Hybrid financing the norm as gas-fired projects become larger and more complex

Hybrid financing will appear more frequently in natural gas projects as plants become larger and appetite among traditional lenders decreases, according to speakers at the 3rd Annual Natural Gas to Power Generation Summit in Philadelphia last week.

Funding for Panda's Hummel coal-to-natural gas conversion project was completed after plenty of due diligence (Image credit: Panda Power Funds)

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One of the conference speakers noted that several projects are under development with 1 gigawatt-plus capacities, compared to the norm of 700,000-800,000 megawatts from 2012-15. At the same time, he said some commercial banks have expressed a desire to invest less or bow out altogether because of commodity risks and global uncertainty.

Hybrid financing refers to a capital structure that combines several tranches of debt, typically accessed through various debt markets. Speakers predicted a larger role for flexible capital solutions from mezzanine-debt providers and opportunistic lenders, because these projects are complex, take a long time to put together, and at the time they are ready to reach financial close it may be uncertain as to whether debt markets are accessible.

Kevin Phillips, Joint Global Head of Power & Utilities at Jefferies global investment bank, said every energy project he had been involved in over the past decade had been hybrid to some degree. Using the example of a German wind-farm project that saw eight separate tranches of funding, he said: “Some investors want short-dated [debt] paper, others want longer-dated paper, some want euros, some want dollars, some are German pension funds that have regulatory requirements and need the paper to be listed on some European exchange."

He added, “If you’re really trying to optimize the capital structure to drive the best returns for the equity, then a lot of the time that does require digging in and getting your hands dirty in putting together a hybrid structure, as painful as it often is."

Variety of needs, variety of options

There are broadly four types of debt markets available in the power-generation space, one speaker explained: the term loan A market, term loan B market, fixed-rate insurance market, and opportunistic lenders.

The term loan A market is comprised of about 50 American, Canadian, Japanese and European banks that typically price their transactions at the Libor benchmark rate plus 2-3.5%. These banks like contracted cash flows and are willing to finance single assets. About a dozen of these banks are willing to finance financially hedged projects, and half of those dozen are open to leading the structuring of that debt.

The term loan B market is comprised of collateralized loan obligations (CLOs), mutual funds, business-development companies, and a handful of commercial banks, with new entrants coming into that market such as pension funds and Asian investors. These lenders generally require credit ratings, and strongly prefer portfolios over single assets. They have some appetite for commodity risk, but only a handful are willing to accept construction risk.

Fixed-rate insurance is offered by the likes of Prudential Capital Group and John Hancock at rates of 4-6%. They require very stiff prepayment penalties which reduce their attractiveness.

Opportunistic lenders also go by names such as mezzanine-debt funds, credit-opportunity funds, alternative lenders, lenders of last resort, and hedge funds. They tend to look for returns of 10-18%, and achieve that through being very selective as to where they play in the capital structure.

Projects ‘will get done’

Phillips and Andrew Dete, VP Project Finance at Goldman Sachs, both spoke of their involvement in financing and refinancing of combined-cycle assets in the area covered by the Electric Reliability Council of Texas. Both men agreed that investors have yet to realize the tightening reserve margins and associated scarcity pricing underlying investment decisions in ERCOT.

Dete said investors had been deterred by low spark spreads (gross margins) and by the lack of a capacity market, which has made ERCOT less supportive for new-build investment than PJM Interconnection and ISO New England, the regional transmission organizations that cover much of the northeastern United States. He added that a couple of assets had been traded in the past couple of years, but “there aren’t great stakes in the ground around asset valuation, and… that leaves people in phase two where they’re not exactly sure how to benchmark their investments against the valuation of the market”.

Phillips noted that reserve margins in ERCOT were expected to reach around 20% next year – well within the range of available reserve capacity generally need to safeguard against blackouts. But with lignite-fired plants retiring, he said “you can see the bull case that [gas-fired] assets and combined cycles in ERCOT are going to be needed, and there’s investors who are willing to understand that story.”

But he argued that it would be difficult to sell an ERCOT term loan B to a group of CLO lenders, “because of the amount of diligence and thought and the depth of understanding the market that’s going to be required.”

Last year saw a significant shift in the way investors view natural gas, Dete said. In November 2014, Goldman Sachs and several other parties acted as joint lead arrangers for the senior debt financing of Panda Power Funds’ 778 MW Stonewall combined-cycle power plant in Virginia. Debt capital of $571 million was raised “with flying colors”, Dete recalled.

Almost one year later, Goldman Sachs helped arrange $710 million in debt financing for another Panda project, the conversion of the retired Sunbury coal-fired power plant in Pennsylvania into the 1,124 MW combined-cycle gas-fired Hummel Station power plant.

“Panda Hummel’s effectively the same credit but every last detail was diligence. We spoke to every single investor over the course of many days and getting everybody comfortable. I think there’s a pullback in risk appetite. I think people are still really focused on these assets as a good combination of credit quality and yield. I don’t think that they’re gone, I just think that deals are harder. And that’s not necessarily an awful place to be in the market,” Dete said.

“That’s the reality we’re living in given the commodity environment, but as long as rates stay low and the credit quality of these assets stays high, these investors will be here and you just have to have really well-structured projects but they will get done.”