The Search for Lowest Cost Capital
Rates in both the debt and tax equity markets appeared to touch bottom in late May or early June and then edge up slightly. The following is an edited transcript of a roundtable discussion that took place in mid-June about current rates, terms and liquidity for bank, insurance company and capital markets debt, DOE loan guarantees, tax equity and equity raised through initial public offerings of corporate stock. The discussion took place at the 21st annual global finance conference hosted by Chadbourne in San Diego.
The panelists were Steve Greenwald, managing director for global project finance with Credit Suisse, Jon Fouts, managing director for global capital markets with Morgan Stanley, John Eber, managing director and head of energy investments for JPMorgan Capital Corporation, Michael Canavan, senior vice president of RBS Global Banking & Markets, and John Tanyeri, director of power & energy strategic investments for MetLife. The moderator was Rohit Chaudhry with Chadbourne in Washington.
MR. CHAUDHRY: Jon Fouts, what sources of capital are available in the market today and how do you rank them in terms of liquidity?
MR. FOUTS: Let me start at the bottom of the capital stack. There are subtleties and nuances at each level. Starting with equity, investors remain interested in shares in US renewables companies, particularly Asian and European investors. Next up the stack, tax equity is available, but it remains in short supply. Our prediction is that the supply will continue to increase later this year and into next year as tax appetites come back. We are seeing tax equity yields in the single digit range, which is a nice change, but the market is not broad or deep. In terms of debt, we are seeing fairly robust bank and capital markets in terms of availability or liquidity. However, availability varies significantly with the quality of the project, the quality of the power contract, how the power contract is structured and so forth, but we are seeing tenors and maturities being pushed out to more than 10 years with fairly attractive rates.
MR. CHAUDHRY: What about the term B market. Is that market available? Is it liquid?
MR. FOUTS: It is probably not open today. It probably was a month to two months ago. We have not seen it play an active role in the renewables sector; it is kind of an on-again-off-again market.
MR. CHAUDHRY: So the bank market is one of the most liquid markets. Mike Canavan, as a banker, what impact are the troubles in Europe having on the bank market for renewables projects in the United States?
MR. CANAVAN: Bank debt is available and is usually the most efficient source of capital for construction financing and working capital facilities. The tenors for term debt are being pushed out, even past 15 years. It is mainly the smaller European banks that are offering the longest tenors; not all institutions are prepared to go out that far. My sense is that tenors will shorten a bit due to liquidity concerns and that developers will look at hybrid structures where the banks provide construction debt and working capital facilities and the institutional or capital markets provide the term debt.
MR. CHAUDHRY: Steve Greenwald, you also told me the B loan market has been closed for the last month or two. What happened during that period to shut down the market? Is it the sovereign worries in Europe or something else?
MR. GREENWALD: It is just overall market conditions. The B loan market tends to run in sync with the high-yield market. We have done a few wind deals in the B loan market, but that market has never been a primary source of funds for wind and solar projects. The way I characterize the B loan market is that if you cannot borrow from a bank because the project credit is just a little too dicey for the bank market, you give it a go with the B loan market, but that market still requires a mid-to-low BB rating or BA rating from Moodys and getting that rating for some of these projects is tough.
MR. CHAUDHRY: There has been a sense this year that it has been easier for developers to borrow money, but then the acquisition debt for Calpine to acquire Conectiv assets flexed up two weeks ago by 200 basis points. What does that say about the market?
MR. GREENWALD: The deal got caught up in a storm over the last few weeks, but it got done. It was the same across all markets — debt, equity, high yield. You saw a flight to quality with yields falling on 10-year Treasuries as people rushed to safety.
MR. CHAUDHRY: John Eber, are there certain types of projects or certain types of technologies that you think are more suited to certain sources of capital?
MR. EBER: If you are talking about the tax equity marketplace, it is focused really on proven technology. It has been hard for new technologies to get financed in either the tax equity or the debt market.
MR. CHAUDHRY: What about a solar thermal project, for example? What are the financing prospects for such projects in the bank or bond market?
MR. GREENWALD: I think really the issue is size. Solar thermal is clearly a proven technology. I think you could raise $700 million to $1 billion in debt for a solar thermal project provided you get an investment-grade rating and provided the sponsor is one of the top three in the market and the debt can be raised without a DOE loan guarantee. You would have to use a combination of banks and institutional funds, whether it is through a private placement or a section 144A offering. The project will need an investment grade rating. DOE has a BB threshold for its guarantees. The project would certainly have to have at least a BBB rating.
