The virus, the bear and the cost of capital
Three lenders and the managing partner of a private equity fund talked in late May about how coronavirus and the economic downturn are affecting the cost of capital for the US power sector, especially for renewable energy projects. They also talked about how project valuations are being affected.
The lenders are Michael Pantelogianis, co-head of power for North America for Investec, Steve Cheng, a partner within the credit business of Global Infrastructure Partners, and Manish Taneja, managing director and deputy global head of infrastructure credit for The Carlyle Group. Scott Harlan is managing partner of Rockland Capital. The conversation took place on Zoom and was organized by Solar Media UK. The following is an edited transcript. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
Current deal flow
MR. MARTIN: Mike Pantelogianis, how would you characterize current deal flow in the US market?
MR. PANTELOGIANIS: Deal flow varies by sub-sector. Conventional power is somewhat slow. There was a lot of activity in that area in the last year or two.
Renewables seem to be strong in terms of volume. Obviously getting the projects done by the end of the year is a focus, so this area is very active both on the equity and the credit sides.
For midstream oil and gas, which we focus on as well, we see more attention being given to trying to address the liquidity needs as a result of the crash in oil prices.
MR. MARTIN: Scott Harlan?
MR. HARLAN: We are busy. I agree with Mike. The busy-ness is there are more renewable energy deals getting done while the bid-ask spread on the non-renewable investments has widened. Sellers of fossil generation are cautious about going to market right now. We see a lot of opportunities in development-stage renewables projects and less opportunity to invest in deals at the start of construction, and there are not a lot of transactions involving operating projects.
MR. MARTIN: Are the renewables deals solely project sales or also financings?
MR: HARLAN: We participate on the M&A side of the market, so I cannot comment as much on financings. We are building out solar projects for which we safe harbored equipment in 2019. We are still looking for more projects in which to invest equity.
MR. MARTIN: Steve Cheng, how do you see the market?
MR. CHENG: We see the same thing that Scott and Mike see. The traditional thermal generation market is slow. Pretty much the only activity we see in that sector is refinancing of debt with upcoming maturities or potential restructurings.
Most recent activity for us is in the renewables space and oil and gas. The oil and gas activity is pretty much liquidity plays. Companies are dealing with the decline in oil prices and are looking for liquidity to ride out this trough in the market.
On the renewables side, it is a lot more development stuff rather than opportunities to pick up operating projects. The more traditional lenders, like commercial banks and insurance companies, are more focused on construction and term debt. As an alternative lender, we have to focus on the higher value-add parts of the capital structure. This includes more development and pre-construction types of opportunities.
MR. MARTIN: Manish Taneja, how do you see the market?
MR. TANEJA: I agree with what has just been said.
The only thing to add is that sponsors and borrowers that can wait and do not need capital immediately are choosing to wait for a number of reasons. The availability and cost of capital both come into play. Despite that, deals are getting done. It is all about relative value. As an investor, we are seeing opportunities, but when we look at opportunities, we have to think about how they compare to what is on offer in the secondary market.
Trump Grid Order
MR. MARTIN: President Trump issued an executive order on May 1 that bans the purchase, transfer or use of as-yet-unidentified equipment from foreign adversary companies that might be used to harm the US power grid. Is the order having any effect on financings of projects with Chinese equipment?
MR. PANTELOGIANIS: We have a couple projects under construction in our portfolio that will use Chinese equipment. They are conventional power projects. In each case, there have been a couple months of delays due to equipment coming from China, but there is still room in the construction schedule to accommodate the delays.
MR. MARTIN: So you are still moving forward with the equipment despite the order. Does anyone else have any experience with the order?
MR. HARLAN: We are following it fairly closely. We are not currently in financings of any of our projects, but we purchase equipment from countries like China. We are concerned about it and will be reluctant to order more equipment from China. We also have Chinese equipment in some of our existing projects. We are in a wait-and-see mode to see how the regulations are promulgated.
Availability of debt
MR. MARTIN: Regulations are not expected until the fall. Mike Pantelogianis, how is coronavirus affecting the availability of debt?
