New trends: View from the investment bankers
Five investment bankers had a wide-ranging discussion at the Chadbourne global energy and finance conference in early June about new trends in the market. The following is an edited transcript. The five are Jonathan Cody, managing partner and head of investment banking at Whitehall & Company, Jonathan Fouts, managing director at Morgan Stanley, Andrew Redinger, managing director and group head, utility, power & renewable energy, at KeyBanc Capital Markets, Roberto Simon, managing director and head, project and energy finance, Americas, at Société Générale, and Raymond Wood, managing director and head of global power & renewables, at Bank of America Merrill Lynch.
CHADBOURNE: We had a number of yield cos rise rapidly and then come crashing down to earth, and now there seems to be nothing to take their place. What do you make of this trend, and what do you see going forward in terms of who comes in and takes the place of yield cos? Andy Redinger, let’s start with you.
MR. REDINGER: Maybe they have gone below what we would consider their fair value, but that is because they became overheated. Some have come crashing down. I think we know who those are. I do not think there is anything that takes the place of yield cos, except more yield cos.
I have been saying this for quite some time: I think it is an education problem. I would put this asset class up against any other vehicle that provides investors with a yield and a little bit of growth. We forget that when the first yield co, NRG Yield, went public, we all said it was wildly successful. That yield co went public at a 5% yield, and in its S-1, it said it hoped to grow the dividend at 3% a year. It think it tried to say 5%, but the SEC said, “You can’t say that.”
That was a wildly successful yield co that started this marketplace, and we need to remember that. There are a lot of investors that like that model. The existing yield cos are obviously fighting a lot of headwinds at the moment, but I suspect the yield cos that have already gone public will recover. Calmer heads will prevail. I think there are more yield cos on the horizon.
CHADBOURNE: Jon Fouts, any comment on that?
MR. FOUTS: I agree. Over the long term, there is certainly a place for yield cos. We have to remember that if you look at yield cos versus the master limited partnership market, the MLP market over the past 20 years has certainly had its ups and downs, and I think we can make a pretty compelling argument that the yield co model, compared to the MLP model, is just as good, if not better.
That said, short term, there is clearly a dislocation in the market. It will take a while to get through that. We need more market cap and more flow to have yield cos work over the longer term.
They are not a panacea. Last year, I think people thought yield cos, to a large extent, were a panacea, and they are not. It will take a while, but long term, we are bullish on yield cos.
Public v. private equity
CHADBOURNE: All of the capital markets are in some way connected. As you look across the market, you still see a quiet period in terms of raising equity capital. The IPO market seems very quiet. How is that affecting the renewables sector in general, especially with respect to new technologies? Ray Wood, do you want to comment on that?
MR. WOOD: I don’t think we have seen a drop off in overall capital deployment, but it is hard to predict how long the education process will take before people return to buying stocks. I share the optimism about the longer term.
That said, there is just a wall of money in the private markets coming in to buy projects that are at the notice-to-proceed stage. There is no problem with liquidity once a project is fully developed, or reasonably fully developed, and there is increasing appetite in the private market for a certain amount of development risk with proven sponsors.
There are ongoing cost reductions and efficiencies and technological innovation in materials. PPAs continue to show up from utilities as well as from corporations, and hedges are still available.
The capital is there. It is an odd time in the public markets. There is no IPO activity. We recently sold a controlling stake in a battery deployment company in California. We ended up not selling it to a pre-IPO growth investor or a yield co. We sold it to a large European strategic. There continue to be buyers in this sector.
MR. FOUTS: But on the private side.
MR. WOOD: On the private side.
MR. REDINGER: We are not seeing any new equity on the public side. Just to add to the litany of data points, independent power producers generally are trading in the public markets at $400 to $500 a kilowatt. Meanwhile, conventional assets are getting sold in private deals at $700 to $800 a kilowatt. There is clearly a dislocation between the public markets and the private markets, and that is what is driving a lot of this private investment.
MR. FOUTS: One piece of tangible evidence to support the optimism you hear here today is the astounding recovery of the high-yield debt market since mid-February. There is a correlation. The public equity markets should start recovering fairly soon, subject to the uncertainty imposed on all the markets by the US presidential election.
MR. SIMON: There has been a re-pricing of risk by the market, so even on the private side, especially for development risk, we are seeing valuations come down. We are marketing a small solar company now and getting interest from strategics. What is interesting is it is European strategics that are rationalizing price on the basis of other growth opportunities within their diversification efforts.
CHADBOURNE: Going back to the point about a gap in pricing between the public and private markets, which market do you think has it right and which one corrects and how?
