New financing trends
A group of veteran investment bankers and commercial bankers did the equivalent of a journalist panel on the Sunday morning talk shows — they had a wide-ranging discussion about new financing trends, including the term loan B market, green bonds, state green banks, yield cos, financing for merchant plants and other topics — at the Chadbourne 25th annual global energy and finance conference in late June.
The panelists are Michael Eckhart, managing director and global head of environmental finance at Citigroup Capital Markets, Thomas Emmons, managing director and head of renewable energy financing at Dutch bank Rabobank, Steven Greenwald, managing director for global project finance at Credit Suisse, Michael Kumar, managing director and head of project finance for Morgan Stanley, and Andy Redinger, managing director and group head of utilities and power at Keybanc Capital Markets. The moderator is Rohit Chaudhry with Chadbourne in Washington.
MR. CHAUDHRY: Andy Redinger, what are the key trends in financing this year? How has the market evolved since last year?
MR. REDINGER: We have been lending to renewable energy companies since 2007. In the past, these were project-level loans. This past year, we reached a watershed of sorts in that we saw more holding company loans. Key Bank is much more interested today in talking to developers about providing holding company loans versus just project finance, and that tells me the industry is maturing.
MR. KUMAR: There is a more widespread acceptance in the institutional debt market of project risk. There was a time when you would do a long roadshow to explain the risks. Such road-shows have become less common in the last 12 months.
MR. EMMONS: We are seeing more liquidity. The additional liquidity is coming not only from the traditional sources like banks and institutions, but also from other sources like yield cos and securitizations, so it is a good market for developers to be doing financings.
MR. ECKHART: The big trends are yield cos and multi-project instruments so that institutional investors do not take project risk, but do take multi-project managed risk. We also saw the emergence this year of green bonds with the acceptance of a set of green bond principles in January. Green bonds are expected to become an enormous market. The third trend has been the re-emergence of the multi-lateral development banks, which are moving more than $50 billion a year into the space and, as we heard in one of the Chadbourne briefings this morning, the World Bank is now prepared to guarantee power contract revenues in some emerging markets.
MR. GREENWALD: Liquidity is the big thing. Tom Emmons mentioned it, but I call it liquidity squared because the amount of bank money available today for even large projects is far greater than what was available a year ago.
Lots of Liquidity
MR. CHAUDHRY: Michael Kumar, one trend has been the increased volume of deals in the term loan B market. How liquid is that market? What deal volume do you expect in that market this year compared to last year?
MR. KUMAR: Last year, the market was north of $3 billion. This year, already year-to-date as of yesterday is $1.8 billion. Given these trends and the fact that a lot of transactions tend to get done in the third quarter, volume will probably double this year compared to last year. What is interesting about the term loan B market is that it is the merger of three distinct investor bases: CLOs, long-term loan funds and banks. We priced a transaction yesterday for Bayonne where about half the book was commercial banks.
MR. CHAUDHRY: How does the term loan B volume compare to the volume of commercial bank deals?
MR. EMMONS: Commercial bank volume was around $20 billion in 2012 and $25 billion in 2013.
MR. CHAUDHRY: When you said the term loan B market was on a tear, I had expected it to be more significant in relation to the volume of bank deals.
MR. KUMAR: Certain types of transactions will always go to the traditional commercial bank market. For example, a wind construction loan is never going to get done in the term loan B market. The large construction facilities for LNG projects at least initially are always going to get done in the commercial bank market. Merchant power is going to get done in the term loan B market. When we parse it, the term loan B market is on a tear, but it is used for certain niches in our sector. B loans are used for riskier projects.
MR. CHAUDHRY: Steve Greenwald, people have been talking for the last couple years about the demise of commercial banks in the project finance market. Basel III and other market reasons are supposed to lead to a big withdrawal of commercial banks, but these numbers do not show that. Why? Were the predictions wrong?