MR. PANTELOGIANIS: It depends on the sector. There is less liquidity for the midstream space. There is still debt capital for renewable energy and conventional power. Smaller deals can get done. The larger deals have struggled. The marginal dollar to clear a transaction is expensive. Sponsors with deep relationships in the banking sector are able to close their deals and fund them, but COVID has definitely had an effect on pricing and the overall appetite for credit.
We are open for business. We are deploying capital and closing transactions, but we are being selective.
We want to deliver to clients, but the uncertain economic outlook leads to a level of conservatism that all banks are practicing. We are able to get deals done, but there is a higher marginal cost of funding and liquidity today. The guy without existing relationships is probably having a little tougher time finding capital.
MR. MARTIN: Have you written any new term sheets or letters of intent in the last month?
MR. PANTELOGIANIS: Yes.
MR. MARTIN: For what types of deals?
MR. PANTELOGIANIS: Renewables, refinancings of existing debt facilities and bridge financings. There are quite a few bridge opportunities that are smaller in size for which we are competing. It is still a competitive landscape for lenders. We have been surprised by the reasons why we have not won particular mandates. There is capital out there.
MR. MARTIN: We closed construction loans without tax equity take-outs recently. This may be a sign of difficulty raising tax equity. Are you seeing that as well?
MR. PANTELOGIANIS: We do not do a lot of construction financing around renewable energy because the cost of capital is very, very inexpensive. The economics do not work for us.
Our expectation is that if earnings are dampened, it will affect the tax capacities of banks that are the principal source of tax equity in the US market. If they start sustaining losses through other areas of their businesses that are affected by COVID, it will mean lower earnings which means less investment
MR. MARTIN: Let me go to one of our two private equity fund lenders, Steve Cheng. Have you written any letters of intent or term sheets in the last month?
MR. CHENG: Yes.
MR. MARTIN: For what types of deals?
MR. CHENG: We have written term sheets for all different types of assets and all different places in the capital structure: senior debt, traditional mezzanine debt, holdco debt and preferred equity transactions. A lot of it is in the midstream oil and gas space.
We have had discussions and put out some term sheets on the renewables side, and we even did one traditional power generation transaction. As Mike said, there is competition to be the lender in all of these transactions, so clearly there is still a fair amount of liquidity in the market.
There are fewer people who are open to doing midstream oil and gas transactions than before the downturn. More people are doing renewables, although anecdotally we have seen some institutions not exit the market, but certainly pull back. They are being more selective.
The issue is the opportunity cost of capital for lenders. You have to weigh in terms of portfolio construction whether to have more oil and gas, where there are relatively higher returns for higher-risk opportunities, or to focus on lower-risk types of opportunities: renewables, for example, where there might be more competition.
MR. MARTIN: Mike Pantelogianis, your colleague Ralph Cho said in January that there were 80 to 100 banks and grey market lenders chasing deals. Do you have any sense what the number is today?
MR. PANTELOGIANIS: Not much has changed. Our treasury guys tell us that the cost of funding for banks is starting to normalize and come back.
We saw a big spike in the cost of funding early on, call it mid- to late March. The cost jumped by 25 to more than 100 basis points for a bank to borrow. Since then, our cost of funding has come back in by almost 50%. A sense of normalcy is returning, but people are still being choosy.
MR. MARTIN: Manish Taneja, how are debt terms being affected by coronavirus?
MR. TANEJA: We are going to be a bit more conservative in our terms today than we were three months ago. It is all about supply and demand. Demand has come down, but so has supply. We have seen a lot of banks that were active in this space on an opportunistic basis drop out. That has led to a smaller number of banks providing capital.
From a terms perspective, obviously we are putting in more protections to address the uncertainties around how much longer the economic downturn will continue. For example, for projects under construction, there may be disruptions in the supply chain where material cannot get from Asia to the US, but such disruptions can be addressed by having additional reserves to mitigate construction delays. Broadly speaking, terms are definitely more conservative today.
We are being more conservative on leverage as well. We are very active and have been putting out new term sheets.
Renewables are a sector that is very attractive for obvious reasons even though there is a lot of competition among lenders.
