- While project finance transactions are generally structured to provide protections to lenders, some term loan Bs (TLBs) in the merchant power sector have exhibited creditor terms that may result in prioritization of equity over debt,
- We view transactions in which lenders have the ability to reject cash flow sweeps as risky for credit quality because short-term gains could lead to long-term credit pressure if markets are weak close to the refinancing period.
- A combination of credit protections can partially mitigate speculative-grade TLB credit risks such as power price volatility, fluctuating interest rates, and refinancing challenges.
- While amendments and extensions to TLBs can provide relief when market conditions are weak, upsizing facilities for distributions are negative for credit quality overall, generally leading to downgrades, outlook revisions, and/or a reassessment of recovery ratings.
- We continue to view cash flow sweeps as the strongest indicator of a project's financial performance when it comes to evaluate how a transaction is performing.
Cash flows in the merchant power generation sector are generally volatile. They can be influenced by extreme or mild weather, regulations, the retirement of inefficient or uneconomic units, and intermittency of renewable generation. Project-financed power assets are typically financed with term loan Bs, which usually involve a 1% mandatory principal repayment over seven years, and a likely need to refinance by its maturity date. Projects financed with TLBs are typically single assets or portfolios of power generation facilities with revenue lines that depend on merchant power prices, and/or capacity prices. The regional spread of projects that we rate is vast, spanning the Pennsylvania, New Jersey, Maryland (PJM) Interconnection LLC, Independent System Operator (ISO) New England Inc., the New York ISO Inc. (NYISO), and the Electric Reliability Council of Texas (ERCOT) market. We also rate project-financed assets in the California ISO (Cal-ISO).
We have observed that term loan B structures can still be aggressive on distributions to sponsors even when protections are embedded in the agreements, which can sometimes affect a project's credit quality and--ultimately--its rating. Here, we assess the nature of term loan Bs and recent approaches to risk that both sponsors and lenders have been incorporating in the agreements.
What is a term loan B?
- TLBs were introduced in industries with volatile cash flows as a self-help approach to financing. They're typically seven-year loans structured so that only 1% of the principal is amortized on an annual basis. This feature mitigates the risk of default of putting a high fixed amortization profile against cash flows that vary substantially year over year.
- As such, TLB agreements often include a cash flow sweep mechanism that requires projects to apply excess cash flows to pre-pay debt after annual project-related costs are covered. If there are no free cash flows, then no sweep occurs, and the project will need to pay only the mandatory interest, plus 1% annual amortization. In essence, the premise of a TLB is to swap default risk for refinancing risk. Given that power prices are subject to varying economic cycles, and because of the capital structure of most project financings, TLBs typically reach their maturity date with a debt amount that needs to be refinanced (ideally less than 50% of the original amount), and this is often refinanced with another TLB.
- TLB debt is similar to bank debt but sold to the institutional market. The documents comprising a TLB are similar, but borrowers in the TLB market tend to have fewer occasions when sponsors needs to come back to the lenders for approvals. A TLB facility is written so that the interaction between the holders of the term loan and the borrowers is limited.
- Additionally, given their speculative-grade credit profile, TLBs are important for capital formation in the collateralized loan obligation (CLO) market, in which lenders also consider the project's collateral value (in case refinancing isn't possible or there's a default) and not just its operating cash flows.
Cash Flow Sweeps
Not surprisingly, we view projects that sweep as much cash as possible as positive for a project's credit quality. Typically, TLB transactions include cash flow sweep mechanisms that range from a 50% cash flow sweep to a 100% cash flow sweep. However, there are often other triggers to sweep such as target leverage profiles. For example, if a project's leverage is above 3x, it may be required to sweep 75% of its free cash flows, and if it drops lower than 3x, terms may soften to allow it a smaller 50% of its free cash flows, with the residual typically going to sponsors as a distribution.
This is because to refinance its debt, projects must show a sustainable capital structure with a track record of successful operating and financial performance. If not, sponsors will need to add more equity to make the refinancing viable, or lenders will require a higher premium, or they could even pull out of the deal. When structuring deals that will have to be refinanced, projects and investors are exposed to cash flow uncertainty, as well as interest rate risk (e.g., when projects were financed in 2020 and 2021, LIBOR rates were about 1%; it was hard to imagine that by 2023 the benchmark rate (now SOFR) would be greater than 5%).
We view the rejection of cash flow sweeps as credit negative, adding long term uncertainty and financial pressure to projects. Lenders sometimes decline cash flow sweeps, even if free cash flows are available, because they may decide to collect the high interest rate on the higher debt outstanding rather than receive more principal payments (TLBs typically have floating-rate interest). This "option to decline excess cash flow prepayment" is specifically included in the financing documents of certain projects we rate (not all). While we don't judge lender's decision to do so in our analysis, our ratings represent our opinion of a company's or project's ability to fully repay its debt, and there's an implicit probability of default incorporated within our rating assessment.
