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Moor power
US Energy Systems raised the first ever B loan for a power asset outside the US. Behind this benchmark lies a business plan that focuses as much on gas sales as power. Tom Nelthorpe talks to CEO Asher Fogel and senior vice-president Adam Greene about the Ryedale acquisition.
Term B loans are a peculiarly US instrument. While they are a testament to the inventiveness and depth of the US capital markets, they are also a reflection of the limitations of the US bank lending market. The leveraged finance market in Europe has thus typically been a community of banks.
Examples of B loans raised against non-US infrastructure assets, particularly those that are not valued in US dollars, are few. International Power and Mitsui considered using one when they bought Edison Mission's international generating portfolio. Mirant will raise a B loan through Credit Suisse against its generating portfolio in the Philippines before then selling it.
In August, though, US Energy Systems (USEY, according to its stock ticker symbol), previously best known as a developer of biogas and environmental power facilities, closed a $143 million B loan to finance the acquisition of the 42MW Knapton power project and 62.4 billion cubic feet of proved and probable gas reserves in England. The Credit Suisse-led financing, which closed on 7 August, is a rarity, and reflects a business that is much more about the production of natural gas than power.
There's gas up North
The United Kingdom's onshore oil and gas production industry enjoys a long pedigree but is insignificant next to the country's offshore production assets. Oil and gas was discovered in Eskdale in north Yorkshire in the 1930s, and in the 1970s, Canada's Home Oil developed the fields around Pickering, on the county's moors, with the aim of producing 100 million cubic feet per day (cfpd). The reserves are an extension of the Southern North Sea Gas Basin onshore.
The UK's gas industry was then nationalised, and its electricity largely came from burning coal. The gas proved to have a slight sulphur element, which was initially treated using Belgian arsenic-based technology. It also produced at most 65 million cfpd, and when the operator encountered higher water levels, and production dropped down to 36 million cfpd, the reserves were abandoned. The arsenic treatment technology was also removed.
In the 1990s the developer CeltPower took control of the six licenses to produce gas in the area and proposed to Scottish Power that it build a power plant close by and produce electricity with the gas from the reserves. The agreement had the advantage that the owner of the gas would not have to install costly compression equipment, and Scottish Power agreed to build the power plant.
The most important aspect of the project was that Scottish Power agreed to buy the gas at the cost of £0.10 per therm (equivalent to £1 per million BTU, or $1.87 at today's rates). This price, a reflection of the lack of alternative markets for the fields' gas, is less than half the present level in the UK. While the Knapton plant has a high heat rate, of roughly 12,000 BTU per kWh, compared to 6,500 for newer units, and is thus a little inefficient compared to its peers, the gas contract became even more lucrative for Scottish Power as prices edged up.
Independent, but taking liberties
Tullow Oil, then a junior independent, expanded its stake in the gas assets from 14% to 60% in late 1999, took over operation of the power project, and while constrained by the low contract price, wanted to explore raising production levels. The other investor in the assets was Edinburgh Oil & Gas, which had held 23% of the licences, but increased its stake to 40% at the same time as Tullow. But when Tullow bought BP's reserves in the North Sea, and the Knapton plant experienced an extended outage in 2002, it decided to move on.
In 2003, Tullow and Edinburgh sold their interests to Viking Petroleum, which paid $8.3 million in October for Tullow's stake and £3.2 million in December for Edinburgh's stake. Viking had a good idea of the potential that the reserves held – by this time technology and access to capital for juniors had become much more sophisticated.
It needed to raise sufficient capital to cover the purchase and develop the reserves, and closed $40 million in financing from TCW's Global Project Fund II in 2003. The new owner attempted to install some upgraded compression technology, which would have increased gas flow from the fields, but was unable to obtain cheap and certified technology quickly enough. The producer defaulted, and TCW and ScottishPower began legal proceedings as TCW tried to end the below-market gas contract.
Enter USEY
In July 2005, Adam Greene, then a managing director at Marathon Capital, travelled to Yorkshire to look at the assets, and to Glasgow, where Scottish Power is headquartered, to talk about their potential sale. Marathon was a small investor in US Energy Systems, which had recently been taken over by a group of investors and management that included its new CEO Asher Fogel, a former colleague of Greene's.
US Energy owns a portfolio of 22 biogas plants that are currently the subject of a leveraged financing from the Countryside Income Trust. The developer subsists on the residual dividend from these assets, and some of its previous management, including chairman Lawrence Schneider, remain. Convertible series C stock holders Bernard Zahren and Frederic Rose, had filed suit against current management and current and former directors, but dropped this in return for grants of common stock.
