Portfolio Sales and Consolidation
Edison Mission Energy and BP Wind are just the latest companies to put portfolios of operating projects up for sale. More portfolios are expected to follow as some larger players pull back from new wind and solar development or find their European parents no longer willing to provide capital for new development. Various portfolios of gas-fired power plants are also for sale. There has been ongoing consolidation in the distributed solar market as a few national brands emerge. Is this a good time to buy? What does it take to win the bidding? A panel discussed the market for projects at the 24th annual Chadbourne global energy and finance conference in California in June.
The panelists are Ted Brandt, CEO of Marathon Capital, Jon Fouts, managing director of the global power and utilities group at Morgan Stanley, Andrew Murphy, senior managing director of Macquarie Infrastructure, and Declan Flanagan, CEO of Lincoln Renewable Energy. The moderator is Eli Katz with Chadbourne in New York.
MR. KATZ: What trends do you see in the US market? Who is buying and who is selling?
MR. BRANDT: Clearly NextEra has been a net buyer through thick and thin, but it is hard to judge the rest of the players in the top 15. Everybody knows that BP and Edison Mission Energy will soon be selling large portfolios of wind farms. [Ed. BP later withdrew its portfolio after receiving bids.] There will probably be other divestments, but it is not clear who will be the buyers other than NextEra. There are some private equity firms that would like to bulk up and get larger. There are a lot of people who are thinking about public exits as opposed to strategic exits.
Motivations to Sell
MR. KATZ: Where do you think the next wave of sellers will come from? Why would they be selling now?
MR. MURPHY: We would like to be a buyer in this market. As an infrastructure fund, we have some challenges that the other potential buyers do not have. We cannot use tax benefits that are a large driver of the economics. We are only interested in contracted portfolios with stable returns.
That being said, it really is a question of looking at who are the natural longer-term holders of the assets. An emerging trend is for companies to sell off assets into yield cos. NRG is putting some of its solar assets up for sale into a yield co. This highlights the fact that NRG is not necessarily a long-term holder; it needs to free up the capital that it has invested in that business. This is one of the drivers of portfolio sales. You see some of the other strategics exiting or partially exiting the space.
We could be a natural long-term holder of those assets if we can deal with the structuring issues. We can hold assets for 10 or more years. You are beginning to see that dynamic at work as some of these portfolios mature. There are more natural places to put them for the longer term so that developers can free up capital for reuse.
MR. KATZ: Some large investors put a lot of money into wind and solar and now infrastructure or private equity funds have taken them out. Do you see that trend continuing or can you even call it a trend?
MR. FOUTS: We see that trend continuing. The reason that a lot of the Europeans entered the renewable energy market in the mid-2000s is as much strategic as anything else. Now the assets are migrating to new owners who can hold them long term at a lower cost of capital. People are optimizing their portfolios. We are seeing a lot of Canadians buyers. They have long-term hold periods, they are sitting on other assets with yields in the single digits, and they have a lot of money to put to work.
MR. KATZ: There has probably been some maturation of wind and solar assets that make them more attractive to people who used to buy conventional assets. What are the differences for a buyer looking to buy a portfolio of conventional assets versus renewable assets, and what might motivate him to do one over the other?
MR. FLANIGAN: Ultimately, it comes down now to contracted cash flows. That is what people are buying. Whereas years ago, it was all about supporting renewable energy and helping with climate change, that is completely gone as a motivator. Now it is about contracted cash flow, and the technology elements that lie below that can be less important. That being said, in renewable assets, most of the major economic decisions are locked in up front and so there is less room for optimization than in a gas plant. The kind of play where people buy at the right point in the cycle on gas plants and multiply their capital by reselling in the right cycle is harder to do when you are buying a wind or solar project with a 25-year power purchase agreement.
MR. KATZ: Do you see a new type of buyer focused on renewable energy assets, and are there more complications with a renewable portfolio than a conventional portfolio?
MR. BRANDT: You have to look at wind and solar differently. Wind is clearly moving toward maturity. Solar is pretty fragmented, and it is not yet clear who will be the ultimate long-term owners, although MidAmerican is pretty strong right now. With wind, unless you have 1,000 megawatts, you cannot really be a scaled player in the wind business. There has been a huge effort to get to the point; there are now something like 10 players who are at about 1,000 megawatts. The guys who are at 1,000 megawatts are saying they would really like to get around 3,000 megawatts. There is a desire to consolidate in a difficult market with scarce PPAs.
On the other hand, there is probably more capital available for a developer than ever before, and there is passive capital for the first time. Just a few years ago, you only had the choice of active capital where you had to give up control in order to get access to capital. Now the pension funds are viewing contracted renewable projects as infrastructure quality, and we are seeing pension and infrastructure funds with wide open wallets. I would not call it an ATM card, but a contracted project will give a developer the ability to attract capital.
