2017 market trends
More than 250 people gathered in New Orleans at the annual Infocast projects and money conference in January to hear what the year ahead might hold in terms of deal flow. A panel of three investment bankers and an industry consultant spoke on the opening panel about whether the possibility of corporate tax reform is already affecting deal flow, the wall of private money, particularly from Asia, looking to invest in US assets, current discount rates used to bid, the potential for energy storage to displace gas-fired power plants, what the panelists are putting on their own business plans this year as potential areas for growth, and other topics.
The panelists are Andy Redinger, managing director and group head, utilities and alternative energy, KeyBanc Capital Markets, Ted Brandt, CEO of Marathon Capital, Jonathan Cody, managing director at Whitehall & Company, and Shanthi Muthiah, vice president and power sector lead at consultancy ICF International. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: We start 2017 with probably greater unpredictability than any year I can remember. The Republican sweep in the elections makes corporate tax reform more likely. Is the threat of tax law change already playing out in deals and, if so, how?
MR. REDINGER: It is early. People are still feeling their way.
MR. MARTIN: Ted Brandt, you put out a paper about the potential effects of tax law change. The wind sector was the main focus. How do you see this playing out in deals?
MR. BRANDT: It was really solar and wind, but our conclusion was that the expected corporate tax rate reduction will not affect solar very much. It will affect wind largely because wind is more tax intensive. It will play out pretty significantly. Sponsors will have to put up more equity. There will be new structures where risk sharing that has not been part of the calculus will have to occur. It will add friction to the market.
One of our conclusions was that the uncertainty about tax reform favors people with balance sheets and with lots of capital, and that could fuel M&A by small and medium-size developers to grow larger.
MR. MARTIN: You thought that there would be more M&A in the wind market, but hasn’t that sector already consolidated? What is left to consolidate?
MR. BRANDT: There are a few.
MR. MARTIN: Why not also in solar?
MR. BRANDT: Our analysis is the tax credits are not going to go away. What will happen is the tax deferral from accelerated depreciation will decline in value due to the tax rate reduction.
The offset is that you are paying less taxes once you are on the other side of the flip. The present value of that pickup more than offsets the loss in deferrals for solar projects. Unfortunately, that does not happen for wind.
MS. MUTHIAH: Obviously a lot of focus is on how this will affect the renewable sector, but we continue to see M&A activity on the conventional side, and we do not expect any slowdown in that sector while Congress is debating how to rewrite the tax code. So far we have not seen any direct effect on M&A pricing or even in the pricing of independent power company stocks and valuations.
MR. MARTIN: You anticipated my next question, which is whether the financing and M&A markets will function normally this year while Congress is debating major tax reform.
MR. REDINGER: I think there will be an increase in M&A activity. There is a way to structure around the tax risks. The potential for future changes in tax laws may cause people to act. The big unknowns are where the corporate tax rate will land and what sort of cost recovery, if any, will be allowed on imported equipment.
MR. MARTIN: Is there an inconsistency in saying you expect an active M&A market and there are two big unknowns?
MR. REDINGER: A market will remain for seasoned projects that have already been financed and maybe are at or through their tax equity periods. Operating projects will be more valuable. Tax reform is largely an upside for them.
MR. MARTIN: Operating assets will be more valuable because the lower corporate tax rate will mean the after-tax cash flow from operating them will be higher. Yet the buyer does not know what sort of cost recovery he will get. How does he bid?
MR. REDINGER: Maybe you include an earn out. There are ways to structure around uncertainty. The sheer amount of capital chasing this asset class is still immense. Given the number of potential investors and the amount of capital chasing, you will find people willing to structure around that risk.
MR. MARTIN: Ted Brandt, do you agree?
MR. BRANDT: Yes. The wild card is the House Republican tax plan has full expensing for capital spending, and it eliminates interest deductions. These proposals will affect what ultimately happens in M&A. We could also see a shift from partnerships to corporations that will be taxed at a lower marginal rate. Less leverage due to loss of interest deductions could give strategic investors an advantage over financial investors.
MR. MARTIN: Do you agree with Andy Redinger that the market will continue to function normally in the face of the uncertainty this year?
MR. BRANDT: I agree that there is so much capital trying to get deployed in American assets that creative people will figure it out.