MR. CODY: I think the private markets are closer to reality than the public markets, and a couple of data points lead me to that conclusion. Look at how the markets are valuing conventional power assets currently. When you work from the valuations back to the income statements, it is clear the public markets are assuming natural gas prices will be way below $2 an mcf. But that is not where most equity research analysts have gas going. So you start to ask the question, “Well, wait a minute. If your valuations are using a sub-$2 gas price, but the forward price curve is suggesting something higher, there is a clear disconnect.”
I don’t think the public investors, whether they are retail investors or institutional investors, spend as much time as the private guys do trying to understand the dynamics of some of the fundamentals driving prices. So I am inclined to believe that the private guys are closer to reality than the public guys in terms of valuation.
MR. REDINGER: I agree with that in concept, but when I see where assets are trading today, I have to second guess myself. We are in the market ourselves with a few contracted solar assets. They are already operating. I am seeing the private guys bid these assets at a 30-year levered pre-tax IRR of 9%. The bidders are assuming a negative IRR for the first 15 years and I ask myself, “Geez, is that what I would do?” So I agree with you, but then I see where these assets are trading, I question whether we are correct.
MR. CODY: We continue to see people migrate from being limited partners to co-investors to direct investors. Do they get it right versus the public guys? It is a tough question to answer because you are comparing apples and oranges. You have a lot of legacy assets at the public companies. There are some that are worth close to zero, and there are some that are in line with private valuations. Most of the private-side investors with whom we work are looking at single opportunities or defined portfolios.
CHADBOURNE: Let me go back to the pricing of assets. Part of the reason people pay these valuations is because you bankers are willing to lever up their assets. So for the prices to begin to moderate, somebody has to step off the gas. Will it be you guys? How does the music stop? Or do the valuations just keep going higher?
MR. WOOD: I don’t think Wall Street is propping up valuations. There may have been a time when there was reckless lending. I would say that time has passed based on the stricter supervision from the Comptroller of the Currency and the Federal Reserve and on what it takes for me to get something approved.
A lot of the buyers of this type of asset are not leveraging. People are buying renewable assets at returns that are unlevered and after tax equity, and they are buying conventional assets at levered equity returns because you do not have the complication with conventional assets of an inter-creditor or forbearance agreement.
Wall Street is not propping up valuations. We are seeing returns come down as well on utility cash acquisitions. It is not as if buyers are bidding much lower returns when buying a toll road or solar project than buying an equity interest in a regulated utility.
I think returns are coming out around a seven handle after tax equity returns, depending on your assumptions. Yes, leverage is being used, but I don’t think we are in a period of aggressive overleverage. We may see some people lose money on some of the new builds, but it will be the equity losing the money, not the debt.
CHADBOURNE: Let me shift to another big trend that has dominated the renewable energy sector this year, and that is SunEdison. If you had been hired as an investment banker to SunEdison three years ago, what would you have told the company to do?
MR. FOUTS: We all need to be careful here, but I would say it is not a problem with the quality of the assets. All those assets are good assets. I think it was just too much growth, too fast.
MR. CODY: We were hired by a couple groups to sift through some of the SunEdison assets, and I would respectfully disagree that all the assets were good assets. It is easy to be a Monday morning quarterback, but it looked like there was a pretty significant lack of discipline in evaluating projects and a real confusion between actual IRR and current yield.
MR. WOOD: I would go beyond that. I think there was a rush to assemble the earnings engine for the incentive distribution rights machine, for the general partner interest.
They built wind development capability, solar development capability, and pushed to develop behind-the-meter residential and commercial rooftop capabilities with Vivint. That was all good, but the velocity of deals coupled with pretty aggressive leverage and use of a captive yield co as the source of value creation led the equity market to close on them.
The yield co model with an 85% or 90% payout requires constant access to capital. Whatever form of yield co that emerges in the future has to have either a sugar daddy or a better liquidity facility. You cannot make a big acquisition contingent on an equity raise six months from now. Maybe it is not that you cannot do that as much as everyone was doing it at the same time and, when the music stopped, there was no capital to raise and prices fell. This is a classic case of relying on capital markets to take you out of reasonable positions. The capital markets open and shut. It is dangerous to assume they will always remain open.
This then reverberated through the development side of the business. Maybe milestones started being missed. This is a portfolio that fundamentally had value, but when you miss a milestone and you lose an interconnection agreement or lose a PPA, that value goes away pretty quickly.
CHADBOURNE: There has been a lack of understanding about how many assets are in play. Who do you think the likely winners of those assets will be and at what prices do you think they will trade?
