The last time merchant power plants could be financed and developers were able to raise 100% of the project cost in the debt markets was shortly before Enron collapsed. Now such financings are back. Panda raised term loan B debt for a merchant gas-fired power plant at 600 basis points over LIBOR, and the transaction was “reverse flexed.” Moxie Energy, Invenergy and others have been in the market with merchant financings. In what circumstances are such terms available? What does it say about the market? A panel discussed the subject at the 24th annual Chadbourne global energy and finance conference in June.

The panelists are Todd Carter, president of Panda Power Funds, Scott Taylor, CFO of Moxie Energy, Ray Spitzley, senior managing director at Morgan Stanley, Mike Pantelogianis, co-head of power at Investec Bank, and Andrew Rosenbaum, a director at Royal Bank of Canada. The moderator is Rohit Chaudhry with Chadbourne in Washington.

MR. CHAUDHRY: Is it a real trend toward merchant power or just a smattering of projects?  

MR. ROSENBAUM: There is no trend per se. There are a lot of banks chasing a relatively small number of deals. Non-merchant deals are more prevalent than merchant opportunities.  

Pricing is at very tight levels. There is a lot of private equity in the market. A number of funds have been raised and dedicated to this sector at a time when the opportunities have been harder to come by. Pension funds have also been drawn into the sector. There are broken price signals. Some lenders are willing to lend despite what the rest of the market is seeing in terms of inadequate capacity payments and projected demand-supply imbalances.  

MR. PANTELOGIANIS: There are pockets within the broader US market where capacity is needed. We are starting to see activity in ERCOT and PJM where investors are comfortable that enough cash flow will be generated from merchant projects not only to cover debt service, but also to earn an equity return. Refinancing or new construction are much more achievable today due to the factors that Andrew Rosenbaum mentioned plus the fact that capital is more widely available as a consequence of QE3. Is this sustainable? I think it is.

MR. SPITZLEY: If you look back over the long history of project finance, sound fundamentals are important. It is good for project sponsors that we have frothy debt and equity capital markets, but the fundamentals need to be there. We are one of four banks participating in LS Power’s West Deptford project, which is a fully-merchant greenfield project. That four banks participated was not a capital markets phenomenon. It was wholly driven by the fundamentals of the project, its location and what we saw in the forward price curves and PJM. There is a skilled operator and sponsor behind the project. The healthier the markets, the better the pricing that will be on offer, but we need to have the fundamentals first.

Fully Merchant?

MR. CHAUDHRY: You said the project is “fully merchant.” Does that mean there are no hedges or other supports to put a floor under the electricity price? Is it the only project being financed in the current market that is not quasi-merchant but purely merchant?  

MR. SPITZLEY: That’s right. We are aware of other projects that have synthetic revenue that helps to provide comfort in the early years. Those projects are in ERCOT where there is no spare generating capacity. The West Deptford deal is in PJM which has a forward-capacity market, so there is visibility with respect to contracted capacity from the regional transmission organization. You can debate whether that is fully merchant.  

MR. TAYLOR: There are companies that are consciously pursuing merchant as a strategy, but there is no broad trend. Those companies have a positive view of certain markets and want to benefit from that.  

There are projects that are being developed on a merchant or quasi-merchant basis that backed into it out of necessity. I will use our project as an example. We developed our project with the goal of having the fundamentals to support a purely merchant project. When we started, the concept of going merchant was pushing the envelope. We thought it made sense as a business matter, but we were trying to land a power contract at the same time. We thought we had a couple opportunities, but we were naïve and found out quickly that it is easy to get a longterm power contract if you take a price that does not work economically. Getting a PPA that actually makes sense is more difficult, and we were unsuccessful. Fortunately, because of our fundamentals, we then quickly shifted toward a merchant or quasi-merchant structure.  

There are some other developers who had no intention of ending up in the merchant market who got a project developed in an attractive area and then backed into, “I need to find a way to get my project done.” Deals ready to close do not get better with time.  

