The Merchant Asset Fire Sale: Deal of the 21st Century?
March 15, 2003
By Michael T. Burr
Companies that were on a buying spree before 2001 are putting assets worth billions n the block
A casual observer might expect that the industry's economic condition would produce a cornucopia of cheap assets for acquisitive companies (see "Making a Buyer's Market," p. 5). Eventually it might, but so far, it generally has not.
"Many investors enter this market with the impression that because the industry is in trouble, you will be able to buy assets at low prices," says Jeff Bodington, president of Bodington & Co. in San Francisco. "That may be true in some situations, but if you want to get good assets you still have to pay top dollar."
In 2002 and into the first quarter of 2003, prices have remained strong for high-quality assets-those with firm, long-term agreements and solid operational characteristics (see "Electric M&As in 2002," p. 26). The reason? A "classic flight-to-quality market," according to Bodington.
First, investors are eager to acquire high-quality assets, so demand is strong. At the same time, investors are shunning projects that lack long-term contracts, or those with operational problems.
Second, companies (and their creditors) are understandably reluctant to part with their strongest assets, but they are eager to dump those considered, in PR lingo, "non-core" or "non-strategic." Indeed, many companies are banking on their ability to sell those assets. As a result, the number of strong assets on the market has been limited, and the number of weak ones is growing by the day.
This supply/demand combination is keeping prices buoyant for contract-secured assets. Others, however, are not yielding their book value or their original cost.
Merchant plants, as a class, are suffering the worst devaluation in the secondary market, mainly because of exposure to three huge risk factors: anemic power markets, rising fuel prices, and persistent regulatory uncertainty.
In some cases, developers have cut their losses and withdrawn from plants that were under construction. NRG Energy, for example, pulled out of the 1,168-MW Pike project after it was 20 percent built, leaving more than $100 million behind. NRG and other companies have been forced to absorb losses on operating assets as well. But in most cases, where facilities are producing cash flow, their owners have resisted pressure to sell at a steep discount.
"The companies that own these assets don't yet face severe enough liquidity pressures to drop prices," Bodington says.
In some corners of the industry, the hardships of 2002 foretell fire sales in 2003.
"The initial array of bankruptcy filings that we have seen is the first phase," says Michael Zimmer, a partner with Baker & McKenzie in Washington, D.C. "It's possible there will be a phase two of bankruptcies in the next 12 to 18 months. It is the logical outcome of the inability to sell or restructure."
Others echo these sentiments, but positive trends are evident as well.
First, some merchant power plants might be transformed into contract-supported facilities. Utilities that are seeking low-cost, medium- and long-term power supplies see such contracts as a way to get price security in illiquid and volatile wholesale power markets.
Second, liquidity and stability might begin returning to the wholesale electricity market, making merchant plants more saleable. For example, energy clearinghouses could facilitate growth in trading. Likewise, increased activity by large trading houses and financial institutions would bring greater liquidity into the market. And progress to implement the Federal Energy Regulatory Commission's (FERC's) standard market design (SMD) could bring greater volume as well.
Third, companies might find alternative ways of raising cash. For example, master limited partnership (MLP) vehicles have been used by petroleum companies to securitize and manage diverse oil and gas assets, and this structure holds potential for merchant power assets as well.
These and other trends seem poised to break the logjam that has been holding back a veritable flood of assets in the secondary market. If and when the logjam breaks, the industry could embark on an asset reshuffling that will change the industry for good.
Merchant Malaise
In some ways, the utility industry seems to be regressing to an earlier stage of its development.
The most dramatic example is found in the wholesale electricity markets. Robust markets- which in part spurred development of more than 90 percent of U.S. capacity additions since 1997-have shriveled to less than one-third of the volume they traded before Enron's December 2001 collapse.
With no fluid marketplace to sell into, merchant generators are forced to retreat back to an earlier independent power producer (IPP) type of business model.
"People want to go back to something more traditional, with predictable, longer-term cash flow," says John Boken, a senior director with Kroll, Zolfo, Cooper, which is the restructuring arm of risk consultants, Kroll Inc.
Thus, merchant generators are now hunting for longer-term contracts, and some are finding them. Atlanta-based Mirant, for example, recently signed contracts to sell 325 MW of capacity through 2008 to Nevada Power Co. The contracts offload power from Mirant's new 533-MW plant at Apex Industrial Park near Las Vegas.
Other generators have signed similar contracts recently, and more might be coming as utilities seek price stability in an unpredictable wholesale market. But regulatory treatment of such contracts will determine how prevalent they become.
"Utilities want to offer tolling agreements and long-term power contracts, but they won't do it unless they can pass the costs to ratepayers," Bodington says. "Ratepayers will pay for volatile markets one way or another. The smart way to do this is for utilities to manage the volatility in markets on a portfolio basis, with the prior approval of regulatory commissions."
This trend might even evolve into the return of competitive bidding, as with the utility solicitations that spurred IPP growth in the early 1990s. Some utilities-including Xcel Energy and Duke Power-already have issued significant requests for proposals, and more might follow as utilities review their power-supply portfolios.
