Q&A: M&A and investment in the energy & utilities sector
November 2014 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES SECTOR
Financier Worldwide Magazine
November 2014 Issue
FW moderates a discussion on M&A and investment in the energy & utilities sector between Christopher Ryan at Beowulf Energy LLC, Hermenegildo Altozano at Bird & Bird LLP, Carlos Ramos Miranda at Hogan Lovells BSTL, S.C., Fintan Whelan at Mainstream Renewable Power Ltd., and Charles Peterson at Pillsbury Winthrop Shaw Pittman LLP.
FW: How would you describe the current environment for M&A and investment in the energy & utilities sector? What major trends you have witnessed in the last 12-18 months?
Ryan: The M&A environment in the power and utility sector remains strong. There are a few trends we see. First, the larger utilities continue to consolidate and focus on their core business and sell non-core assets. Dynegy’s acquisition of the Duke Midwestern unregulated portfolio is a good example of this. Second, buyers have been moving out on the risk spectrum and paying full values for high quality merchant assets. Lower risk contracted assets have become very expensive and can’t generate the necessary returns, so buyers are forced to take on more risk in order to transact. Finally, the emergence of yieldcos and similar income oriented securities has resulted in a compelling alternative to an outright sale, particularly in the renewable space. This should lead to higher prices for cash yielding assets, on a relative basis, as public market return requirements are lower than private equity.
Ramos: The last 12 to 18 months in Mexico have been characterised by a substantial level of activity, particularly since December 2013, when Constitutional reforms were enacted, ending more than 70 years of Mexican state monopoly of the upstream oil and gas sector, and power sectors. In anticipation of the reform, many foreign investors began to position themselves in Mexico either by setting up directly, buying interests in established companies or entering into joint ventures. The oil and gas sector will experience further M&A activity as bidding rounds to grant host government contracts approach. The opportunities in the sector are simply overwhelming and therefore most players and potential participants are eager to set up shop in the Mexican market. These opportunities include not only conventional plays, but also deep water, ultra deep water, shale, and other non-conventionals, where major investments and technology are required. Midstream will also imply major investments as Mexico requires substantial infrastructure to cover the territory’s energy needs. In the power sector, while there has also been important activity, players are still hesitant to make major investments until such time as market rules and other implementing regulations are issued and enacted.
Whelan: We see the ongoing fallout from challenges to the established utility model with divestment of existing generation assets to financial and industry players and utilities partnering with these same players along with the supply chain on new builds. This is a consistent feature in offshore wind. But utility divestment of bundles of onshore windfarms has continued. Also, on both sides of the Atlantic we have seen the emergence of yieldcos as vehicles into which utility assets can be transferred and funded on the public markets. This is the relentless search for the best cost of capital. It is still a strong trend in the US but the UK market is taking a breather with some fundraisings not reaching target and other planned yieldcos having their launches pulled in the face of uncertain appetite.
Altozano: In Spain, due to the turmoil created by retroactive changes to regulations governing the production of electricity out of renewable sources, there has been an increase in investor appetite for photovoltaic, thermal solar and wind assets. In addition, conventional power production plants have attracted the interest of large utilities, mainly as a result of E.On’s disinvestment plans. Another trend is the launching of yieldcos to group renewable assets and attract additional capital.
Peterson: The development of new generation and transmission has been disrupted by the war in the Middle East. In the last few months, the tensions with Russia have created more uncertainty, which has chilled the market. Many projects are delayed and may be abandoned. This is trend unlikely to change in the near future.
“We see the ongoing fallout from challenges to the established utility model with divestment of existing generation assets to financial and industry players and utilities partnering with these same players along with the supply chain on new builds.”
FW: What factors are driving deals in today’s market? Which segments and regions seem to be offering the most lucrative opportunities?
Whelan: Penetration of renewables – particularly solar in Germany, although the trend is universal – has disrupted traditional utility models. They must adopt capital-lite strategies. So they must do deals, either to release capital or avoid having to raise it by using joint ventures. This is a real feature in Europe. Meanwhile, the emerging markets appear relatively attractive for utilities that are suffering at home. Investors generally have heightened concerns about regulatory risk and projects being forced into more market exposure without natural hedging capability – this is driven by EU policy and biting in the UK and Germany. Never have FITs been more attractive. This weight of interest is imposing itself in, for example, South Africa, where new wind can deliver electricity at a price well below that of new build coal in that country.