MR. REDINGER: There are probably a lot fewer assets available in the US than people think. My impression is the market thinks there will be a huge wave of SunEdison assets hitting the market in the US through the section 363 bankruptcy process. There will be some. There appear to be more assets overseas, but it is hard to get your arms around what is there.
CHADBOURNE: What is your sense of who has the lowest cost of capital to bid for these assets and at what discount rates the assets will ultimately trade?
MR. FOUTS: Since the yield cos are off the table, we are seeing a ton of interest from pension funds and particularly from ones in Canada.
The cost of capital will be in the high single digits to low double digits for levered returns to equity, and there is a lot of capital at these prices. The biggest issue is these types of investors want to write big checks and some of the packages coming out of SunEdison are smaller, so it makes it tougher for such investors to put capital to work there.
We have also seen some interest from investors in emerging markets, like India, and from some Middle Eastern sovereign wealth funds. This is capital with a cost in the single digits.
MR. SIMON: We are also seeing European strategics looking to diversify into renewables. We are also starting to see some Chinese utilities look at this sector in the Americas: not necessarily in the US, but in the broader region.
MR. WOOD: SunEdison’s big assets are TERP and TERP Global. SunEdison has control positions in them. The question for the creditors and bankruptcy court is whether to liquidate those positions and sell a control position in the public yield cos to a new sponsor in an effort to revitalize the yield cos, given the optimism here. Neither TERP nor TERP Global is in bankruptcy. Such a sale would be the best referendum on where the market is today with respect to yield cos and renewable portfolios.
CHADBOURNE: Let me shift to energy policy more broadly, because obviously that dictates the market to some extent. It has often been said the US has no energy policy, and maybe never will. There seem to be a lot of tailwinds now for a market that is moving to a more distributed model and a market that is moving toward clean energy. What would it take to accelerate that trend? Do you think all the pieces are in place?
MR. SIMON: I don’t think the US will ever have a coherent energy policy in the same way that some of the European countries have them. The reason is that we have 50 state governments in the US that determine energy policy to a certain degree.
Unless we do away with our federal system, it is very difficult, other than through tax incentives and so on, for the US to push a coherent energy policy as we define it. So the trend will be continued use of tax policy to provide incentives. I don’t see tailwinds frankly. As long as natural gas and oil prices stay relatively low, the effort to use tax policy to force a shift will continue to face headwinds.
MR. REDINGER: I agree with that. I think the distributed market got out of the gates quickly. We are seeing a little bit of a slowdown. Keith Martin mentioned that 10 states are expected this year to revisit their net metering policies. It is not that the policies are being changed to make it harder for rooftop solar to thrive — some of them are being changed to the positive — but the fact that they can be changed so quickly is a little unsettling to a long-term lender. Who knows which way the political winds will blow five years from now. They could change again.
The bank market in the distributed world has not developed as quickly as we thought it would develop, which is concerning. When you look at the alternative financing options and the take outs in the distributed market that we thought would be there, the ABS market is there, it is just not at a price that people who invested in the space thought it would be. There are a lot of short-term maturities coming up in the distributed space. It will be interesting to see where those go.
CHADBOURNE: Roberto Simon, you touched on the US presidential election. As we get closer to it, does the market react in any way? Is there any trade based on the uncertainty and will there be any obvious play the day after depending on who wins?
MR. SIMON: With my personal money, when we get to late June, I plan to sell everything I have in equities, because people are going to panic no matter who gets elected. And then after the election, everyone will realize that the president is important, but does not really run the country, because we have three branches of government. I will buy my equities back. I have no idea, honestly.
MR. WOOD: Buy puts.
MR. FOUTS: One dynamic that we are watching pretty carefully is it is hard to overstate the amount of scrutiny that the banks have gotten from the regulators on things like tax equity, lending requirements and risk capital. If Trump gets elected and he starts rolling back some of the regulations on banks, does that open up the tax equity market more for us? Does it ease lending requirements? I don’t know how to quantify that, but it is one dynamic that I would watch pretty carefully.
MR. SIMON: We are regulated by two entities: the European Central Bank and the Federal Reserve. In the last 12 months, life has changed dramatically. We have constant visits from both entities. My view is this will not change after the election. They have hired bazillions of new people. It is not going to change for a long time because we now have technocrats running the process. It is very difficult to unravel a bureaucracy once it is in place.
Tightening bank regulation
CHADBOURNE: Basel IV is somewhere in the pipeline. What would that do, when do you think that’s coming, and how does it affect banks in the power sector?
MR. SIMON: The Basel committees regulate the amount of capital that the bank is required to have to support its lending. European banks, unlike US banks, are regulated by risk-weighted assets. That is how European regulators try to have us manage our risk.