Merchant projects still need to have the fundamentals to close on financing. The frothy debt market is not leading to crazy financing structures. It is driving down the spread, but not allowing deals that lack the fundamentals to get done.  

MR. CHAUDHRY: What are the fundamentals that make these merchant projects work?  

MR. CARTER: They depend on the opportunity. The forward market is broken in Texas. We had to figure out something that would work in that market, and we were able to get our first project off and, shortly thereafter, a second and a third. The three fastest growing cities in the country are Austin, Houston and Dallas.

Geography

MR. CHAUDHRY: Which markets in the US do you think are well suited for a merchant deal? Which markets have the fundamentals for getting a project done on a quasi-merchant basis?  

MR. TAYLOR: We picked PJM for our two projects because of the liquid electricity market, but the real driver was the ability to put two projects right on top of the gas supply. This gives us a gas supply-basis benefit that we believe is sustainable because there is not enough takeaway capacity to support the volume of gas. If a gas producer wants to increase its takeaway volume, its only option is to pay transport charges on an incremental basis. We get a benefit by being right there and allowing gas suppliers to avoid incurring those transport charges.  

The founder of our company focused on PJM because we have western hub energy pricing, a capacity market and the gas benefit. The energy and the gas benefit were the two big drivers. The capacity market is important, but it was not the driver.  

MR. CARTER: The ERCOT market was attractive to us because the market fundamentals were right. Power was needed in Texas. There was no capacity market, and you could not get a long-term, forward heat-rate call or any kind of forward hedge. So we took a position on that particular marketplace.  

We are focused on lots of different markets. We like the PJM market because it has a lot of strong fundamentals. We like the ERCOT market because it has growth, unlike PJM.  

I know there has been a lot of discussion about PPAs. They are like the mythical unicorn — very difficult to find. When you do find one, you should be very proud. As a general rule, we would not put a project on the ground without a long-term PPA.  

MR. CHAUDHRY: Which markets do you think are easily financeable for a merchant deal?  

MR. ROSENBAUM: We have not seen any greenfield construction outside of PJM and ERCOT. There is no sign that merchant developers are exploring other markets. That goes back not only to the fundamentals, but also to the regulatory structure.  

There is probably a need for some new development in California, but the regulatory risk in that state is such that you need a PPA.

However, look at it from a different perspective. There is a healthy trade in existing power plants. Almost all sales of existing projects require the purchaser to take some form of backend tail risk. The projects were financed originally on the basis of a PPA or heat-rate call option, but buyers are committing capital beyond the known revenues that they see in front of them. We see that happening in every market around the country, some more than others. The secondary market is taking merchant exposure in every region of the country.

MR. CHAUDHRY: Coming back to the PJM market, there was a recent capacity auction. What were the results and what impact will they have on developing projects in the PJM market.  

MR. TAYLOR: We were disappointed by the $119-a-day clearing price. We had projected higher numbers. It is easy to take that price and quantify the one-year hit to capacity revenues, but we are driven by our energy price. The capacity price is important because it helps with financing — it helps provide some benchmark for covering fixed costs — but our long-term view is based on energy and locking in a spark spread because of cheap natural gas.  

The results in the PJM market should be kept in perspective. We would not develop a project based on a one-year number, particularly if that one-year number is a relatively small percentage of your total revenues. Even though it knocked off some cash in the first year, the silver lining is that there are other projects that were behind us in the development queue and were planning to line up their deals for next year’s auction that are probably now slowing down their efforts.  

MR. CHAUDHRY: What percentage of your overall revenues are capacity payments?  

MR. TAYLOR: Less than 10%. It highlights, in an indirect way, the sophistication of what people are doing. The capacity market was supposed to provide a forward price signal to induce new construction. We are saying it is not really a factor at all. Developers really have to take a different and more sophisticated view of the market instead of relying on the same price signals that others may use.  

