When it Comes to Energy, Buyout Firms May Be Left in the Dark –

Perhaps the energy crisis in California is just a prank being played out by the capitalist gods. First Silicon Valley sees a dotcom boom that makes millionaires of investors and computer techies alike. Then, just three years later, a balancing force thrusts investors into dark times – literally – with a bungled attempt at deregulation in the electric industry.

While some grassroots groups are decrying the effects of deregulation, investors are busy transitioning their strategies to invest in energy companies that stand to see sharp growth in order to meet the clearly unmet demand for power supply.

Energy as an industry is a relatively new interest for most private equity investors. Greenwich, Conn.-based First Reserve Corp. became the first private equity firm to focus investments on energy companies in 1983, when it initiated its buyout activity. Nine energy-focused funds later, First Reserve and Odyssey Investment Partners recently announced an agreement to purchase Dresser Equipment Group from oil giant Halliburton Co. (see story p. 9) The $1.55 billion deal, which is the largest buyout deal to date in the energy industry, is certainly calling attention to the possibility of further LBO activity in the industry. However, if there is one common call from those players involved in the energy sector, it’s “buyer beware.” If you are not a veteran like First Reserve, it seems the energy arena is not an easy one to break into, much less succeed in.

A quick glance at the preferred industries of buyout firms indicates quite a few players are trying their hand at energy companies. However, a more thorough inspection of past and present portfolio companies reveals that more often than not, those same buyout firms lack even one investment in the energy industry.

It is possible that the winds of fortune will be on the backs of buyout investors in the coming years. Major changes are taking place in the industry, and if there was ever a time to get a foot in the door, this is it. As seen in California, the energy companies in the U.S. have been neglected for some time and now demand growth and improvement. Severe spending cuts over the last decade have spurred consolidation and mergers between the major oil companies in the past few years. The result is a flux of divested energy companies that are being picked up by investors who are ready to take on the capital-intensive businesses, prepping them for the next boom, which is due to hit very soon.

Certainly strategic buyers are poised to pick up the pieces, but buyout shops also have something to offer small companies in a space filled with giants. Last year, Montana Power Co. decided to transition itself from electric utility company to telecommunications company by shedding all of its energy businesses and retaining Touch America Inc., its telecom business. The company sold the energy assets off at two-week intervals, gaining $2.5 billion in proceeds. M. Douglas Dunn, an attorney with Milbank, Tweed, Hadley & McCloy LLP, who advised Montana Power, says a purchase by a buyout firm gives a small company three to five years to determine its future plans, rather than immediately being merged with a larger company.

Despite greater demand today for all energy products, production has generally been on the decline for 30 years. According to the Department of Energy, in 1970, 9.64 million barrels of crude oil were produced per day, while in 1999 that number was down to 5.93 million barrels per day. In 1985, there were 647,000 oil-producing wells, while in 1999 that number was down to 554,000. And in 1981, there were 324 operable petroleum refineries, working at 68.6% utilization, while in 1999 there were 159 working at 92.7% utilization.

“Right now, we think [the energy industry] is attractive primarily because of the fact that we have used everything up,” says William Macaulay, chairman and chief executive at First Reserve. “We have dissipated our reserves. We’ve used up drilling rigs. We’ve pushed our refineries to full utilization. We’ve pushed our power plants to full utilization. We’re getting short on natural gas. And that means it’s a good opportunity if you’ve got the right situation and the right management and capital to invest in the industry.”

After trimming every budget that could withstand it in the 1990s, many energy sectors are getting back on track and rebuilding their capabilities. Oil and gas exploration and production (E&P) are once again becoming a priority, making fuel storage another sure bet. Coal companies will likely see good times as many electric utilities are considering it as a source for new power plants, and this month the DOE announced its “Power Plant Improvement Initiative” aimed at developing clean coal technologies. Additionally, like most industries, the integration of technology into practices is revolutionizing efficiency and operation in many areas of energy.

To be sure, opportunities abound in the energy sector. The key for buyout players is to find the right company at the right time, because not only are gas and electric prices going to be high over the next three to four years, but prices will also be very volatile, says Larry Bickle, managing director at Haddington Ventures, which invests in energy infrastructure and technology. “The problem is with these violently fluctuating prices…it’s not a very stable environment to invest in,” he says. “So you have a Catch-22 where the prices are high but they’re volatile, so when you start looking at the option value . . . you begin to worry maybe if they’re this high now, they’ll go low.”

