Project Sales: Strategies That Work in the Current Market
The market for power plants in the United States is both turbulent and evolving. It is also fracturing into new segments. Once-hot business models have become orphans, once-boring models have become the most sought after acquisition targets. All this activity creates both opportunities and risks for buyers and sellers. Understanding the market is the key to success.
Many speeches, articles and books describe the growth of and now tumultuous times for both independent and utility owners of electric generating capacity in the United States. A measure of the change, and one that is an indicator of whether much money is being made and lost, is activity in the market for power project ownership. After beginning in the 1980s with sales of PURPA projects and then rising rapidly as regulated utilities began to divest their assets in the mid-1990s, sales of net operating equity interests peaked at over 55,000 megawatts in 2000.
Then, most visibly beginning in mid-2000, power companies started coming under financial pressure. From the 55,000-megawatt peak in 2000, power plant sales declined during 2001 and fell to a low of approximately 12,000 megawatts during 2002. From over 150 transactions during both 2000 and 2001, the number fell to 62 last year. Buyers that buoyed the numbers during 2001 and prior years were absent or turned into sellers during 2002. AES, Allegheny Energy, Calpine, Mirant, NRG and the PG&E National Energy Group are examples of buyers during 2001 who had turned into sellers by 2002. Stock prices declined and remain low, bankruptcies have been declared or are eminent, many projects that are under construction have been abandoned or mothballed, and lenders are holding substantial amounts of troubled debt.
This distress for some in the industry means opportunity for others. Substantial sales are likely during late 2003 and 2004, but they will be a lagging indicator of the changes in value and strategy that are happening now.
Flight to Quality
Uncertainty in markets usually sends buyers toward higher-quality assets, and the prices of lower-quality assets decline. This is exactly what happened to power plants during 2002. Although many factors determine the value of a power project, the amount of merchant risk has become one of the most important. Until last year, transactions involving merchant risk were common. By last year, many merchant assets were for sale, but few sold.
Of the 62 already-operating projects that sold during 2002, only two were merchants. The other 60 transactions involved projects whose revenues were secured by long-term contracts that shifted market risks to other parties, usually the ratepayers of a regulated utility.
Another segment of the market showed a similar flight. While power projects under construction did sell last year, most were purchased by reluctant buyers who did so to protect their existing investments in the projects. Several were taken by constructors who were owed substantial sums, and several others were taken by lenders through foreclosure proceedings. At least one solicitation of a partially-constructed merchant plant attracted material interest but no bids. Although the project was 50% constructed and major components were on site, the projected spark spread did not justify the risk of completion. In another solicitation, the bids received were actually negative. Potential buyers were not willing to put up any cash, and they wanted the lenders to reduce the debt the project will have to repay in the future.
An example of why buyers were so reluctant is the plight of several recently-completed merchant projects in the western US. Although the heat rates for these natural gas-fired combined-cycle projects are nearly 7,000 Btu/kWh and they are designed for baseload operations, they have actually been operated only sparingly. Power prices have rarely been high enough to cover the fuel and variable operating costs.
The prices of projects sold also indicate a flight to quality. This is great news for sellers of projects with contract-secured revenues that involve little or no merchant risk. While $/kW is a signpost to value at best, the average price paid for an oil- or natural gas-fired facility actually increased during 2002. The average prices during 2000, 2001 and 2002 were $505/kW, $500/kW and then $561/kW last year. Deal-specific prices have occasionally topped $1,000/kW even during the first third of 2003.
More telling, but more difficult to track, is the after-tax return on equity required by buyers. As risk rises, so too does this return. Deals done during 2002 and early 2003 provide no indication that this return has increased for facilities with contract-secured revenues. Buyers are willing to accept the lowest returns for high-quality projects with well-hedged energy operating margins. Interest in this type of facility is high, and competition among buyers remains intense.
In contrast, the returns required on merchant facilities have increased so much that very few deals are closing. This is a classic flight to quality. The yields on high-quality assets do not change, and the spread between high and lower-quality deals increases. The auctions of merchant power projects noted above show that such projects often have very low value. In the case of a 7,000 Btu/kWh project that cannot cover its variable costs, even though it is already constructed at a cost over $400 million, its capital value is nearly zero. Lenders and owners face what could be a substantial loss.
