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Utility M&A: Buying Time

Buying Time
Fortnightly Magazine - October 2004

market in late 2002 and invested heavily in Williams and Centrica, a lot of other hedge funds saw what he did and jumped in after him," says Daniel M. Morash, managing director and global head of project finance for CIT Power, Energy & Infrastructure in New York. "As more investors entered the market, securities prices recovered. Companies could then sell their assets, restructure their balance sheets, and the industry could move on."

Since then, utilities' financial positions have stabilized, but private equity funds remain significant players in the industry. The reason is that energy assets that remain undervalued in the current market represent an excellent fit for the investment strategies of equity funds.

"Asset valuations have been driven by earnings, and there are lots of circumstances in which assets are probably worth more in a private buyer's hands than in the public market," says Jeffrey Holzschuh, a managing director with Morgan Stanley in New York. "Private equity has an advantage in these situations."

Indeed, private equity funds view the utility industry's combination of risks and uncertainties as an opportunity they are uniquely equipped to pursue. "When you are dealing with a lot of unknowns in your business and industry, it's tough to map out a strategy if you have to deal with a volatile capital markets," says Marc S. Lipschultz, a partner with KKR in New York. "There's a value-added role for someone who can provide patient capital and give companies the time they need to map out that strategy."

This value-added role has allowed private equity and hedge funds to buy into a significant number of energy and utility assets. The list of funds that have entered the market sounds like a who's-who of investment funds: Berkshire Hathaway, KKR, and Texas-Pacific Group, to name a few.

The entrance of these funds into an industry they've historically avoided has some analysts wondering how these funds expect to squeeze double-digit returns from assets that strategic buyers-mostly utilities-have generally shunned. The answer lies in the basic strategy that equity funds pursue.

Traditionally, such funds make money by taking control of businesses when they are having trouble, spending a few years turning them around, and then selling them to strategic investors when the business is in a better financial position. Equity funds are experts at maximizing value from distressed assets. They work to improve operations, and also to optimize financial structures, unbundling and re-bundling assets in ways that will increase their value.

"We have greater flexibility than a lot of the strategic buyers," says Dan Revers, a managing partner with ArcLight Capital in Boston. "As cycles occur, we can move to where the value is very quickly. We can buy a coal mine one day and a gas-fired power plant the next, without boards and shareholders and rating agencies to slow us down."

These funds look at investments on a 3-, 5-, or 10-year timeline. This investment horizon might seem short-term in the context of the utility asset lifespan, but it is actually a very long horizon compared with the hair-trigger behavior of public stock