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Fund wizards from Oz at work in wind

Just five short years ago the wind sector had little idea of where the money would come from to propel it from cottage industry to mainstream power supplier. The arrival of fund manager Babcock & Brown as a major player in the wind sector demonstrates just how far the business has come in the eyes of institutional investors theworld over

In less than two years, fund manager Babcock & Brown has become the world's fourth-largest wind power generator and certainly the most geographically diverse, with a global portfolio of interests in 1320 MW of operating and nearly completed wind farms across North America, Europe and Australia. The investment company's willingness to not just buy-up finished wind projects, but also take on at least some of the risk of developing them, gives it a distinct identity in the general swell of burgeoning financial investor interest in the wind sector. Its involvement at the development stage of projects also underpins the viability of Babcock & Brown's overall wind power business model.

Although the world's fourth largest wind plant owner, Babcock & Brown is not in the same league as Iberdrola of Spain and US generator FPL, the sector leaders for the past several years. They again tied for first place at the close of 2005 with just over 3260 MW each, according to the annual global ownership ranking published by Emerging Energy Research (EER), an American consultancy. But according to EER's tally of 1100 MW of operational plant, Babcock & Brown is not that far behind third-placed Spanish industrial group Acciona with 1227 MW. It is a meteoric rise for a company that did not even figure in EER's top 20 for 2004.

Global portfolio

The big push into wind came after Babcock & Brown converted itself into a publicly-held entity with an initial offering on the Australian stock exchange, the ASX, in autumn 2004. Since then it has rapidly built up a global portfolio of interests from practically zero. These include investments in 16 wind farms with a combined capacity of 698.6 MW which are held by the Babcock & Brown Wind Partners (BBWP) vehicle, which the company listed as a separate entity on the ASX in October 2005 (Windpower Monthly, November 2005). It is the first pure-play global wind fund yet to see the light of day. The BBWP portfolio currently contains the Lake Bonney 1 and Alinta wind farms in Australia, the Sweetwater 1 and 2, Caprock, Combine Hills and Blue Canyon wind farms in the US, the Olivo portfolio of six wind farms spread across Spain and the Niederrhein and Eifel wind farms in Germany. While BBWP enjoys practically 100% ownership across all the Australian and European assets, stakes vary between 40-64% on the US wind plant, putting the fund's actual net equity-owned wind capacity at around 523 MW.

The remainder of the Babcock & Brown wind business is currently held by the listed parent company, or BNB as it is known under its ASX ticker code. These BNB-held interests include the roughly 500 MW portfolio of wind farms Babcock & Brown gained with the acquisition late last year, in a EUR 1 billion deal, of Portuguese renewable energy company Enersis (Windpower Monthly, January 2006). It also recently acquired an interest in US wind farm development partnership G3 and it has a half-share in the 70 MW-plus Ulassai wind project development joint venture in Sardinia, Italy, with local refinery group Saras. The word "currently" is important, as the nature of the ongoing relationship between BNB and BBWP is at the heart of the Babcock & Brown wind power business model.

The business model

Publicly-listed BBWP is not actually "owned" in a majority sense by BNB. Parent Babcock, however, holds a significant minority interest in the vehicle through being the pre-existing investor which transferred to the fund prior to floating practically all its current wind assets, apart from Eifel, which was bought from another Babcock & Brown-controlled company around the turn of this year. Babcock-controlled entities currently hold 35% of BBWP. Of this, BNB has 18.5% and another of its listed funds, Babcock & Brown Infrastructure Group (BBI), 16.5%.

Regardless of actual ownership, BBWP is nevertheless completely controlled in day-to-day terms by BNB, its manager with responsibility for all decisions regarding the fund itself and the assets held by the fund. With BBWP, Babcock has replicated a model it has successfully instituted in other sectors -- such as BBI for public infrastructure, including conventional power generation and transport assets, and Babcock and Brown Environmental Investments (BEI) for the non-wind power environmental sector.

