Energy sector: the power and the glory?

Last year the lights went out in both New York and London as these major cities and areas of other developed countries such as Italy, Sweden and Denmark, suffered large-scale power cuts. Suddenly people’s attention turned to the challenges facing the energy sector. Where there’s change there’s opportunities for the private equity industry and a number of drivers mean the energy sector is likely to be the focus of increased investment activity in the years to come. Louise Cowley looks at what and where the opportunities are and who’s best placed to take advantage of them.

In the last decade, when private equity has achieved record levels of activity, investment by the industry in the energy sector has been relatively low. According to EVCA, for the five years from 1998 to 2002 the total amount committed to the sector is €1.622bn or just 1.3% of total European private equity investment over this period. These figures belie the level of wider activity in the energy sector, which globally is one of the largest industry sectors.

Investors have been put off by the volatility in prices in the energy sector and in the realms of private equity such a seemingly low tech industry lost out to businesses and more recently to bio and nanotechnologies, but this looks set to change. Investors are looking at all of the sub sectors within the energy bracket with increased interest and there are opportunities ranging from early stage technology-based projects up to buyouts worth several billion. Each of the sub sectors within the industry is different and requires a distinct set of skills, knowledge and risk appetite. The most significant theme driving increasing interest in all of these areas is the anticipated global growth in the demand for energy.

Subhead] Power

Of the industries that are included in the energy sector, power is the private equity industry’s current sweet spot. January’s news that Soros Private Equity Partners has hired Nick Baldwin, former chief executive of UK energy company Powergen, to look at investment opportunities in the utilities sector is indicative of the current high level of interest in the power industry in the UK and Europe. Although there is potential for consolidation of both water and telecom companies it is electricity generation that is the main draw and Soros is already reported to have teamed up with Texas Pacific Group (TPG) to bid for two UK power stations.

Soros and TPG are not alone; other major buyout houses are also investigating the opportunities and private equity firms are not the only ones eyeing possible investments in this area. In recent months six European banks have formed a company, CGE Power, with the aim of buying indebted and distressed power stations in the UK. The banks behind the vehicle; Abbey National, Bank of Scotland, Lloyds TSB, Royal Bank of Scotland, Bayerische Landesbank and HVB, are among some of the biggest creditors to the independent power sector. Last year competition was intense when Drax, the UK’s biggest power station, was on the market. Bidders included Drax creditor Goldman Sachs, investment firm Miller, McConville, Christen, Hutchison & Waffle, mining firm BHP Billiton and the eventual winner, a utility called International Power.

To understand the situation giving rise to these potential deals it is helpful to look at the development of the power market in the US and the private equity industry’s role in it. Until the 1990s the US power industry had traditionally been dominated by heavily regulated monopolies, but state and federal legislation eroded this and encouraged a more competitive market. A significant surge in the demand for electricity, linked to the growing popularity of all things telecoms- and Internet-related, was widely predicted. Deregulation gave rise to a new group of power producers, merchant energy companies such as Enron, who built new power plants hoping to cash in on the lucrative wholesale energy market. The increase in demand failed to live up to expectations and instead power producers found themselves in an over supplied market with falling energy prices jeopardising their profitability.

Speculating on the price and demand for energy did not pay off and has left the US littered with distressed utilities. The value of power plants has in some cases fallen to below their build cost wiping out investors’ equity. The expansion in power producing capacity in the US was highly leveraged, often financed by European banks, and in the current situation creditors are looking at any option that can give them some upside. Private equity buyers provide one such solution.

Lyons Brewer is a partner at placement agent CP Eaton, which is currently raising a private equity fund dedicated to the power sector. “Energy is a big sector of the US economy, earning between a quarter and half a trillion dollars annually it accounts for around 5% of the US economy. So far there’s not been deep penetration by private equity investors but now they are teaming up with experts to exploit the current train wreck situation,” he says.

Power plant assets themselves are attractive and the financial distress of the merchant power companies means they, and other non-core subsidiaries, can be acquired at a steep discount. Private equity investors have the opportunity to restructure the debt, run the plants at a breakeven level and wait for a recovery in the demand for power. Brewer says: “It’s a sector of the economy that’s ideal for private equity funds, they’re patient and can deal with initial operating losses. Other utilities won’t touch these power plants because of book losses.” The growth in demand, although over-estimated by the merchant power companies, is inexorable. In addition to increasing consumption, old generating plants are retired each year and in the current situation construction of new plants is going to be limited. It is estimated that in five to seven years there will be a need for more capacity and power plants will be in demand again, providing an exit route for investors.

