Private Equity Firms Discover Electricity -- and Lead the Charge for Energy InvestmentPublished: April 26, 2007 in Knowledge@Wharton
Earlier this year, a consortium of private equity firms led by Kohlberg Kravis Roberts banded together to acquire TXU Corp., the Texas utility company, for $32 billion in one of the largest private equity deals ever proposed. According to private equity experts, a new regulatory climate and innovative derivatives smoothing volatility are drawing attention to energy, along with a macro-environment in which emerging economies demand a growing share of the world's energy resources. Meanwhile, other firms are making investments throughout the sector, including funds established to finance infrastructure and others dabbling in alternative energy.
"I would say this has been the most active period for private equity involvement in energy I've ever experienced. There's a lot of competition for deals that are out there, and there seems to be interest in just about all sectors of the energy industry," says Jim Dillavou, who leads the national energy and utilities practice at Deloitte & Touche in Houston, Tex.
While energy encompasses a range of businesses with widely varying profiles, a survey by the Association for Corporate Growth and Thomson Financial predicts that energy will be among the top three sectors for deal-making in the coming year, behind health care and life sciences, but ahead of business services.
Demand for energy is expected to keep growing. According to the U.S. Energy Information Administration, despite world oil prices that are predicted to be 35% higher in 2025 than was projected in 2005, world economic growth continues to increase at an average annual rate of 3.8% over the period through 2030. Total world consumption of marketed energy is expected to expand from 421 quadrillion British thermal units (Btu) in 2003 to 563 quadrillion Btu in 2015, and then to 722 quadrillion Btu in 2030 -- representing a 71% increase.
Now Within Reach
When Jonathan Farber, cofounder and managing director of Lime Rock Partners, a private equity firm specializing in energy, started the company in 1998, there were just five or six other private equity firms in the energy business with about $2 billion worth of capital invested. Now, there are 15 to 20 competing firms with $30 billion invested in the industry.
"It was very rare, to the point of never happening, that generalist private equity firms would dip their toe in the water of the hard-core energy space," says Farber. "Firms didn't look to oil and gas as an appropriate place to invest."
Now, some of the biggest names in private equity -- Kohlberg Kravis Roberts and Texas Pacific Group -- are teaming up to buy TXU. Dillavou says the new interest in energy is driven by the volume of capital pouring into private equity overall. At the same time, he says, investors are deciding they want to be more involved in this key segment of the economy, particularly following the recent rise in commodity prices. Meanwhile, capacity shortages in many markets make energy an appealing sector for private equity investors, at least for the near future.
"There are a lot of opportunities, and some that didn't look that attractive a few years ago look much different today," says Dillavou.
Wharton professor of business and public policy Matthew White says the enormous capital requirements of most energy investments have, until now, been beyond the reach of private equity firms. These days, however, with so much money pouring into private equity funds, deals on the scale of the TXU transaction are possible.
White adds that private equity movement into the electricity and gas markets remains difficult because these parts of the energy business have a lot of regulatory and political oversight. "The rules of the game are changing substantially over time. Deregulation in electricity and gas continues in fits and starts, and a lot of it is at the state level. There's a great deal of uncertainty about the reward to investors, and that will give any set of investors pause during due diligence," says White. "One might look at this and say there are greener pastures elsewhere -- at least until the regulatory environment becomes a little more transparent."
Pulling off a change of control in this area is very difficult given the political approvals that are necessary, according to White. New Jersey regulators balked when publicly held Exelon, of Chicago, attempted to take control of Public Service & Gas in their state. Private equity firms have hit similar roadblocks. In 2005, regulators prevented a $1.25 billion bid for Portland General Electric Co. over concerns about potential rate increases and the short-term nature of TPG's investments. Arizona regulators refused to sanction a buyout of UniSource Energy Corp. in 2004 by a group of investors that included KKR, J.P. Morgan Partners and Wachovia Capital Partners.
The private equity firms bidding for TXU have already aligned themselves with environmental groups and have pledged they will not sell the company for at least five years in an attempt to fend off opposition that began to boil up in the Texas statehouse within days of the announcement. "Change in corporate control at this level is fraught with regulatory uncertainty and a need to appease a broad array of political constituents," says White. "It's a daunting prospect."