Under this model, BNB leverages the several decades of experience it built up prior to its listing as a financial advisor, debt arranger and investor specialising in "hard" infrastructure such as property, power plants and transport assets. It selects suitable assets for the funds it manages, financially re-engineers the assets upon acquisition into what it sees as the optimum capital structure and then manages them on behalf of the funds. In return for generating a suitable return for fund investors, BNB is paid management and performance fees, these fees being the bread and butter of the parent company's business overall.

Predictable and long term

Underlying this model is a presumption in favour of assets generating predictable long term revenues. This stability is a strong base for standard financial re-engineering ploys, such as increasing the amount of debt attached to an asset to boost the return on the remaining equity interest, or gaining economies of scale in terms of loan pricing as dictated both by size and risk through bundling previously separately owned assets into a single, cross-collateralised portfolio. Anything offering a regulated, utility-type cash flow is grist to the mill -- for that reason wind power is a good investment class.

The increasing interest of a wide range of financial investors in what are often essentially government-backed revenue streams attached to wind power assets is now well-noted across the industry. BNB is not alone in its approach to infrastructure asset-based funds in general. Its fellow Australian player, Macquarie, is perhaps the best-known exponent, with a range of funds holding investments ranging from toll roads through to ports, airports and power and gas distribution networks, to wind power. On the occasion of the BBWP listing on the ASX, one Australian newspaper described BNB as "looking more and more like a junior version of the Macquarie Bank fund fee factory." The description was not intended as a compliment.

The crucial difference

Babcock management disagrees. It maintains that in wind power, in particular, its offering is in a completely different league because it is willing to take development risk. This differentiates the BNB wind power business model from that of other fund-type players in crucial respects. While funds are keen to leverage the predictable regulated incomes accruing to wind farms when they are operational, they are in general not so keen to take the quite significant risks associated with bringing projects through the development phase from conception to construction. Most will buy assets in the secondary market once completed and operational, or perhaps in construction if they have already been funded and the engineering and other associated risks are contractually parcelled-out to other parties.

BNB in contrast will take development risk, which it feels eminently qualified to do due to a long pedigree in the business, having been involved in the sector since the early wind farms in California more than two decades ago and more recently through both various advisory roles and development phase equity participations, not just in the Sweetwater and Lake Bonney developments, but also in the Robin Rigg offshore wind station in Britain, the Finven wind project portfolio in Italy (which was sold to Spanish utility Endesa prior to construction) and the Ulassai project on Sardinia.

The risk is only accepted at the level of the parent, BNB. The BWPP vehicle, more in line with other fund players, buys into projects when they are ready for construction or are beyond that stage. There is a deliberate symbiosis between the two activities, which is key to understanding the Babcock & Brown's wind power business model. Essentially, the thinking is that practically all wind power assets which BNB holds or buys into going forward will in due course be passed on to BWPP, with BNB profiting both from the sale price it realises on transferring the assets to BWPP and then subsequently from managing the same assets as part of BWPP.

Not entirely incestuous

An independent assessment will decide whether or not BWPP should buy the assets proposed to it by BNB and also the price at which assets will be transferred. On approved transfers BNB will reap reward from adding earlier stage value, either through having funded the project through the riskier development stages or having bought it from someone else and re-engineered their capital structure before passing it on. What BWPP buys from BNB is the equity interest in the wind farms, invariably a fraction of their total value as the bulk of the capital structure of the projects in question will be long term project financing, non-recourse to the equity shareholders -- secured just on the assets themselves with the banks having no claim on the equity owners if, for whatever reason, the project fails to repay their loan. There is some A$420 million -- equivalent of project debt currently attached to the BWPP portfolio.

BNB management is reticent on worked examples of the complete business model, simply confirming that the internal rate of return (IRR) it looks for as a hurdle to take projects on is in excess of 20%- -- unremarkable in terms of pricing development risk. Nevertheless, as a listed fund BWPP is predicated on delivering an annual yield to its investors somewhere in the 6-8% range on the basis of its A$1.40 per share initial offering price, currently on-track to deliver its first full-year target of a 7.25% yield.