MR. PANTELOGIANIS: Don’t you also look at how many new projects other developers have announced they are pursuing in PJM? Take New Jersey, for example. As we look at the queue, we see projects that were supposed to be locked up and contracted, but because of disputes with the regulated utilities, the projects are now going to be constructed on a quasi-merchant basis, and they depend more heavily on capacity payments from PJM.  

The meltdown occurred 10 years ago because of a realization that more projects, many of them merchant, were under construction than the market could support.  

New Jersey announced several more projects including the 800-megawatt CPV Shore project. EIF has teamed up with Hess and has started building a project entirely with equity. NRG won a contract, but I don’t think the project will make the cut and be built. As I look around, I ask myself, if I am dependent on capacity revenue to help me cover my costs, then I need to get comfortable that the market will remain stable over the next five years.  

MR. CHAUDHRY: Scott Taylor, you said people should not place too much weight on the auction results because capacity payments are a small percentage of your revenue stream and they are only one-year numbers.  

MR. TAYLOR: It goes back to the fundamentals. If you have a project where the capacity price is a small percentage of total revenues, it must be a small percentage either because you have favorable energy prices or cheap gas. It depends on the project. If the developer views the capacity payments as the real long-term benefit, then the recent auction results will cause work on the project to slow down. Projects with good fundamentals will keep proceeding, and projects that are on the margin will be more inclined to slow down when they see these types of price signals.

MR. CHAUDHRY: So there are a lot of projects coming on line. You may have some that rely on capacity revenues for a larger percentage of overall revenue. Are these new additions already factored into the recent auction prices? Will they cause developers to worry more about more depressed prices in future capacity auctions?

MR. TAYLOR: The $119 price reflects the projects that bid into it. The $119 price does not reflect projects that might be bidding in next year.  

Necessary Fundamentals  

MR. CHAUDHRY: Todd Carter, you have done three projects in Texas. What are the fundamentals you rely on to make a successful merchant project?  

MR. CARTER: They are location, location, location. You have to be able to get your electricity into the marketplace. Do you have a willing community that supports your project? Do you have access to the lower-cost gas?  

Everything starts with the location. I cannot stress that enough. We look at this as a private equity shop. I cannot tell you how many projects we have looked at for which we would not pay two nickels. The interesting thing about Scott Taylor’s projects is the gas price. The gas price is phenomenal. It is negative 30¢ in Henry Hub. In the old days, all the gas was being brought up from the field, and it was 15¢ to 75¢ plus in Henry Hub.

MR. CHAUDHRY: How do renewables fit into a market with low gas prices? Is it possible to get a solar project done on a merchant basis?  

MR. CARTER: You need to have a favorable offtake contract or a large tax credit. I hope we build all the solar and wind that we can. We think, because we use natural gas, that we are perfect dance partners for renewables. You have to have something there when the wind is not blowing or when the sun is not shining. It would be very difficult to do merchant renewables.  

MR. PANTELOGIANIS: PPAs have been a big driver in the renewables market. If there is enough resource that you can make it work without a PPA, so be it, but it is tough to see merchant renewables.  

MR. CARTER: You need an offtaker to make the economics work. You need predictable power prices as an offset to the intermittency of renewable resources. Solar residential is a merchant play of sorts. There are some sustainability goals that are served, but the business model is driven by grid parity. In markets where homeowners can lower their costs by installing solar, the business model flourishes.

MR. ROSENBAUM: Theoretically, there is room for merchant renewables, but think about combined-cycle gas turbines operating in a base load capacity. They give you a high degree of visibility toward the earnings potential. Compare that to renewables, which are generally interruptible and it is very hard to get a clear view of cash flows, which is what necessarily leads to a discussion about PPAs and other price supports.

The other factor with renewable energy projects is that the cost is known going into them. You have stakeholders that all need to get their pounds of flesh out of the project. Whether it is hedge counterparties that need to be paid an appropriate return for the risk they are taking, the lenders that need to be paid an appropriate return for risk or the equity. If those three parties can find a way to split the value and still leave something meaningful for the developer, then the opportunity to proceed on a merchant basis exists.  

