It was only four short years ago that the experts in the power business were all speaking of the deregulation of the power markets as inevitable and virtually unstoppable. At the same time many of us also believed in the integrated trading model, powered by low cost natural gas fuelled merchant plants and including strong trading prowess. The underlying premise for this article is that when Enron filed bankruptcy in December 2001, the event fundamentally caused the halt of any further deregulation in the power markets and virtually eliminated the gas-fuelled trading model for all but the strongest of firms, at least in the medium term.

In M&A terms, the market, over the last several years, has shifted from a point shortly after the Enron bankruptcy when we were long inventory and short capital to the present, where contracted assets in particular are highly valued, the inventory overhang has largely been eliminated and numerous groups with ample liquidity are competing for those assets which have not yet turned over.

How does the halt of deregulation, except in Texas, as well as the demise of the merchant model as previously envisaged, affect M&A activity?

At the time of Enron's crash, I think it is fair to say that virtually every major gas and electric utility, trading entity and public IPP were, to varying degrees, chasing the Enron model. Common thinking was that over the near term, the industry would be deregulated and that utilities would, in many cases, be forced out of the generation business. Corporate Boards, investment bankers and analysts were all consistently reminding all energy executives who would listen, that their traditional utility multiples of 6-10 times earnings were very boring (and might be at risk in deregulation) and would be far exceeded by the higher multiple available to an integrated energy company. This model generally involved leveraging a balance sheet to support a strategy of trading around a variety of owned, to-be-developed and contractually controlled assets.

While the model was certainly not officially supported by the major rating agencies, most of the market participants, at least before the Enron bankruptcy, were deemed, by the agencies, to be investment grade.

Times of retrenchment

The Enron bankruptcy was truly a seismic event in the power industry and across the US. Not only did the publicity surrounding Enron halt or in some cases reverse what previously seemed to be the inevitable deregulation of the power industry, but virtually all the Enron copycats were thrown into a retreat. Almost immediately after Enron declared bankruptcy, the rating agencies dramatically shifted their views of trading risk, as well as their views about required capital, development activity, off-balance sheet borrowing and leverage for power/gas companies. This change in outlook did not seem obvious at first but in retrospect it now seems clear that the market turmoil in late 2001 and which lasted into early 2004, created a dramatic reshuffling of assets within the deregulated segment of the US power markets.

Since 2001, many banks and the power related credit markets struggled with portfolio problems and many participants reduced liquidity to the sector. Trader after trader, generally right after a credit agency downgrade, announced that they were pulling back or leaving the trading markets. Some of the largest traders threatened bankruptcy, leaving even the strongest traders to rethink their strategies with regard to counterparty risk and energy trading as a business. Developer after developer announced the cancellation or postponement of even late-stage merchant development projects. Utility after utility announced their intention to get back to the core business of being a regulated utility (boring became fashionable again). Sponsor after sponsor defaulted on project loans.

The California utilities were in deep trouble and even many of the perceived strongest national utilities such as Duke, AEP, Xcel, PSEG, Reliant and TXU started to look very over-extended. Smaller and medium sized utilities like CMS, TECO, Northwestern and SRC were punished significantly for any diversification from their core utility business. Diversified pipeline firms such as El Paso and Williams were weakened and gasping for liquidity and formerly strong trading firms such as Dynergy, Aquila, NRG, Mirant and Calpine could best be described as walking wounded as evidenced by speculative bond ratings and extremely low stock valuations. Against this backdrop and the well-publicised 2000-01 disaster around the ill-conceived deregulation in California, State after State either eliminated plans to deregulate or in some cases re-regulated previously deregulated markets.

It became increasingly clear to market participants that the rating agencies had made this fundamental shift and that the financial markets were much more difficult or impossible to access than previously. So company after company made the tough decisions to both decrease (or eliminate) its trading activities and to deleverage their respective balance sheets.