An equity analyst tracking BWPP says that to achieve this level of dividend, distribution projects vested in the vehicle would have to average an IRR of around 13% on the price paid for their equity. BNB should be achieving an IRR through acquiring or developing the same projects and then selling them on to BWPP for at least 20-25%, but possibly considerably more, perhaps 30%-plus in the case of some Spanish assets. In terms of splitting the overall rewards of these wind power developments through their lifetime, he says there is "no doubt that BNB is getting most of the upside from these projects," particularly as it is continuing to reap rewards from management fees after the asset sale.

Nevertheless, there are clear benefits for buyers of BWPP fund paper from this set-up. One big one is that through the first refusal arrangement with BNB, BWPP benefits from a visible pipeline of projects to be offered to the fund: it does have to bid against other secondary market buyers for assets to keep growing. Secondly, as BNB retains an upside interest in the wind farms it sells on to BWPP through the performance and management fee structure, it is in its own interests to ensure that the financial engineering it puts in place on the assets and the prices paid for them do not compromise their ability to keep delivering the required IRR for the fund.

Inflated bids

BNB management believes the secondary market for wind farms is seeing some particularly inflated bids right now as players scramble to grab assets for strategic, as well as financial, motives. It is a game BNB cannot play due to the intended ultimate destination of the assets it is buying: "A trade player or a utility might need to do something strategically, but we would question how much substance there is to a lot of their figures. What we're going to do with the assets is transfer them into the fund, and we've got to transfer them in a very transparent way.... One of the worries we have right now is that people are getting carried away with what they are paying for assets, they're going to have problems as a result of that and this is then going to reflect on the whole industry."

There is also a positive flipside to the analyst view regarding how much parent BNB will gain from the development of wind farm assets compared to how much gain will be passed on to the BWPP vehicle. Whether fairly or not, Macquarie has been criticised for allegedly front-loading the benefits of the financial engineering it performs on the assets in its managed vehicles, supposedly deriving short term headline gain for its stable of infrastructure funds to the detriment of potential investor yields later on. Leaving aside the issue of whether this is true -- and there are plenty of analysts who disagree with the criticism -- B&B management says it has no need to boost fund performance in the short term at the expense of long term value precisely because it benefits from a second stream of revenues derived from the development phase business.

The model in action

The huge Enersis deal in Portugal really shows the BNB model in action. BNB completed the EUR 490 million acquisition of the Portuguese generator just before Christmas using some EUR 300 million of one-year non-recourse acquisition debt provided by Portuguese bank Banco Espirito Santo (BES). Including non-recourse project debt attached to the Enersis assets, mostly wind but also including some mini-hydro, the enterprise value of the company is seen to be around EUR 1.1 billion. In operational terms, the roughly 620 MW Enersis portfolio will remain united under its current local management, which came over to BNB as part of the acquisition and which Babcock cited as a major plus in the deal.

In capital structure terms, however, Enersis will be broken up. The mini-hydro assets will be transferred to the BEI fund, while in the second half of this year BNB intends to transfer Enersis' 500 MW wind portfolio to BWPP. BNB will go out to the project financing bank market this month to seek perhaps around EUR 500 million or so of non-recourse debt to refinance these assets, with this debt scheduled to reach close in tandem with the transfer of assets to BWPP. Importantly, the amount of debt attached to the Enersis wind farms will be significantly boosted from current levels.

The idea is that the new debt, plus the price BNB will be paid for the assets by BWPP, will in total be sufficient to both refinance the old wind farm debt and also pay back at least the portion of Enersis acquisition costs -- including the associated loan -- relating to the equity in the wind farms. BWPP is set to pay for its equity share of new assets both from the A$277 million of cash it has sitting in its capital structure as a result of the listing and also with corporate debt, debt in which lenders do have a claim on BWPP itself if they do not get paid. While BWPP currently has a corporate debt facility of up to EUR 30 million, with EUR 6 million of this already drawn, it is in negotiations to extend this facility to EUR 150 million.

