The financial turmoil that started in the summer of 2011, particularly in Europe, raises concerns regarding the availability of financing in 2012. Is access to financing still available? What have been the main sources of acquisition financing? What deal structure trends have emerged?
The following is an edited excerpt of the transcript from a panel discussion, moderated by Jonathan Melmed, a Chadbourne M&A partner, at the Infocast green energy M&A conference in California in November 2011. The panelists are Scott Mackin, Co-President and Managing Partner of Denham Capital, Frank Napolitano, Managing Director and Group Head of U.S. Power & Utilities at RBC Capital Markets, Anastasia Pozdniakova, Managing Director of Fieldstone Private Capital Group, and Partho Sanyal, Managing Director of the Global Energy and Power Group at Bank of America Merrill Lynch.
Access to Financing
MR. MELMED: Frank, could you talk a little about what you are seeing in terms of public markets as well as acquisition financing for more traditional clean technology or utility M&A activity?
MR. NAPOLITANO: Sure, there has been reference to the markets being open, which I concur with. Let us talk about why the markets are open, and what is a market. Partho earlier talked about a coupon for investment-grade utility at 4%. With a 10-year treasury at 2% and a 30-year UK treasury at 3%, that sets the overall cost of capital for many different people to think about how many multiples of those risk-free rates they need to make for a given modicum of risk, whether it be that risk in debt, in mezzanine or in a cash-flowing renewable project in the form of equity (or at HoldCo equity).
A good amount of money is moving around the system. Private equity funds are well funded. Pension funds are well funded and their portfolios have remained intact. Institutional investors who buy fixed-income debt are well funded and they are chasing yield. So it all comes back to cash flow values. How much is the cash flow at the base project? How much cash flow can I attribute on a risk-adjusted basis to a HoldCo that might contain a development portfolio as a series of nested options? How do I capitalize that series of cash flows in some mixture of simple debt and equity?
On the debt side, thinking about it from the bottom up, the banks that are in business are still in business, and the banks that are not in business are probably not in business for a reason. Maturities that favored issuers, which were, for a renewable project, a construction period of around 1 to 3 years plus the term-out period, which, at the peak of the debt markets and the commercial bank project finance markets, appear to have been 18 years. So C + 18, which really equates to 20-year bank debt. That is hard to come by anywhere but in the mortgage market here in the U.S. It is really hard for anybody to get 20 year bank debt. That sounds more like an institutional product, more like a bond, or a private placement note of some kind. And if one looked at the cost of capital of those deals, which again, favored issuers, so issuers are supposed to take it when it is on offer if it is money good, versus those bonds, the negative arbitrages of the banks lending the money at that term versus where it ordinarily should have priced out at an appropriate cost of capital in the bond market, was material. In effect, you could say that those banks spent themselves out of business.
Who gave them the subsidy to do that? Subsidies in our space were not just all of the direct subsidies that were talked about in all of the panels to date, which is a form of tax or other revenue benefit, whether it be feed-in tariffs or mandated contracts due to RPS. It truly was a global cost-ofcapital subsidy, in this case thank you to the European Union. It seemed like everyone was lined up to subsidize the U.S. renewables space. Now not everyone is lined up to do that any longer. I think we are in an M&A cycle simply out of necessity to allow projects that should be funded to get their funding and companies that should be funded to get their funding in what seems to be a pressure-shrinking, addressable market based on the macro points that have been raised earlier. The commercial banks that are still in business and lending commercial bank capital are hanging together in club form and are willing to do deals, not necessarily at negative arbitrages that get bankers fired, but at an appropriate risk-reward for the risk that is being taken on.
MEMBER OF AUDIENCE: 2012 looks to be a huge year for construction for wind, and banks are rationalizing how much, and the terms under which, capital is going to be available. I have heard a lot of people say there is debt for good projects, which we generally agree with, but is this coming build cycle going to run into problems in access to capital, both debt and equity, for projects?
MR. SANYAL: My sense is that there will be enough debt capital, notwithstanding $16 billion of government financing having disappeared post-1705 [DOE Loan Guarantee Program], which will have an impact on the private debt market. I think the tax equity market will be the tail wagging the dog a little bit. The amount of tax equity available that could be closed before these projects have to be in operation, which is the end of 2012, will determine how many of these projects get built. It typically takes 3 to 4 months to put a tax equity deal together if you do it the old-fashioned way. There is just not enough time to go out and launch a deal today, get tax equity all lined up, and then finish construction by the end of 2012. So, it will be a mad race to the finish to get projects built.
MR. NAPOLITANO: In simple terms, I think the bank market will be there, but I think it will be at shorter tenors than construction period +18 years. The bond market will be there as well. I think there will be some hybrids between bank and private placement issuers who will get together to help finance projects, with a mixture of fixed and floating rate instruments. The private placement market is wide open for business on the debt side. I agree with Partho that the tax equity market will be the tail wagging the dog. In fact, we have heard that some entrepreneurial financial institution groups, who are now actively prospecting amongst the banks who bought tax equity in the 2006 through current period, are looking to sort of cycle their vintages, because they think in 2012 they are going to be able to pound the table and get whatever it is they want because they have the market trapped, at least under the current rules.
I think tax equity definitely has the premium seat and true equity is going to have to look for very long-dated situations in terms of ownership to get paid. The wind regime is another interesting one where there is a debate between whether to take the grant or whether to take the production tax credit. Folks are looking at the consulting reports about bigger machines and higher hub heights, but tell me about the wind debt that ever got upgraded since issuance from 2006. That has been a challenge that I think is on the minds of institutional investors. They are there to do deals but I do not think they are going to materially widen out the spread to do those deals. However, they are definitely going to do their diligence because there is more data since 2006 on where the wind has been and how various turbines have performed in a variety of wind regimes versus the base cases that were originally projected.
