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Distressed Generation Assets: When Is the Price Right?

An overview of the buyer and seller, and a discussion of current values for distressed assets.
Fortnightly Magazine - March 15 2003

assets close to home.

Another class of buyer will be the unregulated arms of utilities that still have strong balance sheets. These companies are well positioned to add an asset, or a group of assets, to their portfolios at costs much lower than building, or acquiring even a year ago. Many of these companies are less tied to a specific location or asset-type and more focused on getting good assets at good prices. The latter point is most critical since they do not want to degrade their balance sheets or credit worthiness. Similarly, this group will be most interested-and therefore willing to pay more realistic prices-in those assets that have at least part of the capacity contracted with third parties. This group is also most likely to partner with the last group of buyers, the private equity companies.

While not new to the energy sector, the number of private equity firms and the amount of focus they are placing on this sector is unprecedented. Large, well-disciplined value investors like Warren Buffet's Berkshire Hathaway and insurance giant AIG have made multi-billion-dollar commitments to this sector over the past year and are looking to invest more. These financially savvy players have a history of buying assets at the low end of their intrinsic value and then exiting when both the intrinsic and extrinsic value have increased. They are also the group that is least concerned about asset type or location, and most concerned with acquiring assets below their intrinsic value with a near-term likelihood of recovering prices.

At What Prices Will Deals Transact?

Should sellers find willing buyers in 2003, the majority of transactions may not involve cash. For existing assets, offers that match, or, in more desperate circumstances, come close to the level of existing debt, may be accepted.

At the time this article was written there was speculation in the trade press that Aquila might be forced to accept a price for its U.K. Midlands assets that is equal to or even slightly below Midlands debt. For assets that are under construction, buyers may be able to acquire assets at a price equal to the cost to complete construction. While either scenario will enable sellers to reduce their debt burden, they may actually have to find additional capital to pay off any shortfall (the negative difference between the asset's sale price and the outstanding debt).

When Will Value Recover?

We can all agree that current values for distressed assets are well below replacement cost, and in the aggregate, they are likely to remain depressed. When will they recover? The following chart demonstrates the net operating profit that a merchant combined-cycle plant coming online this year can expect to realize over the next 10 years in several different regions.

Market equilibrium is defined by a range of annual, levelized earnings necessary to achieve a return on invested capital sufficient to attract new combined-cycle projects into the market. When the annual operating profit by region reaches the target profitability line, the market achieves equilibrium and future profits will be capped at new combined-cycle economics.