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Reign of the Bond Kings

S&P, Moody's, and Fitch tell why credit issues now rule the energy sector.
Fortnightly Magazine - October 15 2002

spreads, pure merchant plants are not nearly as valuable in the current market as original plans envisioned," he says. "Sellers are essentially at the mercy of the forward price curve."

In other words, buyers are scarce. There are few companies with strong balance sheets like Mid-American Energy, Southern, or TXU that could contemplate power plant purchases, but even they are being cautious. Beyond that, Schreiber identifies a few other candidates on the buy side: Blackstone Group, Texas Pacific, or Kohlberg, Kravis, Roberts & Co. (KKR).

Furthermore, some energy executives say they might even wait until some distressed companies go into bankruptcy before they swoop in on the assets-a strategy that bankers warn is riddled with problems.

James McGinnis, a managing director at investment bank Morgan Stanley, tells why.

"The intuition for corporate buyers is to stay away from assets being sold through a bankruptcy process, because there is only limited true bilateral negotiation ability. You have to bid in the context of a jump ball auction, with perhaps many tosses and re-tosses of the ball, and that takes a lot of time, effort, and negotiation."

As McGinnis explains, the deal often is not final in a bankruptcy until the judge and the credit committee has made the approval. "When you shake a hand in a transaction within a bankruptcy, it may not really be a meaningful exercise."

For example, McGinnis cites the bankruptcy process as why most potential buyers stayed on the sidelines when Enron initially tried to sell the Northern Natural Gas Pipeline. "Enron's advisors marketed the asset broadly, but buyers generally did their due diligence and then waited until Dynegy owned it (at a full purchase price) so that they could have a meaningful bilateral discussion with the new owner and reach closure," he says. "Other, more creative transactions might have been achievable outside of the bankruptcy process, but never saw the light of day."

George Bilicic, managing director at investment bank Lazard Frères, adds that private investors generally are not yet comfortable with energy sector risk. Schreiber recommends internal restructuring as an alternative: "Ideally, the first course utilities should pursue would be to reduce debt and improve liquidity through internal resources," he says.

"But this is not happening because some utilities are not making sufficient returns, primarily due to the decline in market prices, to generate the cash flow needed to improve their financial condition." In the alternative, he says, utilities must step into equity markets or look to sell assets.

Bilicic blames irrational exuberance in the unregulated merchant sector.

"As a general matter," Bilicic explains, "I do not believe that capital structures in the sector were designed with a view to what is now showing itself to be a cyclical industry. I don't think advisors and executives at companies and regulators understood particularly well when these capital structures were put into place that the unregulated segment of the utility industry would be subject to the intense cycles we are now seeing.

"This is not to suggest," he adds, "that there is blame to be assigned across the board.