MS. MUTHIAH: I agree with that to a point. M&A activity could start strong, then the market could be thrown into limbo as the tax law changes come into clearer focus, and there could be a period of wholesale repricing.
MR. MARTIN: Ted Brandt, you often represent sellers. In some deals currently in the market, people are adding “schmuck insurance.” No one buying assets wants to feel like a schmuck for having overpaid when the law changes, so there is a one-time price reset after any tax overhaul bill clears Congress. Do you think this will be attractive to sellers? They would take the risk of tax law change.
MR. BRANDT: We shall see. I am in the middle of a whole bunch of schmuck insurance conversations.
MR. MARTIN: The House tax reform plan has been thrown into disarray. It would reduce the corporate tax rate to 20%. Trump wants to go to 15%. It would deny interest deductions. It would allow immediate write-offs for new equipment, but no cost recovery at all for imported equipment.
Starting with the interest deductions, do you see companies rushing to put in place construction or corporate revolvers so that the debt will be grandfathered from the loss of interest deductions? Presumably interest will remain deductible on existing debt when the tax laws change.
MR. BRANDT: We are not seeing that yet, but I can see your point.
MR. MARTIN: How do you expect the denial of cost recovery for imported goods and services to affect the market? Are you seeing any change in behavior in anticipation of this potential tax law change?
MR. BRANDT: It would sure affect solar. I think you have one or two companies that manufacture solar panels here, so it would have a huge effect. Wind should not be affected as heavily as more and more wind equipment is manufactured domestically. I think gas turbines by and large are made in the United States.
MR. CODY: Isn’t this the equivalent of an import duty? Wouldn’t it violate the GATT treaty to which the US is a party and end up before the WTO? There is a lot of chatter about the so-called border adjustment. The volume is probably louder inside the Beltway than outside.
I think the market functions normally until the tax reforms come more clearly into view. We are seeing people take proactive measures on the tax equity side. The tax equity investors are looking for indemnities. That obviously affects what sort of sponsors will be able to conclude deals. They need to be creditworthy enough to stand behind indemnities.
MR. MARTIN: What should a developer do when bidding into a power contract solicitation? The developer has to make some assumption about his or her cost of capital.
MR. BRANDT: What we are hearing from the very largest guys is that they are trying to pass this off to the utilities in their power purchase agreements, but so far they are being straight armed. The risk obviously has to be borne by someone. It will probably end up being borne by the cash equity investor. The dollar amounts could be large.
I do not know whether anyone in this room has looked at what deficit restoration obligations for tax equity investors will look like if you have full expensing and no interest deduction. They go through the roof and could exceed the original investment. No tax equity investor will step up to such an obligation.
MR. MARTIN: Let’s break that down. Many renewable energy companies raise tax equity through partnership flips. It is impossible to transfer all the tax benefits to the tax equity investor in such a structure unless the investor agrees to invest additional money when the partnership liquidates in the amount of any negative capital account. Each partner has a capital account. Capital accounts are a way of tracking what each partner put in and took out. A partner with a negative capital account took out more than his fair share. Tax equity investors in these structures do not start with a high enough capital account to absorb all tax benefits. You are saying that tax reform will make the problem worse. Tax equity investors will have to agree to even larger deficit restoration obligations than they do today.
MR. BRANDT: Correct.
MR. MARTIN: Won’t investors simply stick to the level of DROs with which they feel comfortable today? The end result may be tax equity will be a smaller share of the capital stack for the typical wind or solar project.
MR. BRANDT: Time will tell.
MR. MARTIN: Returning to the border adjustment, or the idea that no cost recovery will be allowed on imported equipment. This part of the House Republican tax plan would raise $1.2 trillion. It would shift $1.2 trillion in tax burden over the next 10 years from one group of companies to another. Trump told The Wall Street Journal two days ago that he is not a big fan. He thinks it is too complicated. He prefers import tariffs.
If the border adjustment falls away, then who knows where the House Republican plan is left. Advocates of the border adjustment say it is no big deal for importers because the dollar will appreciate so much that imported equipment will cost less in dollar terms. The $1.2 trillion will be a wash.
What effect, if any, will a stronger dollar have on our market?