We are seeing more opportunities in the transportation sector, and we have put out a few term sheets on transactions in this sector recently. There are also opportunities in the telecom sector. With all of us working remotely, we are seeing opportunities to strengthen some of the infrastructure behind the scenes that supports our ability to work from home.
MR. MARTIN: Sponsors who can wait will do so to see whether the terms improve. Those who need the cash now of course are in the market now.
Mike Pantelogianis, how are bank debt terms changing: maturity dates, LIBOR floors, spreads, sweeps, commitment fees? If bank term debt for renewables was pricing at 125 to 137.5 basis points over LIBOR in January, where do you think it is today?
MR. PANTELOGIANIS: We see that market in the 175-over-LIBOR range.
MR. MARTIN: And maturity date? Is it seven years? Longer? Shorter?
MR. PANTELOGIANIS: Seven years is fine. Is there a marginal benefit to keeping it at five? It helps bankers achieve returns, but generally speaking seven is fine.
MR. MARTIN: Spreads have widened by about 50 basis points we heard earlier. We have heard that banks are pricing off a 1% LIBOR floor.
MR. PANTELOGIANIS: We personally do not require a LIBOR floor. We are comfortable about our ability to fund through LIBOR markets. We are not dependent on asset managers to help clear a deal. I think larger transactions might require such a floor where the incremental dollar needs to be facilitated from a nonbank player.
MR. MARTIN: As far as cash sweeps and commitment fees, has there been any change?
MR. PANTELOGIANIS: Not really.
MR. MARTIN: Steve Cheng, how do you think spreads have been affected in your market segment?
MR. CHENG: It a question of relative value and where the best return is for the risk. When you look at where deals are pricing in the midstream space, they are pricing much higher than before the oil price downturn.
On the power side, if you look at spreads in the secondary market, other than some special situations, the market as a whole has more or less traded back almost to where it was, and so you are not seeing spreads that are much wider than what they were pre-COVID.
For renewables that are in construction or operation, spreads have widened by 25 to 50 basis points.
There has been a bigger increase in pricing for projects that are still in the development stage or for so-called pre-NTP capital, which is why it is a bigger focus for us right now.
MR. MARTIN: Let's drill down a bit more into power since a large part of our audience is focused on renewables. Focusing on power, are there concerns about liquidity of utility and corporate offtakers or of independent generators and, if so, in which situations?
MR. HARLAN: Probably not for utility offtakers. I would think there will be a greater focus on the liquidity and credit quality of some of the corporate offtakers.
As for the independent power sector, the balance sheets are slightly stronger this time around than they were during the last shock in 2008 and 2009. That said, power prices are down. Energy margins are down. We are holding our breath, but we are in a much better position from a liquidity perspective this time around.
MR. PANTELOGIANIS: We have been doing a lot of analysis for our credit committee to understand what is going on in the US power markets. The most recent findings for April show the biggest drops in load demand ever. We saw drops in the 8% to 9% range. Scott, I don't know whether you have seen load demand decrease by that much, but do you think the utilities will be in front of the regulators soon asking for relief?
MR. HARLAN: Yes, I do. What we have seen across the country is that demand is off between 5% and 15% depending on the location. I think the regulatory commissions are going to be loathe to allow their utilities to be dragged down by liquidity problems in a situation like this. Certainly utility revenues are down. That is unmistakable.
MR. MARTIN: Some utilities have rates that automatically adjust without the need for a rate case.
MR. HARLAN: Some do, and others don't. It varies by state.
MR. MARTIN: That's right.
A lot of the activity in the renewables market in the US recently has been quasi-merchant deals in places like Texas. The projects sell into the spot market, but they have a hedge that could be a virtual power purchase agreement with a corporation to put a floor under the electricity price. Has there been any change in the willingness of lenders to finance that sort of project?
MR. CHENG: We are putting out term sheets on deals like that. A hedge delivers a lot of value in the form of certainty of cash flow. Obviously you need a good balance sheet behind the hedge from somebody of investment grade quality or else it may need some credit support.
MR. MARTIN: A number of new business models were gaining traction before coronavirus struck: community solar, standalone storage, electric vehicle charging infrastructure. Has there been any change in the willingness of the financial community to finance these types of projects?