The Front Line

Many sources confirmed that energy is indeed of interest to buyout firms, but truth be told they just haven’t been able to get in the game. Milbank Tweed’s Dunn, who was also an advisor in the recent buyout of TNP Enterprises, the parent company of Texas-New Mexico Power Co., has witnessed the emergence of buyout firms at energy-related auctions. He says LBOs are getting in and bidding for these companies; the problem is, they’re just not the highest bid.

Evercore Partners, Haddington Ventures, Odyssey Investment Partners, First Reserve Corp., Harvest Partners and Texas Pacific Group are some of the firms that have been able to put private equity dollars to work in energy. Dunn says “the usual suspects” are also looking to get involved.

Royal Bank Capital Partners, the private equity arm of the Royal Bank of Canada, kicked off a new fund this month focused on energy, following the lead of other investment banks who have succeeded in the industry, like J.P. Morgan Partners and Credit Suisse First Boston. Paul McDermott, who will head up the Royal Bank fund, says it will focus on growth situations in the service area for the hydrocarbon industry for oil, gas and coal, power utilities and power technology (see story p. 3).

New York- and Santa Monica, Calif.-based Evercore Partners, which recently agreed to pick up one of Montana Power’s divestitures, made its first energy investment in November 1999, picking up a majority stake in Energy Partners Ltd. (EPL), which it took public late last year (Buyouts Nov. 20, 2000, p. 3). The changes in the industry – the consolidation of the major companies and the introduction of new technology – is what first caught the firm’s attention, says Austin Beutner, a founding partner of the firm, who like some the firm’s other general partners was involved in energy investments prior to Evercore. These changes are optimizing the industry’s risk and cost-effectiveness, says Beutner, and that, combined with consolidation, is opening up many opportunities. But he cautions the careless investor. “I think it’s a space you have to know well. There are a litany of people who have made unwise investments in the area, and I think we looked at lots of different things before we chose [EPL],” he says.

Beutner likens energy to the telecommunications industry, in that both have many opportunities, but not many good ones.

Federal Reserve’s Macaulay says that his firm has been making good money in energy for 20 years, but they may not be the norm. “It’s not an easy business to make money in and probably more people than not during that period have lost money,” he says.

Sources say experience and expertise are vital to success in the energy industry. Odyssey Investment has not seen the same consistency as Federal Reserve in its energy investments, said Stephen Berger, the company chairman, but Odyssey still likes the sector. “Our sense is that we prefer a particular kind of industrial side of it and that we wanted to have a partner that was deep in the industry,” he says of the Dresser Equipment deal. “While we have been able over the last decade to make money in the industry, it’s clear to us that the kind of knowledge that First Reserve has gives us great comfort as we’re going forward.”

Watts the Deal?

Lucky for buyout firms, the decision to foray into energy may get a little easier with the increased use of technology. Companies such as Silicon Energy Corp. and Cadence Network Inc. are changing the way the energy industry works through a new concept called real-time load management. The idea is that people can save money and energy by reducing a particular building’s power intake at the times that it is most expensive based on real-time energy pricing information provided over the Internet. Some investors, like Haddington Venture’s Bickle, think that creating a market in nega-watts – the negative watts shed during this process – is going to be a very hot area. “That’s something we can do almost instantly,” he says. “California could probably solve its problem with just that for next summer. If nothing else they can begin to solve their problems.”

Not only does the introduction of such technology give way for LBOs well-versed in Internet and technology to make an entrance into energy, but it can also save millions as compared to some of the investment alternatives. “A 1,000 mega-watt coal-fired power plant, which is the only kind I would build today, is a $1 billion investment,” says Bickle. “I can get 1,000 nega-watts of load-shedding for less than $100,000 . . . it’s only available because of Internet-enabling. You couldn’t have done it 10 years ago.”

Another business-to-business Internet model that is making its way into energy is online auction houses. Houston Street Exchange, which launched last summer, is one of at least 12 Web sites that allows investors, including buyout shops, to trade energy companies online.

So what’s the outlook for those firms who are determined to break into the energy industry? As they say in show business, the work is good – when you can get it. The best chance may be to partner with an experienced firm or strategic partner or follow Royal Bank Capital Partners’ lead and take on a general partner who spent many years in the sector to lead the effort. And for the firms who are determined to do it on their own, Milbank Tweed’s Dunn notes that “nothing makes you want to win like losing.”