Sources of Financing
MR. MELMED: In terms of sources of financing, what have been the main sources of acquisition financing in 2011? Stated another way, what have been the main types of buyers? What is your sense of the outlook for next year in this regard?
MR. SANYAL: The majority of financings in 2011 across clean energy and clean tech globally have been cash financings ― strategics using their balance sheet. Cash has been an important driver. The exceptions have been Iberdrola’s purchase of Iberdrola Renovables and EDF’s purchase of EDF Energies Nouvelles ― they were catering to a similar investor base so they took stock of the parent company. Given where stock valuations are, people are likely skeptical about the value of what they are getting if they are getting paper, whereas if they are getting cash, they can do what they please with it. If you have a liquid stock, in theory, you can sell it and do what you please with it, but much of the consideration in the deals we are seeing has been in cash.
Going forward, it is hard to think about the whole sector in a general sense; it is region-specific, I would think, but my sense is that people will buy these depressed companies at these low valuations if there is strategic value. I do not expect failing companies to be somewhat re-engineered and strategic buyers magically finding value out of such companies. They have fallen for a reason; they have fallen because their technologies either are no longer working in a competitive sense or they are being subjected to demand/supply inequities. One reason solar valuations have depressed is that there is 40 gigawatts of supply and 23 gigawatts of demand, and that 17 gigawatts is being shipped out at depressed valuations. The market capitalization of the top ten solar companies in the world about four years ago was about $100 billion. Today that number is $15 billion. There have been drastic shifts in value for some of these publicly-traded stocks, so it is hard to see how somebody would accept stock as a currency for M&A.
MS. POZDNIAKOVA: In terms of what I have seen in the market, there are strategics, infrastructure funds and private equity funds that have all been active. It often depends on the underlying project value. For example, we worked on offshore wind projects in New Jersey that had great development risk that should be, in theory, attractive to private equity funds, but private equity funds would not take that risk because the underlying projects could only be approved by the government issuing RFPs at levels that are attractive to strategic investors. Only somebody with a balance sheet who can look at low, unlevered returns would be interested in these opportunities. As the underlying project value continues to drop, the more opportunity for strategics to jump in.
MR. MELMED: As we see less and less government assistance in this industry, what is your view of the viability of other sources of capital in the U.S.?
MR. NAPOLITANO: I will try to marry a couple of concepts together. Without the subsidies, what is the industry? If there are those who believe in the industry for non-economic reasons, then there will be that segment of the industry that will continue to live. If the segment is purely dependent upon cash-flow returns and appropriate risk adjusted returns for whatever piece of the capital structure is required and the industry cannot support those, I think that segment will come out in the wash, which will likely lead to a series of M&A events because the strong could likely mate up with each other to create critical mass and be more financeable and be more diverse and possibly have a different series of fuel-types in the mix. If you look at U.S. publicly-traded companies in the independent power space, which is what these projects are really an amalgamation of, there are core thermal companies looking to migrate into renewables where it makes sense for them, because the return on money makes sense, but you do not see many pure renewable generating companies out there.
MR. MELMED: I hear often that there does not seem to be much capital at the venture growth or early private equity stage; in other words, revenue positive companies not quite ready for a U.S. listing or a sizable M&A deal. Do you see that space filling up?
MR. MACKIN: I think the market is somewhat rate-ofreturn constricted in the U.S. This general market ― growth equity for development ― is where private equity should play well. If you have a great management team and proven technology, and if you have a playing field where there is a PPA market or feed-in tariff or the like, it is fertile territory to invest. But, it is difficult because in the U.S. you have all of the development pitfalls that you face elsewhere, but then you make less money at the end. We are working in the U.S. and want to do more in the U.S., but we have spent most of our focus right now elsewhere, for example, with a play in South Africa that just put bids in on wind and solar. Construction is going to be a bit more expensive there because they do not have the infrastructure quite yet, but returns are more commensurate with taking a lot of early development risk. And, particularly with the ever-changing nature of solar, most people are trying to look for the next window of opportunity for better returns. We have seen good windows of opportunity in the past in Italy, and now in India and South Africa. Those are the places that we and a lot of others may try to invest when we can because the returns are higher.
MS. POZDNIAKOVA: There is definitely a gap between venture capital and private equity funding that gives rise to the phenomenon we often refer to as the “valley of death.” We had an experience working this year with a company that is in the residential solar space. As it turned out, the company was not of interest to venture capital because it did not have any proprietary technological components, but private equity was also telling us that it was too late because the market was already saturated due to successful models that have already been proven here in California.
MR. MELMED: One trend that I am seeing in terms of deal structures is the teaming up of private equity. Often the merchant banking arms of major banks are teaming up with solar and other alternative energy developers, sometimes under the guise of getting in at the holding company level, where there is a significant minority or even a majority level investment with an equity percentage that ratchets upwards or downwards based on project financing milestones at the project company levels below. Scott, are you seeing that from a private equity perspective?
MR. MACKIN: For private equity-type returns, we think you generally have to take some development risks in this field. The old-fashioned private equity LBO model does not really work so much because the market is better defined by growth and not many mature, distressed companies that you can get in and shake things up. So, generally, what we and some others have done is to get in at the corporate level. And, at the corporate level, you can structure equity ownership to be linked to ultimate returns.
Private equity is constantly arbitraging the market — trying to figure out whether you can bring in cheaper equity and whether that is ultimately going to be accretive for an exit. As a growth equity provider, if you have not provided value, which generally translates to a high life cycle rate of return for the assets that you created, then why are you in there?