MR. BRANDT: It is not a single variable analysis. We are seeing an influx of global capital into the United States wanting to invest in dollar-based assets with the expectation that the dollar will strengthen. The amount of inbound US investment is potentially enormous.
MR. MARTIN: From where is the money coming?
MR. BRANDT: Surprisingly, we are seeing a lot from Europe, but most of it is from Asia. There is also an incredible amount of money coming down from Canada.
MS. MUTHIAH: Asian investors have been focused on this market for some time, with the Japanese leading the pack and the Koreans on the fringes. We are starting to see greater interest from China.
If you look just at PJM combined-cycle development as an example and at what is in the pipeline today, 15% to 20% of it has some share of foreign ownership. The vast majority is Asian ownership. The European focus has been more on the renewables side. The US has been an attractive market, and we see it remaining so.
MR. MARTIN: The European focus has been on the renewables side. The Asian focus has been on gas, renewables, what?
MS. MUTHIAH: Japanese investors have been focused largely on gas in general and combined-cycle gas-fired power plants in particular. The burgeoning Chinese interest has been in the renewable energy sector.
MR. MARTIN: What is bringing these people in? Is it the anticipation of a stronger dollar or something else?
MS. MUTHIAH: It has been more limited opportunities in Asia versus better opportunities here. It is not a post-Trump phenomenon.
MR. BRANDT: I think your 15% to 20% estimate is low. I think the figure is closer to 50% Asian participation in new builds.
MS. MUTHIAH: Going forward, the figure is clearly increasing.
MR. CODY: Another factor is the risk-adjusted yields are better in US projects.
Wall of Money
MR. MARTIN: Jon Cody, you and Andy Redinger were on a panel last summer on which the participants said a “wall of private money” is coming into the US market. Would you say that remains true? Is the amount increasing?
MR. CODY: It seems to be. There is an unending amount of it. This is never ending. It has staying power. I am not seeing any change whatsoever.
MR. REDINGER: If anything, it is picking up. We have seen Korean investors become much more active in the last 12 to 18 months, and we think that trend will continue. The Koreans will probably make the transition from being senior lenders to putting in more equity.
MR. MARTIN: Yesterday we heard on a cost of capital webinar that the interest rates are falling in both the bank and term loan B markets, but tax equity yields have remained flat. In which direction do you think equity returns are moving: up or down? If there is a wall of private money, should they be increasing?
MR. CODY: It has been a roller coaster ride. Honestly, we are seeing equity returns recover a bit. The yield co blow up hurt them. The wall of private money helps developers because it bids up valuations for their projects.
It depends on the market segment. We have not seen much movement in quasi-merchant projects with hedges. However, when you look in PJM, for example, at any gas-fired assets with a 15- or 20-year PPA, the return requirements are stunning.
MR. MARTIN: Give us some numbers.
MR. CODY: We are looking at equity returns in the mid-teens for a hedged merchant project.
MR. MARTIN: Pre-tax?
MR. CODY: Pre-tax. A lot of these folks, especially the Japanese, have very different tax positions based upon their activity in North America. So everyone is looking at pre-tax. We are seeing mid-single digit returns for a contracted peaker.
You can see where a solar project that has far fewer moving parts than a peaker could price at close to the offtaker’s credit rating, but people are pricing even a relatively simple technology like a peaker through the floor. That is the effect of the wall of capital.
MR. MARTIN: Jon Cody, the previous speaker, William Nelson from Bloomberg, put up a number of slides. One of the interesting things was how prices in California for ancillary services and for electricity in the late afternoon and early evening when solar drops off the grid are spiking in order to give gas-fired power plants enough incentive to remain on line during the day time when they are getting crushed by inexpensive solar and running up big losses. The high prices during peak hours allow them to recover their losses and earn a small profit. Nelson said there is a golden opportunity for energy storage companies to steal that revenue.
That does not say much for the long-term viability of gas in California. What about in PJM?
MR. CODY: California is a market unto itself. Government policies and actions by the local utilities influence power prices in ways that prices may not move in other parts of the country.
MR. MARTIN: Will you see the same arbitrage opportunities for storage facilities to displace gas in the east?
MR. CODY: We do not see as much penetration by solar or storage in the east as we do in California and Texas.
