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REPs Should Avoid Fast Growth Without More Collateral: Lender
Small and medium-sized retail energy providers (REPs) need more financial discipline as they grow to avoid being undercapitalized in times of market volatility, a secured lender said at a recent event in Washington, D.C.
Key Takeaways: Retail Energy Growth and Collateral Risk
Every source of failure in retail energy, be it from hedging, collateral, liquidity, regulation, bad acquisitions or the weather, stems from growth that outran capital or proper controls, John Fox, chief credit officer of Capital Foundry, said at the EMC26 Conference on October 19.
As an example, Fox asked an audience at a workshop if their capital was deep enough to handle winter storm Uri, the February 2021 event that caused blackouts in Texas before moving northeast to affect the PJM Interconnection, New York and New England.
Power and natural gas prices soared in all of those markets. Fox said REPs make mistakes a full 18 months before price volatility occurs if they double their books without additional capital, collateral, hedging discipline and an enhanced relationship with a lender.
Fox said growth can kill REPs in four ways:
- The balance sheet, because the deal that looks best on the sales report often drains the most cash.
- The market, because hedging mistakes and weather changes will prompt a margin call that lands when customers use the most and pay the slowest.
- The regulator, because failures with variable rate books, marketing and compliance arrive exactly when a company can least afford legal costs and a hit to renewals.
- Decisions like bad acquisitions, because earnouts and attrition “are where the bodies are buried.”
An earnout is an acquisition structure wherein a portion of the price is paid to the seller only if the business hits specific post-closing performance targets.
REPs can outgrow their letter of credit from a bank, Thomas Donahue, president of Capital Foundry, told the group.
“With a weather event that costs [a multiple of] four times overnight, how will you keep your book that has never been stress tested?,” he asked.
Collateral calls change along with prices, so REPs should be in touch with a banker or a lender like Capital Foundry ahead of time. “Every client asks for more money in a three-day period,” Donahue said. “A lot of people are not prepared. You can outgrow your lending if you grow your book.”
All loans become out of formula in a cold snap, he added. Some clients of Capital Foundry have had plans in place to stay alive, while the lender offloaded a different group to other types of financing, Donahue said. A lot of those former clients declared bankruptcy quickly.
“You need a support system for the peaks and troughs,” Fox said, adding that survivors in the retail energy industry employ these five methods:
- Price liquidity into every deal.
- Keep a live line of sight from the sales desk to the balance sheet.
- Build your lender relationship before a 2 a.m. distress telephone call.
- Match your hedging discipline to your growth rate, because a book growing rapidly needs more risk control, not less.
- Stress-test collateral before the weather does. “Know your ISO posting under a one in 10 event, and who funds it,” Fox said.
A grid operator posting is the official financial statement that reconciles wholesale electricity purchases, transmission charges and grid services against an REP’s actual customer load.
Capital Foundry, which does not take exposure without collateral, becomes highly knowledgeable about its clients.
The firm is uncomfortable with REPs that use upfront brokers, Fox said, considering it to be a foolish practice.
An upfront broker is an intermediary that charges a predetermined fee to procure energy contracts, rather than building a commission into the per-unit rate of electricity or natural gas.
Capital Foundry will ask a prospective borrower to explain the entire story of an account, Donahue said, and the ability to receive credit will hinge on the answer. The company is also aware of broker payment requests, and new relationships with other lenders, which are “a huge red flag.”
“A lot of companies have been burned by lenders that try to do too much,” he said. “We do not have a generalized pool of collateral. We could, and it would be cheaper, and we could collapse.”
A generalized pool of collateral groups diverse assets into a shared credit facility to secure trading obligations.