But the Yorkshire assets offered a solid opportunity, providing the contract could be restructured. As Greene notes, "there was a lot of interest in the gas reserves. But very few of the buyers were looking at the assets as a contract restructuring before the acquisition." In starting the process by meeting Scottish Power, the prospective acquirer viewed coming to terms with the offtaker as key to restructuring the portfolio.
The gas in the reserves was yielding such a low price that any buyer would find it difficult to justify spending any great amount of capital upgrading the gathering and compression technology. Scottish Power had a relatively cheap, but intermittent, source of power. USEY's pitch was that the offtaker could secure greater supplies of gas and power so long as it was prepared to pay a higher price for them.
This bargain is at the heart of the acquisition and refinancing. It enables the buyer to raise a greater amount of debt against the assets, and to invest in additional pipeline and gas gathering infrastructure. USEY and Scottish Power reached a tentative agreement on the acquisition and the necessity of a higher contract price by the end of 2005.
The UK Energy Systems acquisition structure
Resources large and small
But, USEY is, by CEO Fogel's admission, a small company. "We took over a company sitting on roughly $14 million in cash, and wanted to grow the business. The background of the new management team lies more in investment banking and restructuring than in project development. We wanted to put in place a financing that gave us sufficient time to bring the assets' production up to higher levels."
The buyer engaged Credit Suisse as financial adviser in November 2005, and by March 2006 was able to announce an agreement in principle to buy the assets, and bring a halt to the litigation. The two sides had agreed to place the case in expert review while the process went forward.
The buyer spent roughly $7 million developing the prospects before reaching financial close, and was able to provide a $400,000 deposit to Scottish Power to secure the power project. The sum was small, but it at least convinced the offtaker that the buyer was serious during the period of renegotiating the gas and power agreements. These were not finalised until the end of June 2006.
The new agreement calls for Scottish Power to buy all of the electricity that the plant produces, and all the gas from the reserves, at a 7% discount to the reference UK pool price, up to a certain quantity, equivalent to 67 billion cubic feet, and then at a 5% discount. The agreement expires in 12 years, or when Scottish Power has taken 100 billion cubic feet, whichever occurs first.
In the interim, USEY also finalised the due diligence necessary to convince both lenders and prospective counterparties that its faith in the potential of the Yorkshire properties was well-placed. It hired PB Power as independent engineer, and initially hired Helix RDS to produce reports on the gas resource, before the requirements of the US lending market, and Helix' business book, led the buyer to hire Gaffney Cline to finish the job.
The current proven reserves at the sites of the six licences are 46 billion cubic feet, while proven and probable are 63 billion cubic feet. Scottish Power was thus able to lock in the discount for much more than the current probable life of the reserve. This probably gives up much more of the upside than USEY would have liked, but still makes the assets financeable. The cost of the purchase, which closed at the same time as financial close on 7 August, was $70 million, which bought up $40 million in TCW debt as a tax-efficient means of taking control of 65% of the gas assets, and $29.6 million for the station and 1% of the gas licenses.
Hedge held
US Energy, then, is exposed to commodities risk, as well as currency risk, since the buyer is located and listed in the US. Credit Suisse, which slipped into a lead arranger role in March 2006, and has a deserved reputation for financing unusual, and potentially risky, energy assets, thus had to assemble a debt issue around these twin risks.
The debt featured three additional enhancements, including a standard interest rate hedge from Credit Suisse. The debt benefited from a cross-currency hedge that locks in an exchange rate of $1.905 to £1 for three years, and the two hedges have an upfront cost of $7 million, with an additional $20 million due after three years if it decides to extend the hedge. The interest rate and currency hedges come from Credit Suisse.
The final hedge is a little more unusual – and is required to bring the Knapton station up to full operation. The Kyoto-mandated emissions allowance for the plant was set when it operated at a much lower level. Running it continually will require the purchase of additional carbon credits, and in return for a fee of under $1 million Credit Suisse has thus agreed to sell the project credits to make up the shortfall at a fixed price for 2006 and 2007.
The commodity risk is mitigated through a put option with Goldman Sachs' J Aron commodity trading arm, which insulates the producer from prices slipping below the levels necessary to service the debt. This hedge has an electricity floor price of £43.75 per MWh for three years, and a gas floor of £3.41 per million BTU. The hedge is expensive (it costs roughly $15 million), but raising the necessary debt, and achieving USEY's desired leverage, depends on it.
Making strong margins is unlikely to be difficult, however, since as Greene notes, "we acquired the proven and probable reserves at roughly $1.20 per million BTU, but the 3-year forward day ahead strip price in May was approximately $12.80 per million BTU." Nevertheless, the UK market is comparatively illiquid – the result of troubles earlier in the decade with high-profile traders such as Enron and TXU. While 2 or 3 counterparties pitched to provide USEY with a hedge, and power prices are usually set with reference to the price of gas, the market than still has the potential for volatility.
