With the demise of the Enron subsidiaries and the recent passage of new energy legislation, merger activity in the $300 billion energy sector is expected to increase significantly in 2004. And private equity firms are leading the charge.’
“[Private equity] firms are crucial to the trends that are developing in the energy industry, particularly in the electricity sector,” said Mitchell Hertz, a Kirkland & Ellis partner and head of the law firm’s energy practice.
For example, GTCR Golder Rauner recently purchased Hardee Power Station from TECO Energy for $115 million, plus the assumption of all outstanding debt. Powered by natural gas, the contracted power plant produces 370 megawatts of electricity and serves West-Central Florida. One megawatt serves approximately 1,000 homes.
Indeed, sources say the purchase of contacted power plants in the generation sector is fast becoming a trend. Within the generation sector, private equity firms either choose to purchase merchant assets (power plants without contracts to supply energy) or contracted assets, which are power plants that have long-term service agreements in place.
“The industry’s recent turmoil has had the biggest impact on partially-built and merchant plants, while those with long-term contracts have remained viable,” said Hertz. “Private equity firms are initially looking to transact in the contracted asset space.”
Returns for contracted assets, however, do not equate to the grand slam returns PE shops strive for. But the deals are popular as a means to an end. “Some shops are using the acquisition of the contracted assets to gain a foothold in the energy industry,” said Hertz. “It’s then that they step into the higher risk sectors, such as merchant trading, and buying plants that lack contracts. And so far, banks are willing to lend a hand and the creditors are betting on a turnaround. Now we’re seeing a mismatch in values between buyers and sellers.”
Government Creates Spark
Helping fuel interest in this area is the U.S. House of Representatives, which, in November, overwhelmingly passed the Energy Policy Act of 2003, which would offer up $23 billion in incentives mostly to companies using renewable fuels. Perhaps even more important, the bill also looks to eliminate the Public Utility Holding Company Act of 1935 (PUHCA), which does not allow public utilities to merge unless they are connected or capable of being connected. For example, under current PUHCA standards, a public utility in California is forbidden to merge with a public utility in another state, because there is no direct connection. The other major benefit would be the elimination of ownership restrictions that make it difficult to structure the acquisition of public utilities. (See the PUHCA sidebar for more information)
“Without PUHCA, or other ownership restrictions, it should be easier to allow [private equity firms] to make acquisitions, and that will spark M&A activity and open up a universe of buyers,” said Chris Behrens, a partner with JPMorgan Partners and head of JPMP’s energy and power sector investment team since 1995.
Despite the House’s enthusiasm, the bill was squashed in the Senate. However, the bill lost by only three votes, which means it will remain a hotly-contested debate well into 2004, when it will get tweaked and reintroduced to Congress. What the outcome will mean in regard to private equity deals in the energy sector is still up in the air.
“I’ve worked in the energy sector for nearly 30 years and there’s been talk of PUHCA being rebuked the entire time,” said Dick Powers, an energy lawyer with Padilla Speer Beardsley. “There’s a good chance this bill never passes.”
But even if Powers is right, that doesn’t mean M&A activity is going to fizzle out. “As long as any new regulatory ground rules get applied consistently, the space will provide for attractive investment opportunities with or without PUHCA intact,” said Behrens. “Transparency and consistent application make the sector more attractive.”
JPMP, along with Kohlberg Kravis Roberts & Co., certainly didn’t let PUHCA or any other regulatory red tape stand in the way of its recent $3 billion deal to purchase UniSource Energy Corp., an Ariz.-based public utility and parent company of Tuscon Electric. The utility serves more than half a million customers, and its stock price surged 20% to about $25 a share after the buyout.
While this is JPMP’s first foray into the public utility sector, the firm has completed 45 deals in the energy sector since 1984, investing more than $1.2 billion. It has its share of success stories, including a $50 million investment in BearPaw Energy in 2000 that realized more than four times a return on investment in less than two years, via a sale to strategic Northern Border. The firm has been in the news lately due to its ongoing negotiations with ABB Ltd, a British energy company looking to offload its oil, gas and petrochemicals division for just under $1 billion.
Oil & Gas
Meanwhile, the oil & gas segment of the energy sector has been just as active as the electric & power side. Morgan Stanley Capital Partners holding company Triana Energy Holdings Inc. recently paid $330 million for Columbia Energy Resources, a gas exploration company. Earlier this year, Morgan’s team purchased Williams Bio-Energy LLC, a producer of ethanol, in a deal worth $75 million. And on the same day of the Columbia purchase, Morgan’s commodity group paid Shell Gulf of Mexico $300 million to acquire an interest in the natural gas reserves produced by Apache Corp.
The Carlyle Group, in a joint venture with Riverstone Holdings, recently paid $32 million to an undisclosed seller for natural gas properties located in South Texas. Carlyle and Riverstone are co-GPs on two energy-focused funds, one of which is nearly fully invested, and published reports have stated the firms are in the midst of fund raising for its follow-up fund. The purchase was made through portfolio company Legend Natural Gas.
“We focus on four sectors in energy and power,” said Pierre Lapeyre, co-founder and managing director of Riverstone Holdings. They include: the mid-stream sector, which focuses on logistics and infrastructure pipelines, tanks and terminals; traditional upstream, including exploration, production and drilling of natural gas and oil; oil field services, which encompasses drilling rigs, supply vessels and companies that provide services to the oil and gas industry; and lastly, the power business, which includes generation, transmission and power service companies.
“We tend to be less active in the renewable fuels and emerging technologies, i.e. fuel cells, as these tend to still be development-oriented companies, unproven economically and have substantially longer required investment time horizons,” said Lapeyre. “In many instances, these companies still rely on government tax or other incentives that if taken away would make the returns unacceptable. However, as these alternatives mature and become more competitive on their own with current fuels, they will be of greater investment interest for our fund.”
What It Takes
To be sure, it takes more than a fat wallet to do a deal in the energy sector, especially with special interest groups and watchdogs eying every move. Texas Pacific Group pulled a skillful maneuver by locking arms with high-profile locals in its $2.35 billion takeover of Portland General Electric (PG&E), the Oregon utility previously owned by Enron Corp. Texas Pacific bid $1.3 billion for the utility, and will assume more than $1 billion in outstanding debt, and has partnered with Neil Goldschmidt, former Governor of Oregon (see Buyouts, 12/01/2003).
“A number of firms were after [PG&E], but TPG made the smart move by creating a local feel to their buyout group,” said an energy-sector private equity pro. “It will end up being a nice risk-reward payoff for them.”