MR. GREENWALD: That is the $64,000 question. I was talking to a colleague about it last night. While Basel III was not expected to put the kibosh on commercial banks, it was expected to lead to shorter tenors. Commercial banks are showing a strong preference for loans with five- to seven-year tenors. The Cameron LNG deal just got done with roughly $2 billion of commercial bank debt with a term of 16 years. The Japanese banks are in the market in a very big way, lending long term and with big checkbooks, and we are seeing many European banks doing the same. The US banks are still not interested in long-term lending.
There is a lot of liquidity in the bank market. Raising $4 to $10 billion for large LNG projects does not seem to be an issue if you keep the loan tenor in the sweet spot of five to seven years. I do not know why some banks are willing to lend 15 or even 17 years. You hear stories of their arms being twisted by the sponsors.
MR. EMMONS: The term loan B market is really not cannibalizing the bank market. The two markets have different objectives. The bank market is always going to be there for complex deals and for deals that require flexibility in terms of funding. For instance, banks will do construction debt. Banks will do highly-structured deals.
MR. REDINGER: The pricing in a lot of these deals was out of line in relation to risk. The asset class was largely misunderstood. Lenders have a better understanding today of the riskiness of the asset class. It is becoming a more mature market.
MR. ECKHART: Our perception of risk has a lot to do not only with the project, but also with who are the sponsors and the other participants. As a 200-year-old bank, we have clients we have worked with for decades, and our knowledge and level of comfort with these companies is key to our project financings.
The developers whose projects Basel III makes it harder to finance are the smaller independent sponsors who do not have that history or relationship. The fact that we have known a sponsor for decades is a material factor in our risk evaluation.
MR. GREENWALD: I would take issue with that. The Freeport LNG project on which we are working has never had a banking relationship. We went out for $4 billion, and we have multiples of that in terms of orders. Admittedly, the sponsor had a fine track record with respect to a re-gas terminal it built four or five years ago, but it has no real banking relationships. A good project, even with a relatively unknown sponsor, will attract a lot of bank capital which is not something I would have said a year and a half ago.
MR. REDINGER: I tend to agree with Steve Greenwald. The bank market is alive and well. If you are look for a loan with a tenor of up to 10 years and you price it appropriately, you can raise an incredible amount of capital.
MR. CHAUDHRY: So the bank market will take the risk on a well-structured project, but the term B lenders tend to be more aggressive on risk. Is that right, Michael Kumar? What is the risk appetite in the term loan B market? What kind of things are lenders in that market willing to take?
MR. KUMAR: That is a good way to put it. Broadly speaking, the bank market is a triple B or triple B minus — maybe BB plus — type of credit. Once you get below that level, the banks will generally not touch it. There are a few exceptions. The term loan B market will go from a single B all the way to investment grade. It is a market for projects with more merchant risk or other exposures that are not what the commercial bank market will take. The term loan B market can price risk. The bank market is generally binary.
MR. CHAUDHRY: You told me earlier that the term loan B market is starting to do covenant-lite deals again. What is a covenant-lite deal, and what kind of risks are lenders taking in such transactions? How much can a sponsor get away with?
MR. KUMAR: A sponsor can get away with a lot these days, unfortunately. It is a question of how much of a bubble there is. It goes in waves. Long loan funds will do covenant-lite without any problem. The CLO’s are much more disciplined because they have in their CLO charters that they have to have covenants, but what the covenants are is open to interpretation. Often you see transactions that notionally have covenants, but the thresholds are set so low that they are meaningless.
MR. CHAUDHRY: Let me ask that question in reverse. What kind of risk is the term loan B market not willing to take? When you go to investors, what the types of things are complete non-starters?
MR. GREENWALD: The term loan B market is less willing to take construction risk than the banks are. The banks understand that risk better. The reason you go to the term loan B market is the project has a post-construction risk profile that does not fit the banks.
MR. CHAUDHRY: I want to move beyond bank and term loan B deals into green bonds. Michael Eckhart, you mentioned green bonds as one of the trends you see. What is a green bond?