MR. CHAUDHRY: Michael Caravan, is there an optimal size that the bank or bond markets will finance? Steve Greenwald just talked about a $1 billion deal possibly getting done. The Ruby gas pipeline deal that closed recently was $3+ billion project.
MR. GREENWALD: Ruby was looking for $1.5 billion of debt and we raised well over $2 billion for it, but it was about as plain vanilla as it gets. I don’t think there is a financing being contemplated in this room that will fit the mold of a classic project financing and is down the middle of the fairway. MR. CARAVAN: I think the optimal size is somewhere in the $300 million range. For pure bank debt, Steve is right. Once the project requires more than $500 to $750 million in debt, it will require an institutional debt tranche as well as bank debt. We were in the market talking about a solar construction revolver recently, and everyone assumed unfortunately that it would work like the Calpine revolver, and that is not what we were trying to do. I was struck by how steep a learning curve there still is with a lot of the banks on solar. I agree that solar thermal is a proven technology, but I don’t think a lot of commercial banks would touch it right now. Give me a $300 to $350 million utility-scale photovoltaic project with an investment-grade and a strong power purchase agreement, but if the debt required is in the $500 to $750 million range or higher, I think you will struggle to raise all that debt solely in the bank market.
MR. EBER: I agree with that. We did a $250 million solar thermal deal a couple of years ago. It is only one that has closed in the US since 1991 and it was very difficult to get it covered even at $250 million. We had about half of that in tax equity and the other half was in bank debt. It took a technology that had been around for 15 years as well as very strong support from the sponsor to make that happen. Steve calls the solar thermal technologies proven, but there is more than one type of solar thermal technology and a couple years doesn’t quite make it with an investment community that is looking for something that has been operating 10 or 15 years before it considers the technology proven. That’s why everyone is focusing on PV. That is what is most manageable in the near term, because it is an accepted technology and you can break it down into smaller pieces for financing.
MR. CHAUDHRY: John Eber, staying with proven technologies, what about new entries to proven technologies? I am thinking here about Chinese turbine and Chinese solar panel manufacturers. Can such turbines or solar panels get financing in this market in the US?
MR. EBER: The ones that are not yet proven in the US market may have trouble in the near term. Most will probably be financed by the manufacturers themselves.
MR. CHAUDHRY: John Tanyeri, what is your view? MR. TANYERI: I agree. I think it will be difficult to finance projects using such equipment. Let me also add to something that John said earlier. Speaking as an institutional lender, one of the concerns that we do have when faced with a proven technology versus a revolutionary technology is it is possible to structure around some of the unknowns with proven technology. For example, no one knows what are the long-term operating costs of a solar plant — PV or solar thermal. It is an easier issue to structure around with a proven technology than it is for a revolutionary technology.
MR. CHAUDHRY: I want to look forward and have each of you make a projection. Project over the next six to 12 months what are the most significant changes you expect to see in the way capital is raised? Steve Greenwald, let’s start with you.
MR. GREENWALD: Within the next 12 months, we will actually see some DOE money come out the door, and that will be a big change because, so far, I don’t think a dollar has come out the door. God bless those guys.
MR. CANAVAN: I think you will see tenors coming in a little bit on the bank side and more use of hybrid structures that combine bank debt with institutional or capital markets debt.
MR. FOUTS: I would say the tax equity market improves to a point where we see deals getting done that we have not been able to do recently, driven by the big financial institutions returning to having reasonable tax appetites.
MR. EBER: I think the tax equity market has already come back. Even though we have not seen a lot of closings this year, a number of deals are in the process of closing now. The market is much stronger today than it was a year ago. More than $2 billion in tax equity deals have already awarded this year. That is more than we did all of last year. We are on a pace to doing as much as we did in 2007, which was the high water mark in terms of tax equity deal volume in the renewables market. New players are coming into the market. This will take some of the pressure off if Congress fails to extend the cash grant program or fails to extend it in the form we want. A healthy tax equity market means the industry will at least have a means to finance itself. MR. TANYERI: The sovereign debt crisis in Europe will start to affect us in the United States and be somewhat disinflationary for the US. There could be a substantial move in the yield curve, especially at the back end. That would allow institutional investors with long-term liability financing needs to match up perfectly against power purchase agreements that are also long term. I hope Mike Canavan is correct that the banks will retrench from their 15- to 17-year floating rate loans and we can pick up market share.
