site in a good location and he has either signed a financeable power purchase agreement or at least has a draft power contract with a utility and is fairly far along in the negotiations. There is not much appetite among strategic or financial buyers to get behind a project that is likely to sit on the shelf for a couple of years and that will just be a drain in the meantime on capital.
MR. MARTIN: Alex Darden, are you looking only at operating projects or will you come in at the developer stage?
MR. DARDEN: We are not a greenfield developer. I don’t rule out taking development or construction risk, but, at the end of the day, we are looking where we can add value, whether it is through operational enhancements or additional capital investments.
MR. MARTIN: Jon Fouts, how much of a company should a developer trying to raise equity at the corporate level figure he will to have to give up in ownership? Is there a formula?
MR. FOUTS: No, there is no formula. It comes down to perception of value and many of the variables we have been talking about in terms of location of the asset, the quality of the management team and the returns on assets. It is really tough to generalize.
MR. MARTIN: Investment bankers were telling people at conferences like this one three or four years ago, particularly in the wind sector, that developers should move to initial public offerings as a way to raise capital rather than continuing to do one-off tax equity deals around projects. Do you think the wind sector is finally ripe for IPOs; hindsight suggests it may not have been when the investment bankers first started suggesting wind companies move in that direction.
MR. FOUTS: Look, I would make two observations. One is that there are very few opportunities for public investors to invest in renewables companies in the US market. Whether it is wind, solar or geothermal, there are just not that many opportunities. One thing that we learned when taking a lithium battery company public a couple months ago was that public investors are basically saying, “Bring me your deals because we have a renewables mandate, and there is nothing to invest in.” We need a US-domiciled renewables business to invest in.
Second point: 2009 was a beta trade market in terms of, if you put money into the market, it didn’t matter what sector or what stock you bought, you basically made money. I think 2010 will be more of an alpha market, which means you have to pick the right place to put money. Even within the renewables space or the power and utility space, the name matters.
To answer your question directly, I think we will see some wind companies go public in the next 12 to 18 months.
MR. MARTIN: A senior executive at a California utility told me that his company has doubts about whether renewables are an appropriate investment for public companies because they tend to produce a big earnings bounce right off the bat in the form of government subsidies, but the long-term cash flow after that is weak. Do you agree?
MR. BRANDT: The conclusion doesn’t sound right to me. The FPL Group gets roughly half of its earnings from renewables. The analysis is certainly not right if you are talking about a regulated utility owning renewables because utilities earn a fixed return off a variable rate base. Anything that adds to rate base gives the utility more earnings.
MR. MARTIN: Do you see any trends in how buyers are paying the purchase price for companies or assets?
MR. BRANDT: We used earnouts as a tool in 2009 to bridge the gap between what sellers thought their assets were worth and what buyers were prepared for pay for them. Convertible instruments were another tool that were used to keep the seller involved rather than just disappear after the sale.
MR. MARTIN: What is “market” in terms of how long seller representations survive?
MR. BRANDT: That depends on which law firms are representing the seller and buyer. It also depends on who the seller is. Obviously a deep-pocketed seller who can put some heft behind the reps and warranties may have one view and a distressed seller who is selling at a very low price will have another. We have been involved with distressed sellers for the last year, and reps in distressed deals have been virtually as-is-where-is, do your own due diligence, and this is reflected in the price. In the more distant past, where people were paying sizable premiums for development companies, some percentage of the purchase price — say 10 or 15% — would be paid into a cash escrow against possible future claims and then released a year to 18 months later.
MR. MARTIN: Ted, you said during our prep call that “the ultimate question is the cost of capital” and you touched on this a little earlier. What should the cost of capital be to own a contracted wind farm or solar, geothermal or biomass project? Is there a large disparity between where the cost of capital is today and what these projects need to be economic?
MR. BRANDT: I will put a stake in the ground and say we are big believers that leveraged leasing will make a comeback and become a bigger part of the financing mix. We think the weighted average cost of capital in a leveraged lease are well below 8%, probably even below 7%, when you look at the blended cost of the debt and equity. A lease generally provides 100% financing. The sponsor may have to leave some cash in a reserve to ensure payment of rent, depending on the profitability of the power purchase agreement. It is not hard to see the opportunity for lease structures because, if you ask tax equity investors currently in the market about the cost of tax equity in partnership flip deals, it is closer to 10% for a wind project, maybe 9Ê1/2% on an unleveraged after-tax basis. So there is a huge amount of inefficiency in the market. I think the cost of capital today is 9Ê1/2% with pressure to move lower. We will see where it goes.
MR. MARTIN: When you say the cost of capital with a lease structure could be as low as 7%, is that true of all asset classes or is that the figure for wind farms, and the cost of capital is higher for other types of projects?
MR. BRANDT: Leases certainly work for solar projects and some of the better biomass projects where there is a pass through of the fuel risk. There have been leveraged leases of hydroelectric projects for years. The production tax credits are probably too valuable in geothermal projects, and anyone claiming production tax credits must stick to a partnership flip.