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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

illiquid the market and the larger the position that may need to be liquidated, the greater the potential impact on forward prices. Given its importance, the incorporation of potential market impact into liquidity reserves therefore can have a significant effect on the net-transaction price.

Structured Deals

In many respects, structured deals straddle the continuum of asset types. These typically are longer-term transactions that require contracts reflecting customized structures and terms. As a result, they often are much more complex and exotic than the typical position found in the trade portfolio. Clearly, these assets share many of the features and risks normally associated with physical assets. This is especially true for power-purchase or tolling agreements, long-term storage or transportation-capacity agreements, and other transactions intimately tied to physical assets. But these deals also involve the liquidity and other risks typically seen in trade portfolios. Therefore, the discussion above regarding long-term forward curves is applicable equally to the structured deal portfolio, as are the reserving issues previously addressed.

But the use of customized contracts for these transactions results in a set of risks that are unique to this type of asset. Embedded within these contracts, we often find one or more of a wide variety of derivative structures that can have a significant impact on the value and risk of the position. For example, these may include options to terminate the agreement at certain points in time or in response to predefined triggers. In some cases, the trigger is a market-based event, such as the realization of an average price level over some period of time that is above a defined threshold. In other instances, an option to terminate may be conditioned upon a change in control or ownership of the asset or of the counterparty. Alternatively, renewal options may be present.

Renewal and termination options are but two examples of the myriad of embedded derivatives that are fairly ubiquitous in structured deal portfolios. In spite of their materiality, such options often are not captured in the seller’s valuation, position, and risk reports. And in those cases where they are, these derivatives often are modeled and reported incorrectly. The due diligence process should ensure that the buyer has the information needed to avoid the potential landmines some of these options represent, and exploit the untapped opportunities that may be associated with others.

Energy Trading Groups

Energy trading organizations themselves have become a tradable asset of late. Typically, however, these need to be evaluated as part of a deal that also includes some or all of the other asset types discussed above. We have detected a growing tendency to use high-level benchmarks, such as trailing earnings multiples, to value such organizations. This is understandable given the difficulty in constructing valuations based on a detailed assessment of the people, systems, and processes comprising the organization. However, high-level valuation metrics can be misleading when they are based on entities whose marketing and trading businesses are not comparable to the organization at hand.

Whether the buyer opts to use a multiple, a bottom-up value and risk assessment, or both,