MR. CHAUDHRY: I want to do a series of rapid-fire questions to get a sense as to current market terms. What type of leverage is being offered in the bank market right now, Mike Canavan?
MR. CANAVAN: Banks wants a 1.4 coverage ratio. This assumes the project has a power purchase agreement with a creditworthy offtaker. Debt covers 50% to 60% of the project cost in a typical renewable energy project. It covers a larger percentage of cost for a thermal project. MR. TANYERI:It is the same story on the institutional side. We are looking for an investment grade credit rating with a debt service coverage ratio of 1.4.
MR. CHAUDHRY: What about tenor?
MR. CANAVAN: We are seeing 15+ years in the bank market with a few deals between 10 and 15. Going forward, loans will probably still be in the 10- to 15-year range, with 15 being a little long. MR. TANYERI: We have so many mini and maxi perm structures, but we are starting to move away from them. Sponsors are looking for longer deals, and the forecast of 10 to 15 years seems reasonable.
MR. CHAUDHRY: What type of pricing do you see in the debt market?
MR. CANAVAN: In 2009 and early, a 3% to 3.5%% spread above LIBOR was typical. As we get farther into 2010, for well-structured renewable energy projects, we have broken the 3% barrier and we are now down to 2.75. There is at least one deal in the market currently starting at 2.50. Clearly, spreads are compressing. On upfront fees, the same thing is happening. Such fees were typically 3% and above in 2009. We are now seeing deals with upfront fees of 2.5% and even 2.25%. The 3% floor for both rates and upfront fees has been broken coming into 2010. MR. TANYERI: On the investment grade side, we are flirting with that Treasuries plus 3%.
MR. CHAUDHRY: Capital markets?
MR. FOUTS: It is probably 50 basis points wide of that. The European debt crisis probably has affected the capital markets a little more than the bank market. We have seen some of the outflows from mutual funds reverse in the past six months, but people are still tapping the brakes.
MR. GREENWALD: I have a question for the other panelists. I heard two of you say tenors are only 10 to 15 years in the capital markets. I would have said 20 to 30 years. At least we tell our clients that if you have a 25-year power purchase agreement, we will lend you 25-year money. MR. TANYERI: We will, too. However, I have not seen it happen in practice. Bank financing is obviously the most liquid type of financing, and we have seen it move from the mini-perm firm structure out to the 15-year part of the curve. The 15-year part of the curve is pretty much a place that is being played mainly by some of European banks.
DOE Loan Guarantees
MR. CHAUDHRY: Let’s move to DOE guarantee. Steve Greenwald, only one guarantee has been issued to date. To my knowledge, there are roughly another 10 commitments, all for new technologies, and there has been no commitment under the section 1705 program. [Ed. The first commitment for a guarantee under the section 1705 program was issued a week later.] My question to you is, is the DOE program for real or is it just a lottery?
MR. GREENWALD: I don’t know. I hope it is for real, but as someone said, “Hope is not a strategy.” I think they really want to get deals out and my perception about the section 1705 program is that the blame for the slowness of it does not necessarily all rest with the government. The section 1703 program is a different story. It has been nothing short of a travesty. But my observation about the section 1705 program is that the deals that have been handed to DOE have been mature enough, frankly, they were not the kind of deals that DOE hoped to see under section 1705, that is, deals that are really circled up, have gone through credit committee and are just waiting for the government to check the box and provide an 80% loan guarantee.
The deals they have been seeing are less mature than that and would not have been able to close even in the best of markets, say in 2007 before the economy collapsed. There may be problems with the power purchase agreement, maybe the final consents have not been received or there are still holes in the construction contracts.
MR. EBER: It is a Catch 22 program. Wind developers whose projects are properly buttoned up do not bother going to DOE. They need to close on financing. They go to the private market because they need to get it done.
MR. GREENWALD: All I am saying is the jury is still out on the section 1705 program. There are problems with the program, but it is too early to write it off altogether.
MR. CHAUDHRY: If a developer comes to you with a project that can be financed in the bank or bond market without a DOE guarantee, but there are potentially significant cost savings with a DOE guarantee, Jon Fouts, what do you advise a client?
MR. FOUTS: It depends on the project, but I can’t think of a situation where we have advised a client to go through the DOE process on a wind deal because the process of developing and constructing a wind project is short enough that it is better get the project built rather than sit in limbo while waiting for DOE. Now on a gasification plant or other large project, we will talk about it. On a solar deal, if the project is all wrapped up and can get through the DOE, those are the projects you can finance without a federal loan guarantee. It is the stuff that is tougher to do for which you need the DOE loan guarantee and, in that case, you can’t get it through DOE anyway. It is a very awkward situation.