"Competitive bidding would be a more economic use of merchant power assets than gratuitously letting them get stranded in a Darwinian survival-of-the-fittest exercise," Zimmer says.
At the same time, merchant plants also could benefit from implementation of FERC's SMD. Significant complications impede the progress of the SMD nationwide-including challenges in the U.S. Congress-so market risks will persist in the near term. Nevertheless, progress is occurring. For example, ISO New England announced that its new SMD-based market would go live on March 1, 2003.
Ultimately, the SMD should increase trading volume and liquidity, giving merchant plants access to a more active marketplace, and thus firmer footing in the secondary asset market. Meanwhile, some merchants are finding more fertile trading ground in multilateral energy clearinghouses, such as NYMEX and the IntercontinentalExchange.
"A third-party clearinghouse function allows exposures to be mutualized across the market," says Kevin Howell, head of the trading group at Dominion Energy.
By spreading counterparty risks, clearinghouses reduce credit-clearing costs and facilitate greater liquidity in over-the-counter markets. Both FERC and the Committee of Chief Risk Officers (CCRO) recently have recognized the importance of this role. To the degree companies accept these clearinghouses as a place to hedge their risks, merchant power plants could become more saleable assets.
Securitize Those Assets!
As they weigh their least painful options for extracting cash from assets, companies are considering all manner of spin-off vehicles. One of the more interesting approaches might be the master limited partnership, a structure that petroleum and real estate companies have used to consolidate assets for tax purposes.
"MLPs have been effective for managing diverse oil and gas properties, so this may be a viable approach for managing electric properties," Zimmer says.
An MLP is essentially a subsidiary company that is established to own and manage a given set of assets. Plant owners "drop down" the assets into the MLP, whose securities can then be leveraged, sold, and traded.
This structure holds some promise for companies seeking to spin off power assets. A big attraction is that the general partner can continue controlling the assets with as little as a 1 percent ownership stake in the MLP. This means the asset owner can both liquidate assets and retain their strategic value.
Further, in some circumstances an MLP structure can bring higher prices by combining assets in strategic ways. "You can maximize the value of the asset if the cash flow is good, and if the market is putting more of a premium on net revenues than could otherwise be obtained in an asset sale," says Byron Egan, a partner with Jackson Walker LLP in Dallas. "You need certain operating synergies for it to make sense from a cost standpoint, but the assets don't have to be tied together."
Spin-offs like MLPs also could expand the universe of potential investors-a critical factor in today's tight capital markets.
"A lot of banks are reluctant to lend into this industry, regardless of the economics presented to them," says Kroll's Boken. "An MLP or equity-backed investment fund could be used to put banks in the position where they are not bearing the kinds of risks they have borne in the last few years."
Under New Management
Estimating the deal volume for assets entering the liquidation pipeline is difficult, given that many companies are not advertising the full extent of their sell-off aspirations. Rumors suggest that some major players have put their entire merchant fleets up for grabs. Official announcements, however, are less specific, and indeed many companies are still formulating liquidation strategies.
"People are making tough decisions about what to keep and what not to keep," says Douglas Fried, a partner with Chadbourne & Parke. "There is more of a willingness among companies to enter partnerships and joint ventures with other companies and financial investors that have more liquidity. There are more opportunities now to bring financial players into these projects than we've seen in a long time."
Other behind-the-scenes trends also suggest the industry is changing in ways both subtle and dramatic.
"Corporate paper-bonds and bank debt-is where the activity is happening," Boken says. "People who expect to be players in the utility industry for a significant period of time are buying paper at a discount and exercising their influence to ensure that the core assets of these entities are not sold off on a one-off basis."
In some cases, these players might be acquiring corporate paper with an eye toward a future Chapter 11 bankruptcy filing. "It's not unusual in restructuring situations to find an equity player buying senior debt at a discount and ultimately negotiating for the equity out-of-court or in a Chapter 11 process," Boken adds.
Whether through bankruptcies or not, a major asset reshuffling seems likely to begin in 2003. Some of the buyers will be major utility companies from the United States and elsewhere. "European utilities may come back into the market, and there is growing interest among Japanese and Canadian utilities that may be viable long-term players," Zimmer says.
Additionally, significant assets will likely enter the hands of equity investment funds.
"There will be a shift here," Boken explains. "The buyers will be financially sophisticated people who are accustomed to investing in distressed markets. The industry will be dominated by very disciplined boards that are put into place by these financial investors." Later, when the market's health returns, ownership will shift again as these financial investors exercise their exit strategies.
Ultimately, these shifts might benefit the industry by bringing greater discipline to utility asset management. "Being an optimist, I'd say that the industry is going through a cleansing," Fried says. "In the long run, it will be stronger after the problems are resolved."
Michael T. Burr is a Fortnightly contributing editor and freelance writer based in Minnesota. He can be reached at mtburr@msn.com.
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