California versus capitalism
Published November 5th, 2009
Poseidon Resources’ decision to apply for an extra $50 million of private activity bonds caught my eye. It also seems to have captured the imagination of California’s media, but for quite different reasons. I was interested primarily because I am intrigued by how Poseidon is going to make a return that justifies the fantastic risks it has had to take on in order to get the Carlsbad project this far. It seems to me that the extra money is a sign that things are going well for the company.
The reason I think things are going well is because the construction costs are pretty well fixed at $360 million for the plant and the pipeline. The revenues are also pretty much fixed, in that Poseidon has signed water purchase agreements with its customers. There are a few other things like contingency, the developers’ construction period costs, the environmental mitigation and required reserves which are not included in the EPC contract, but which are quite easily quantifiable in advance for an experienced developer like Poseidon. That leaves just three things which might have changed which would have added to the cost: the expected cost of finance, the debt to equity split in the project, and the value which Poseidon puts on its equity in the project.
It seems to me unlikely that Poseidon has had to increase the amount of debt in the project from $480 million to $530 million simply because the debt has turned out to be more expensive than anticipated. The main reason why the cost of finance would rise would be because potential investors are worried about the level of risk in the project. If that were the case, it would be unlikely that Poseidon would be able to increase the amount they are borrowing. Rather they would need to be reducing the leverage in the project. In fact, it appears that the reverse must be happening: Poseidon is finding sufficient appetite in the market for exposure to the Carlsbad project, that it can increase the amount of debt, and reduce the amount of equity. For example it might have started with the assumption that it would need to split the debt and the equity 65-35, which would require $480 million of debt, but now it discovers that there is sufficient appetite in the market for Carlsbad private activity bonds to enable it to push for a 75-25 debt/equity split. Assuming that the total project cost is around $700 million, the total debt would then be $530 million.
In that scenario the value of the equity would be $170 million, and this is the interesting bit. Poseidon has already sunk $40 million into developing the project, and it has been one of the most protracted and bitter development battles since Mulholland arrived in the Owens Valley. If I were Jacek Makowski (the energy investor who has been backing the project since the very beginning), or indeed one of the more recent investors such as Citigroup’s Sustainable Development Investments, IBIS Capital Management or Mandeville Partners, I would want to know that I was getting a very big pile of money out of Carlsbad after all these years of blood, sweat, and tears.
The way I would do it would be to mark up the price at which I sold equity to new investors against the value of my historic equity in the project. Suppose for example that the project company has 100,000 shares. I, as Poseidon, take 60,000 shares in exchange for my historic $40 million investment developing the project. That works out as $667 per share for me. I then sell the remaining 40,000 shares to outside investors for $130 million – that is $3,250 per share. It raises the money I need and keeps me in control, but I could do better. I could take my interest in the project down to 50.1% of the company by selling 9,900 of my 60,000 shares to outside investors at $3,250 per share, making me $32.2 million. I would have my cake and eat it.
Poseidon has made no comment whatsoever about its financial model, so all this is just speculation. However it is difficult not to draw the conclusion that Poseidon’s decision to ask for extra private activity bonds is a reflection of strong investor confidence in the project. This is a good thing considering the state of California’s public finances. It means that there is a rich and viable alternative to doing everything on the public’s overstretched balance sheet. The sad thing is that opponents of Poseidon don’t see it that way. They see it as a rapacious private company grasping public subsidies while exploiting a commodity which is the very essence of our existence.
But what are the alternatives? If Poseidon is not allowed to issue private activity bonds (which are tax exempt), then California will be stuck with its failed public finance model. This system is the main reason why California is facing a crisis today: public bodies have not invested enough in water infrastructure over the past 20 years. The private sector can help, but only if it can compete on equal terms to the public sector. That means access to private activity bonds and the 250/AF (0.20/m3) subsidy from the Metropolitan Water District. This anti-private sector stance taken by many Californians shows an ideological purity which we should respect. But unless Californians want to live like North Koreans, they should be prepared to make compromises with capitalism.