The US has already seen a number of substantial private equity-backed deals in the power sector. Most recently El Paso Merchant Energy sold 25 power generation facilities to Northern Star Generation, a wholly owned subsidiary of AIG Highstar Generation, for $746m plus the assumption of $174m in debt. This is not AIG’s first transaction in this sector and Carlyle, Madison Dearborn, CSFB Private Equity and Morgan Stanley Capital Partners have all already committed to power deals.

Power generation is a capital intensive business and power plants, even when sellers are distressed, do not come cheap. The size and scope of these deals has limited the number and type of firms able to look at them and well-financed, established generalists have been among the first to take advantage. However, the size of deals, coupled with investors’ enthusiasm for their opportunistic investment strategy has led to first time power funds in the US raising amounts exceeding a billion dollars. CP Eaton is currently raising the Tenaska Power Fund, a specialised buyout fund focused on investing in strategically located power assets. Tenaska, a privately held power generation company, has teamed up with Bain Capital, which has allocated up to $500m, to create this power fund.

There are fears the US will move towards re-regulation of its utilities but for now the shakeout of the power generation market continues apace. Although the pain suffered by power companies is not as acute in Europe, activity is showing signs of picking up. If you look at the parallels with the real estate sector, where the American savings and loans scandal created opportunities for private equity investment there and then players began to look at European deals, then it seems only a matter of time before the power sector here attracts investment.

The more fragmented European power industry hasn’t been deregulated to the same extent as in the US but, despite transmission problems that give the appearance to the contrary, Europe also has a glut of capacity. In the UK, privatisation of the energy sector and competition increasing measures introduced by regulator Ofgem led to the collapse of wholesale prices in the late 1990s, putting pressure on the independent power plants, many of which are owned by the same troubled US energy groups.

Multi-billion dollar US generalist funds are likely to be the most active in pursuing power deals, with their European counterparts not far behind. “We believe that it’s not an industry that should be entered without the expert knowledge and advice of someone with operating experience. You need an understanding of the deregulation issues and market dynamics. There can be pollution concerns and you have to deal with communities; there’s a lot of responsibility to ownership,” says Brewer.

Despite their experience in the sector, the dedicated power funds raised in the US are unlikely to look at Europe. Power is a local business in the US and the regional regulatory intricacies of Europe present a significant hurdle, which, with plenty of opportunities at home, US funds have no need to overcome. Dedicated European power funds also look unlikely for the time being, in part due to the attitudes of limited partners. “European investors are still hesitant about industry specific funds, based on their experience of telecom and technology funds. More US investors already have an allocation to energy, which includes power funds,” says Brewer. There is European interest in power funds but LPs are wary and need educating on the sector’s opportunities.

Subhead] Oil and gas

Within the energy sector, the oil and gas industry probably has the longest history as a destination for private equity investment. In the US substantial exploration funds have been around for approximately 20 years and in Europe 3i has been active in the sector for a similar period. Other players with experience include Aberdeen Murray Johnstone Private Equity; its Scottish heritage has put the firm close to opportunities arising from the industry in the North Sea. In January 3i announced two investments in the sector; alongside Candover and JPMorgan Partners the firm is acquiring ABB’s oil and gas services business for up to €768m and at the other end of the scale is backing DES Operations with a £2.5m venture capital investment.

Aberdeen-based DES Operations has developed a sub-sea interface for wellheads that enables pumping or processing equipment to be located on top of the wellhead as opposed to at the surface, at the manifold or in the well as is currently the case. This has significant advantages to the oil companies in terms of recovery rates, cost and risks. The buyout of ABB Vetco Gray and ABB Offshore System, now to be known as Vetco International, supports the incumbent management team. The company manufactures drilling and production equipment for rigs and production platforms as well as designing and managing the instillation of sub-sea production systems. It also modifies and maintains existing offshore installations and constructs new fixed and floating production facilities.

This is not the first oil and gas transaction for co-investing firm Candover either. Previous oilfield services deals include the 1992 investment in Expro and in 1999, Candover invested in Pipeline Integrity International Limited (PII), which provides pipeline inspection services for the oil and gas industry. Last year the firm led the €141m MBI of Wellstream, a manufacturer of flexible pipe for the offshore oil and gas sector. John Arney, director at Candover, said: “Candover first approached ABB almost two years ago with a view to acquiring the oil and gas business as part of our strategic intent to build a significant presence in the upstream oilfield services sector.”

Oil and gas companies seem to appeal to the public markets, even in difficult conditions. In 2002, 3i listed two oil and gas businesses; John Wood, the UK’s largest oil service company, and oil and gas production company Venture Production. Candover’s Expro investment was also realised via a London Stock Exchange flotation in 1995. Trade sales in the sector have proved lucrative too; Candover sold PII to GE Power Systems in 2002.