Purely Cost of Capital?
MR. KATZ: Does the bidding for projects come down simply to who has the lowest cost of capital? How does anyone differentiate himself? What are potential bidders doing that might give themselves an advantage?
MR. MURPHY: One of the challenges we face is how to differentiate ourselves. Our cost of capital is low, but not as low as some others. What we try to do is go farther up the risk spectrum by coming in during construction. We also look for opportunities to build strategic relationships because we want to write bigger checks. If we can talk about writing a big check in pieces over time and develop a relationship with a partner who can bring multiple projects over time, that is another way to try to avoid being just a cost of capital play, and it has value to the good developers.
MR. FOUTS: This is an important but subtle change that we have probably seen over the past 12 months. Twelve months ago, the focus was entirely yield and current cash flow. In the past 12 months, the pendulum has swung back and people are willing to take exposure to development and construction risk. They want that growth dynamic.
One way to distinguish yourself as a seller is to have a development team with a proven track record in developing assets and getting them through construction. Buyers today are putting more emphasis on that.
MR. FLANAGAN: Once the project is ready to start construction or beyond, it is exclusively a cost of capital play. Anyone who is looking to be a buyer is probably wasting time at the notice-to-proceed stage or beyond, unless he has a compelling cost-of-capital advantage.
MR. KATZ: What about post-PPA revenues? Can there be differences in what people expect the power prices will be after the power purchase agreement expires?
MR. FOUTS: It is the tail wagging the dog. The cost of capital is still key. A residual assumption discounted over 20 years is not going to swing the deal as much as a 100-basis-point advantage on cost of capital.
MR. KATZ: Who has the edge today between financial bidders and strategic bidders? Is there a different answer in renewables versus conventional?
MR. FOUTS: Clearly, what happens in the BP and Edison Mission Energy sales will be the story of 2013. A strategic player like MidAmerican that can use the tax credits and deferrals on a real-time basis has a fundamental advantage over everybody else.
Warren Buffett's money is pretty attractive. MidAmerican can write a big check, and it has been smart about not leaving much money on the table. Clearly it has more room to increase the price if it has to do so to win.
MR. MURPHY: Other than MidAmerican, there are not many players with tax appetite. That narrows the field pretty aggressively. After MidAmerican, it is back to some of the pension funds and infrastructure funds that are buying on a cost-of-capital basis.
MR. BRANDT: I agree. The tax capacity of the strategics is a huge differentiator. The strategics are more efficient buyers than anyone who has to go to Jon and his colleagues for tax equity structures.
On the conventional side, it is a different dynamic. It depends on where the asset is and its locational value. A conventional power plant can be a compelling play for a strategic if it fits into a portfolio and can bring synergies. Some strategics can be competitive on that, even if it is a fully contracted asset. It depends on the asset itself, because the ability to use tax benefits is not a differentiating factor.
MR. FLANAGAN: A few years ago, no doubt a strategic had the edge. The best long-term owner of these assets was clearly a strategic, but the advantage is now with the financial investors due to their lower cost of capital. The gap is narrow, but tax capacity cannot tilt it back the other way. It goes back to who wants to be the long-term owner. Strategics do not want to be long-term owners. Everyone is ultimately trying to get to that mythical 6% yield-seeking retail investor. That changes the dynamic completely from where it was four or five years ago.
Shift in Buyers
MR. KATZ: Jon Fouts, you had some interesting statistics about what happened in 2012.
MR. FOUTS: In 2010, most buyers of US renewable energy projects were Asians. It was strategic driven. The Chinese were interested in getting into the US and putting their equipment here. That has shifted so that the majority of buyers of renewable assets today are Canadian infrastructure funds. They account for two thirds of the market, and they have been very, very aggressive.
The story is different on the conventional side. In 2010, we saw Japanese, Korean and Chinese bidding aggressively for conventional contracted assets. Today the bidders are more likely to be private equity funds. They have a higher cost of capital, but many private equity guys are betting on gas prices. There is growing view that gas prices are going to recover, replacement values are improving or reserve margins are getting better. We are seeing people take selective bets on conventional assets in very specific markets. It is counter-intuitive that private equity funds should be able to win given their costs of capital. They are winning in a different way on the conventional side.
MR. BRANDT: If you have a utility-scale solar project under 150 megawatts, tax equity is efficient and we see a lot of people who have been able to compete very nicely with the strategics. The larger deals have had very short bidder lists because they exceed the capacity of the tax equity guys to do them. They come down to a pure cost of capital bid among four to five utilities. As you move into distributed generation, it is a completely different world, and we have not seen the strategics take an interest.