Blazing a bond trail

Through financial engineering (optimising the amount of project debt attached to the wind farms), BNB will in effect have gained the rewards of acquiring Enersis and transferring its wind farms into BWPP "for free." Options for the new project debt include a bond, which would probably have to be guaranteed by a monoline insurer to assure potential buyers of its investment grade status. If a capital markets issue does result, this in itself will be a major innovation. To date only two such deals have been associated with wind farms in Europe and both were smaller. The transaction costs of bond issues make them uncompetitive with bank loans for small deals, but as capital requirements grow toward the level of the planned Enersis deal, they become more economic than loans as bond investors in general require slightly less return than banks.

The Enersis deal also offers jam tomorrow as well as today. BNB claims to have a pipeline of 3000 MW of projects to pass through to BWPP in due course. Enersis accounts not just for 500 MW of this in the near future through its actual assets, but also a further 400 MW of planned developments which BNB acquired the rights to when it bought the company; some 200-300 MW of this is planned for France. Following the BNB acquisition, Enersis is also participating in a consortium with Galp Energía, Martifer and turbine manufacturer Repower to compete in the Portuguese government's tender for 1500 MW of new wind power capacity, with La Caixa and BES backing the bid.

Projects lined up

The 3000 MW BNB-to-BWPP asset pipeline includes visible near term transfers, such as the Enersis tranche and upcoming transfers of assets under framework agreements BNB has struck with project developers. This year these deals will see BWPP gaining a fresh 70 MW of projects in Spain from Gamesa and a further 50 MW of assets in Germany from Renerco. Beyond these visible transactions, BNB claims on developments elsewhere in Europe include a further 300 MW or so from Gamesa, the Enersis pipeline, some 40 MW of projects in Greece and interests in various Italian joint ventures in Sardinia and Sicily with a combined capacity of up to 500 MW. Perhaps some 700-800 MW of the pipeline is set to come from outside of Europe.

Target markets for BNB, and by extension BWPP, are those which utilise fixed purchase price tariff-type remuneration regimes. These reduce market risk to practically zero and leave operational and technical risk as prime lender concerns, relatively easily mitigated by competent management and suppliers. This risk profile, rather than the more competitive "green certificate" market structures in countries such as the UK with its Renewable Obligation Certificates (ROCs), guides BNB's strategic acquisitions of renewable assets in Europe.

Italy is the exception to the rule and here BNB is exposed to a green certificate market. Importantly, however, the Italian green certificate market is seen as more fungible than the UK ROC market and for this reason more suitable as a basis for structuring deals. By fixing a floor price for the green certificates, Italy's grid operator, GRTN, effectively removes much of the risk for investors. In the UK, ROCs have yet to bed down in a fungible, commoditised fashion and the transparency and stability of ROC pricing is questionable.

So good so far

Babcock & Brown's business model has so far held its ground. While BWPP listed at A$1.40 per share in October, by the end of last year this price had risen to A$1.76, meaning the vehicle's market capitalisation had grown from A$692 million initially to A$870 million. As a result of the performance incentives, which specifically reference gains in the security price over the ASX all-share index, BWPP ended up owing BNB an incentive fee of A$33 million, which pushed the BWPP vehicle into an operating loss of some A$18 million. Nevertheless, due to its status as a stapled security (a trust-type vehicle), BWPP is allowed to pay a dividend out of operating cash flows even if it has made a loss.

Both BNB management and independent analysts note that the current loss is an anomalous situation, as the security posted very strong gains to year-end. But in terms of income, BWPP only managed to squeeze in three months of revenue from its assets before the year end. Despite his views on the bias in rewards from the overall business model toward BNB and away from the fund, the analyst quoted above sees BWPP probably moving into operating profit this year and still generating enough cash to pay out a dividend in line with expectations. As he says, "The real risk to shareholders is government incentives [for wind farms], not the fund structure. The structure is sustainable."

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