Business & Money
After FERC's Market Power Ruling:
Will financiers dominate the market?
The recent approval by the Federal Energy Regulatory Commission (FERC) of its "interim" market power screen and policies on investor-owned utilities (IOU) affiliate transactions is changing the market dynamics for buying and selling generation assets. Yet, while the market test has drawn plenty of comments and complaints, the long-term effects are still uncertain.
One possible consequence will be a decrease in the number of buyers in the market. IOUs that fail the market power test stand to lose their market-based rate authority, a threat that is likely to dampen their ardor to purchase generation assets. And fewer buyers in the market will serve onlyto further stoke the fire that has been accelerating the purchase of generation assets by financial players.
The recent purchase of a dozen or so of Centerpoint Energy's Texas plants by a consortium of private equity funds marks the latest, and certainly the largest, generation asset acquisition by a financial player. The consortium, whose members include Kohlberg Kravis Roberts & Co. (KKR), The Blackstone Group, Hellman & Friedman LLC, and the Texas Pacific Group, paid $3.6 billion for a portfolio of assets with an aggregate net generating capacity of 14,153 MW.
This transaction continues a trend started several years ago following the collapse of the U.S. power markets. Falling generation asset prices and increasing capital requirements in the industry has attracted a considerable amount of interest from financial players that entered the market hoping to buy assets on the cheap. Meanwhile, many traditional players-merchants and utilities-were relegated to the sidelines by heavy debt loads and reduced credit quality.
The shifting ownership paradigm to private equity groups first took shape when it became clear that many banks had overexposed themselves to the industry and were now unwilling-or unable-to meet burgeoning capital requirements. At this point, hedge funds, followed by private equity firms, swept in to fill the void. Others, including investment banks have also been acquiring assets, as witnessed by the deal announced in March by Bear Stearns to purchase a number of plants from American Electric Power (AEP). Also active in the market are private equity/developer combinations and other non-traditional players capable of leveraging their significant financial reserves, such as GE Capital, GMAC, insurance companies, and pension funds.
Initially, almost all of the deals involved above-market contracts associated with the assets. Others were sold to buyers in a unique position to utilize the asset. Prices during this period were relatively high-ranging from $400/kW to over $1,000/kW-reflecting the value of the associated contracts in most cases.
More recently, merchant plant deals have been coming together. In March, a consortium of Sempra and Carlysle Group/Riverstone Holdings an-nounced that it would buy 10 merchant plants totaling nearly 4,000 MW from AEP for $430 million. Duke's announced sale of eight gas-fired merchant plants in May continued the trend that fed into the Texas Genco transaction referenced above. What started out as one-off individual sales had now progressed to entire portfolios of diversified assets (see Figures 1, 2, and 3). As expected, prices for the recent merchant deals are considerably lower than what previously was witnessed in the market. Although always difficult to compare due to differences in asset-specific characteristics, prices on these merchant transactions are closer to the $100/kW to $300/kW range.
But how long will these new financial players remain in the industry? While the ultimate impacts are still unknown, the market power screen will likely impact both the number of asset sales to financial players and the amount of time they hold the assets. Given the number of assets for sale in the industry, and the potential that banks currently holding assets will soon tire of those positions, more assets are likely to be sold to those willing and able to put capital to work in the current market. With traditional merchant buyers limited by credit and balance-sheet problems and the new market power screens hamstringing regulated utilities, financial players will continue to build ownership share.
How long they retain ownership of the assets, however, will depend on a number of factors, including how quickly the next wave of buyers materializes. That is a function of how quickly the merchants rebound, whether or not outside interests enter the market, and to what degree the new FERC market power screens actually affect regulated utility purchases in the future. But no matter how much of a foothold the financial players gain or how long it takes to sell, ultimately the assets will return to their natural owners (companies with ownership characteristics that match the underlying investment).
Generation Assets: Likely to Follow a Circuitous Route
The electric power industry is characterized by a number of factors that tend to delimit the universe of entities that can be successful in the market in the long term. Electricity production is cyclical, highly capital intensive, commodity-based, and volatile. Cyclical, capital-intensive industries are characterized by relatively low long-term returns. And while the current industry downturn is likely more severe than future down cycles (due to the exceptionally high degree of current overbuilding), the ability to survive and profit through these cycles requires certain key strengths.
These strengths include low cost of capital, portfolio size, and a large capital base that can provide scale and accommodate the sometimes large capital and major maintenance expenditures required by the industry. In addition, generating plants are complicated facilities to operate, and the markets in which they run require skills and infrastructure. Expertise in risk management and trading, contract management, market modeling, the environment, technology, and regulation can provide a competitive edge in a market defined by long-lived generating assets.
Finally, all investors acclimate easily to constant high returns. It's the downturns that tend to separate them. The market for generation is cyclical, and the cycles can be deep and long. Lack of a long-term (10-plus years) investment view will keep many players out of the market, unless specific opportunities arise on a very opportune and short-term basis.
Clearly, the inherent nature and characteristics of generating assets speak to the type of investor that is likely to be successful over the long term. When viewed in this context, the profile of the new capital in the market (relatively high captial costs, short tenors, etc.) brought by the financial players can be quite different. While the characteristics of the new capital in the market are not well suited to significant and long-term ownership of generating assets, there certainly are roles to be played in the near term. As evidenced by the first round of transactions, one use of private equity is in deals that include assets with associated supply contracts, but these are difficult to obtain and highly competitive. As a Goldman Sachs representative recently noted, the company "acquire[s] long-term contracts and commercial relationships. … Physical assets … [are] not what we are really paying for!"1 Some firms look for smaller, sponsor-originated deals that are not competitive and play to particular in-house strengths such as specific market or asset knowledge. Other firms focus on special corporate deals, like the UniSource/KKR leveraged buyout deal. Activity by financial firms in the market for secondary debt, which represents either a pure financial play on the value of the debt instruments or a move to obtain control of certain assets through creditors' committees, has been significant. And, more recently, financial players are starting to provide much-needed liquidity to the merchant plant market.
With the increase in merchant plant sales to financial players, such deals will be done with an eye toward relatively rapid resale as soon as the markets show signs of recovery. Resale will minimize exposure to industry cycles, monetize investment gains, and free up capital for new rounds of investment in other, more attractive financial opportunities. Those assets that are purchased by private equity are likely to be sold-in fact, almost must be by the nature of certain fund convenants-within 5 to 7 years.
Therefore, over the long term, we believe that the industry will follow the less glamorous but well trod path of similar industries, which ultimately results in placing these assets in the hands of their natural or strategic owners-the large, low-cost-of-capital player. Whether or not the IOUs are the buyers of the future will depend on the ultimate outcome of whether FERC and state policies are in place to make that possible. There is no reason to believe that financial returns in the industry will trend anywhere but toward the low return on invested capital seen in other cyclical, commodity-based industries-about 5 to 8 percent. Cost of capital will be the key component of the successful company's strategy, and the result will be control by entities with a commitment to the industry and the ability to weather its inevitable cycles-a description, we hasten to add, not usually associated with private equity.
1. Larry Kellerman, "Cause and Effect: Business Model Selection and Execution as the Key Determinant of the Enterprise Success," Global Power Markets Conference, March 29, 2004.
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