Practical advice about optimizing generating portfolios
By Jeff Bodington, with Bodington & Company in San Francisco
Optimizing a portfolio of generating assets by weeding out some assets in the portfolio or adding others is about enhancing synergy.
It can make sense to sell assets that have become poor fits.
It can make sense to buy assets that spread fixed costs, improve operational flexibility and lower risks in addition to growing earnings.
This article discusses the sell-side motivations and the accounting, tax, financing and regulatory issues that are unique to portfolio-driven sales. It also addresses the buy-side motivations and key portfolio-related issues for buyers. There are some lessons learned, too: sellers usually wait too long and buyers are at risk of over-estimating the values of their turn-around capabilities and synergies.
Portfolio-related considerations are an additional reason why an owner may decide to buy or sell specific generating assets. The portfolio-level considerations most often involve lack of synergy. B&Co has advised sellers who lack project-specific expertise and cost-sharing synergy because an asset is one of a kind that requires unique operations, maintenance, parts, compliance, staff and knowledge. The seller may own the asset because it came as part of a purchased portfolio that contains assets that are a poor fit. The seller may want to sell a project in an isolated location or a difficult state regulatory environment. Selling off what have become orphans is part of focusing ownership and expertise.
Portfolio optimization is also a tool of corporate finance. Selling off minority ownership positions is part of consolidating ownership, improving control and simplifying financial reporting. Owners also sell marginal- and low-or-no-synergy projects to fund new development and improvements to projects with more potential.
The orphan assets are sometimes obvious. More often, an asset-by-asset evaluation needs to consider a broad range of factors.
Projects to consider first are those that are geographically isolated from the rest of the portfolio. Unless owning that project is a foundation for strategic growth in a new region, that project may be costly to manage. Maintenance, operations, accounting and regulatory compliance costs involve material diseconomies of scale. A project may both be costly to own and worth more to a regional owner who can amortize fixed costs over a number of local projects. In one case, a far-away owner felt that managing the project had become difficult and that replacing on-site leadership in a drive for scale economies would be dangerously disruptive.
A detailed analysis of how well a project fits requires an examination of synergies with the rest of the portfolio in operations, maintenance, critical spare parts, power sales administration, regulatory compliance, roving operating staff, major maintenance crew rotations, forced outage response, managerial control and expectations of future financial performance. Forced outage response can be the deciding factor. Delays in repairs at one facility caused the capacity factor to fall below a PPA threshold and triggered substantial power price reductions. In another case, although there had not yet been an outage and there were no contractual penalties, the fear of failing to supply power to certain customers, and the resulting harm to the owner’s local reputation, led that owner to sell to a larger owner with a deep quick-response capability.
Once one or more assets are identified for sale, getting the deal done can be worthwhile but difficult. The reasons for sale may not be unique to the seller; thus the market may be thin. More often, the challenges can include getting the owners of a jointly-owned project to agree on a reservation price and terms, unwinding an interest rate swap, and getting upstream lenders and bondholders to release collateral interests. In some cases, obtaining a necessary regulatory approval adds a condition precedent with a long lead time to close. For regulated utilities that are optimizing their portfolios of generating assets, obtaining desired rate treatment can add risk and six to more than 12 months to a closing schedule.
Book and tax accounting issues can be key considerations to sellers.
Selling a project can be a tool for managing earnings. Public companies need to consider the magnitude and timing of a gain or loss on sale within the context of consolidated earnings. Planning to close and book a sale during a specific quarter is common as the seller keeps an eye on other projected changes in earnings that quarter. Although privately-held companies may not be as concerned as public companies about reporting net book income, covenants in bond indentures and other financing agreements may be tied to book results, and these could also have a bearing on timing.
Income tax issues are important. It may be useful to match taxable gains or losses on the sale of a project to losses or gains due to other activities at a portfolio level. Material changes, such as expiration of a key supporting contract or financial distress for other reasons in advance of a sale, can lead to prickly accounting and tax analyses and decisions. Appraising and reporting an impairment loss, and writing down an asset for tax purposes, may smooth reporting of book losses and accelerate some cash income tax savings.
Although lenders may consent to a sale and leave a financing in place, that may not be assured. If debt needs to be paid off and potentially refinanced, consider the cost of breaking a swap and the process of releasing collateral.
