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 now just a fraction of what they once were.

The energy-asset market not only is more liquid and active, but more efficient as well. The counterparties and competitors the transactor faces are increasingly sophisticated, and it takes a lot more to establish a market edge in identifying, evaluating, pricing, and structuring successful deals. So while the importance of thoroughly assessing an asset’s value and risk prior to acquiring it never has been greater, neither has the pressure and difficulty in performing appropriate due diligence.

While we do believe that a due-diligence effort should provide a comprehensive assessment of value and risk for the transaction, our practical experience has shown that it pays, literally, to focus more deeply on some issues than others. And the issues that tend to be of greatest concern generally are a function of the types of assets that are involved in the transaction. Therefore, we now will highlight one issue for each asset type that we believe merits special attention.

Physical Assets

When they are present, physical assets usually represent the lion’s share of a merchant-energy firm’s valuation. And physical assets, especially power plants, constitute the majority of transactions on a stand-alone basis as well for the types of assets shown in Figure 1 (see p. 34). Unfortunately, they also tend to be the most complex to evaluate. The typical power plant poses a myriad of operational, regulatory, environmental, and legal issues that must all be taken into account when assessing value and risk.

It is market risk, however, that often poses the greatest challenge. Plant valuation and risk assessment require very long-term forward curves. These will determine when and how often the plant is dispatched, and how much margin is realized throughout the entire useful life of the plant. This creates a need for forward prices, volatilities, and correlations for electricity and fuel that extend out for as many as 30 years. Unfortunately, transparency is limited to a maximum of five years for many markets, and may be as little as one or two years for some.

In response to this constraint, many transactors have opted to use forecasts beyond the observable forward-curve horizon. These forecasts usually are generated by simulation models that rely on a myriad of assumptions and expectations regarding future levels of supply and demand for the commodity. They employ a market equilibrium framework, in which price levels are computed such that future supply and demand are in balance.

The resulting “market-clearing” curves indeed may provide a reasonable forecast for future spot prices. Unfortunately, however, these are not forward curves. And therefore, this approach poses several significant problems that can undermine plant valuation and risk analysis. For starters, model-generated curves will not produce valuations and risk measures (value-at-risk, etc.) that represent the asset’s market value. Instead, the results will at best represent the transactor’s proprietary view of the asset’s value and riskiness. Now it legitimately can be argued that both are necessary—a proprietary view of asset value, as well as an estimate of where the market will transact. However, we have found that many who are using forecasts are not implementing valuation models correctly and are, in effect, producing neither result.

For instance, a common yet problematic practice is the use of a combination of forward curves and forecasts within a model, without the appropriate adjustments. This could involve the use of forward prices for market-visible tenors with a transition to forecasted prices beyond the observable horizon. This is in spite of the fact that forecasts represent the transactor’s (or third-party analyst’s) proprietary view of future spot prices, while forward curves represent the market’s expectations of future spot prices, but only if they can be adjusted for the presence of any risk premium. Nor is it appropriate to use risk-free rates with the price forecasts, so the discount rates need to be risk-adjusted. And so on and so forth.

Fortunately, the explosive growth in deal flow now provides transactors with the opportunity to estimate long-term forward curves and asset values based on market levels, rather than based on forecasts or other approaches. Implied forward curves that are consistent with transacted asset prices should help transactors overcome many of the limitations of current approaches and enable them to develop a market-based assessment of value and risk for physical assets.

Trade Portfolio

On the other end of the spectrum are the shorter-term transactions that comprise the trade portfolio. The portfolio typically is made up of thousands or tens of thousands of physical and financial positions, most of them plain-vanilla derivatives that span across geographic markets, commodity types, and underlying risk factors (volatility, basis, etc.). The tenors normally extend from the next day through several years into the future, although longer-term positions are not uncommon. So while curve visibility tends to be less of an issue, due diligence certainly should address other curve-related concerns. These may include which brokers or other sources are used for particular markets, and any systematic biases within the curve-marking process.

Given the potentially enormous quantity of positions involved, and the breadth and complexity of the exposures, quite a few other issues can present themselves in a portfolio transaction. One that probably should receive more attention than it normally does, however, is whether or not the reserves that have been designated for liquidity, credit, regulatory, and other risks are adequate. Reserve estimates are especially important because they are a key measure of the dollar impact such risks will have on the value the portfolio ultimately will realize and because they will often have a direct bearing on the transaction price.

When estimating liquidity reserves, for example, some practitioners focus primarily on the spread between bid and offer prices, or the “bid-ask spread.” They use the bid-ask spread to estimate the degree to which a “mid-based” (i.e., average of bid and offer) forward curve underestimates the value that would be derived in the event that the position needs to be liquidated.

But liquidity risk can be much more dependent on the impact of a potentially large purchase or sale on the forward market than it is on the bid-ask spread. In fact, the more 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, a key consideration in the analysis should be the business mix of the group being evaluated.

Marketing and trading businesses might engage in a wide spectrum of activities. These include proprietary trading, hedging, market-making, asset optimization, and energy management. There are very few marketing and trading businesses in existence today that have significant and balanced levels of activity across all of these areas. Instead, most groups tend to focus on a small subset, and this largely is a function of industry. For example, most investment banks focus primarily on market-making, or “customer-flow” business, while hedge funds engage mostly in proprietary trading.

Risk and expected returns vary considerably across these trading activities. Providing customers with energy management services typically is a business with more stable cash flows than might be expected from an operation that is heavily dependent on proprietary trading. The lower risk should come with lower expected returns as well, however. The multiple used should reflect the particular risk-reward profile of the organization being evaluated. The due-diligence process therefore should assess each trading activity’s individual contribution to overall risk and return. The valuation and risk assessment also should project how risk-reward performance might change with anticipated changes in the business mix, because trading groups often are acquired with the intention of shifting their business mix toward activities that better complement and support the buyer’s strategic objectives.

A Final Word

A recurrent theme should be apparent just beneath the surface of each issue we have highlighted: the importance of risk assessment when evaluating a transaction. Valuation analysis alone is not a sufficient basis upon which to base a bid or justify a transaction. There needs to be a firm understanding of the riskiness of the asset as well. These types of assets require sizeable commitments of capital, not only to acquire the asset, but also to support their operations. Unless the asset can generate required returns on all of the capital it consumes, both before and after the acquisition, the transaction will be difficult to justify. For a due-diligence process to be most beneficial, it therefore should provide a balanced assessment of both value and risk.