MR. PANTELOGIANIS: We have been very comfortable with the CCA model for quite a few years now. We have done CCA financings. We believe that California has a good framework to protect the credit of CCA offtakers.
The experience with community solar over the past two or three years has shown that the financing markets are pricing it in a very aggressive fashion at least from a senior lender perspective.
The residential rooftop model was moving to a very attractive cost of capital. Because the ABS markets have shut down since COVID, we have seen residential companies looking for more expensive capital compared to what they had pre-COVID. Pre-COVID, they were getting deals done with banks at about LIBOR plus 200 basis point. Today they are negotiating term sheets at LIBOR plus 325 basis points.
MR. MARTIN: The federal government is printing a staggering amount of money through Federal Reserve purchases and fiscal stimulus measures. Are there growing inflation concerns? Think about the aftermath as we try to climb out of this. How will it play out in deals?
MR. HARLAN: It is a loaded question. You are right. There is a tremendous amount of stimulus going on and right now. It is fine because consumer demand is off. A headline this morning said consumer demand had the biggest one-month reduction ever in history.
We are setting a lot of records now. It remains to be seen how consumer demand will be affected by the stimulus. Once we start to get into the recovery, I am very concerned. Rockland is concerned about inflation and that has an impact on how we look at possible exits from investments in contracted renewables deals.
Obviously if you have fixed cash flows and you have inflation, then those equity positions are going to be harmed, and our exit in five to seven years could be affected.
The concern is causing us to underwrite investments in development-stage and construction-stage contracted projects to slightly higher levels.
MR. PANTELOGIANIS: Interest rates in the high-yield bond market are up 32% year over year. The ability of the leveraged debt players to get paper done in the 6% to 8% range has led to a lot of activity in the high-yield space in the midst of a crisis. It is very strange.
MR. MARTIN: Does it change anything you do?
MR. PANTELOGIANIS: Yes, I think so.
MR. MARTIN: How?
MR. PANTELOGIANIS: We are a bank, so we are primarily relationship focused. So Scott Harlan calls up and needs capital. We have finite resources. We are probably looking at a very aggressive transaction being priced by a bunch of banks. The risk may be the same as other deals where the competition is not as fierce. It is a difficult thing for us to argue to our credit counterparts within our bank who want to give us capital, but only at a reasonable price.
That relative value discussion has been probably the hardest element associated with going to credit today because they are seeing what lenders are able to get in the leveraged debt market. Our business, generally speaking, is a BB-type business, so our credit desk asks, "Why would I give you the capital at 4%, when I could go give it to somebody else at 6%?" We are having to deal with a lot more of those discussions.
MR. MARTIN: Let's move to the term loan B market. It was essentially shut down to new issuances in April. That's an institutional debt market. It is for single B and BB credits. It is sub-investment grade. The average B loan instrument for independent power producers was trading at about 80¢ to 84¢ on the dollar in face amount. That was for secondary trades in April. Has that market come back to life for new issuances?
MR. PANTELOGIANIS: The market is back, but it has been slow. I think issuers are finding the high-yield bond market to be more attractive.
MR. CHENG: We have seen the secondaries trade back up. Most of the names are back to the mid-90¢ range on the dollar.
There are a few specific issuances with some amount of distress surrounding them or else they are by borrowers with some link to coal that have not traded back to anywhere close to where they were.
I don't think a new power deal has been done in the term loan B market since the downturn. At least a couple such deals are in the wings. Everyone is waiting to see what happens to them.
MR. MARTIN: Those numbers suggest a spread perhaps in the 400 to 500 basis-point range.
MR. CHENG: Correct.
Central bank support
MR. MARTIN: The Federal Reserve has been propping up the investment grade market by offering to do direct lending to private borrowers. It extended the offer recently to borrowers a little below investment grade. Are private lenders feeling any effects from the competition from the Federal Reserve? It is shorter-term money.
MR. TANEJA: The support being provided by the Federal Reserve is not geared to the types of borrowers that this panel supports. We are not seeing it have any impact. As you mentioned, the tenors are much shorter in duration than are needed for project finance transactions.