Peterson: Energy, particularly transmission and energy storage, remains one of the hot segments in the market, but a high level of activity is only possible in countries that have money, usually oil money, and relatively stable governments. This is focusing attention on the markets in the Middle East. The leader is the UAE with four large nuclear plants coming on line. Saudi Arabia may overtake the UAE in nuclear power and renewables, if the succession plan leads to a stable government in the near future.
Altozano: The main deal drivers are returns and predictability of cashflows. Power generation, both conventional and renewable, and power distribution, as well as gas distribution, are among the segments which may offer more opportunities. As far as regions are concerned, the renewable energies segment is of particular interest in the Canary Islands.
Ramos: The whole energy sector is currently offering a wide array of opportunities. However, the upstream and midstream oil and gas sectors are receiving the most attention since the rules of the sector in Mexico are clearer. The market is now open to all sorts of players; thus, the opportunities are not only for major international oil companies, but also for mid- and small-cap companies, investment funds and financial institutions looking to finance exploration and production projects. Given the location of Mexico’s hydrocarbon resources, major investments will occur in the northern part of Mexico, and all areas covered by the Gulf of Mexico. Midstream activities will firstly concentrate on the northern part of Mexico, in order to fully connect Mexico’s systems with those of the US, and thereafter towards the south, which is currently less developed. Mexico’s current stable political system, solid financial sector and vigorous economy make it an attractive recipient of investment. However, important efforts need to be made with respect to transparency, personal security and corruption, which have become deterrents to investment.
Ryan: Availability and flexibility of financing has been an important driving factor. B loans are available in the merchant market, which was not really the case a year or so ago. Yieldcos are a relatively new phenomenon in the power space. Cheap natural gas is transforming the energy sector generally and important subsectors more specifically, including electricity, pipelines, LNG liquefaction and transport, and coal. Obviously, some sectors will benefit from cheap natural gas, while others, like coal and coal fired generation, will be challenged. We see opportunities on both sides, and are looking at assets that directly benefit from cheap gas, like ammonia production, as well as assets, like coal fired generation, that have become less expensive as a result.
“Energy, particularly transmission and energy storage, remains one of the hot segments in the market, but a high level of activity is only possible in countries that have money, usually oil money, and relatively stable governments.”
FW: What general advice can you offer to parties on negotiating and closing deals in the energy & utilities sector? Are there any particular characteristics unique to this sector, and how should dealmakers handle them?
Ramos: In our experience, foreign players are used to the international practices and standards of doing business, particularly in the oil and gas sector. Though Mexico is sophisticated in the international arena, investors need to keep in mind that the country is just opening its doors to the sector, so it will take some time to fully adopt and adjust to such standards. Importantly, it is a civil law country, with a highly formalistic culture. On many occasions, form is more important than substance. Thus, investors need to understand that the manner of approaching authorities, filing for permits and generally conducting business needs to be made in the appropriate manner for Mexico. Expecting to do deals in the manner they are done in other jurisdictions, such as the United States, may set challenges for investors.
Ryan: Due to the highly technical nature of the underlying assets, the due diligence process is very important. Even contracted or hedged assets are not immune to risk if the facility is not working properly. This is something we are very focused on, and every opportunity we review is heavily scrutinised from a technical and operations perspective. Similarly, the energy business is highly contract oriented, even for merchant assets. Energy hedges, fuel supply agreements, service agreements, and so on, can have important financial implications. We see the ability to create significant value by seeing opportunities in contractual relationships that might not be obvious.
Altozano: Dealmakers need to consider that, due to regulatory changes the market is not as predictable as it used to be. Relevant contracts should carefully contemplate changes in the law and include mitigation measures. The sector is very sensitive to tariffs established by the government.
Peterson: The secret to making an energy transaction proceed is to ensure that it has a broad base of public support. In most countries, without public support, transactions are likely to have long delays and an uncertain future. It does not matter what logic is behind the project, the risk is driven by perception.
