Business & Money

Merchant plants now draw investors from three different worlds-each with its own agenda.

It's tempting to chalk up the recent bubble in merchant generation to just another industry cycle, but there's more to consider. Investment in the industry was far from even, leaving some regions teeming with unused peaking plants while other regions continue to struggle with a need for capital investment. Technology also has evolved, opening up a new suite of potential options like demand-side management, more efficient transmission and distribution, and localized generation.

The growing concern over energy security and the environmental impact of the current fleet of generation assets also has created further flux. Change is the only constant in today's world-and change brings opportunity.

How has this experience affected investment? Few if any who invested during the generation boom have escaped unscathed. Nonetheless, we see the ongoing potential of the power sector. New investors have moved quickly to raise or redeploy capital and invest in an industry that is far from dead. Current investment in the power market increasingly flows from three distinct sources: private equity, institutional debt, and venture capital.

Private Equity

At one end of the risk spectrum, many private-equity investors have sought to purchase and finance contracted power assets. Large equity funds, which have tended not to see power as a core investment focus, have been drawn into the market by the opportunity to fund significant amounts of capital into strong, cash-producing assets. This trend has progressed steadily from single-asset acquisitions to large generation-portfolio purchases.

While private-equity investors may have been drawn to the market initially by the potential to acquire contracted cash flows at attractive prices, these opportunities have been fleeting. The sheer number of interested financial sponsors, a general dearth of bargain investments in other industries, and the availability of attractively priced debt have resulted in fierce competition and pressure on prices. As a result, power producers have been able to divest non-core or distressed assets at attractive valuations.

At the other end of the risk spectrum, many power producers and financial institutions are holding poorly performing merchant assets. These assets have proved difficult to value and therefore difficult to sell, although some have begun to change hands. Private equity investors have started to purchase these assets under two broad scenarios. First, merchant assets with strong fundamental characteristics (, coal generation in a gas-margin market) have appeal. Second, deeply discounted assets with no obvious structural economic advantage have sold to investors who see the potential for asset-value appreciation. They intend to contract assets successfully off of a low-cost base. The clear differences in the merchant segment are significantly discounted valuations and higher-debt costs for the purchaser.

The entry of private equity investment has served the useful purpose of providing liquidity to support ongoing industry efforts to restructure and deleverage. This growing class of investor is looking to profit from a short-to-medium term market imbalance and likely will exit these initial investments once stability returns. Depending on their experience with this initial foray, private-equity investors could present a deep pool of