The regulators have decided that having two models — a European and a US model — is too complicated, and they are trying to simplify the process. There is a possibility they will put in place a minimum capital requirement that assumes a higher loss in the event of default. What that will do is it will change the amount of risk-weighted assets that banks have to put toward a loan. It will basically cut into the return on equity for every loan that an institution makes.
There is really only one way to compensate for that, and that is to increase pricing. So if Basel IV goes into effect and those changes are made for European institutions, what we expect to happen is for tenors to be shortened considerably and for pricing to go up.
Right now, US banks occasionally will lend short term. They get in and out very quickly. The Canadians are just behind them, and then you have the Europeans and the rest of the world lending long term.
I think the Europeans will dial back close to where the Canadians and Americans are. We will be short-term lenders. Pricing will be higher. We will be looking for riskier assets to justify the higher interest rates. It will be more difficult for developers who are accustomed to long-term European bank money to find that money. It could have a dramatic effect on the project finance market.
MR. WOOD: I agree with that. If we have to use a higher-loss-given-default methodology because we are being bundled in with other industries or because the Fed is forcing us to do that, then that will be disproportionately painful to the asset-intensive finance sectors like power and other energy infrastructure.
We saw the regulatory impact and the oil and gas problem last year, with the rapid decline in prices, or let’s call it price volatility to use a nicer term, and what happened was a lot of these asset-based loans had to be called, and there was no extension because the Fed said no.
There was then a wave of bankruptcies. We can talk about whether that was better or worse for the system three or four years from now when we know. But there is no question the regulatory impact is being felt.
MR. CODY: Last year, Bob Diamond from Barclays wrote a really interesting article after someone asked him about his vision of the future for commercial banks. His perspective was that the regulators are angling to have the banks be utility providers of capital and that any business that is outside an approved risk spectrum will eventually be routed out of the system.
CHADBOURNE: Maybe the public markets priced some of this in. Let me pick up on the theme about pricing differently to corporates and utilities. One of our panels is about the large wave of corporate PPAs coming. Will the bank markets price these differently because you have essentially long-term debt from corporates. How do you think about that? Will there be different pricing?
MR. SIMON: With all due respect to all the project finance bankers, we are probably the worst at pricing risk.
CHADBOURNE: Worse than lawyers?
MR. SIMON: Probably. Because you guys take a step back. We look at the last deal. If you look at the LNG space, there have been projects that have been financed on the back of long-term tolling agreements with corporates. In theory, there should be no reason why you cannot finance a project with a corporate PPA. However, when people dig deeper, they realize there is a lot more volatility in the earnings of a corporate than there is in the earnings and cash flow of a regulated utility, and the odds are reasonably high that over a 20-year period, or even a 10-year period, they end up having grossly mispriced the risk.
I won’t name the company, but there is a concrete example. An LNG facility was financed a year ago for a BBB company that is a toller. That company today is rated a single B. The project has a really different risk profile than the day you financed it, and the change happened in a very short period of time.
MR. CODY: I agree with Roberto. When you have a core asset that is part of an obligation to serve, which is what we have with most of our assets in the US power space, that is a different type of arrangement than a long-term obligation with a corporate.
MR. WOOD: Get used to it, guys. Utilities are not going to be signing up given the move of technology and given where price points are now. Gas is merchant and needs intermediate term hedges, depending on where it is in the merit order and where people view forward commodity prices.
There is no question that for LNG, getting leverage two years ago against 20- and 30-year offtake contracts was easier because oil prices were high and the arbitrage was in the money.
Fast forward to the fourth quarter last year, there was an LNG export terminal that was fully permitted and trying to get built. The developer managed to raise the money, but it was time to grit teeth. It is not that the fundamental analysis of the contract has changed. It was what happens if the contract goes away: the what if.
The dislocation in the public markets means this was bank debt designed to be a bridge to a capital markets permanent takeout. When you have volatility in the underlying commodity market and you have volatility in the takeout market, it is going to freeze up the bank market.
MR. SIMON: Let’s forget Basel IV for a moment. Developers have become accustomed to getting 14- and 15-year money from European and Japanese banks. I think if you see one or two mistakes by lenders and then all lenders will start thinking, “Well, maybe I should be 10 years with a sweep.”
There will be an effect on both pricing and structure that developers will have to take into account, because it will affect their returns when it occurs.
Link to oil prices
CHADBOURNE: Let me turn to commodity pricing because it is hard to have a discussion with bankers without you guys referring to commodity pricing. It is fairly obvious to most people how the price of natural gas affects the value of assets in the power sector. What about the price of oil? Oil goes down, the equity markets seem to go down, asset trading gets more volatile, and oil now goes up. What does oil have to do with asset pricing in our markets, if anything?
