With the power market in the US regaining some of its shine, private equity firms are increasingly looking to the power market for big returns on distressed assets. Some firms have been at it for a while, but for many it is a new market with growing potential  - with assets now undervalued relative to the risk involved. But some market players say few firms have the credit clout to make a go of it. But with restructuring, and with expected regulatory changes to come - including the repeal of the Public Utility Holding Company Act of 1935 (PUHCA) - there will certainly be many opportunities in the years to come both for PE firms and for other buyers of power assets.

The dust is finally clearing over the remains of the US power market after two years of wildfire bankruptcy from bad corporate governance and tremendous oversupply. With the market once again settling down, companies are evaluating their positions, restructuring in the face of a changed marketplace, and trying to sort out where to go from here.

Much of the market was a wasteland of assets and securities worth only a portion of their former value. But all this is changing. With little or no new builds in the past few years and demand continually on the increase, the pendulum is once again swinging, and IPPs are regaining their shine. Says John Buehler, managing partner of private equity firm Energy Investors Fund (EIF): "Few power plants have been built for a while, and the industry is now behind the curve in some areas in terms of supply and demand. It is a fabulous time for buying assets."

Many of these underpriced assets are now getting snapped up, and as a consequence their value is once again rising. When this rise began, so did the interest of investors looking to cash in. Many former power execs turned distressed asset buyers overnight, as did a number of private equity firms, looking to get in on the upswing and participate in the return to value.

Explains Ted Brandt, CEO of boutique Marathon Capital: "The stars are all reasonably well-aligned for private equity investment. What you have is a market where asset quality has certainly been up for debate, but in our opinion is underpriced relative to the turmoil of last couple of years. Any time you have an industry that is this large and complex with a lot of opportunity, private equity firms will start looking."

Existing plays and players

Some PE firms, such as Goldman Sachs, Arclight Partners and Energy Investors Fund, have been involved in the market for quite some time with successful results. Arclight was set up in 2001 specifically to look at buys in the power market. The group has since closed a number of transactions - including core portfolio company Trout Coal and most recently the $300 million purchase of assets from Aquila. Arclight has agreed to buy 12 power plants from Aquila, producing 643 megawatts in total, in the states of California, Florida, Georgia, Maine, New York and Washington, and in Jamaica.

EIF, which has been around since 1987, closed its latest fund - the $250 million USPF fund - in December and has commitments for about 60% of it to date - including primarily operating assets, but also a stake in California and a construction-stage asset. The goal is to have a portfolio providing between 15% and 18% yields, according to Buehler. Another fund is expected to close in the second or third quarter.

Dresdner Bank, the parent company of EIF, announced just recently that it has sold its entire 100% stake in the PE firm to management, for an undisclosed sum. The deal closed in late December, and the bank cites changes in strategy and a refocus on core efficiencies for the departure. It has scaled back balance sheet exposures across most industries. Buehler says the sale is a positive thing for the firm. "The corporate overlay structure that you get as part of large corporation is not always attractive to institutional investors, so this is positive for us," he says. "Investors want to know that the people they sit down to discuss strategy with are the people who are making decisions."

Buehler is, naturally, optimistic about the opportunities for PE firms in the power sector. He says that there will be a huge turnover of assets in the US market over the coming few years. "It is likely that as much as 15% to 20% of this marketplace will change hands. We will have bought and sold a fifth of the largest grid in the world, and that fifth of the market is roughly equal to next largest grid in world. That is extraordinary. Many of these assets have already been put on the market and sold. We expect that to continue for quite some time, although inevitably there will be price compressions."

While some firms have managed to successfully move into this market, a number of firms have failed to close deals. Although technically the market appears to have good synergy with the equity investment models espoused by private equity firms, this is not always the case. First, there are drawbacks for PE firms. Second, in many instances private equity may not be viewed as the best way forward for the companies themselves.

The biggest question mark for PE firms, according to one adviser, is the potential return. Says the adviser: "Their return requirements are higher than what is generally possible in this marketplace, so the gap between bid and ask is significant. Thus we have not seen a significant number of closings. The question is how do they bring home targeted returns of as much as 20% in a market that normally sees at most 13% to 15% returns?"