Right now, a combined-cycle gas turbine operating in a baseload fashion clearly has the opportunity to proceed on a merchant basis. At RBC, we did a merchant hydro deal with Brookfield. It was a secondary trade — it was not construction financing — and it was in a market where we had very clear price signals allowing us to size debt appropriately.  

MR. CHAUDHRY: Are there any utility-scale wind or solar projects which have been done on a merchant or quasi-merchant basis or that are currently in the market?  

MR. CARTER: Historically, there have been many quasi-merchant projects with financial hedges overlaid. A ton of activity occurred in ERCOT. A lot of the transmission issues in Texas are a function of the mass capacity additions that we saw in the mid-2000s associated with wind construction. Fundamentally, equity looks at achieving its returns during the period of the financial hedges. The hedges went out on the shortest side for only five to seven years, but it was more common to see 10-year hedges.  

MR. CHAUDHRY: Andrew Rosenbaum, as a banker, what are the fundamentals you look for to make a merchant project or a quasi-merchant project attractive?  

MR. ROSENBAUM: We focus on the risk that the project will be unable to pay debt service. Equity needs to be there in sufficient size. We look at how the project can de-lever when any hedge or cash flow support that was baked into the project expires. We look at the loan-to-value ratio. There are technology factors that will matter significantly. There are some things that we just cannot get our minds around and probably will not be able to lend through, but in terms of the base factors, that is probably it.  

MR. SPITZLEY: Sponsorship is critical to us. We see the projects as being very complex. Not just anyone can build and operate a plant. If you look at who has been able to finance a merchant plant recently, two names, Panda and LS Power, keep coming up. There have been only two sponsors who have successfully financed large merchant projects to date.  

After a good sponsor, we want cash flow stability during the tenor of our debt. Finally, we look strongly at what liquidity there has been around these types of assets in the M&A market.  

Pricing and Leverage

MR. CHAUDHRY: At what rate is the debt for merchant projects being priced?  

MR. CARTER: Ours was priced at about 950 basis points over LIBOR in July 2012 with fewer than 10 participants. We financed our second project 45 days later with 35 investment groups at 725 basis points over LIBOR in September 2012. We financed Temple II a few months ago at 600 basis points over LIBOR. We could talk about lots of other things. The original issue discount was much better. It was 98 the first time, then 98.5 and then 99.  

MR. CHAUDHRY: There was such a dramatic decrease in the pricing between your first one to the third one in a matter of months. To what do you attribute this?  

MR. CARTER: The first one is always hard. We were clearly the first project in ERCOT. There were a lot of people swirling around saying, “Man, I am trying to get a handle on this. There is no futures market. Okay, put a synthetic hedge in place.” That was a big part of it.  

The second part is that the potential pool of investors is larger. We went from a small investment to a larger one and then to an even larger one by the third project. People got comfortable with the structure because we did not change it much. People became better educated about ERCOT and the risks over time.  

MR. CHAUDHRY: What kind of leverage did you get?  

MR. CARTER: It was not great. Our first project was less than 50% debt, so we had to come up with a significant amount of equity. Then we got a little bit over 50% debt in the second project, which was 45 days later, and then closer to 55% debt by the end.

MR. CHAUDHRY: Scott Taylor, you are in the market currently and talking to banks. There have been press reports as to what pricing is being thrown around.

MR. TAYLOR: I cannot go into the details of what we are doing right now, but I will comment generally. We started looking at different financing structures from last year — with hedges, without hedges — but one of the key things that has not changed is the leverage and overall structure. Even last year when we were looking at higher pricing, the leverage levels that we were being told we could achieve were above 50% because of our gas benefit.  

The reduced pricing is not a sign that there are more people willing to lend into weak deals, which goes back to my comment earlier. I do not think you are seeing lenders stretching to take on credit risk, but we are benefiting from lower pricing. We were looking at pricing last year of 625 to 725 basis points, but now the price is definitely below that. We are benefiting from the deals that went ahead of us and an improved market.