Companies offering services to the oil and gas industry seem to be the most popular investment area but there are a variety of opportunities in the sector and 4D Global Energy Advisors has just raised Europe’s first fund focused exclusively on the sector. Sponsored by Société Générale Asset Management, the fund closed at $81m in October. It plans to invest, in Europe and elsewhere, in each of the four main segments of the industry: upstream (exploration, development and production), midstream (processing, transportation and storage), downstream (refining and marketing) and services (providing services and technology to the industry). Common themes for investee companies are consolidation and generational change in Europe, the opening of new markets outside North America and the EU, and portfolio rationalisation by the major oil companies in the North Sea and elsewhere.

Simon Eyers, Jérôme Halbout and Tighe Noonan, the three partners behind 4D Global Energy Advisors, gained their experience of the energy sector through investment banking. Although the oil and gas industry appears to be dominated by publicly quoted giants, private medium-sized businesses account for 15% of global reserves and production, compared to the 10% represented by listed companies. “These private companies are looking for investment banking skills and backing but investment banks focus on higher value deals and lose interest in companies valued at less than $200m in the energy markets,” says Noonan.

Boutiques focused on energy have not met with much success, leaving European mid market companies in the industry with no obvious partners so they often end up dealing with generalist banks with no knowledge or skills in the sector. “We were struck by the need of private entrepreneurial companies to have access to capital?so we decided to put our money where our mouth is as a shareholder. No one else is doing this here, there are funds in the US but they’re mainly doing domestic investments and have no experience or appetite to invest outside the US,” says Eyers.

In the last ten years the global energy economy has undergone a transformation as M&A activity has been driven both by the need for listed companies to appeal to investors globally and by the scale of projects such as pipelines that were too big for even the largest players to undertake alone. Sector restructuring has provided good opportunities for private equity investors. The creation of large conglomerates isolates orphan assets, like smaller production units in the North Sea, which the parent companies no longer want. Mergers have also freed up senior management with skills and knowledge of opportunities, who are free to pursue new careers and more willing to take risks.

In oil and gas there are investment opportunities ranging from large LBOs to venture capital deals but 4D is looking to take minority stakes in five to eight businesses with enterprise values ranging from $50m to $500m. The type of companies that appeal are well established, often family-owned, cash flow-based and with a proven management team. Relatively low risk, these investments are more akin to development capital deals. “We’re really investing in management, supporting shareholders in a transition stage,” says Noonan. Being based in Paris gives 4D an advantage when it comes to continental deals: “There are some firms doing these deals in the UK but there’s no one in Europe looking at the $50m to $200m deal sizes,” says Eyers.

4D has agreed two deals and a third completion is expected soon. The fund’s first investment backs Italiana Energia e Servizi in Northern Italy, a 50 year-old crude oil refining and marketing company with 110 service stations and a wholesale business. Management are the core shareholders and want to move on. 4D aims to help improve margins and build the business, rationalising some aspects of it and investing to strengthen others. The second deal is a French oil field services company, the market leader outside the US, in scientific measurement during drilling. Established in the late 1950s and still majority owned by the founder, 4D provides competences and contacts not found in-house.

Subhead] Alternatives and renewables

The final area of the energy sector attracting private equity investment is alternative and renewable sources of power. This is a fast growing sector and with the EU aiming to increase the share of energy from renewable sources from 6% to 12% by 2010 this growth looks likely to accelerate.

The drivers behind investment here are perhaps more obvious than in power and oil and gas. The depletion of fossil fuels threatens the existing energy economy and the search for alternatives has been on the agenda of governments worldwide since the 1970s. In the following decades environmental issues came to the fore, with concerns about greenhouse gases and carbon emissions. Gianni Operto, a principal at SAM (Sustainable Asset Management) Private Equity, says: “Following deregulation people have more choice and they look at what they’re buying. They don’t want nuclear power and have issues about climate change. Now utilities have to treat them like customers not just consumers.” With the number and severity of power outages rising, both domestic and industrial customers are looking at alternative, and hopefully more reliable, power sources.

Thirty years of state-sponsored R&D has produced a range of new technologies and investment opportunities are ample. In 2003 SAM, which invests in water, materials and nutrition as well as emerging energies, saw around 700 business plans, although it made just four new investments. Wind and solar power are currently the major sources of renewable energy, with companies in these industries receiving mainstream private equity backing such as Doughty Hanson’s investment in wind turbine manufacturer LM Glasfiber. As well as technologies that increase the efficiency and reliability of traditional energy sources, there’s the opportunity to invest in alternatives like biomass, waste derived fuel, geothermal and various water generated energies.

