Distressed asset funds, or vulture funds to their enemies, will have a significant role in the restructuring of the overleveraged US electricity industry. Indeed, they have been factored into a number of scenarios by which banks forced into taking the keys to power stations can get out of the power sector. But there are signs that some of the more aggressive players are looking at taking debt positions in troubled generating facilities, and potentially dashing hopes of a tidy restructuring.

The background is one now familiar to lenders - sponsors without access to capital markets and with near-worthless credit ratings have been unable to inject promised equity into large construction ventures. The two most high-profile examples are NRG Energy and PG&E's National Energy Group (NEG). NRG is in talks with banks regarding a series of defaults on debt and equity obligations, including $1 billion to round out a construction revolving credit facility led by Credit Suisse First Boston.

The NEG has already given some indication of the direction it plans to take by essentially asking its lenders to make good its equity contributions to the four plants in the GenHoldings I facility. It is understood that the Citigroup- and SG-led syndicate now finds itself in the plant construction and operation business. The NEG has also defaulted on $431 million due under a corporate revolving credit.

The two are close to Chapter 11 proceedings for different reasons - the NEG because while relatively creditworthy was forced to use ratings triggers to make itself financeable in the absence of a creditworthy parent. Pacific Gas & Electric, also part of PG&E Corp., filed for bankruptcy in 2001. NRG's problems lie more in its breakneck expansion, and the fact that it may have overpaid for assets in a softening market.

The second parallel development is the increase in activity from non-traditional sources of capital. The first sign of this was the move by MidAmerican Energy to take control of Williams' Kern River pipeline. This was swiftly followed by a deal with MidAmerican's parent, Berkshire Hathaway, and Lehman Brothers to provide $900 million secured on Williams' Barrett Resources assets.

Lehmans and GE Capital provided a $1 billion loan to PG&E that was secured on a stake in the NEG. This has been reduced and extended, and GE has sold up to Watershed Capital, a fund run by a number of experienced ex-employees of Farallon ? the largest hedge fund in the US. And CSFB and Berkshire recently lent Houston's CentrePoint Energy $1.3 billion to help it secure a refinancing on its $4.7 billion corporate debt. Most of these unconventional deals carried interest rates in excess of 10% ? a clear sign of the returns expected by these investors.

These deals have excited a lot of interest in the market, although some observers have gone so far as to compare such bailouts as predatory lending on a grand scale. Certainly CSFB's portion of the CentrePoint loan traded above par, and received a warm welcome at debt funds, in the days following its completion. But such deals will not be the norm. Tom Kilgore, El Paso's head of structured finance, says that ?the value proposition behind what distressed funds can do has not yet sunk in. But Lehman-type deals will not be that widespread.?

Power generation assets are a little less attractive to such funds because many of them simply are not cash generative. The attraction of utility stakes is that they provide access to respectable and solid, if uninspiring, cashflows. Plants require much more solid work on valuations and taking a position on the future shape of the US power market. This is good news for due diligence consultants, which have been able to replace lost fees from new loans with advisory work for these secretive clients.

These assets also usually come with a syndicate of lenders attached which have bought into a deal at par and have little intention of sacrificing this position to a fund that bought in at a discount, especially when they believe that they can effect a recovery. It is here that psychological warfare begins to play a role ? under what circumstances would a project debt holder want to liquidate its position?

Some analysts, including those at the ratings agencies, have claimed that representatives of funds have been attempting to get credits notched down, occasionally by using incomplete or misleading tips. Having an unfavourable market report on a target credit is another useful way of bidding down its debt. If a hostile debt bidder can control a project's debt, especially by buying in at around 50 cents on the dollar, the rewards, even in the current electricity market, can be huge.

These rewards, however, can be difficult to quantify. The first reason is that forcing a bankruptcy and subsequent restructuring is not a precise process. Much will depend on the disposition of bankruptcy judges, and the process can drag out for a long time, even for relatively simply encumbered assets. This factor alone is enough to discourage a number of vulture funds. Forcing a bankruptcy without unanimous approval is a difficult process, and there is no magic majority required to gain approval.

Douglas Fried, partner at Chadbourne & Parke and head of Chadbourne's Project Finance Workout and Restructuring Practice, says that ?there are certain rights in financings that I consider sacred. These include changes to interest rates, payment dates, payment terms and amortization schedules, which typically require unanimous consent to change.?