MR. EBER: I have talked to numerous people working in the program, many of whom are private contractors who came out of banks and insurance companies. They are being asked to review applications as if they were still working in the private sector. They are getting deals that are difficult to finance in the private sector — which are precisely the sorts of deals the program was supposed to support — and turning them down on grounds that they cannot be financed in the private sector. They are trying their best to make the program work, but there is a fundamental conceptual issue.
MR. CHAUDHRY: And just to put on the table what the allure of the DOE is, Steve Greenwald, what is the difference in pricing between a DOE deal and a deal without a DOE guarantee?
MR. GREENWALD: If you are talking about projects with commercially-proven technologies, it is probably close to 150 basis points, so it is not chicken feed. MR. TANYERI: Some of the sponsors are being advised that maybe the 150 basis points isn’t worth it and it is time to get the shovels in the ground. We are typical project finance lenders. We understand the risk. We are willing to be paid to take that risk. Having a DOE loan guarantee is not going to change our credit underwriting principles in terms of whether or not we are willing to lend. We are not going to put more risk on the books because the repayment of the loan is guaranteed in part by the government.
MR. CHAUDHRY: Mike Canavan, the lender is the applicant as opposed to the developer under the section 1705 program. How are banks reacting to that? Is it a quirky process? Are you comfortable doing that?
MR. CANAVAN: We don’t mind. I have to agree with the others. When we talk to our clients and they ask whether they should try for a DOE loan guarantee, there is a measure of time when the due diligence overlaps for both markets so you can say, “Sure, throw in a first-phase application and see how it goes.” The application process is somewhat of a free option, right? You get the application in and then you just assess your timeline and it depends on how important the guarantee is to the project economics whether you continue once the private financing is ready to roll.
I’m less optimistic than the others that the program will bear any fruit. Even if the project makes it far along in the DOE process, there is always the risk of the government raising a big issue at the 11th hour and then it taking another year to work through the process anew.
There is also the problem that banks do not want to hold the paper for the full term of the DOE guarantee.
MR. CHAUDHRY: Steve Greenwald, is that what DOE is requiring?
MR. GREENWALD: There is no way we are holding paper for 25 years. I am lucky if I can get us to hold paper for five years sometimes. I think the route we plan to go is to bring in another bank to be the administrative agent and trustee for the full term of the paper. One transaction on which we are working currently will involve a couple banks, ourselves and another bank, holding paper for a relatively short period of time, and then we hope to structure a special purpose vehicle that strips out the bulk of the debt into triple A and triple B pieces and the trustee for those bondholders will also be the administrative agent for the banks and do all the work with the DOE. This has not been fully tested. We don’t know yet how the government will react.
MR. CHAUDHRY: Last question on the DOE program before we move on. There was also a lot of talk about intercreditor issues. Have those been sorted out or do they remain murky?
MR. CANAVAN: They have been sorted out from a term sheet prospective, but more work remains to be done on them before any deals close.
Treasury Cash Grants
MR. CHAUDHRY: Let’s move on to cash grant tax equity as the next source of capital. The Treasury cash grant program is set to expire at the end of the year except for projects that commence construction by December. Is the program likely to be extended? John Eber, what are you hearing?
MR. EBER: The only thing that has been officially proposed as far as I know is the refundable tax credit bill that has support in the House. [Ed: Senator Maria Cantwell (D.-Washington) attempted unsuccessfully later in June to amend a “tax extenders” bill in the Senate to extend the program. See the next article entitled “Cash Grant Update.”] That seems to have the best chance right now. The industry would prefer a simple extension of the current program, but the House tax committee staff does not view that as a realistic option. The House proposal is revolutionary and has the potential to change the tax credit industry permanently going forward if it becomes law. The primary difference between it and what we have now is timing on when the cash is received. It could be as long as a year and half after a project is completed under the House proposal, compared to what is supposed to be 60 days under the current program, but recently has worksed out to as long as 120 days in fact.
MR. CHAUDHRY: If Congress ends up passing the House proposal, do you think projects can still get financed? Will banks still provide bridge loans against the future cash grant?
MR. EBER: It is the same benefit as before. It just comes later in time. If the proposal is structured properly by Congress, equity bridge loans should still work.
