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The Devil in the Deal: Notes From an M&A Practitioner

A look at due diligence for energy transactions, and at what’s driving them.

Fortnightly Magazine - September 2007

By the end of last year, much was being made of the failed attempts at multibillion-dollar mergers by FPL with Constellation, Exelon with PSEG, and Southern Co. with Progress Energy. In spite of the repeal of the Public Utility Holding Company Act, these mega-mergers still required regulatory approvals from multiple state and federal agencies, and their high profiles attracted attention and resistance from a vast array of special interests.

But these failed attempts did not in any way impede overall deal flow in the marketplace for energy assets. Instead, they may have served to encourage capital flows into lower-profile yet less-regulated assets. These include physical hard assets such as merchant-power plants, but also structured deals, derivative portfolios, and even energy trading teams.

Interestingly, these types of assets comprise the traditional merchant-energy firm (see Figure 1) . Once primarily owned by, and housed within, utility holding companies, alternative investors are discovering opportunities to realize greater returns on these assets. Financial buyers such as private-equity and hedge funds are able to exploit the strong cash flows of these assets through the application of leverage and financial risk-management strategies. Strategic buyers usually are more concerned with how these assets might complement their existing business portfolios and yield operational, geographic, or other synergies.

Underlying all of this activity, however, a number of primary forces are at work. These types of assets are of greatest interest to both types of buyers when energy prices are strong and there is plenty of liquidity. Spark spreads have widened considerably, increasing projected cash flows and valuations while allowing financial buyers to tap into an unprecedented level of investor interest and liquidity to finance and leverage transactions. Rising valuations are especially important to these types of buyers given their relatively short-term investment horizons. Strategic buyers also benefit from increased liquidity and energy prices, even though they typically are not in as much of a hurry to monetize their investments. They may have to pay a premium given increased competition for assets, but this is much easier to justify in an environment with strong asset cash flows and capital availability.

Eventually, however, there surely will be a downturn in the energy-asset market. It is management’s responsibility to understand and monitor these drivers.

Due Diligence

For an acquisition to be successful, the buyer must have a deep understanding of both value and risk, and must price and structure the transaction accordingly—regardless of when a market downtown occurs or how deep it is. But performing due diligence that is adequate to this task can be quite challenging. The energy-asset market is more active and liquid than it ever has been before. As a result, transactors often find themselves with more promising deal prospects than they can evaluate given their limited internal resources. Also, shorter transaction cycles are making things more difficult. Due-diligence schedules, from initial bids to final bid acceptance, signing, and closing, are

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