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Business & Money

Merchant plants now draw investors from three different worlds-each with its own agenda.
Fortnightly Magazine - November 2004

risk-tolerant capital that will continue to provide broader funding options for corporate partners.

Institutional Debt

Almost in tandem with the entry of large-scale, private-equity investment in the power sector has been the emergence of a deep second-lien institutional term loan market. The "Term Loan B" market, as it is known colloquially, has provided the debt capital necessary to support leveraged acquisitions by private-equity investors. This growing investor class largely comprises high-yield mutual funds and other institutional investors seeking liquid debt investments with attractive rates of return.

This form of debt appeals to financial sponsors because it is abundant and flexible. Covenants are light. Penalties for prepayment are usually minimal, as are fixed repayment requirements that typically rely almost exclusively on cash sweeps. In effect, these structures provide interim financing for private-equity investors pursuing a short-term acquisition and medium-term exit strategy.

Similar to private-equity investors, Term Loan B lenders were drawn into the market by the promise of attractive rates of return for a given level of risk. Similar again is the resulting compression of pricing margins as investors have crowded the market. Yields are not particularly high relative to perceived levels of risk in the transactions they fund. The depth of the Term Loan B market has worked in tandem with the availability of private equity capital to provide liquidity for the power industry's necessary restructuring efforts. This type of debt is not an ideal form of long-term financing, but it provides the sort of risk capital required by the market today.

While the Term Loan B market has seen an explosion in participation, the traditional long-term, fixed-rate institutional debt market, which has typically played a significant role in the power sector, has been conspicuous in its lack of activity. This certainly does not imply a lack of interest or investment appetite. The current lull in the long-term, fixed-rate market is best understood as a result of the rise in Term Loan B financing. Private-equity investors, who must look ahead to an exit or refinancing strategy, are not well served by long-term fixed-rate loans that carry prepayment penalties. As investment activity shifts back to strategic corporate investors, who are more concerned with showing consistent earnings, balance is likely to return. Long-term, fixed-rate institutional debt has not disappeared, but, for the moment, the transactions in which it makes sense disappeared.

Venture Capital

Venture capital in the power industry has been dominated in the past by early-stage development equity for large-scale generation projects. This activity continues at a reduced scale while a new wave of technology-driven investors becomes more active. Revolutionary power technology has long been a marginal curiosity in the industry. However, recent developments in advanced technologies have presented promising opportunities to venture-capital investors. Some of these technologies, such as load curtailment systems, are commercially deployable today. Others, like solar, wind, and fuel-cell generation, still require some level of subsidy but are demonstrating steady advances in cost reduction. Clean coal, waste-to-energy, and emissions curtailment technologies also hold great promise as this country seeks to limit its dependence on foreign sources of fuel, while