Operto is convinced ocean wave generated power, a long-standing but previously imperfect technology, is finally coming of age. He says: “It’s been around for 20 years now and has learnt lessons from the off-shore oil industry, such as how to survive storms. The technology is efficient and waves have the highest energy density of all alternative sources. There’s plenty of it around, it’s steadier than wind and more predictable.”

Another growing trend is decentralised power generation systems. In response to the growing demand for power, utilities have built bigger centralised plants but the power lines needed to transport the electricity are unpopular with communities and as a result it’s virtually impossible to build new ones. The existing system has become congested and bottlenecks are vulnerable to problems that have disrupted supply across Europe recently. As power failures increase there is also more demand for back-up electricity generation. One solution that’s both cost efficient and environmentally sound is to produce electricity in small, local generation units on the site of consumption. This reduces the burden on the transmission system and the excess can be sold back to the grid.

Initially, this might look like the end of today’s utility companies but distributed generation can be turned to their advantage. Utilities see the opportunity to install and operate local generating systems that they would own, these can be grouped together to form virtual power plants and controlled centrally. Under this system, supply could be matched to demand more efficiently, the risk of power failures reduced and customers would continue to buy electricity from utility companies. SAM has invested in technology for small generating systems, such as micro-turbines, and is looking at systems for centrally controlling them, as there is likely to be demand for both as utilities fight to continue their market dominance.

Fuel cells, electrochemical devices that convert fuel (e.g. hydrogen, methanol, methane) directly into electricity, are another focus for venture capital investment. They are more efficient than internal combustion engines and have the potential for higher power storage capacity than lithium-ion batteries. As such they could become the dominant technology for automotive engines, power stations and the power packs for portable electronics. Europe already has at least one fund, Conduit Ventures, dedicated exclusively to fuel cells and related hydrogen technologies. Backed by international corporates such as Shell Hydrogen, Mitsubishi, Danfoss and Johnson Matthey, the firm invests primarily in Western Europe and North America.

Early stage energy investments announced in January include two fuel cell companies. Ceres Power, a UK company developing fuel cells for distributed power generation, received a £5m second round investment from the Carbon Trust, Imperial College, NPI Ventures (part of the Nikko group) and funds managed by the Fleming family. Conduit Ventures, alongside the VC arm of the UK’s Carbon Trust, invested in the first financing round for CMR Fuel Cells, a spinout from Cambridge’s Generics Group.

Ceres Power is developing fuel cell products for distributed power generation; potential markets are commercial applications such as the domestic boiler market, auxiliary power units for transportation applications and generators for secure power supply. These fuel cells can operate on hydrogen and existing hydrocarbon fuels, such as natural gas and Liquid Petroleum Gas, while ensuring carbon dioxide emissions are minimised. CMR Fuel Cells is developing a flow through fuel cell using mixed reactants that aims to make fuel cells ten times smaller, more powerful and up to 80% cheaper. Applications include battery chargers, auxiliary power units, laptops, power tools, robotic devices, portable generators, and portable military applications.

The wealth of investment opportunities has led to an increase in the number of VC firms actively investing in this sector. “In the US there’s a community of energy investors, and this is developing in Europe. We’re very happy about this as we need co-investors to help develop companies,” says Operto. He estimates there are around a dozen specialised funds in Europe, many of them backed by corporates with a strategic interest, as well a number of technology funds, looking at the energy sector.

SAM Private Equity currently manages €90m, of which 75% is dedicated to making investments of between €5m and €8m in energy-related companies. SAM’s LPs include traditional private equity investors like banks and insurance groups but Operto says the fund is more strongly supported by those looking for strategic benefits, such as international utilities including Hydro-Québec, Ontario Power Generation, EDF, Mitsui and Norsk Hydro, which has its own venture capital fund investing in the energy sector. The firm is currently raising a new fund with a target of €100m to €150m, 50% of which will be allocated to energy investments. “In the new fund we expect to see continued interest from strategic investors but there’s clearly a growing interest from traditional financial investors. It’s an opportunity for them to diversify into a promising new sector and although its still unfamiliar to many, we are confident the new fund will be carried more by financial investors,” says Operto.

Specialist knowledge is needed for early stage investment in energy as it is for successful investment in life sciences or IT. Although top exit valuations for energy-related start-ups may not be as high as the stellar deals in IT or biotech Operto believes the risks can be lower with a proven technology and the risk of failure lower than in other sectors. Renewable technologies are driven by politically motivated regulations and subsidies and although the sector benefits from subsidies and R&D investment, it is this, rather than the technology, which is perceived to be the greatest risk. Another danger is that sustainability is often associated with not-for-profit investment and VCs specialising in this area can attract entrepreneurs that are motivated primarily by environmental concerns, rather than profit.