The restructuring of the UK power market followed a path that was, if anything, more convoluted for the US developers. The introduction of the new electricity trading arrangements caused the collapse of several UK merchant financings, and while assets recovered relatively quickly, not before making some banks and hedge funds substantial sums, lenders are still wary of the sector.
Debt dialling
The putative term sheet from interested project lenders demanded that any buyer spend more equity upfront on the assets, and surrender even more of the plant's potential improvement to lender economics. It was, according to Fogel, "not a very interesting way to finance the assets, nor something that would have been in accordance with our business model."
The B loan market offered the buyer a chance at high leverage and flexibility in repayment terms. The resultant debt package breaks down into a $113.5 million first lien loan due 2013, and a $29 million second lien facility due 2014. The J Aron hedge will provide sufficient cashflow for both facilities, with their split determined largely, says Fogel, by the financing model. The first lien loan has an initial interest rate of 11.5%, equivalent to 550bp over Libor, while the second has an initial rate of 14%. The lenders also receive an additional 6% in capitalised interest.
The terms are generous to lenders, the more so compared to current norms in the B loan market, but initial feedback from the market suggested that lenders wanted USEY to contribute more equity. According to Greene, "two hedge funds, Kenmont and Silver Point, were already looking at the deal, Kenmont at the debt and Silver Point at the equity, and agreed to provide a $23.3 million loan at the holding company level." This loan carries warrants allowing the funds to convert them to common stock, and carries an initial interest rate of 10.5%, with all interest capitalised. It is secured on all assets of USEY, except for those pledged to lenders to the Biogas assets and the UK assets on which the first and second lien lenders have security.
The pressure on the buyer to refinance the debt is strong – to maintain its shareholding, US Energy management will try and refinance the loan once it has brought the fields up to higher levels of production. Says Fogel, "once we have brought the Knapton project up to a level where we are running on a normalized basis it at close to (24-7 at 85% to 90% availability) and more of the PUD's are converted to PPD, we will look for better terms in the capital markets. We have always viewed this financing is very much a bridge."
Moreover, the debt was not rated, an unusual step to take for a loan pitched to B lenders. The move may have decreased the number of investors that could look at the deal, particularly the more conservative money market account managers and loan funds. But hedge fund interest, especially at the yields on offer, was enough to fill the underwriter's book, and according to Greene, "the time and expense of a rating would not have given us substantial benefits in pricing."
Forward focus
For the foreseeable future, USEY's focus will be improving the performance of the current assets, and building out the infrastructure necessary to exploit the gas reserves more fully. The long-awaited compressor arrived on site, and is now being installed, and the new owner will now have to upgrade the gathering technology for the northernmost fields and build a pipeline to connect the assets to the UK's gas transmission grid.
In all, USEY will spend $24 million on improvements at the fields, including connecting up non-producing fields that lie 14km north of the gathering system, and a 4km extension to the portfolio's 30km of pipeline to link it to the grid. Getting the size of the pipeline right will be a challenge – few contractors have the expertise to complete it, and the dimensions of the project will be governed by the amount of gas that the owners believe can be extracted from the fields.
At present every single therm of gas goes towards fuelling the Knapton project, but in time the plant will likely be run as a peaking unit. The 42MW project uses relatively new GE LM600 technology, and has not been run for too long – and the manufacturer's technicians are currently working on the plant with the aim of bringing its heat rate below 11,000. But elsewhere in Scottish Power's roughly 6GW generating fleet there are units that will burn USEY's gas much more cheaply.
USEY now contemplates two refinancings – for the UK portfolio and for the biogas plants. Silver Point, Kenmont, VTEX Energy and Credit Suisse have all received warrants in return for their assistance in closing the financing, and USEY will be looking to pay them down. In the cases of Credit Suisse, this will cost $1.125 million, and in the case of Kenmont just over $6 million.
UK Energy Systems
Status: Closed 7 August 2006
Purchase price: $70 million
Location: North Yorkshire, UK
Description: 42MW peaking power plant and six gas licenses with P2 reserves of 63 billion cubic feet
Sponsors: US Energy Systems, Marathon Capital
Senior debt: $144 million
Sole underwriter and financial adviser: Credit Suisse
Convertible subordinated debt: $23 million
Subdebt providers: Kenmont Capital and Silver Point Finance
Independent engineer: PB Power
Reserve consultants: Helix RDS, Gaffney Cline
Pipeline consultant: AMEC
Gas and power consultant: Tradelink Solutions
Insurance consultant: Moore-McNeill
Insurance broker: Aon
Environmental consultant: ECUS
Borrower's counsel: Hunton & Williams, Pinsent Masons (local)
Underwriter's counsel: Shearman & Sterling
Subdebt providers' counsel: Skadden Arps
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