As such, we consider an option to reject cash flow sweeps as negative from a credit standpoint because the project won't be able to de-lever in periods of strong cash flow generation, adding long-term uncertainty about its credit quality. In fact, a project not sweeping as expected (whether due to lenders' rejections or other reasons) will have future lower debt service coverage ratios (all else equal given the higher principal and therefore interest to pay), and higher outstanding debt to refinance, which could lead to downgrades. We view that when a project has market tailwinds such as a high power price environment, it should use it to delever as much as possible, as it will be better positioned in the future to navigate periods of weak market dynamics (within the 7 years of the TLB life, we expect strong and weak periods to typically balance each other).
If power prices decline, operational issues occur at power plants, or interest rates rise, then future free cash flow generation will drop and lenders will face the risk of receiving minimal sweeps before the TLB maturity date. It is easier to predict events when we shed the preciseness associated with that event. We know that unexpected events happen, even as we don't know when they will happen. For example, recent winter storm Elliot in the PJM region affected several projects, preventing them from dispatching power as requested. This failure resulted in large penalties by the PJM regulator. We downgraded projects such as Elwood Energy LLC and Parkway Generation LLC by multiple notches following the storm due to the penalties received and their need to use operating cash flows to pay those sanctions rather than sweeping cash. This resulted in a higher-than-expected debt balances when the TLBS matured.
These types of events create uncertainty about a project's capital structure when it comes time to refinance. Investors could pull out of the transaction, ask for a higher margin, or sponsors will need to add equity to make the refinancing viable. For example, we have included as a downgrade trigger situations in which lenders decline sweeps and we don't see a benign market environment, as happened with the recently launched transaction Generation Bridge Northeast LLC (see Generation Bridge Northeast LLC Term Loan B Assigned Preliminary 'BB' Rating (Recovery Rating: ‘1’), published July 27, 2023).
When a TLB is issued, most of the proceeds go to refinance existing debt and fund working capital or reserve accounts, but often a portion is distributed to the project sponsors. These distributions can be more or less aggressive depending on the characteristics of the sponsor (usually a private equity entity, asset manager, or an infrastructure fund).
We're also sometimes presented with what we consider "equity" scenarios rather than "credit" scenarios, in which sponsors present a case in which debt is fully repaid before maturity dates with no need to refinance, because assumptions with relatively strong power prices, high capacity prices and no upsizings envisioned; . However, over the past several years, no single TLB we rated was fully repaid with operating cash flows before maturity (though full repayments have occurred with refinancings or sponsors selling the assets for monetization purposes). Moreover, we typically see that after a few years of good financial performance and some deleveraging, or when interest rates are low, sponsors upsize the TLBs by refinancing the project, amending the existing loan, or requesting a waiver from lenders.
Similar to the ability to reject cash flow sweeps, lenders often take a more benign view of market volatility and accept an upsizing of the transaction in the midst of the seven-year term. We see this more often for transactions were lenders have greater comfort with the estimated loan to value ratio. .
While upsizing loans for distributions are by definition negative for credit quality because they add debt to a transaction without adding any operating cash flow (which is different from upsizings whereby the project uses proceeds to make an asset more efficient or extend its life), most of the transactions include covenants that limit additional debt. Nevertheless, sponsors find ways to get distributions from the project structure by fully refinancing (even though it may result in a downgrade), requesting waivers from lenders, or maintaining the rating despite upside rating potential due to deleveraging in the past years.
Some examples of prioritization of equity over debt that resulted in rating actions or recovery or outlook revisions include:
- Invenergy Thermal Operating I: The project issued a $350 million TLB in 2018 and then upsized by $75 million in August 2019 after lenders approved an amendment to the financial documents. We affirmed the 'BB' issue-level rating with a stable outlook although the project had a lower financial cushion following the close of the transaction. In October 2023, the project changed its portfolio composition and fully refinanced again, which included a $37 million distribution to sponsors. We then downgraded the project to 'BB-' with a stable outlook, given the increase in leverage and uncertain market conditions, as well as weak capacity prices in the PJM market.
- Parkway Generation LLC: After raising $1 billion in April 2022 for the acquisition of a portfolio of eight power plants, the project upsized its TLB by $75 million in November 2022 to fund a distribution to sponsors. Following the transaction, we revised the rating outlook on the project to negative from stable and affirmed our 'BB' debt rating based on our assessment of weaker capacity prices and increased debt.
- Carroll County Energy LLC: In October 2020, the project upsized its outstanding $409 million TLB by $25 million to fund a distribution to its sponsors. While we affirmed the project's 'BB' rating at that time, we revised the recovery rating to '2' from '1' reflecting that under a distressed situation and a default, the recovery for senior lenders would be lower.