MR. ECKHART: It is term for bonds whose proceeds will be used in ways that help reduce global warming. Citi and BAML wrote a set of green bond principles almost exactly a year ago. We had placed a $1 billion green bond for the International Finance Corporation in February 2013 and sold it in an hour.
Why was there so much demand for the bond offering? In talking to our bond sales people, it was clear that the attraction was not only the triple A credit and the IFC track record, but also the IFC was doing something that the investors liked and trusted, and trust was the key word.
The IFC was declaring its investment criteria for the funds and what decision-making process it would follow. It committed to track the funds separately and, most importantly, it promised to report after the fact what specific projects the funds went into so that investors could, should they wish to, calculate the environmental or climate impacts of their investments. Those four things are the green bond principles.
We debated three big issues while writing the green bond principles. One is: “What is green?” That is an on-going debate. We are trying to create, not contain, a market. We are trying to prevent any gatekeeper from controlling the market with any single definition. The second issue is: “What should be the effect on pricing for the bond issue?” We decided not to touch that. The third issue is how to maintain the trust, transparency and integrity of the market. That is the one thing we decided to address, and it turned out to be the correct choice. To use the term “green bond,” the issuer must adhere to the green bond principles.
We are in the process of getting a trademark and copyright for the term green bond. Anyone who wants to use the term will be allowed to do so; it is a free license to any issuer who pledges to follow the principles.
The green bond space is a transparency and disclosure space at this point. A little over $20 billion in green bonds have been issued since January 2014 when the green bond principles were adopted. We should be at $25 billion by mid-year and $50 billion for 2014 as a whole, which compares to $14 billion in green bonds issued last year. We think the market will double every year.
MR. CHAUDHRY: Those are big numbers. That is way bigger than what was mentioned earlier for the bank market and the term loan B market. Will this market eventually dwarf the bank market, term loan B market and project bond market?
MR. ECKHART: Yes. It has been 25 years to get to a project bond market. The reason the principles were issued is that there were rumblings of bad behavior, so all the banks came together. Now 75 organizations have signed up as members or observers in green bond governance. Eighteen are on an executive committee, and there will be a serious global meeting in China on green bonds in two weeks. This is an instant global institutionalization of the market to protect the integrity of it. We do not want any bad behavior.
MR. KUMAR: But this is not the same as the bank- and term-loan-B-type of credits that we were talking about before. These are really full corporate or super-national credits.
MR. ECKHART: That is correct.
MR. REDINGER: The definition is use of proceeds. The focus in bank deals and the institutional debt market is the source of repayment and not the use of proceeds.
MR. CHAUDHRY: I still want to understand this. If you do get the certification of being a green bond, what benefit does that give you in marketing the bond? Pricing? You said you did not touch pricing. What is the benefit of being a green bond?
MR. REDINGER: We have not seen a real benefit from a pricing perspective.
MR. ECKHART: Correct.
MR. CHAUDHRY: So how would green bonds benefit the people in this room most of whom are developers of renewable energy, conventional power and other types of infrastructure projects?
MR. ECKHART: The benefit is not to the issuer. It is to the investor. This was not created as a marketing gimmick for issuers. There is a green halo effect, but it is a nonfinancial green halo.
The benefit is to the investors; the benefit is the integrity of green. Is anybody going to trust this? There was a considerable degree of distrust. What we have seen with placements we have done so far — GDF Suez, Toyota, Unilever — is a definite spreading of the investor base for each of those companies. In the case of Toyota, which was not considered a green company, many investors bought that bond who had never shown any interest before in Toyota paper. The Unilever offering drew nine green investors who originally distrusted the space, but who now trusted it because of the principles. You have a spread of the investor base and a green halo, but that was not the purpose of the enterprise.
MR. CHAUDHRY: Moving beyond green bonds to state green banks, how many state green banks are there today? Tom Emmons?
MR. EMMONS: I think there are about five. They are in New York, Connecticut, New Jersey, Hawaii and maybe another one.
MR. CHAUDHRY: Why should developers be interested in green banks? What do they do?