Whelan: Parties need to pay attention to the possibility of assets being stranded by policy or regulatory shifts. Note the direction of market exposure for the output of renewables projects, particularly the variable renewables technologies, to understand what hedging capabilities are necessary and how securely they are in place – it is possible to handle this, even in advance of market rules that are more sensible for a low carbon world. In solar, beware cowboy product and cowboy installers. There is an impression that solar is a commodity but hard experience is showing that this is not the case. There is no substitute for solid analysis and robust due diligence. Beware sweeping assumptions.
“The energy sector in Mexico is still undeveloped and has not adopted international best practices and standards; consequently, it is easy for expectations not to be met.”
FW: What risk management considerations do dealmakers need to make when acquiring energy & utilities assets? What options are available to mitigate risk and protect future value?
Altozano: It is advisable to carry out detailed due diligence in order to assess the regulatory status of the relevant assets. The main risk is that represented by regulatory changes. Bilateral Investment Treaties and instruments such as the Energy Charter Treaty should be also considered in the investment equation.
Whelan: Contingent consideration must be based on delivered outcomes. As in all M&A, the seller knows more about the product and maybe the market for the product’s output than the buyer. Plugging the risk, and therefore the value gap, with an adjustment based on outcomes can get a deal over the line. Exploring a sell-back option and the seller’s behaviour as you tease out the issues that might arise can reveal a lot about the core deal. It will certainly reveal a lot about the seller’s perception of what the outlook would be for the asset at the back end of its life where much of the upside potential for the buyer will lie – if only because of the mechanics of discounted cash flow. A seller taking the initiative with this turns the tables.
Peterson: This may be the turning point in energy development. The old, each town has a power generation plant and power from grids are the exception, is collapsing. The public is demanding green power. Solar, wind, hydro and geothermal power need massive distribution grids. Solar and wind also need utility-scale power storage to address the frequent spikes. The new grid may require underground transmission in order to be publically acceptable. Energy storage may be shifting to liquefied air, since NIMBY and environmental interest groups oppose pumped storage. In addition, we may see the first fusion plants coming on line before the plants that we are building now run out of life. Fusion should not be measured by the slow and uncertain pace of ETR. Many smaller fusion power companies are getting funds. These companies are frequently led by well-educated physicists with years of relevant experience. The Lawrence Livermore National Laboratory recently confirmed ‘theoretical’ breakeven – more fusion power out of a pellet than they put in.
Ryan: There are three ways to effectively mitigate risk. The first is to buy assets at a low enough price so the downside is limited and the option on the upside is significant. An example of this would be coal fired generation, which we like if priced right. The second is to minimise commodity, interest rate and operational risk. This can be accomplished through hedges or PPAs, swaps, and long term service agreements. This comes at a cost, however, as the upside will be limited. The third way, which may seem somewhat counterintuitive, is project development. While an individual development project may entail risk, as not all projects succeed, we see development of a portfolio of projects as a good way to generate good risk-adjusted returns. Ultimately, by providing superior returns, investing in some development projects can mitigate the risk of low return investing and protect the future value of a portfolio on an aggregate basis.
Ramos: Risk analysis is the most important element to consider. In making such analysis, it is important to have substantial knowledge of how business is conducted in Mexico. Investors should not make assumptions, but rather confirm even the most basic concepts. Language barriers are also important. Although most Mexican businessmen and authorities speak English, the official language in Spanish. Being able to properly communicate is key to identifying and mitigating risks. Most important are risks associated with tax compliance, anti-corruption and money laundering compliance, and labour. Investors need to conduct thorough due diligence on the companies and assets they intend to acquire to do business in Mexico.
FW: Are you seeing dealmakers adopt different strategies in developed versus developing countries? What particular issues and risks can they expect to encounter in emerging markets?
Peterson: Developing countries need financial support, and certain suppliers are willing to supply that through their governments. Developed countries continue to rely on national and regional governments. Emerging markets have not fully matured and the markets are unstable.
Ryan: Emerging market investing does require some different strategies versus developed countries. Clearly, a sovereign risk premium is usually warranted. Care must also be given to ensure that all local and US laws are followed – we take Foreign Corrupt Practices Act compliance very seriously. That said, we see a lot of opportunity in the less developed countries, and we are currently evaluating opportunities in the Caribbean and Eastern Europe.