MR. CHAUDHRY: Mike Canavan, are banks fully financing cash grant bridge loans in the current market?
MR. CANAVAN: Yes. They have gotten comfortable with the existing cash grant program and the risks involved in lending against a future grant.
MR. EBER: The bridge often comes from the tax equity investor rather than a bank. All the tax equity deals being done are essentially financing in part for the grants. Whether the tax equity is financing the grant for 120 days or a year and a half, it is the same risk.
MR. CHAUDHRY: I take it an equity bridge loan is not an interesting product for an institutional investor like you, John Tanyeri. MR. TANYERI: We provide some tax equity as well. I agree with John. Whether we are exposed for 60 days, 120 days or a year and a half, it is the same risk.
MR. CHAUDHRY: Jon Fouts, are lenders comfortable with recapture risk with respect to these cash grants where certain things happen after the cash grant comes in and the Treasury wants the cash back?
MR. FOUTS: As long as you have a perfected lien on the assets, yes.
MR. CHAUDHRY: Wouldn’t a lender also look for sponsor recourse on the recapture liability?
MR. FOUTS: Generally not.
MR. CHAUDHRY: After the cash grant is received, do lenders allow the project company to distribute any part of it to the sponsor, assuming the cash grant bridge loan has been repaid? Would you allow some to go the sponsors to reduce the leverage?
MR. FOUTS: In terms of sponsors taking money off the table at that point, generally not. We like to keep the money in the deal.
MR. CHAUDHRY: In light of these cash grants that are available, John Eber, why would a developer still look for tax equity?
MR. EBER: Part of the tax subsidy on these projects is in the form of depreciation. Sponsors appear to be foregoing tax equity on about half the deals in the current market, keeping the grant and relying solely on debt.
MR. CHAUDHRY: How is the uncertainty about extension of the cash grant program affecting your deal pipeline?
MR. EBER: It is not affecting the pipeline of what we are working on today, but it is accelerating projects because of the rush to get construction underway by year end to qualify for a grant. Regardless of what happens with the cash grant program, there will be a substantial number of cash grant deals in the market at least through mid-year next year.
MR. CHAUDHRY: How many deals were done in the tax equity market in 2009?
MR. EBER: We track the wind market a lot more closely than we do the other markets because it is an easier market in which to collect data. We saw 16 tax equity deals close in the wind market in 2009 funded with about $1.8 billion in tax equity. We have already seen the same deal volume in terms of awards in the first five months of 2010. That’s why I am expecting a strong year in the tax equity market.
MR. CHAUDHRY: What are you projecting for 2010 in terms of the number of deals?
MR. EBER: I don’t make projections. Let’s just say we already have 11 deals awarded for $2 billion worth of tax equity, an that is just in wind alone. Only a few solar deals have been in the market so far this year. There are a lot of solar deals that are likely hit the market in the second half of the year, as well as additional wind projects. I think it will be a strong year.
MR. CHAUDHRY: Moving to our last topic, Jon Fouts, how much M&A activity did you see last year and what change do you see this year?
MR. FOUTS: We are running at $2 billion so far this year in private equity or alternative investment into the renewable energy sector. The volume is up about 25% to 30% from last year. I expect to see pretty strong activity going forward for this year. The drivers have changed. Smaller developers are thinking this is a good time to sell given the need to get projects under construction by year end. The tax equity market is rebounding. Power purchase agreements are still very difficult to get utilities to sign. The renewed interest of Asian and European investors in the US market is helping. Then some of the big corporates that have renewable portfolios also are looking for other sources of capital to help fund growth.
MR. CHAUDHRY: How aggressively do you see lenders backing bidders on M&A transactions?
MR. FOUTS: A well structured transaction with a good PPA and proven technology will get backing.
MR. CANAVAN: You can get the debt. I don’t think that is the gating issue with deal volume in the M&A market. There were a couple large wind portfolios on the market recently. I will run the debt at x debt service coverage ratio. I will lever it up to the next percentage, depending on the strength of the power contracts and so on. Then is becomes a question of equity. Some portfolios have bee pulled from the market. The sellers are wondering whether the bidders will come in with the right returns to allow them to reach the minimum prices the sellers need to sell. MR. TANYERI: There is no question that acquisition debt is available to buy project pipelines. We saw a nice lift in terms of how people were valuing pipelines in the first quarter of this year. If only the market felt better, given what is happening in Europe. We have seen equity returns go back up significantly lately for pipelines, meaning valuations have come down.