These pressures created a dramatic increase in assets held for sale including; mid-stream gas assets, newly finished and partially built natural gas plants and numerous qualified facility investments powered by a variety of fuels. Most of the sellers came from the ranks of the companies who were previously chasing Enron and included deregulated subsidiaries of utilities, IPPs, pipeline companies, trading companies and a new class of seller, the project finance banks. For much of 2002 and even into 2003 however, the power segment was considered toxic by the financial markets and it was not clear who the ultimate buyers of this significant inventory might be or even whether the supply of capital existed to fund the purchases.

On the block

Who then were the prospective buyers? To really address this question, it is probably best to divide the various assets held for sale into three buckets.

The first bucket includes the various assets, generally based in the US, Canada or the European Union which were either entitled to a regulated return or subject to a long term commodity purchase agreement with a credible industrial and/or utility offtaker.

The second bucket includes the various merchant plants that had been built or were being built across the US by a variety of different types of companies.

The third bucket included the various international projects that were owned and/or being developed in emerging nations.

Buyers for bucket one appeared almost immediately. Power-focused energy funds were always traditional buyers for contracted QF projects and both the traditional funds and the newly formed funds bought a lot of assets. New funds focusing on the QF segment came into the market and the Canadian trusts and strategic buyers were fairly consistent buyers. It is interesting to note that on the Aquila, QF asset sale handled by Lehman Brothers, more than 50 indicative responses were received before the deal was won by Arclight.

Bucket two was different. As 2002 went on the talk was not about what deals were getting done but about why nothing was ever closing. To solve the problem of having no real buyers for uncontracted assets, several industry veterans moved from senior perches within utility/trading companies into positions at large private equity firms or larger financial institutions with rock solid balance sheets and came back to engineer the purchases we've seen over the last two or three quarters. (I reference Matlin Pattenson's recently announced purchase of Duke Energy's SE Assets).

Finally with regard to bucket three several sellers report that the market values which were being assigned to emerging markets assets were so disappointing that many have chosen to wait for an uptick in interest and relatively few transactions of note have occurred.

Another way to view this transitional period is to look at required equity returns during different period of times. In 1999 we were working with a developer of a greenfield merchant plant in Indiana and a publicly-traded IPP agreed to provide the leveraged equity at about a 15% pre-tax rate of return (based upon pricing forecasts for gas prices and power prices). Two and a half years later in 2002, the same representative of the IPP, who was now a principal at a significant equity fund, issued a term sheet saying that it would supply leveraged equity for an existing co-generation project, subject to a long-term contract with a good utility and full pass through of gas prices, at a pre-tax rate of 23%.

This is an extreme example but shows how different the markets can be over time. Here we have a risky asset like a merchant plant receiving an 800 basis point better equity rate than a fully contracted project only three years later. Today, in mid 2004, I believe that required equity rates have dropped back down and if I had the same gas plant in the market, we could achieve a yield at perhaps a pre-tax return of 15-16%. Available project leverage has had a similar transition. In 1999 any viable sponsor with equity could obtain senior debt for a project, with or without a contract, at spreads no higher than 250 basis points over the risk free rate. In 2001 and 2002 little leverage was available in the market and those lenders which were still lending were receiving spreads of as high as 550 basis points. Recently we are seeing senior loans spreads tighten significantly as competition for the better deals has driven spreads back to pre-Enron meltdown levels.

The power industry is a huge complex market, which certainly looks different today than it did four years ago, and certainly much different than, I believe, almost anyone would have envisaged. The Enron meltdown, for reasons already discussed changed the world for virtually all participants in the power markets. We continue towards the future with a partially regulated, partially deregulated market subject to a patchwork quilt of state and federal regulation. I would say that the M&A surge caused by the availability of inventory from the various sellers weakened and hurt by the Enron effect is almost - but not quite - over.

Bucket one is pretty much gone and the market now must wait to see how the funds which purchased the assets ultimately choose to monetize them in the future. Many of the very good assets in Bucket two have traded, although there still are some that will trade. Finally there are a number of international assets that are available although it is not at all clear that the necessary private capital is available in many countries and regions that will allow these trades to occur.