Ramos: Cultural differences are the most important issues to understand. Once there is an understanding of the different cultures and expectations of the other party, it is easy to get deals done. The energy sector in Mexico is still undeveloped and has not adopted international best practices and standards; consequently, it is easy for expectations not to be met. Investors who are better prepared to deal with these issues and who appropriately manage their expectations will have a better chance of success. This includes hiring appropriate and reliable local consultants and experts that can assist in transiting through the deal making process. Failing to properly cover all bases from the outset is likely to result in material setbacks in negotiations and growing businesses.
Altozano: Emerging markets may in some cases offer better and more stable opportunities than developed countries. The key element is the existence of reliable flows of income. This can be achieved through sale and purchase supply agreements which include price and foreign exchange stabilisation practices. In the case of greenfield projects, supply agreements – including BOS and EPC – should contemplate the material adverse change or change in circumstances represented by regulatory changes, including but not limited to exchange control.
Whelan: The prospects for selling power through creditworthy PPAs is a principal obstacle in developing countries. There will be a primary issue of the quality of the sovereign credit and the political and regulatory risk environment. Strategies to manage this are well established, involving the umbrella offered by multilaterals with development agendas. They know that international investors will need to see credit support for debt, and in some cases equity, and have an evolving toolkit designed for this purpose. When an underdeveloped local supply chain meets local content requirements, they pull in different directions from the viewpoint of economics. Importing capital intensive electrical generation kit has currency impacts. Distances between projects means an effective O&M capability for the region of operations must be developed. Health and safety issues must be addressed effectively. Corruption is no stranger to developed countries but institutions tend to be weaker in developing countries. The involvement of multilaterals and partners with strong corporate governance demands is helpful.
“Lenders are back to lending in the energy and utilities sector, although the guarantees required from the sponsor are tighter.”
FW: How would you characterise the financing environment for energy & utilities deals? Are lenders demonstrating a willingness to support transactions in the sector?
Ryan: We see the financing environment as very open and flexible. Through the end of September, the high yield market was ahead of last year’s record pace and the activity in the energy sector was strong. Despite a slight increase in rates recently, we see continued enthusiasm among borrowers and lenders alike. We see this trend continuing for the foreseeable future, absent a material market event or change in policy.
Altozano: Lenders are back to lending in the energy and utilities sector, although the guarantees required from the sponsor are tighter. Refinancing schemes are in the process of being established in Spain in the renewable energy segment as a result of the ‘haircut’ arising from the retroactive measures. This situation has translated into longer tenors, revisiting base case and predictions, new requirements for debt service coverage ratio and cash sweep obligations.
Whelan: The same iron laws of gravity apply, but good projects get funded. New players are also looking in – debt platforms funded directly by institutional investors – are either competing for a slice of the cake or making up for bank capacity that went missing in 2008 and has not returned, depending on your perspective. Official lenders like EIB, KfW, EX-Im and OPIC are still steadfastly supportive, subject to their requirements. Yieldcos avoid debt by and large and therefore in effect the cash flows they receive that would otherwise be servicing debt flow-through as dividends to public equity investors.
Ramos: The most important deals are yet to occur, once bidding rounds commence and contract areas for exploration and production activities are awarded. We see a wide array of investors and financiers already set up and ready to provide financing for projects. Initially, we see the major players setting up in Mexico and taking the initial deals. These players generally self finance themselves, so direct financing for these projects is still a couple of years away. However, smaller service providers will require financing in order to be able to properly service customers.
Peterson: Lenders want to mitigate risk, and that is difficult in this uncertain world. There are still projects in stable countries that can go ahead. There are also projects financed by governments or backed with sovereign guarantees that can go ahead. Lenders today are very selective.
“We believe the active M&A market for generation assets that started in 2010 will continue for at least two years.”
FW: Going forward, what are your predictions for energy & utilities M&A activity through the remainder of 2014 and beyond? What key factors are likely to shape deals and investments in the years to come?
Whelan: The markets for energy are evolving and disrupting, and this process will continue. These are usually good reasons for assets to be bought and sold as utilities and other investors absorb the changing environment they are in and as they look ahead to understand how they should be positioned for winning. Interest rates are historically on the floor. As sentiment changes on how long this is likely to last, investors – who have found their way to energy for its reliable power sales cash flows, seeking yield – will be reviewing the relative attractiveness of these assets against traditional fixed income where they came from. If they did their analysis and deals right, they would understand the robust qualities of what they have acquired and not be thinking of divestment. However, if there is a move from energy assets to fixed income, that will be an interesting time to acquire assets.