MR. EMMONS: I am most familiar with the New York Green Bank because it is the newest one, and it has been quite high profile. Its main objective is to mobilize private capital. It has been in the market asking financiers what is preventing financing of certain types of projects: things like particular risks to which banks and insurance companies are allergic or structures that can be enhanced by the capital of the New York Green Bank. It is not trying to raise lots of money to lend directly. It is trying to raise enough capital to be able to take risks and then apply that risk taking to particular elements of structures so that the private capital is mobilized.
MR. CHAUDHRY: Andy Redinger, what is your view of state green banks. We heard your views on green bonds.
MR. REDINGER: I think the industry spends way too much time on trying to solve the debt issue. Debt has been widely available to the industry for a long time. It is even more available this year. To spend more time developing other avenues to provide debt to projects is marginally productive; debt has never been cheaper.
There is a role for green banks in providing capital in situations where the commercials banks are not interested in providing financing: to new technologies and those types of things. The green banks are still trying to find their way.
MR. CHAUDHRY: Mike Eckhart, is there a role for state green banks?
MR. ECKHART: I was just in Paris last week for the first world meeting organized by the OECD on green banks. The biggest one of course is in the United Kingdom with £3.2 billion in funding. It has put out just over a £1 billion so far in 26 projects. Others will copy what the British are doing.
New York has yet to do its first deal. Connecticut is a government program that changed its name from a program to a bank. There are green banks now in Malaysia, India, Indonesia and Japan, and more are coming.
Governments are realizing that they cannot reach scale with clean energy solely by spending taxpayer money through grants. Someone put a bee in their bonnet that a financing facility that allows the government to get its money back and earn a return is a very attractive proposition. The UK Green Bank reported that it is earning a 9% return. The UK is in a different position than we are. It is helping local projects and also educating local lenders that lack the expertise to make a decision about these kinds of local projects: waste energy, biomass, local wind and solar. Green banks become the expertise that the local lenders can ride. It is an interesting little sub-niche.
MR. CHAUDHRY: Tom Emmons, what kinds of risk are state green banks looking to enhance? What kinds of credit enhancements are they willing to provide?
MR. EMMONS: An example of the type of thing the New York Green Bank is looking at doing is if a project contract in a particular market can only be five years because the market is not mature or deep enough, but the probability is that the contract will be extended, a green bank could wrap the later years of the contract in order to make the project bankable. A relatively new technology could be proven, but not quite as predictable as some of the more established technologies that we are used to financing. These are risks on the margin. The bank could also price merchant risks.
MR. GREENWALD: Are the green banks basically writing insurance policies?
MR. EMMONS: Again, I do not know about the other ones, but the New York Green Bank is brainstorming now and is getting input from lots of people. It has an RFP out inviting people to submit projects with requests that particular risks be wrapped by the bank. I do not think they would write it literally as an insurance policy, but it would function effectively as an insurance policy covering certain risks.
MR. CHAUDHRY: When the US Department of Energy tried to do the same thing, it was a long laborious process. Should developers be wary of similar efforts by green banks?
MR. REDINGER: No, we should embrace the green banks. They are another tool in the toolbox. What they are trying to do is useful.
MR. GREENWALD: If you are embracing a green bank, you are probably not looking to retire in the next six months. If the DOE is a precursor to what you will be dealing with, you have a long road ahead.
MR. ECKHART: Let’s not leave the impression that these are insurance operations. The UK Green Bank is run by an ex-partner of Hudson who is a very sophisticated financier. The New York Green Bank is being run by Richard Kauffman who had a distinguished career on Wall Street. The president is Alfred Griffin who used to work at Citi and is a 15-year structured finance wizard. We have some pretty smart people running these so-called government operations. I would look to them to be risk mitigators and credit enhancers for sure, but they are also going to put money into deals.
MR. CHAUDHRY: Moving on to the next topic, which is yield cos, three have closed to date. Michael Kumar, how many more yield cos do you see closing before the end of the year?