MR. SIMON: Nothing.
CHADBOURNE: Does everyone agree with that?
MR. CODY: No.
MR. FOUTS: Only on the down side in that when oil goes down, all the solar stocks went down. When oil went back up, there was no rebound. It is a one-way risk and, to me, this is further evidence that the public markets are not the best at valuing or understanding some of these dynamics.
We have seen this most vividly in the solar space where people are struggling for a valuation methodology. Is it retained value? Is it cash flow? It is all over the place. As it relates to the public stocks, I just don’t think people understand the dynamic or the correlation.
MR. WOOD: I don’t think it is just public stocks. Private equity fund managers out to raise fund three or fund four of an energy and power fund are also feeling the headwind. Just having the word energy in the name makes it more difficult when oil prices are falling. It sounds pretty unsophisticated, but people allocate money. If they are all of a sudden feeling over-allocated to energy, power is not necessarily going to get a separate allocation. We have those discussions internally. “No, no, no, this is not really energy risk. There is no commodity price exposure. It is investing against long-term contracts. It is project finance.” But it falls on deaf ears. Power is part of energy.
The reaction is not just in the public markets. There is a private market reaction as well.
MR. CODY: There is no better proof than the institutional term loan market.
MR. WOOD: Absolutely.
CHADBOURNE: Let me turn to the high-yield bond market. We have seen some ability by independent power projects to access that market, but it seems like the examples of such access have been few and far between. Do you expect more activity in that space and, if not, is the problem on the issuer side or the buyer side?
MR. WOOD: I think it is the issuers. The high-yield debt market is a place where seasoned issuers with ready financials can go. A lot of the attempted offerings in the B loan market have been by players without all of those accoutrements. The high-yield market is open. It is very hot right now. We have seen a number of issuers in the power space tap it. You will see more. But you will continue to see the term loan B market used for more asset portfolio financings than single projects. Some of the accoutrements you need to issue high-yield debt are not always there on a timely basis for the B loan participants.
MR. FOUTS: Obviously things got really dicey in the fourth quarter last year and first quarter this year when people were slow to write commitments.
The difference in writing commitments today versus in 2008 is there are very few situations where banks have a big backlog. As a result, people are willing to be a little bit more out on the risk curve, and we are starting to see CLOs come back in the market, so there is liquidity. There is just not enough product out there to give these guys the yield they want. The demand is there. I think people are once again writing commitments.
CHADBOURNE: Since we have only a couple of minutes left, I am going to make a statement and ask you to tell me whether you agree or disagree and maybe add one or two sentences in defense.
There will be little to no market for new-build gas plants without PPAs.
MR. SIMON: Disagree. I think as long as there is demand for the electricity, you will see plants being built without PPAs in certain markets. It is just a question of which markets will accommodate new builds.
MR. REDINGER: Disagree. We will be in the market shortly with one, and we expect it to go very well.
MR. WOOD: Disagree. I think projects get financed based on market fundamentals, not PPAs.
MR. CODY: Disagree. What’s a PPA? I haven’t seen one in years. [Laughter]
MR. FOUTS: The same.
CHADBOURNE: Unanimous. Here is another one: we will see at least one more large-scale bankruptcy in the renewable sector before the end of the year.
MR. SIMON: Disagree.
MR. REDINGER: Besides?
CHADBOURNE: Besides SunEdison and Abengoa.
MR. REDINGER: Disagree.
MR. WOOD: I have no idea.
MR. CODY: I second Ray.
MR. FOUTS: Totally disagree.
CHADBOURNE: Okay. A number of lenders that funded these new quasi-merchant plants are going to get hung when they cannot roll over their debt.
MR. SIMON: Agree. I do not think lenders fully understand the risk they are taking.
MR. REDINGER: We hope so.
MR. WOOD: You should talk to Andy later if you are one of those players.
MR. CODY: I disagree. I think that a lot of the metrics that have been put into place are around asset recovery. It depends on how you define “hung.”
MR. FOUTS: I think it will be asset-specific. There will be banks that lose money.
CHADBOURNE: Last one: most of the deals done in the bank market today should be rated BB, but the ratings are trending down.
MR. SIMON: Agree. I think most of the stuff at which we are looking is BB or BB+. BB+ is probably trending down to BB.
MR. REDINGER: Agree it is BB. Disagree that it is trending lower.
MR. WOOD: It is pretty solidly in the BB range. If it is trending lower, then it is going to a weaker BB, but I don’t see it piercing that.
MR. CODY: I don’t see BB.
MR. FOUTS: Maybe trending, but that is the stuff we like to look at.