An overview of the buyer and seller, and a discussion of current values for distressed assets.
Three groups of sellers likely will market assets in 2003. First, the same companies that were desperate to sell merchant assets in 2002 will continue to market those same assets in 2003. NRG, Mirant, PG&E National Energy Group, and others will continue to market their operating, under-construction, and development assets in an effort to raise cash and reduce debt. With the fundamentals of the industry unchanged, the only reason to expect these assets to sell in 2003 is that many sellers have taken significant write-downs, which may sufficiently narrow the "bid-ask" spread on these assets to allow buyers and sellers to reach agreement.
The second and often overlapping group of sellers will be those with large debt maturities in 2003. This year Mirant has $1.6 billion in debt expiring, Williams has $2.25 billion, and Reliant Resources has an astounding $3.7 billion.
The third group of sellers will be those who never imagined they would be asset owners. Banks, insurance companies, and construction firms have already found themselves with direct or indirect ownership of generating assets. In 2002, NRG turned over its LSP-Pike facility to its EPC contractor, the Shaw Group; PG&E National Energy Group effectively "turned over the keys" to three unfinished plants and one operating facility to its lenders; and Xcel has offered NRG's lenders less than three cents for every dollar of its subsidiaries' outstanding debt. Because many of the assets securing project debt were already marketed to a disinterested market in 2002, lenders face the challenge of remarketing these assets in 2003 or completing and operating these facilities themselves.
Who Will Buy?
Several groups of buyers will be actively involved in buying distressed assets during the next year.
In numerous jurisdictions, state regulatory commissions and utilities have become concerned with the near- and long-term capacity adequacy for meeting native load, almost moving back to an integrated resource planning view of the world. As a result, several utilities are now looking to acquire distressed generation assets as a way to secure future regulated supply needs. Although the need may not be immediate, many of these companies rightfully recognize that the economics of buying at distressed prices this year (or next) can more than offset the carrying cost associated with fully growing into the capacity acquired. Alternatively, for those needs that are several years out, utilities may decide to buy distressed assets under construction, or partially developed sites. For these companies, the assets acquired will more than likely be within or near their control region.
Similar to the regulated utilities, generation and transmission cooperatives are also looking at certain distressed assets. Co-ops have seen steady growth in their service territories, and they need new supply to meet expected future needs. Like their investor-owned utility brethren, these organizations are looking to acquire generation because the prices are better than new builds and because it is increasingly difficult to find an investment-grade supplier with whom they could contract. The cooperatives will most likely be looking at individual assets close to home.
Another class of buyer will be the unregulated arms of utilities that still have strong balance sheets. These companies are well positioned to add an asset, or a group of assets, to their portfolios at costs much lower than building, or acquiring even a year ago. Many of these companies are less tied to a specific location or asset-type and more focused on getting good assets at good prices. The latter point is most critical since they do not want to degrade their balance sheets or credit worthiness. Similarly, this group will be most interested-and therefore willing to pay more realistic prices-in those assets that have at least part of the capacity contracted with third parties. This group is also most likely to partner with the last group of buyers, the private equity companies.
While not new to the energy sector, the number of private equity firms and the amount of focus they are placing on this sector is unprecedented. Large, well-disciplined value investors like Warren Buffet's Berkshire Hathaway and insurance giant AIG have made multi-billion-dollar commitments to this sector over the past year and are looking to invest more. These financially savvy players have a history of buying assets at the low end of their intrinsic value and then exiting when both the intrinsic and extrinsic value have increased. They are also the group that is least concerned about asset type or location, and most concerned with acquiring assets below their intrinsic value with a near-term likelihood of recovering prices.
At What Prices Will Deals Transact?
Should sellers find willing buyers in 2003, the majority of transactions may not involve cash. For existing assets, offers that match, or, in more desperate circumstances, come close to the level of existing debt, may be accepted.
At the time this article was written there was speculation in the trade press that Aquila might be forced to accept a price for its U.K. Midlands assets that is equal to or even slightly below Midlands debt. For assets that are under construction, buyers may be able to acquire assets at a price equal to the cost to complete construction. While either scenario will enable sellers to reduce their debt burden, they may actually have to find additional capital to pay off any shortfall (the negative difference between the asset's sale price and the outstanding debt).
When Will Value Recover?
We can all agree that current values for distressed assets are well below replacement cost, and in the aggregate, they are likely to remain depressed. When will they recover? The following chart demonstrates the net operating profit that a merchant combined-cycle plant coming online this year can expect to realize over the next 10 years in several different regions.
Market equilibrium is defined by a range of annual, levelized earnings necessary to achieve a return on invested capital sufficient to attract new combined-cycle projects into the market. When the annual operating profit by region reaches the target profitability line, the market achieves equilibrium and future profits will be capped at new combined-cycle economics. This equilibrium assessment is primarily a function of the regional energy markets and does not consider metro-constrained areas that may require peaking resources supported solely through capacity payments.
Our analysis suggests that New York Zone J may achieve marginal equilibrium by 2005 (minimal CCGT economic returns) and move into solid equilibrium by 2009. In contrast, the Boston area may see only marginal market equilibrium by 2010 to 2011. Multiple assumptions, including rational behavior by all market participants and projected load growth, predicate these regional equilibrium assessments.
For other regions, the current overbuild situation, combined with the completion of projects currently under construction, will push equilibrium out several years. We see several regions of the country remaining overbuilt through much of the next 10 years, which suggests prices for generating assets will take some time to recover to full asset value levels.
Articles found on this page are available to Internet subscribers only. For more information about obtaining a username and password, please call our Customer Service Department at 1-800-368-5001.