MR. KUMAR: At least another three significant ones. After that, I suspect that this is a tapering phenomenon. This year might be the peak year for yield cos.
MR. CHAUDHRY: And what is the reason for the tapering?
MR. REDINGER: I am not sure I share the view that it is going to taper.
MR. CHAUDHRY: Then how many do you foresee this year?
MR. REDINGER: Three or four is probably an accurate number for this year.
MR. CHAUDHRY: And you do not see it tapering because . . . ?
MR. REDINGER: Ultimately, we believe the yield cos focused solely on the US will end up expanding their footprints and buying international assets. The investor base will understand the need to go international because North America may not be the best place to deploy capital. It may be better to put capital to work in Brazil or Mexico, and having the flexibility to move capital around to countries where it can earn a higher return should be attractive to investors. There is also a need to expand beyond North America because yield cos will need to grow in order to continue to trade the way they do. Although very large, the US market is finite. Yield cos will need to find other ways to feed the beast.
MR. ECKHART: Didn’t we try that about 10 years ago?
MR. CHAUDHRY: Michael Kumar, coming back to you in terms of yields. What yields are investors earning on the existing yield cos, and where to do you see yields headed as more yield cos come to market?
MR. KUMAR: It is better to focus on total return than yield. An equity investor looking at yield cos and master limited partnerships is probably looking for a 12% to 15% total return. His return is the sum of his yield and capital gain. If the investor expects more assets to be dropped in on an ongoing basis, then there will be a low yield. If the investor does not believe there will be future growth, then he will demand a higher yield. That’s why I expect there to be a tapering effect because the number of assets that are available to be put into yield cos in North America is limited.
MR. ECKHART: There are three kinds of yield cos. There is the NRG-style yield co where a 30% ownership interest is sold to investors and the projects do not really move. The original sponsor still manages them and retains majority control. There is a big inventory of projects still to be moved into the yield co. Another type is the Pattern Energy model where both assets and the team that manages them are moved into a new yield co. The third type is a roll up of assets acquired from third parties, like some people are trying to do with solar projects, and then take the company public. It is still a young market in my view, and the final pattern or method has not been settled.
MR. CHAUDHRY: Keith Martin calls yield cos vacuum cleaners sucking up assets. Michael Kumar, what impact are yield cos having on strategics and infrastructure funds as they bid for assets? Are strategics and infrastructure funds changing strategies because of what yield cos are doing?
MR. KUMAR: Absolutely. Yield cos are winning the bidding in asset auctions because they have the lowest cost of capital. It is very hard for an infrastructure fund to compete with a yield co. You see the same phenomenon in the mid-stream space where it is very hard for a private equity shop to compete with a mid-stream MLP. Yield cos are the most competitive and most aggressive buyers because they need to grow. Let’s see if that continues.
MR. CHAUDHRY: I am going to go to the last topic before we run out of time. Andy Redinger, you said one of the trends you see is debt at a holding company level to finance portfolios of residential solar systems and other forms of distributed generating assets. How are lenders getting comfortable with the risks associated with so many small assets? How are they structuring the deals? Do the deals involve blind pools of assets?
MR. REDINGER: We look at the company. We focus on how the company chooses its customers. We do not try to look at every single customer during diligence, but rather we zero in on the process and procedures the company has in place to acquire that customer.
MR. CHAUDHRY: Tom Emmons, do corporate revolvers of blind pools of assets, where you do not know what you are financing, truly work or do lenders end up having to do continuous diligence as additional assets are added to the pool?
MR. EMMONS: There are not many examples. Construction revolvers have been used to finance pools of assets with predetermined criteria so that each project does not have to be analyzed fully. It is prohibitively expensive to do a full analysis on every small project going into a construction revolver. We have done a couple. We use preset criteria, and then we look more closely at anything falling outside the box.