Altozano: Now that the new regulatory frame for electricity and gas is established, we forecast a significant number of deals coming principally from energy and infrastructure funds. New, imaginative structures, such as the creation of yieldcos, are also anticipated. The key factors that will shape deals are the quality and output of the assets, stability of production and flows, and price.
Peterson: Like most speculators, I expect the market to continue in spurts. However, the possibility of the markets being upset by new power generation or storage technology is increasing.
Ryan: We believe the active M&A market for generation assets that started in 2010 will continue for at least two years. There will be an increasing focus on regional scale and fuel diversity. Financing will continue to be available, but balance sheets will need to remain strong to fund capex and accommodate market shifts. As a result, we don’t see excess financial leverage as an issue. Integrated utilities will continue to rationalise their portfolios by selling merchant assets and redirecting focus on their regulated business. Yieldco’s will continue to use their cost of capital advantage to be aggressive buyers of contracted assets, which will push prices up for contracted and merchant assets alike.
Ramos: We anticipate that for the remainder of 2014, and at least through 2016, we will see enhanced M&A activity across the board. We also anticipate M&A activity in other related sectors, such as hospitality, infrastructure, construction and telecoms. M&A in the power sector will revamp in 2015, once the market rules are issued and participants understand the new market structure. Existing self supply projects will need to reshape and refinance, opening the door to M&A activity.
Christopher Ryan joined Beowulf in 2002 and has over 20 years of corporate finance experience. Mr Ryan is responsible for the structuring, financing, monitoring and disposition of Beowulf’s investments. Prior to joining the Beowulf team, Mr Ryan was a partner in the financial advisory business of Evercore Partners, and an investment banker at Morgan Stanley and Lehman Brothers. Mr Ryan holds a B.A. from the University of Pennsylvania. He can be contacted on +1 (212) 343 8353 or by email: ryan@beowulfenergy.com.
Hermenegildo Altozano heads Bird & Bird LLP’s Energy & Utilities practice in Madrid. He specialises in energy, advising on transactions and projects in Spain and Latin America, and provides investment protection and arbitration advice in relation to Latin America. Mr Altozano advises Spanish and international companies on energy projects in Spain as well as in other countries. He has deep industry experience and understanding of not only the legal but also the commercial issues that challenge his clients’ business objectives. He can be contacted on +34 91 790 3202 or by email: hermenegildo.altozano@twobirds.com.
Carlos Ramos Miranda is a partner in the Mexico City office of Hogan Lovells, advising clients on general corporate, energy and insurance matters. Mr Ramos has extensive experience in the energy industry, where he has advised a wide array of clients in the oil, gas and power sectors. He was part of the team that assisted Pemex to implement the Multiple Services Contracts and thereafter incentivised contracts. He can be contacted on +52 55 5091 0172 or by email: carlos.ramos@hoganlovells.com.
Fintan Whelan co-founded Mainstream Renewable Power in February 2008. He is corporate finance director where his role includes creating a direct opportunity for investors seeking exposure to the construction and long-term operations phases of Mainstream’s three offshore wind projects in the North Sea totalling over 7.5GW. Mr Whelan qualified with a Commerce degree from University College Dublin in 1978. He is a Fellow of the Association of Certified Accountants (FCCA) and in 1996 received an MBS in Finance from UCD’s Smurfit School. He can be contacted on +353 (0)1 290 2003 or by email: fintan.whelan@mainstreamrp.com.
Charles Peterson is a partner at Pillsbury Winthrop Shaw Pittman LLP. After employment as an NRC licensed nuclear reactor operator, he became the CEO of the world’s largest uranium trader. He is a graduate of Stanford’s Law and Business schools. He has worked in Japan, Russia, UAE and Saudi Arabia. He can be contacted on +1 (650) 233 4883 or by email: charles.peterson@pillsburylaw.com.
© Financier Worldwide
THE PANELLISTS
Christopher Ryan
Beowulf Energy LLC
Bird & Bird LLP
Hogan Lovells BSTL, S.C.
Mainstream Renewable Power Ltd.
Pillsbury Winthrop Shaw Pittman LLP
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