At the same time, Dillavou notes, the repeal of the Public Utility Holding Act in 2005 is expected to encourage private equity investment in energy because it eliminated numerous restrictions on ownership, particularly in electricity. "We've seen some activity as a result of the repeal, although maybe not as much as some expected, but a lot of people think it could be coming."
White says that it will be interesting to see if private investment begins to flow into exploration and oil field service firms. "Private equity at that level would be one more source of capital for a fairly risky line of business."
Farber of Lime Rock Partners believes the business is likely to remain highly volatile because the capital spending cycles don't match up to the price signals the market sends out daily. If the market needs more capacity, it can take years to find new sources of energy and construct additional pipelines and processing plants. If companies build excess capacity, the price remains low for years, stifling new investment until an acute shortage drives prices up again.
"The nature of the industry is that it can't remove or add capacity on a dime," says Farber. "That still hasn't changed and can't physically change." Indeed, he argues, industry volatility has grown worse as the easiest exploration targets have been exploited. "Now, we're moving into areas with greater political challenges, like Sudan, or technical challenges, like deepwater offshore drilling."
Bill Macaulay, chairman of First Reserve Corp., a 25-year-old private equity firm focused on energy, notes that while activity in the sector is up, it still lags behind other industries that are attracting record private equity investment. In the U.S. and Europe, private equity activity as a percentage of all merger and acquisition transactions is around 20%, while in the energy sector it remains below 5%. "It is still difficult to put leverage on [companies] in the energy business given the volatility of the commodity prices," he says.
Opportunities for Entry
Over the long term that may change, and already new mechanisms to hedge against swings in commodity prices have made leveraged investment in energy easier over the past five years. Macaulay notes that, in particular, hedging in electrical power has made that piece of the energy business more attractive to private equity firms.
The spectacular collapse of Enron has also had an impact on private equity involvement in energy, says Dillavou. "After Enron, energy investment dried up for a while, and everyone's stock price was hurt. That opened up opportunities for private equity to step in and we saw some spectacular returns on investment for people who were able to pick things up on the cheap." In 2004, a consortium of TPG, KKR, The Blackstone Group, and Hellman & Friedman bought Texas Genco, a power generation company, for $3.7 billion. A little more than a year later, they sold it to NRG Energy for $5.7 billion.
According to Dillavou, the rise in infrastructure funds also gives private equity investors a way to participate in the energy industry. The Macquarie Bank, Goldman Sachs and JP Morgan all have created infrastructure funds, he notes. "That is a different profile than the historical private equity investment because of the long-term horizon for the investment," he adds. "The investor is trying to take assets that historically have earned a steady but sleepy return, and increase the return from additional leverage with relatively low-cost, long-term debt and add-on investments. The return is enhanced by the management fees and the ability to profitably sell down its ownership interests in the fund over time."
Dillavou also points out master limited partnerships provide an exit strategy for private equity investments that is unique to the energy sector. The master limited partnership allows earnings to flow to investors in a partnership form in a public environment and only be taxed once. "We have seen private equity firms come in and make investments in companies they believe would have a future existence as a master limited partnership," he says.
Another potential area for private equity investment in energy is alternative technologies, although this area remains highly speculative and difficult for most private equity firms.
"There is tremendous potential there, but in our view -- to date -- most alternative energy investments need to either have a government mandate, such as tax subsidies, or other government assistance if you're going to have a significant change in the technology to make it truly economic," says Farber.
Macaulay explains that alternative energy investments may be attractive for smaller firms or venture capitalists, but they are unlikely to attract classic buyout artists because there is often little, if any, cash flow to pay down debt. "The other important thing to remember is that alternative energy is extremely price sensitive," he says. "You need high prices to justify almost any alternative."
When it comes to energy, some of the concerns about too much capital driving private equity investment are easing because the sector has, at least so far, been less attractive than other industries. But for firms focused on the energy space, there is a larger force to be reckoned with, says Macaulay.
"We still have competition from the major oil companies, and if you roll forward, the national oil companies are a much bigger new competitor to [a firm] like First Reserve than the leverage buyout concerns," he says. Macaulay points to Saudi, Russian and, more recently, Indian national champions as major competitors, desperate to tie up resources to meet demand at home. "Those companies are much more of a factor in our industry in competing for deals than the buyout shops."