MR. MARTIN: A core financing tool in the US renewables market is tax equity. The two largest tax equity investors said on a call in late March that they are operating at close to business as usual. At the same time, many developers report that it feels harder to raise tax equity.
Scott Harlan, you are a consumer of both tax equity and debt. How does the tax equity market feel to you?
MR. HARLAN: It feels shaky. I hear the same thing from the tax equity investors that it is business as usual. Our dealings have been on smaller projects. Our tax equity providers are not the traditional players for large projects. They are all saying that they are still in business and giving us a lot of comfort.
Everything depends what happens to the balance sheets and income statements of these tax equity providers over the next six months. If the recession lingers and it is not a V-shaped recovery, then that is bound to affect the supply of tax equity. So far there has been no effect, but I am concerned for the future.
MR. MARTIN: What about the availability of debt, Scott? You heard from all three lenders that debt is available, but possibly on slightly worse terms.
MR. HARLAN: We are not in the capital markets right now trying to raise debt. We refinanced pretty much all of our fossil-fuel projects in 2019. We are financing some pretty small solar construction projects currently, but not with the big banks or private equity funds.
We are working with very small lenders. It is business as usual. We have not even seen a change in pricing from those guys.
I think what Mike Pantelogianis said is right. If you had relationships with banks going into this, lenders for the most part are trying to stay true to those relationships. On larger deals, obviously the markets have moved and there will be repricing.
MR. MARTIN: People talked in the last few years about a wall of money chasing deals in the US. Three of the four of you work for investment funds. What are you hearing from your existing investors about their liquidity and desire to put capital commitments to use?
MR. TANEJA: I think the view is that infrastructure as an asset class remains pretty resilient in times of difficulty for a number of reasons, including the fact that these are real asset-based financings.
This asset class performed relatively well during the 2008-to-2009 financial crisis.
If you look at how the bonds performed at the time, there were very few defaults and when there were defaults, the recovery rates were pretty high. That is something that the investors or LPs understand. They appreciate the fact that not only does this asset class provide diversification, but it also gives them resiliency in their overall investments.
So the investors are not shying away from this asset class. If anything, they are recognizing the value that it presents.
MR. MARTIN: Is there still a wall of money?
MR. TANEJA: It depends on your definition of the height of the wall. For the right strategies and for the right projects, there is money available.
MR. CHENG: Our investors understand that our strategy is a relatively illiquid one. It is different than if you are focused on either public-sector equities or public-sector fixed income where liquidity is important.
They understand that we plan to hold investments until maturity or until we are refinanced out and that we are not looking to trade any of the paper or deals that we do. They take a much longer-term view for what we are doing relative to some of the more liquid strategies.
When this crisis started, our investors began asking whether this would create new opportunities to invest because, until the dislocation happened, we thought the market as a whole was mispricing risk. We lost a lot of deals before COVID because someone else was willing to do them for less. Now the investors expect us to deploy capital at a faster pace.
MR. MARTIN: The market was mispricing risk. Now it is pricing it more appropriately, meaning the potential returns are higher.
MR. CHENG: Correct, for the risk.
Another thing we are starting to see is deals are starting to come to us that would have, absent this dislocation, gone into the private placement or capital markets because there is a lot more caution among those particular institutions. Borrowers are coming to us with deals that they cannot get done in a regular way in the capital markets. These are generally higher-grade quality deals so high BB, low BBB- type of stuff. We are starting to see more of those where, a couple months ago, they would not have come to us.
MR. HARLAN: I agree with Steve Cheng whole-heartedly.
We have been very frustrated over the last year and a half with the market being overly aggressive and mispricing risk on the equity side. We lost out on a lot of deals. We have not made a significant investment for 12 months, and it is not for a lack of trying.
The difference today is not that you can get outsized returns, but that you can get fair returns. It is a more rational market today.
MR. PANTELOGIANIS: We have seen Korean investors on the debt side run for the hills. For the past four years pre-COVID, they were extremely reliable. They were coming in with big, chunky dollars helping to clear transactions at attractive prices, and that has just stopped. Is anyone also seeing that on the fundraising side?
MR. MARTIN: Scott Harlan?