An important element of value is the willingness of lenders to finance part of an acquisition. Most of the sales of contract-secured projects have not involved new debt. The projects were already financed and only equity changed hands. Lenders have demanded some improvement in security in exchange for consenting to several transactions, but new debt financing was not necessary. Even when new financing was necessary because the existing lenders have pulled back from project loans, some lenders remain who will finance power projects with contract-secured revenues.
Again, a flight to quality among lenders makes the circumstances different for merchant projects. Most of the new debt that went into merchant projects last year went in reluctantly to protect an existing position. Many existing lenders would like to reduce their merchant exposure, and new debt for a power project with material merchant risk may be entirely a thing of the past.
Strategies and Opportunities
Standing back, buyers and sellers are pursuing a few different strategies in the current market.
On the sell side, several of the most distressed sellers are pursuing what could be called a phoenix strategy. These sellers have or will seek protection from creditors under chapter 11 of the bankruptcy code, and they hope to rise from their ashes with their best power projects intact. They have or plan to default on projects with negative value, sell marginal projects when they can, and then emerge from bankruptcy still owning the best assets as a means to repay corporate-level creditors. The assets with negative value are likely to be merchants, and those assets that the owners retain are likely to be projects with contract-secured revenues. For buyers, if and when this phoenix strategy works, this means that the best assets will never be offered for sale. Only the riskiest projects with the lowest values will be sold.
An opportunity for buyers lies with owners too troubled for the phoenix strategy to work. Near-term liquidity pressures, or the need to repay some of the substantial corporate-level debt coming due within the next several years, could force several troubled firms to sell some of the lower-risk and more valuable assets. This has already begun for one of the Texas-based owners. It is also possible that managements will lose the confidence of creditors that is needed to obtain approval of a reorganization plan; chapter 7 liquidation and opportunities for buyers may ensue.
Another sell-side approach involves a seller’s rationalization of its portfolio of projects. These sellers are not troubled enough to court bankruptcy, but they may sell assets in an effort to cut capital spending obligations, improve profitability, bolster capital and perhaps recover an investment-grade credit rating. Several very visible one-time developers of merchant projects have begun this process. Again, the merchant and riskier projects are the first to be considered for sale. High-quality assets are being and will be sold on a case-specific basis. As noted above, competition among buyers for these projects to date is intense.
While a buy-side strategy based on the notion that the values of high-quality projects with contract-secured revenues are temporarily depressed seems unlikely to succeed, there are opportunities for buyers. The first is a strategy focused on lenders to distressed power projects. This is where buyers purchase a project from a lender or through a foreclosure proceeding, and the lender’s financing remains with the project on a restructured basis. Several transactions based on this approach have already closed, and one of the attractions is that the new owners have needed to invest little cash. This opportunity for long-term gain at low initial cost and risk has crowded the field already. More than 20 potential buyers have courted several of the lenders with large portfolios of generating asset debt. To date, lenders lean toward those with operating experience, existing portfolios and knowledge of the subject technology and regional markets. While many of the new firms courting lenders have people with many years of experience in previous jobs, these new entrants have had little success so far.
Another lender-focused strategy involves purchasing a lender’s debt at a discount and then negotiating or forcing an exit of the equity. Several of the new-entrant private-equity funds are pursuing this approach. Bodington & Company has auctioned projects for lenders and requested both this type of proposal and bids from new owners who would require the lender to stay in on a restructured basis. In this sample, the discount required by purchasers of the debt has been too large for lenders to accept. Lenders have elected to stay in the projects and work with new owners to add value while retaining the option to sell in the future at a better price.
Just moving back into view is a strategy that, so far, few can implement. Until late 2001 and early 2002, the number of trading organizations that could provide investment-grade power sales, fuel supply and tolling agreements was increasing. Today, only a few of those survive. The spark spreads and terms on offer are very cautious and cannot now support the full cost of a new facility. This will change. Several commercial banks, investment banks, commodity energy companies and utilities are exploring entries into this niche. Aggregating smaller contracts with municipal utilities and fuel suppliers is another approach under consideration. Substantial movement toward a spread of approximately 1.25¢/kWh and a term of 12 to 15 years will support a new project. Terms less optimistic will still add material value to many of the existing projects with merchant risk. At a minimum, they will contribute to covering debt now in place.
Summing up, tumult in the market has led to a flight to quality. Good power projects with contract-secured and well-hedged operating margins have retained their value, and potential buyers face intense competition. Lower-quality projects, particularly those with merchant risk, have fallen in value. Amidst these changes there is opportunity and both buyers and sellers. Both would do well to focus on what strategies work in various changing segments of the market.