June 1 , 2002
Business & Money
term. When viewed in this context, the profile of the new capital in the market (relatively high captial costs, short tenors, etc.) brought by the financial players can be quite different. While the characteristics of the new capital in the market are not well suited to significant and long-term ownership of generating assets, there certainly are roles to be played in the near term. As evidenced by the first round of transactions, one use of private equity is in deals that include assets with associated supply contracts, but these are difficult to obtain and highly competitive. As a Goldman Sachs representative recently noted, the company "acquire[s] long-term contracts and commercial relationships. … Physical assets … [are] not what we are really paying for!"1 Some firms look for smaller, sponsor-originated deals that are not competitive and play to particular in-house strengths such as specific market or asset knowledge. Other firms focus on special corporate deals, like the UniSource/KKR leveraged buyout deal. Activity by financial firms in the market for secondary debt, which represents either a pure financial play on the value of the debt instruments or a move to obtain control of certain assets through creditors' committees, has been significant. And, more recently, financial players are starting to provide much-needed liquidity to the merchant plant market.
With the increase in merchant plant sales to financial players, such deals will be done with an eye toward relatively rapid resale as soon as the markets show signs of recovery. Resale will minimize exposure to industry cycles, monetize investment gains, and free up capital for new rounds of investment in other, more attractive financial opportunities. Those assets that are purchased by private equity are likely to be sold-in fact, almost must be by the nature of certain fund convenants-within 5 to 7 years.
Therefore, over the long term, we believe that the industry will follow the less glamorous but well trod path of similar industries, which ultimately results in placing these assets in the hands of their natural or strategic owners-the large, low-cost-of-capital player. Whether or not the IOUs are the buyers of the future will depend on the ultimate outcome of whether FERC and state policies are in place to make that possible. There is no reason to believe that financial returns in the industry will trend anywhere but toward the low return on invested capital seen in other cyclical, commodity-based industries-about 5 to 8 percent. Cost of capital will be the key component of the successful company's strategy, and the result will be control by entities with a commitment to the industry and the ability to weather its inevitable cycles-a description, we hasten to add, not usually associated with private equity.
1. Larry Kellerman, "Cause and Effect: Business Model Selection and Execution as the Key Determinant of the Enterprise Success," Global Power Markets Conference, March 29, 2004.
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