Buyer and seller needs

Buehler says that this depends on the needs of the seller and the goals of the PE firm. "In today's marketplace the needs of seller and the needs of buyer can quite easily be at odds with one another. If the seller itself is distressed and is making fire sale either of the distressed assets or of good quality assets in order to raise cash, you can actually get in where the assets are capable of being acquired at an undervaluation, as you have a needy seller. The goals of private equity players are, or course, pretty easy to figure out - more return is always better, and you may have a target of cashflow you are looking. For example, cash-on-cash at 15% and a 20% IRR over the life of the fund. So you bid on assets only where this return is possible. You can certainly find assets that would produce these kinds of yields." But then the question is how to value the assets to ensure that return is achievable.

This is particularly tricky when dealing with merchant assets. "Valuation is a critical question, and getting that right is key for this type of investment, where the potential risk can be significant," says an adviser.

With plants having an existing long-term PPA this is much less of a concern, as buyers know the value of the contract and the yield. There are still a number of external factors that will play a role, but there is a basic cash value for that contract that can be used in private equity models for internal rate of return. But with merchant assets, where the security of a PPA is not there, although the potential reward may be greater, so is the inherent risk. Proper valuation becomes even more critical, and more difficult.

Another big issue for PE firms, according to Buehler, is that of convincing investors of the possible value of looking into this market. "We have to demystify the power sector for institutional investors participating in a fund, and emphasize the benefits of this marketplace. It can present an opportunity for relatively low risk and relatively good returns."

Says Buehler: "If you want to attract the capital that is necessary to grow this market, it has to produce returns that will bring in institutional investors, and continue producing the returns needed to keep attracting them." This means there has to be an equilibrium between the value provided to the power plant itself and its investors, to offtakers, and to the consumer.

Another big issue for buyers is that of credit. Explains one market participant: "The challenge when a private equity firm comes into the power market is in bringing credit to trading assets, particularly when buying anything with a merchant component. How do they add credit capacity so they are accepted as a trading partner? This is key for distressed entities."

Distressed companies can have an impaired ability to trade, in procurement, in selling electricity and in balancing their positions. For companies in a distressed state, without an investment grade credit rating, all of this is much more expensive and much more difficult. Especially for those with project financings or genco financings - where cash is sheltered in a subsidiary and trading operations are housed in the parent company.

Adds Brandt: "The weakness of most PE groups is that they have capital but not credit. Some, such as Goldman Sachs, are successful because they are able to bring the credit rating of their parent company to bear." But for those without that backing, the challenges may outweigh the potential reward.

There is also the issue of understanding how the market operates. "For firms looking at the power market for the first time, there is a steep learning curve, which is not to be underestimated," says the adviser.

Nonetheless, there are a number of firms now in the process of looking at deals, and a number of new firms springing up to take advantage of low valuations to pick up assets. For example, Invenergy - the firm set up by former SkyGen execs - has purchased the 370MW Hardee Power Station in Florida from TECO Power Services (TPS) for $115 million, including outstanding project-related debt.

New York private equity firm Fortress Investment Group is believed to be looking at merchant power plants, contracted facilities and gas pipelines, and ACI Capital is evaluating opportunistic plays for contracted and fully merchant generation assets. A number of firms have also partnered with experienced power industry management teams in order to take out the learning curve - for example Madison Dearborn Partners with Noble Power Assets, and Bain Capital with Tenaska.

A Bush in the hand

Brandt at Marathon says there are two potential plays for private equity firms. "One is to go for assets subject to long-term contracts, but private equity may not be the most efficient capital to do that," he says. "Another is that private equity firms may have an interesting opportunity if the current energy bill goes forward."

If President Bush's National Energy Policy (NEP) gets through, this will mean the repeal of PUHCA - the 1930s law that requires stringent government oversight if a regulated utility hopes to acquire other non-contiguous assets. If it is repealed many market players believe that this will lead to consolidation across the very fragmented power market. In fact, investor Warren Buffet has said that he will invest up to $15 billion in the utility sector if the act is repealed. "This would give good headwind towards consolidation. We will see large utilities buying mid-size entities, and mid-size buying smaller - similar to what we have already seen in telecommunications and banking," he has said.

Ultimately cost, efficiency and economies of scale will drive this fusion. Says Brandt: "If these legislative changes go forward and consolidation occurs, owning equity in small and mid-sized utilities will present an interesting opportunity for private equity firms and other entities for years to come."