Distributed generation is becoming a very, very deep market. We are basically doing project financing of portfolios. A developer will come to us with 10 or 50 projects of relatively small size, but with at least $40 million in capital cost so that there is enough scale to make the financing economic. We do diligence on a sampling basis. We work with an engineer to come up with a diligence method that will give us comfort in the whole portfolio, but without looking at each individual project in the same depth that we do large projects, and then the debt is drawn down over six to 10 months. The loan becomes a project finance term loan, but with many projects rather than a single project.
MR. CHAUDHRY: My last is question for each of you is what other trends do you see beyond what we have already discussed?
MR. GREENWALD: This is a great market for borrowers, and it will remain so as long as the Federal Reserve keeps interest rates low.
MR. ECKHART: Next year will be global. Don’t think US. Don’t think Europe. Don’t think London, because the action is shifting to Asia. Those of us in this business have to think globally.
MR. EMMONS: We are in the middle of a cycle. The current cycle started in 2009 when credit was very tight. We are not yet into the over-aggressive phase, but we know these things go in cycles. There is no such thing as stasis or equilibrium. We are trending toward greater liquidity and greater risk taking. The current cycle probably has at least another couple years to run.
MR. CHAUDHRY: How far away is the next crisis, Michael Kumar?
MR. KUMAR: When the Fed raises interest rates. As long as interest rates stay put, this will remain a very favorable market for borrowers. We expect a lot of activity in North America in the next two years — probably more in mid-stream oil and gas and LNG than in power and renewables, but both will be healthy — and there should be a lot of activity in the next 18 to 24 months.
MR. CHAUDHRY: Andy Redinger, the final word?
MR. REDINGER: Lots of assets changing hands.
MR. CHAUDHRY: Good projection. We have time for two audience questions.
MR. CHERRY: Bud Cherry, CEO of Eagle Creek Renewable Energy. Talk about merchant versus contracted projects. How does merchant risk play in your assessment of deals?
MR. KUMAR: In this market, there is a price for everything. I think that as long as the underlying project has robust economics, meaning if it has locked in fuel costs and will be well positioned on the dispatch curve, it can be financed today. It could not get financed 18 months or even two years ago and it may not be able get financed 24 months from today, but today there is a price for it.
MR. CHERRY: Is that in the B loan market?
MR. KUMAR: Yes.
MR. CHAUDHRY: And is that with or without a hedge?
MR. KUMAR: Without a hedge. We priced the Bayonne transaction yesterday. A portion of it is hedged. There is a capacity market obviously, but it is essentially a merchant plant.
MR. CHAUDHRY: In which markets do you see merchant plants getting financed: just PJM and Texas or more than that?
MR. KUMAR: Primarily PJM and Texas, but depending on the situation, there may be an ability to do something in other markets as well.
MR. CHAUDHRY: Last question.
MR. FREEMAN: Rob Freeman, CEO of TradeWind. One of you made the comment that the total return for equity investors in yield cos is in the 12% to 15% range. How does that translate into a discount rate that yield cos use when valuing assets?
MR. KUMAR: If you ask institutional investors who play in the yield co space what returns they are expecting when they buy the stock, they would say 12% to 15%. That’s what they hope to receive. Whether they actually achieve it is to be determined. Now what are they targeting when they bid for an asset? They are targeting anything that is accretive to their business model, meaning what is the dividend they are paying currently and what can they afford to pay for additional assets that help grow the dividend? The focus is on the margin. If a yield co has a 5% yield, then it should be buying north of 5%. It should not be buying inside of 5%.
MR. FREEMAN: What about renewable energy credits? Are they assigned a value as part of the future revenue stream?
MR. EMMONS: The answer is the same as for electricity. Contracted RECs get full credit as long as the counterparty is strong. As for merchant RECs, the bank market generally discounts, but maybe the term loan B market will give them some credit.
MR. ECKHART: There is risk around renewable portfolio standards because of the efforts by well-funded conservative groups to roll back current targets. Ohio is a little worrisome because of what has happened there. Is Ohio a trend or will concern about global warming cause states to adopt even higher targets? Will we move to a carbon tax in place of renewable portfolio standards? There could be a lot of tumult in the next few years.