One comparatively simple way for funds to buy their way into the sector would be through project bonds, and here there are some interesting distressed assets on offer. These include the NRG gencos, in particular the South Central issue, which has received a notice of acceleration on its bonds. On 21 November the bond trustee issued the notice, which NRG believes is more about protecting existing rights than a prelude to a liquidation. The notice came after it fell behind on a $47 million payment, and the genco has $750 million of a $1.1 billion issue, split between 16- and 24-year notes, outstanding.

The other prime targets are AES' single-asset bonds for projects located in the northeastern US. The two facilities, Red Oak and Ironwood, were both bond financed on the back of tolling agreements with Williams, and the rating of both is now B2, according to Moody's Investors Service. Both have uncertain prospects in a merchant market, since Ironwood is located in Pennsylvania and Red Oak in New Jersey. The PJM market, whilst relatively efficient, is very competitive.

Project bonds are not the most liquid of instruments, although they are more readily tradeable than bank debt. They were designed with buy-and-hold investors in mind, particularly those large pension funds and life companies with the due diligence skills. Nevertheless, spreads over 10-year Treasury have begun to show marked volatility, with genco paper, which includes here debt such as that of NRG South Central as well as senior notes from players such as Mirant, leading the way.

Credit Suisse First Boston's project finance index does not show the spreads on individual issues (that is considered proprietary), but the general trends on the basket of bonds. This is represented below. The lines shows a large increase in spreads in the last twelve months, with much of that concentrated in the last five. To what extent this is responding to changes in cash flow, and to what extent this rise is attributed to influxes of hot money is difficult to determine. Certainly the recent dip has little echo in the stream of bad news from merchant generators.

Another possibility is that the funds and life companies that make up much of the market for project bonds, have been forced to divest themselves of some of their holdings. John Anderson, a director at John Hancock, speaking at Project Finance's Global Energy Summit, said that the institutions ?have got their bucket full of BBB- credits that have subsequently slipped. The liquidity situation is therefore not good for new issuers?. It also makes it likely that existing debt will be on the market. According to Anderson, ?distressed debt players are not yet active at the project level, although I do expect them, but par buyers will certainly have different priorities.?

Where this situation leaves the banks is less clear. Fried at Chadbourne & Parke acknowledges that the situation for bond debt is slightly different, in that discussions with lenders can be a little more interactive. But banks have a set of harsh economic choices to make. Don Kyle, head of project finance capital markets at SG, said at the same event that, ?bank sentiment is crucial, because if lenders believe that there are substantial potential losses then an orderly restructuring will be difficult.?

For Kyle the most important thing for banks holding project debt is for lenders to keep focused on the recovery potential for project assets and, implicitly, the ability of project lenders to extract the best value from such assets. The best way to make these creditworthy, however, will be to place as many of them as possible under contract. But finding municipalities willing to tie themselves into long-term agreements will be difficult with spot prices at historic lows.

Valuations will be crucial for the level of debt that a project can support going forward. Fried, at Chadbourne & Parke, says that ?at the end of the day, for any restructuring to be successful, it will have to make economic sense?. And a full-scale restructuring will have to wait on the resolution internally of what provisions banks will have to take for bad project loans.

This process has barely begun, but some bankers believe that lower debt values will have to be recognised by lenders sooner or later. At this point the opportunities for distressed debt funds will multiply. So long as banks are unable to liquidate their portfolios using collateralised loan obligations, the urge for a fire sale will exist. Should a bank unilaterally decide to withdraw from the lending business this could spark a wider sell-off.

The use of private equity funds as a suitable exit strategy is still the route that banks would be most comfortable with. Moreover, the tension between holding company debt, where the distressed funds have been most active, and project debt brings with it other challenges. Stephen Stolze, managing director at consultants R.J. Rudden, says that ?current debt structures in the industry are financially and legally complicated. Where corporate-level debt supports both regulated and non-regulated utility operations, the issues become vastly more complex.?

Stolze adds that ?many of the projects are going to end up with some form of restructuring, and the debt holders may end up with a large proportion of equity. They will then have to optimise the asset, or put it into a shape that would be attractive to a buyout firm.? Utilities that specialise in outsourced power plant management know who to call.