Estimate the cost of breaking a swap by discounting the difference between the fixed rate and the forward curve for the underlying floating rate using the forward LIBOR curve. The resulting present value is what has to be invested at the forward LIBOR curve to meet future obligations under the swap that the project will no longer satisfy. This present value, plus fees, is the cost of breaking the swap. This cost can be substantial if the forward swap spread is high; that situation is common due to today’s low forward LIBOR rates. The cost also increases as the number of years remaining on the swap increases. A wrinkle in the math occurs when a lender is willing to remain on terms that include a partial pay down or a sweep to prepay. In that case, part of a swap is broken or funds need to be reserved to meet the swap obligation as it materializes. Either way, sellers should plan on that cost and the associated reduction in net proceeds.
Moving upstream in the capital structure, a trend toward corporate-level debt instead of, or in addition to, project-level debt began more than 10 years ago. Much corporate-level debt is now secured by project assets. Corporate-level lenders and bondholders may have a right to consent to a sale of some of their collateral and may demand payment or other security. Sellers should assume there will be a cost to win consent.
Winning approval from bondholders can be a special challenge. In one case, although there was substantial institutional investor ownership of the bonds, many of the non-callable bonds were owned by “widows and orphans” in brokerage account street names. The seller had to run a tender offer, buy a threshold number of the bonds, and then fund a trust to defease those bonds that could not be purchased. The sale of the asset and the tender offer had a simultaneous closing. While the transaction was ultimately successful, closing had to be delayed due to difficulty in finding and buying enough bonds.
For some assets, two other options must be considered. Some assets are just not economic for any potential owner. The growing number of idle biomass-fired power projects in California is an example. Coal-fired and several regulated-utility-owned nuclear units are another example. The exit strategies to date have been case-specific. Although many have assumed for years that residual value would net to zero, B&Co experience so far is that decommissioning and site restoration costs exceed the sales value of salvaged equipment, metals and real property. Electric, fuel and permit infrastructure may have value, but adapting those assets to a new project is likely to require replacements, upgrades, permit revisions and transmission system impact studies. A few idled projects on valuable ocean- and river-front property have been decommissioned, but many sit dark at a cost of liability insurance and nominal property taxes.
In contrast, other projects may be economic under different ownership but have liabilities that are difficult to discharge. Cogeneration projects with uneconomic steam sales agreements are an example. Hydroelectric projects with water supply obligations are another. Owners of several such projects have run liability auctions and sold the projects to the bidders who needed to be paid the least amount to assume the net liabilities. The buyers, for example, have been lumber mills and water users who could monetize non-power values that the current owner could not. For those sellers, the cost of the liability auction was lower than the costs and risks associated with potential litigation, bankruptcy and decommissioning.
Obtaining approvals from regulatory authorities to transfer certain permits and entitlements is a part of closing nearly all transactions. A benefit of selling ownership of a special-purpose entity, rather than assets, is that the special-purpose entity reduces the number of, and process for obtaining, the necessary approvals. Several aspects of that process are unique to portfolio optimization transactions. In one case, the FERC license for a hydroelectric project that covered several projects had to be divided into two licenses. The costs and risks associated with intervenors and new license terms needed to be considered. In another, jurisdiction over a natural gas pipeline had shifted to the Pipeline and Hazardous Materials Safety Administration. An approval that had not been required for the project within the portfolio was required, under a disputed interpretation of the regulations, to complete a sale of that project out of the portfolio.
Buy-side portfolio optimization transactions require additional work. That work is often the source of additional value and competitive advantage.
Economies of scale are material in many aspects of power generation. Power marketing, fuel procurement, daily operations, periodic major maintenance, regulatory compliance and finance involve substantial fixed costs that can be amortized over more megawatts and decreasing marginal costs that can lead to lower average costs and higher average margins. A buyer purchasing another facility near one or more that are already owned will realize such economies.
More interesting are acquisitions with unique synergies. Adding to a portfolio of facilities that can sell power to the same party and then amending PPAs to allow electricity to be delivered from any source can lower the risk of PPA penalties for under delivery and enhance maintenance scheduling. One owner of hydroelectric projects purchased a nearby project so that it could unwind an agreement that required sharing water flows, thereby allowing the owner to run the most efficient unit at maximum output during periods of high flow. Several owners of biomass-fired projects have acquired the critical mass of projects to enable them to establish regional fuel procurement organizations. Those organizations work to increase supply, to improve fuel delivery logistics, and to improve the quality of the fuel actually delivered. For owners of natural gas-fired combustion turbine projects, the cost of a leased engine to use in emergencies or during major maintenance can be substantial. Owning a fleet of combustion turbines that then justifies owning a spare engine leads to cost savings and operational flexibilities.