MR. KATZ: Drew Murphy, before joining Macquarie, you were at NRG, which is probably focused on its stock price and earnings per share. Does that influence acquisition strategy?
MR. MURPHY: Any public company must look at an acquisition through a couple of different lenses. We always focused on showing our shareholders that the acquisition was a wise way to spend their money. We wanted to show a long-term return. The acquisition also had to be accretive to earnings. If you compare that to how a fund like ours looks at assets, the fund has different metrics. We look for yield and some growth. All of that said, often it just comes down to what your actual cost of capital is regardless of other metrics.
MR. KATZ: Private equity funds have put money into portfolio companies that develop wind, solar and even conventional power plants. At some point they want to exit or give the money back to their limited partners. There was a point in time when it looked like they might be able to go the IPO route, but that appears mostly blocked now. Maybe there are some yield co opportunities, but do these people now become sellers in the sense that have to get money back to their investors? How does this figure into the M&A markets?
MR. MURPHY: You have just described several major players in the renewable energy business. All of the well-run companies are hiring banks and exploring options. They are looking at private and public yield cos. They are looking at realizing shareholder value while trying to balance that against overhead and maintaining organic growth.
MR. FOUTS: This is just the natural rotation of funds by private equity. Assets, whether renewable or conventional, are owned by private equity funds and, at some point, the assets will be put on the market to be monetized. That is how it works.
MR. FLANAGAN: The key point is that sellers are motivated by trends, and the current trend is to reach scale. Over the next five or 10 years, you should be looking to be a 10,000-megawatt operator. There are material benefits potentially on operations and maintenance as you reach such scale. There are a large number of sub-optimally small operators today. The rise of these yield co entities is a move toward groups of 1,000-megawatt portfolios. Eventually, they are going to have to more toward greater economies of scale.
We are only at the beginning of major consolidation. Owners of wind assets will be focused on what they own. The strategics who own wind assets have not been motivated particularly by earnings. That is about to change, and you will see people more dispassionately viewing issues of economy of scale and of spares and inventory management, and this will drive aggregation. I would put the new goal around 10,000 megawatts. I know for certain that 1,000 megawatts is still way too small.
MR. BRANDT: Owning one power plant and one wind project in a couple of places is not optimal because it represents too much concentration in single markets and single assets. Buyers will be most interested in trying to buy portfolios that have different yield profiles across the assets and different contract terms so that they can manage residual values and risk.
MR. KATZ: Say you have a fully contracted asset, with a BB or stronger offtaker. At what discount rates do those assets trade in the current market?
MR. BRANDT: Is it a not-yet-constructed asset with a PPA? Is it an asset under construction or is it an asset that is actually operating? Is it a project that will qualify for an investment tax credit, a section 1603 grant or production tax credits over time? Not to dodge the question, but I think wind is still an 8 1/2% to 9 1/2% market using unleveraged, after-tax P50 numbers. Solar is well below 7 1/2% with a few deals below 7%.
Nobody really has a handle on where wind turbine prices are headed. The bigger guys think that there may be more flexibility than what some of the smaller guys are seeing. We are telling sellers not to rush to procure turbines. Let the buyer procure the turbines. That has been a phenomenon for a couple of years with solar projects, where buyers may have a more optimistic view than the seller about where solar panel prices are headed.
MR. KATZ: We have seen some bidders offer capital that is 100 basis points cheaper for a 49% interest in a project, but it may not be wise to take the money because a 49% owner can block the 51% owner from exiting the rest of the portfolio.
MR. FLANAGAN: I agree with Ted's numbers. The solar number is materially lower than wind, but unjustifiably so. It is not that I think solar should be more expensive, I just do not think there should be as big a risk premium attached to wind.
MR. KATZ: In the distributed market, the sense is that maybe five players have consolidated and are dominating. Are they just aggregating a portfolio and trying to sell it later? Where do you see distributed solar portfolios trading?
MR. BRANDT: The discount rate is clearly higher.
MR. FLANAGAN: I think distributed generation is a great space. It is a space in which we are not active. It is so vastly different than utility scale. It is nearly impossible to do utility scale and distributed generation in the same business. It is a very different type of business. That being said, I really struggle with how to value the equity in a distributed generation business. I am not sure how to factor in credit and counterparty risk. A lot of very interesting stuff is being done, but I have no idea of how to value the equity, and I do not think anyone else does either.
MR. BRANDT: You have to distinguish between the commercial and industrial side and the residential side. The residential side is clearly mature and has found scale. The commercial and industrial side has been struggling to find scale and make the business work. A number of private equity guys have broken their picks in the business. Some companies have done well on a regional basis, but there is not yet a dominant national player.