MS. MUTHIAH: In California, it is not just the ancillary services market but also the capacity resource adequacy structure that is causing distress for gas.
MR. MARTIN: Shanthi Muthiah, this is an area of special expertise for you. When you watched William Nelson’s presentation, did you say to yourself, “Storage companies are eventually going to eat the lunch of the gas-fired generators in California?” Do you see that also happening eventually in the east?
MS. MUTHIAH: The storage market is still in its early days and faces a number of challenges. Storage is coming down quickly in cost. We are talking about costs today in the range of $1.4 to $2 million a megawatt. They are still markedly higher than for competing generating assets. The regulators are also still wrestling with how best to compensate storage companies. The regulatory piece needs to be worked out on top of the costs coming down for storage to start to have a transformational effect on the market.
MR. MARTIN: So we are still a little far away from full-scale deployment of storage.
MS. MUTHIAH: Yes. There was some potential for it, but the prospects, at least on the regulatory side, have probably receded after the November election.
MR. MARTIN: Ted Brandt, what are current discount rates for winning bids for wind and solar projects?
MR. BRANDT: People are still absorbing the news and watching Twitter every day. Fully-contracted solar is selling to a 30-year pro forma of about 7% after tax, unleveraged. Wind is about 8.5% to 9%. I don’t think the wind number has changed for a couple years.
The difference is that buyers are now looking at the potential for greater tax deferral if the US government moves to full expensing of investments in equipment. This has not been factored yet into pricing. Any buyers have to rethink whether there are any other risks besides tax law change that should be shifted to sellers.
MR. MARTIN: The 7% discount rate is for utility-scale solar? What about rooftop solar?
MR. BRANDT: We have not seen much difference between well underwritten investment-grade rooftop and utility-scale solar. The discount rates have converged because of the wall of money. We did three distributed generation deals last year, and the rates were right in line with what I just described.
MR. MARTIN: Are buyers already taking into account the possibility of a lower corporate tax rate in their pricing? The out-year after-tax cash flows will be higher. You say no, Ted, because people price on a pre-tax basis. Does anyone disagree? Andy Redinger, you are shaking your head no.
MR. REDINGER: No.
MR. MARTIN: A lot of the solar assets changing hands are in California. One of the challenges in California is that a sale of an operating solar project will trigger a property tax reassessment. The cost could be substantial. How serious an impediment has this been in bids for California assets?
MR. REDINGER: The first owner after a solar project is first put in service gets a break on property taxes, but if the asset is sold later, the property taxes go to fair market value, which can hugely deteriorate value. What some people try to do is have two buyers. Each takes a 50% interest so that there is no change in control. A change in control triggers a reassessment. It has been a significant issue in every California solar asset with which we have dealt.
MR. MARTIN: One more question along these lines, and then let’s move to a new topic. Some analysts are saying that PPA prices will have to rise because of the tax law changes in order for wind and to a lesser extent solar projects to remain economic. But we said on this panel that the corporate tax rate reduction will make operating assets more valuable. Is there an inconsistency in saying PPA prices have to rise to justify new builds, and yet these assets, once built, are ultimately more valuable?
MR. REDINGER: For new builds, the depreciation is potentially less valuable. Someone has to fill in the hole. Either the equity will have to accept a lower return or PPA prices have to rise.
MR. MARTIN: But the owner has a more valuable asset.
MR. REDINGER: True for a mature project, but to get the project built, someone has to fill in the hole in the capital structure.
If I am selling a mature project today, it is more valuable because there will be less in taxes. But for a new build, somebody has to fill that hole. You also have to remember, as Jon Cody said, most of the market thinks of the world as pre-tax because they think that they are going to do enough new deals to shelter the current taxes.
MR. MARTIN: The story so far is the M&A market will continue to function as it has. People will watch Capitol Hill, but they are not stopping in their tracks. They have not changed the pricing in anticipation of something happening on Capitol Hill, at least so far.
Let me shift gears. Debt markets. Where was most of the action in 2016 in the debt market, and do you expect the same in 2017 or are there some emerging new trends?
MR. CODY: The action for us has been mainly in solar. I suspect that will remain true this year.
MR. MARTIN: Andy Redinger?