MR. CHAUDHRY: According to press reports, your deal is being priced in the 600s. What are the potential ranges for pricing and leverage for these types of projects?  

MR. CARTER: I think you have seen the potential price range. The new construction projects have tended to be the highest priced because they are new entrants into the market. Naturally, there should be more speculation associated with those, and that translates into price.  

As for leverage, on the first transaction, it was closer to $400 per kilowatt of capacity, but as we got to Temple II, it had moved toward $500 a kilowatt.  

Then there are the existing, stand-alone, quasi-merchant assets that have proven track records. They have been pricing around 400 to 500 basis points above LIBOR, but may be able to get to 350 to 400. As investors and rating agencies get more confident about the operating assets, the price follows.  

MR. CHAUDHRY: Andrew Rosenbaum, you mentioned to me that the market is pushing back on some of the pricing.  

MR. ROSENBAUM: I would not say that the market is pushing back because that gives the impression that investors are saying things have gone too far and they do not like the terms any more. That is not what is happening.  

Over the course of the last year, we have seen the institutional debt markets tighten. Some were on the verge of 150 basis points. We would not have done a small gen co financing with a high degree of confidence and call it below the BB- ratings range 18 months ago. There just was not a lot of precedent for that. The spread would have been something like LIBOR plus 425 to 450, with a 125-basispoint floor. Everybody that accessed that market has increased leverage and re-priced his deal; some were in the neighborhood of 100 to 150 basis points tighter. The incremental leverage has usually been taken out in the form of a dividend.

We have seen the market get more aggressive in pretty much every measure. In the last couple weeks, the credit markets at large have sold off. Whether it is the market at which Panda and Moxie Energy are looking or what some of the mid-market sponsor portfolios are tapping or the Treasury market, everything sold off over the last couple weeks. You saw the Calpine deal get pulled right after NRG priced its deal. I cannot tell you that there is a meaningful credit differential between those names that explains why one got done and one did not. They are both phenomenal companies with great stories, sort of the sweethearts of the independent power space. But the market sold off and one company got in before the window closed and one tried shortly thereafter. That just happens in credit markets.  

1990s Redux?

MR. CHAUDHRY: Ray Spitzley, you have been doing this for a long time. Merchant, quasi-merchant — haven’t we seen this before? In the 1990s, it all ended badly. Why do you think it will be different this time around?  

MR. SPITZLEY: In the 1990s, a bunch of things were different, but fundamentally that was an equity market. There was a general view that deregulation convergence between gas and power and the new, efficient combined-cycle turbines were going instantly to displace the old coal-fired inefficient power plants. Companies could not start construction fast enough, and you had highly-leveraged companies looking to banks to take bank loans that had been 100% financed for construction projects into the public capital markets. For a while that worked. When Enron collapsed, the music stopped, and there was a re-evaluation.  

The public equity capital markets are not looking for merchant growth. It is a much more disciplined equity environment. Their focus is cash flow, and they scrutinize new projects heavily. It is no accident that the people who are developing new projects are independent entrepreneurial private equity folks and then, once the projects get built, some will be acquired by the bigger publicly-traded players.  

The merchant space is heading toward consolidation. Some of the big names that own generation portfolios will exit the business as we have seen with Dominion, PEPCO and Duke. Some of the private equity portfolios will become public and then, once they are public, will undoubtedly look to merge because the public markets will pay for operating and locational synergies of having a broader portfolio. That is what is really being rewarded in the market today. Private equity will continue to play a role in early development. Consolidation is where it will head.  

MR. CARTER: When I look at my career and what we were doing during deregulation and how we were financing, I remember doing computer models and bond deal after bond deal around gen cos that were rated investment grade. Then all of a sudden, we found out that these were not investment grade. As we were learning about the merchant markets and the merchant game, the market pulled back.  

We are in a far more mature period today on the trading side, the capital side and the development side. That allows for more prudent investing and for the right assets to be developed, and so I am not worried that we will get another head fake from the rating agencies that contributes to what happened the last time.