- Frontera Generation Holdings (no longer rated): A project that originally raised debt in March 2018 ($700 million), upsized by $75 million a few months later (October 2018) for a distribution to sponsors, plus used $50 million that was on the project's balance sheet for a distribution to sponsors. Two years later, in October 2020, the project defaulted after missing interest payments due to a sharp decline in power prices stemming from the fallout from the COVID-19 pandemic, and diminished liquidity because its revolving facility was fully drawn.
- Nautilus Power LLC (formerly North American Energy Alliance and Essential Power LLC): This project originally raised its debt in the 2008-2009. We initially rated the project 'BB+', but it was downgraded over time after some ineffective hedges, cash flow sweep underperformance, and upsizings (one in 2017, and another in 2019). We lowered the senior TLB to 'D' in 2023 after the project was hindered by a PJM penalty. It executed an amend-and-extend transaction in which the nonextended tranche became subordinated to the new senior one. While the sponsor injected equity into the transaction to make the amend and extend viable (98% of lenders agreed), the project was previously re-levered for distributions when the markets were favorable.
- St. Joseph Energy Center LLC: This is a single asset power plant located in the PJM region, which we originally rated 'BB' with a stable outlook in 2018. Its TLB, which initially had a 70% cash flow sweep mechanism, was revised to 50% in 2019. Consequently, we downgraded the project to 'BB-' with a stable outlook, reflecting expectations of lower cash flow sweeps and a higher debt amount at maturity date.
Lackawanna Energy Center LLC, Invenergy Thermal Operating I, and Generation Bridge Northeast recently issued TLBs with six-year maturities, one year shorter than typical for the industry. The main reason for the shorter maturities is that many project financings later become part of a CLO. Their indentures require a weighted average life of the portfolio. Currently, around 40% of syndicated CLOs are coming out of their reinvested period, and with tightening weighted average life constraints and limited ability to add longer-term collateral, the economics have shifted such that a six-year loan is more appealing to issue than a seven-year loan given the larger investor base. Generally, shorter maturities pressure projects to demonstrate financial viability sooner, with the aim of reaching the refinancing date with a good track record. In other words, they have six years to show prudent deleveraging rather than seven. However, we don't view the one-year difference as significantly detrimental to credit quality in our rating analysis.
A combination of several deleveraging requirements will add a layer of credit protection. For example, a TLB can be structured so the sweep percentage will increase if leverage is above a certain threshold, or it will include a target debt balance (i.e., there is an annual target balance and the project must sweep a higher percentage of free cash flows if outstanding debt is higher than the target balance by that period.
A recent transactions included such terms:
- Invenergy Thermal Operating I LLC TLB: Here, the cash flow sweeps are governed by a target debt balance for each of the following six years until maturity: $280 million in 2024, $260 million in 2025, $225 million in 2026, $200 million in 2027, $175 million in 2028, and $160 million in 2029. The project is required to sweep the greater of the amount required to achieve the target debt balance or the leverage ratio for the most recently ended measurement period. If the leverage is above 2.5x, the project is required to sweep 75% of excess cash flow sweeps and 50% otherwise.
Even Though Project Financings Are De-Linked From Sponsors Credit Quality, Financial Policy Matters
When markets are strong (e.g., high energy margins, high power prices on the forward curve, relatively low interest rates, etc.), project sponsors, and sometimes lenders, can prioritize equity over debt, even when the project finance structure has a layer of credit protection that corporate financed entities do not have in their financing documents (i.e. corporate financings don't typically have a cash flow waterfall, distribution tests, limitations for additional debt, etc.)
In favorable markets, such as when power prices are high and interest rates are low, or there's a possibility to hedge spark spreads at high prices for the upcoming years, it is our view that the most credit-protective thing to do would be for a project to sweep as much cash as possible. This is because TLBs have a tight payment horizon and there's always a possibility that a negative or unexpected event will occur. We note that oftentimes periods of high cash flow sweeps are followed by an upsize for distributions, sometimes returning to almost the same level of original leverage. From a credit standpoint, the higher financial discipline a sponsor shows, the better their projects will be able to weather depressed periods or unforeseen detrimental circumstances.
This report does not constitute a rating action.
|Primary Credit Analyst:||Diego Weisvein, Englewood + 1 (212) 438 0523;|
|Secondary Contacts:||Aneesh Prabhu, CFA, FRM, New York + 1 (212) 438 1285;|
|Viviane Gosselin, Toronto + 1 (416) 5072542;|
|Vania Dimova, New York + 1 (212) 438 0447;|
|Luqman Ali, CFA, New York (1) 212-438-0557;|
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