MR. REDINGER: The biggest trend has been the very large tickets being bought by Asian banks in the syndicated loan market. We are talking about holds by Chinese lenders of $125 million. We are seeing Koreans participate more or less as a consortium for $200 to 300 million increments.
MR. MARTIN: Jon Cody, are the Asian banks lending longer tenors? Most of the US banks are at seven years.
MR. CODY: No. In the hedged merchant market, we see construction plus five years as the norm. We do not see any movement on that.
MR. MARTIN: Chinese lenders were rumored to be offering better terms than other banks. At the same time, the Chinese government has been discouraging Chinese companies from investing overseas because of the downward pressure on the Renminbi. How is that affecting Chinese lending?
MR. CODY: We have not seen it tail off. Obviously there has been a sea change in exports of equity capital out of China. However, it has not played out fully yet in the market.
MR. MARTIN: Most of the money coming in last year was looking to invest earlier in the development cycle, at the notice-to-proceed stage, for example. Are you still seeing that or is there a move to invest even earlier in the process?
MR. CODY: Nobody wants to get involved in the notice-to-proceed stage on purpose. They do it because they are not getting any business waiting around for projects that have reached the end of construction. By then, the movie is over, and the deal is gone. We are seeing lots and lots of companies willing to deal with late-stage development risk in the search for yield. Maybe there is a PPA, but there is still some permitting risk, transmission risk, some deposits that need to be put down. Companies that three years ago were purists refusing to take any construction risk are now coming in much earlier.
MR. MARTIN: Ted Brandt, you said at past conferences that there was little interest in buying development rights to projects, particularly where the developer does not yet have a PPA. Is that still the case?
MR. BRANDT: That changed pretty dramatically last year. The open question is how it will be this year. There were a number of wind developers who went long in turbines, but came up short on projects in which to deploy the turbines. They did not foresee that Congress would extend the tax credits at the end of 2015. So there was a big bid for development assets. The open question is what people will make of the outlook with a new administration in power.
MR. MARTIN: It seemed like last year the pipelines had thinned.
MR. BRANDT: By late 2015, nobody was developing post-2016 projects.
MR. MARTIN: Then you saw at conferences in early 2016 CEOs were showing up for the first time in years trying to decide whether to dive back into the development game. Did they dive back in? Have development pipelines been restored?
MR. BRANDT: There were a few new entrants. For example, Tenaska bought a small portfolio and is in the development business. Longtime developers like NextEra described the situation as, “We need more plywood and drywall.” Most developers appear to have dived back in.
Yield Co Rebound?
MR. MARTIN: So the pipeline of development assets is being replenished.
The market was abuzz last year about a number of potential growth areas or rebounds. Let’s start with the rebound story. Andy Redinger, you predicted at this conference last year that yield cos would be the comeback story of late 2016 or early 2017. Do you still see that and what does it mean?
MR. BRANDT: Oh, oh. We are being held to our predictions. [Laughter]
MR. REDINGER: Here are some statistics. At this time last year, nobody was accessing the equity markets. Three yield cos tapped the equity markets in 2016, and if you throw Hannon Armstrong in, that’s four. If you predicted last year that three yield cos would access the equity markets, everyone would have said no. But they did last year. Yield cos outperformed the S&P 500 last year by 300 basis points.
MR. CODY: Weren’t they all private placements or effectively underwritten?
MR. REDINGER: That’s right. There is an investor pool that continues to like this asset class, and I think yield cos are a very attractive way for that investor class to participate. Yield cos not only outperformed the S&P last year by 300 basis points, they also outperformed the utility index by 10 percentage points. All but one are trading above their IPO prices by an average of 15% to 16%. I contend yield cos have come back.
MR. MARTIN: Two years ago the big story was warehouse loans to yield cos. Do we see any more of those?
MR. CODY: How about version 3.0? [Laughter]
MR. REDINGER: Listen, I suspect that will come back.
MR. MARTIN: Do you see any new yield cos coming to market?
MR. REDINGER: Currently I do not.
MR. CODY: It would be tough to bring a new one to market today. Obviously the yield co market is too small for an institutional investor looking at possible places to deploy capital. I think at the height of the yield co phase, market capitalization was something like $12 or $13 billion. That is one fifth of the size of either of the two largest master limited partnerships. It is challenging for an institutional investor to put money into something that small versus things that are more easily benchmarked.
