Going to the Bank

Deck: 

Financial buyers are snapping up power plants faster than at any time in history. The asset shift represents an interim step in a wholesale-market transformation.

Fortnightly Magazine - June 2005

A dam broke last year, releasing a wave that even now is spreading through the U.S. power industry.

That dam held back a flood of transactions in the secondary market for power plants. Deals that had been languishing on the auction block for months suddenly surged forward in 2004, and assets began changing ownership at a torrential pace.

According to public-domain data compiled by Bodington & Co. of San Francisco, about 47,000 net megawatts of power-plant assets changed hands last year in 46 transactions valued at more than $15 billion. That's a whopping 183 percent increase over the total capacity reported for 2003, when less than 17,000 MW changed hands (see Table 1 and “Back to the Rate Base,” March 2004).

Moreover, deal sizes grew to gigantic proportions in 2004, with one deal-Texas Genco's sale to a consortium of private equity firms-totaling more than 14.5 GW. Several other deals were in the 2,000- to 6,000-MW range. In fact, the lion's share of asset sales, 60 percent, was concentrated in just five deals that totaled nearly 28 GW.

Drawing conclusions from these numbers can be treacherous. If could report all the deals that happened during the year, the total numbers likely would be significantly higher. Many deals are not publicly reported, and this is especially true for deals involving financial investors, who play an enormous role in the power-plant secondary market. Indeed, of the 47 GW of asset sales publicly reported in 2004, about two-thirds, or 30 GW, involved financial buyers in a leading role.

Table 1 - U.S. Power Plants Sold, 2004

Understanding what this means for the power industry requires a long-term perspective on wholesale-market trends.

"Historically, financial investors have done a good job figuring out where markets are going," says Larry Eisenstat, a partner with Dickstein Shapiro Morin & Oshinsky in Washington, D.C. "Trends over the last few years have been all about dealing with a glut of capacity. Going forward the question will be how to best position one's self as that glut is diminished."

What Broke the Dam?

The dam-breaking metaphor suffers a critical flaw. Namely, there was no precise watershed moment in the power-plant secondary market. Rather, activity gradually accelerated in early 2004, and even now it continues at a robust pace with many deals still in the pipeline (See Table 3).

Activity picked up largely because of stronger economic growth. As the economy grew, supply margins tightened and supply forecasts increased in many regions. This effectively reduced the capacity glut and improved the value of operating assets. As a result, patience began to pay off for sellers that had been biding their time.

Table 1 (continued) - U.S. Power Plants Sold, 2004

"Many people rushed into the distressed-assets market thinking they'd pick up power plants at fire-sale prices," says Keith Martin, a partner with Chadbourne & Parke in Washington, D.C. "That didn't work because banks were in no hurry to take write-downs on the debt. Also the market recovered enough so independent power companies, with few exceptions, were able to refinance and buy time."

In other words, sellers left the table because prices were too low; buyers swarmed to the table in hopes of finding bargains; and the supply/demand relationship tipped enough to make many deals worthwhile, particularly for bundles of large base-load plants.

"We have moved through that group of assets quickly," says Jim McGinnis, managing director in the global power and utilities group at Morgan Stanley in New York. "The available base-load assets were priced in healthy auctions, and we still see a healthy appetite from a variety of sources."

This has proved true for both contracted and merchant plants. "Last year merchant plants started to move," Martin says. "That still isn't well understood by the market; many people think the merchants are dogs."

Table 2 - Back to Rate Base, 2003-2004

Indeed, before 2004, they were. Very few merchant plants changed hands in 2003. But last year, merchant assets accounted for well over half (57 percent) of the capacity sold.

By far the biggest deals of the year were merchant-plant portfolios. The Texas Genco sale was the big enchilada, with 14.5 GW of generating capacity at 13 plants going to GC Power Acquisition, a group of private-equity firms. Other big deals included KGen/Maitlin Patterson's buyout of Duke Energy North America's 5,000 MW of merchant capacity in the Southeast; and the acquisition of AEP's Texas Central merchant plants totaling 3,800 MW by a partnership of Sempra Energy and private-equity firms Carlyle Group and Riverstone.

On a dollar-per-kilowatt basis, merchant plants have been bargain priced. On average, merchant assets in 2004 fetched $220/kW, compared with more than $480/kW for contracted facilities. Duke's liquidation was the market's loss leader, with KGen buying the assets for just $93/kW.

Interim Repository

The three big deals mentioned above illustrate at least one obvious trend: Private equity and other financial players indisputably led the buy-side of the market in 2004. Understanding their roles and motivations, however, is a little more complicated.

Table 3 - Big Sell-Off Continues

In some cases financial buyers might hang on to the power assets they've acquired, which generally contradicts their modus operandi. Large investment banks like Goldman Sachs, Bear Stearns, Morgan Stanley, and even Merrill Lynch appear to be buying assets with longer-term intentions.

"They recognize that energy is a huge commodity, and with Enron and other traders out of the market there is a vacuum," says Stephen G. Moyer, a director with Imperial Capital in Beverly Hills, Calif., a broker dealing in distressed power-plant debt. "I don't see them as near-term flippers. In addition to trading power, in the future these guys could get involved with trading emissions credits. They see an opportunity, and they are stepping in."

Moreover, such financial investors perceive the value in owning hard assets, largely to hedge their positions in the market. Also they are avoiding the inherent weaknesses of the asset-light strategies that allowed Enron and other pure-paper traders to collapse so quickly and catastrophically when the market turned against them in 2002.

These long-term financial players, however, might prove to be the exceptions rather than the rule. In 2004, the market saw all manner of private-equity investors bidding on power assets. Most of these players are focused almost entirely on a basic buy-low, sell-high strategy-acquiring undervalued assets and enhancing their value by combining and restructuring portfolios. With a few exceptions-notably energy-focused limited partners such as Energy Investors Funds-most private equity firms are likely to stick with their buy-low, sell-high strategies. Thus within several years these firms can be expected to sell off the plants they've acquired.

To whom they might sell these assets is anyone's guess, but one logical buyer group includes investor-owned and public utilities. The raw number of megawatts bought by utilities in 2004 was dwarfed by the overall total of plants changing hands. However, when large portfolios acquired by financial investors are taken out of the total, the back-to-rate-base trend stands out more clearly; utilities acquired about 10 percent of the remaining capacity (see Table 2).

"If you recognize that the big deals included a lot of pretty old plants, and you look at where the new stuff and merchant capacity went, you see erosion in the competitive capacity that remains in the market," says finance consultant and broker Jeff Bodington.

These two trends, taken together, suggest the wholesale power market is going through a major transformation. The industry's final shape won't be clear until private-equity firms sell off their plants, ending their role as an interim repository. Who buys the majority of the assets might depend on regulatory trends, such as the advancement or stagnation of RTOs, competitive dispatch programs, and equitable approaches to paying for reactive power.

"We are in the early phase of testing what capacity payments might look like," McGinnis says. "One hopes that each region will set payments based on the plant's importance to the reliability of the grid."

Such developments might well determine who's still around in five years to buy the assets private-equity firms will be selling. Ultimately, the current direction of the deal flow could reshape the U.S. power industry for decades to come.