Another aspect of buy-side portfolio M&A involves minority ownership interests. Many projects were developed when the Public Utility Regulatory Policies Act limited ownership of independent power projects by utility subsidiaries to less than 50%. Although that limitation was removed in 2003, some PPAs require ownership to continue under the FERC rules in effect “as of the effective date” of the PPA. B&Co has advised non-utility parties who wanted to consolidate ownership by purchasing the interests they did not already own from a utility subsidiary. Often, those purchases were made under a purchase option in the partnership agreement. The details of right of first refusal, right of first offer, appraisal requirements and the definition of an acceptable replacement owner can be advantageous, disadvantageous and a contributor to litigation.
Another consideration for buyers is a filing required under section 203 of the Federal Power Act whenever a “jurisdictional” asset changes hands. While B&Co defers to Chadbourne for a legal interpretation of when section 203 applies, it requires many transfers of public utility assets to receive prior approval from FERC. Importantly, public utility assets in this case include PPAs and transmission agreements with independent power producers. Even the sales of ownership interests in entities that are parties to those agreements may fall under section 203. Among the many issues considered by FERC is whether the transaction will result in concentration that leads to market power in wholesale electric power markets. That is an important consideration for buy-side portfolio optimization M&A.
A purchase and sale agreement may require a seller to make a section 203 filing, and FERC approval may be a condition precedent to close. Indeed, the need to file has stopped several owners from acquiring power projects in particular regional markets. Buyers need to consider the possibility that FERC approval will be required to close and allow time to prepare, file and obtain FERC approval in a closing schedule.
Another consideration for buyers who are adding to their portfolios is the facility-level staff that comes with an acquisition. Integrating that staff into an existing portfolio requires harmonizing job descriptions, job titles, pay scales and benefit programs. B&Co’s experience is that buyers appreciate that power generation facilities do not come with instructions, and the existing staff has essential knowledge about a facility’s idiosyncrasies during start up, operating procedures and maintenance issues. The local relationships of existing staff may be essential for water supply management at hydroelectric projects and fuel supply to biomass- and waste-fired power projects. Although buyers usually plan to re-hire all of the staff upon closing, individual interviews and decisions are part of due diligence and the closing process. In the few cases in which an employee was not re-hired, the employee was already a questionable fit and the sale crystallized a departure that would have occurred anyway.
Buyers must consider various accounting and income tax issues. Key among those for all acquisitions is a step up in basis under section 338(h)(10) of the US tax code for buyers buying a corporation or section 754 for buyers buying an interest in a partnership or limited liability company. Often left to the last minute, allocating the purchase price to various asset classes for reporting on Treasury Form 8594 can have material effects on depreciation deductions and valuations for other purposes, including property taxes and special financing and grant programs. Unique to portfolio optimization buyers is evaluating and deciding where a new asset fits in what can be a web of consolidating entities. Interposing corporations and LLCs can block, alter and redistribute both book and taxable income upstream from an acquisition.
Generalizations are perilous. Subject to that strong qualification, here are several lessons learned.
On the sell side, sellers usually wait too long to optimize a portfolio and sell a project that is a poor fit. At best, a non-core project remains a distraction to management. At worst, there is the experience of one owner who recognized that a project was a non-core asset. That owner trimmed the maintenance budget for the project to favor core assets. Lower maintenance led to the catastrophic failure of a key component, and that failure tipped dominos that ultimately caused default under the PPA and a near total loss of asset value.
On the buy side, acquisitions are a textbook example of bidder’s ruin. B&Co’s experience is that the successful bidder in an auction of a power project is rarely the buyer with the lowest cost of capital. While cost of capital is important, the successful bidder usually has the most aggressive forecast of underlying cash flow. Portfolio optimization buyers are in danger of over-estimating synergies that seem to promise increased revenue and lower costs.
Yield cos built portfolios over the last two years and have been in the news. Many seem to be asset manager “lite” with a primary interest in low-risk projects with predictable cash flow. Some are now sellers after their share prices collapsed.
In spite of the challenges, optimization transactions can yield attractive returns to both sellers and buyers.
Sellers reduce their costs, reduce their needs for external financing and improve the rate of return on their remaining portfolios. Uniquely positioned buyers can earn attractive returns.
Most portfolio optimization transactions are not driven by a search for the lowest cost of capital. The lowest cost is about 8% unlevered after taxes for a good-quality project, plus or minus about 1% depending on the deal. Buyers in optimization transactions are fundamentally able to do something that the seller does not think it can do; thus pricing is determined by a difference in forecasts of cash flows and assessments of specific risks.