MR. BRANDT: The wall of money in the private market continues to be more aggressive than the public market. As long as that dynamic remains, I would think some of the yield cos are considering going private. There are times when the public market trades better than the private market. Right now, the private market is trading at higher multiples. Until that changes, it will be tough for anyone to consider bringing a new yield co to the public market.
MR. REDINGER: And if there are any yield cos who want to go private, give me a call. [Laughter]
MR. BRANDT: One of the things the yield cos have to think about is there could be some activist investors who say, “The private value is higher than the public value. You need to sell off assets, and we will all make money.” That has not happened yet, but it very possibly could.
MR. MARTIN: Andy Redinger, last summer you said that independent power producers were trading at $400 to $500 a kilowatt in the public markets. Conventional assets were being sold in private deals for $700 to $800 a kilowatt. Is the gap still on that scale?
MR. REDINGER: The S&Ps are still trading in that range. That is a broad generalization about conventional power plants. It depends on the asset. On average, if I put hydro, gas and all the rest of it together, that is close to an appropriate metric. I suspect gap has narrowed a little.
But the broader point still holds: the private market continues to value these assets more aggressively than the public market.
MR. MARTIN: Why? Jon Cody, I think you have said before that the private markets are better informed.
MR. CODY: It is easier to make a discreet investment in a project than it is to look at a company, understand fully its prospects and management, and put a value on it. Some of the IPPs accumulated assets pre-renewables and pre-shale gas. It is a much more difficult and challenging analysis when you look at such an IPP. Among the questions you have to consider is whether its capital is optimally deployed. Will its assets continue to generate suitable margins or is there a way by replacing some assets to improve the company profile?
MS. MUTHIAH: I agree with that. The range of IPP valuations right now runs from about $300 to $350 a kilowatt to about $600 a kilowatt. Anyone looking to buy an IPP or asset portfolio has to look at the capacity mixes and the geographic dispersion. Looking at a single asset for purchase is a much simpler analysis.
If you look at what transacted this past year, a lot of it was in portfolios where it is hard to tease out the individual values, but it was in the $550 to $700 range. Frankly, we do not see a significant dislocation between where the IPPs are publicly trading and some of these private values, but you really need to look carefully at exactly what it is you have. You cannot use simple dollar-per-kilowatt-type indications to come up with a value.
MR. CODY: In at least one of those recent portfolio sales, it was buy three combined-cycle gas turbine projects and we will throw in a coal plant for free.
MS. MUTHIAH: It depends on your view of the coal plant platform. Clearly there are some where the seller just hands over the keys. But there are other coal plants that have better prospects.
MR. CODY: Certainly if you are a large formerly regulated utility that is now a massive independent generator, shutting down any of these assets is a complex process with the unions and the states. Transitioning the assets out in some cases just makes more sense.
MR. MARTIN: Let’s move to potential opportunities in the year ahead. Community solar has been gradually getting traction, but perhaps not as quickly as some people had hoped. What do you foresee in the year ahead for it?
MS. MUTHIAH: Community solar is still pretty small at only 100 to 200 megawatts in total, but there has been so much growth in residential solar. I think 2016 was the fourth year in a row in which rooftop solar increased by more than 50%. Roughly half the residential and building sites are not good locations for rooftop solar, so that is the opportunity for community solar. The challenge is there is still a lot of state-level policy making that has to be resolved. There is also a fair amount of complexity. Not all states have programs.
MR. BRANDT: The other thing about community solar, and we sure think about it, is the subscribers are a bunch of consumers and small businesses. There is no investment-grade offtaker. The subscription agreements tend to be short. They allow subscribers to cancel on short notice. You have to be confident that the sponsor can find others to replace subscribers who drop away. The sponsor is also looking for big fees on an upfront basis, and is thinking the whole thing gets done with tax equity and debt.
A financing model will develop that is a lot heavier on equity and that gives the sponsor an incentive to focus on the long-term profitability of the projects rather than short-term fees. These are the things that have been holding back that market. Small stuff has been getting done, but I think there is a real alignment problem.
MR. MARTIN: What about energy storage? We have heard in the past that it will have a transformational effect in the market, but so far standalon