MR. HARLAN: We are not fundraising right now, thankfully.
Maybe some of those investors were part of the mispricing problem. Their disappearance may be part of a return to normalcy.
Our LPs want us to invest the money. They want to make sure that the investments that we are making are down the fairway for the kinds of investments that Rockland makes. They are asking the same questions about whether the current downturn will mean more opportunities than before. We have a few things that are teed up right now. We are getting ready to make some capital calls. I made a few calls to LPs just to make sure that people are not experiencing liquidity problems. They are all in business. They like the power business.
A lot of the LPs are managing investments more broadly in the energy sector, including oil and gas, metals and mining. They are reeling from those investments. It is a breath of fresh air frankly when I call to talk about what is going on in the power sector because that sector has been fairly resilient. They are encouraging us to continue to invest.
MR. MARTIN: We are down to our last six minutes. Let's make this a lightning round. Rapid questions and short answers.
Has there been any change in the sources of inbound capital either geographically or by type of investor? We heard the Koreans have backed off. We know Chinese investment is way down. What about others?
MR. TANEJA: We are not seeing a material change.
The conversations may be taking a little bit longer because everybody wants to understand the impact of the current situation, but we are not seeing foreign investors pull away from the asset class.
MR. MARTIN: How have investors return expectations changed in the power sector, particularly in renewables. Scott Harlan?
MR. HARLAN: I think on contracted deals, investor returns are maybe 100 basis points higher on the equity side because of fears about inflation and the takeout, but there has not been a dramatic effect. Inflation may not be as big of an issue if you do not have a contracted deal. If you have a merchant project, then inflation may be your friend. An uncontracted or merchant plant may be a good inflation hedge.
MR. PANTELOGIANIS: We are currently in an equity placement process for a Texas-based wind project that is under construction. The equity will get a high single-digit return. This may be marginally higher than it would have gotten pre-COVID, but nothing significant.
MR. MARTIN: Ted Brandt with Marathon Capital said in late March the shutdown of the term loan B market tells you all you need to know about the M&A market. He said, "What we're hearing from the financials is why the hell would someone buy a 7% or 8% after-tax return when BBB bonds are on offer at something close to that. And they're completely liquid."
There are a lot of assets for sale. Scott Harlan, you said something at the outset about the bid-ask spread widening. Has it gotten too wide for deals to transact?
MR. HARLAN: Yes. I think it has widened to the point that closing transactions has become difficult. There is a lot of motion, but honestly in the last couple of months I have not seen a lot of equity deals close.
MR. CHENG: That quote is spot on. We already talked about it in terms of the need to figure out how to deploy capital into the best opportunities. Whether it is renewables or conventional power or oil and gas or Manish mentioned transport, you have to look at the choices on a relative-value basis. To the extent that something is mispriced relative to the risk, then you are probably going to have a hard time getting the buyer and seller to meet on a price. You are not going to get anything done.
MR. MARTIN: Two more questions. Steve Cheng, sticking with you, I last visited your company just before the stay-at-home orders took effect. One of your partners showed me a chart comparing how out-year electricity price forecasts varied by consultant. Are out-year electricity price forecasts viewed as riskier today so that people are using higher discount rates to bid assets?
MR. CHENG: Absolutely. I was just on a call before this one where somebody was presenting his macroeconomic view over the next couple of years. The variability in projections is pretty large. I don't think anybody can tell with any certainty what the future holds. Nobody could before, but now the uncertainty is even greater. To make any investment decision in this type of environment, you have to increase the discount rate to take into account that uncertainty.
MR. MARTIN: What do you think is an appropriate discount rate today for bidding on renewable energy assets? I realize this is a very general question. The assets may be at different stages, but give me a range for solar assets.
MR. PANTELOGIANIS: It is difficult to give an absolute number, but I am going to stick with my previous answer of roughly 100 basis points higher than it used to be. For operating assets, when we do a valuation on the assets that are in our portfolio, we use a range of discount rates and we have increased the high end of that range by about 100 basis points, maybe a little bit more, for doing our internal values.
MR. CHENG: I think it is at least 100 and maybe 200 basis points, something in that range.