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Merchant Power: Trash Or Treasure?

By Tim Begany on December 29, 2016

The adage that one man’s trash is another’s treasure aptly describes one of the major M&A trends underway in the utility sector.

To offer their decidedly conservative investor bases steadier returns, many utilities are divesting struggling merchant assets—power plants that operate in unregulated wholesale markets. These assets have plunged in value because of notoriously unstable wholesale prices and the recent energy crash.

However, merchant generation is treasure to private equity firms, which specialize in acquiring unproven or out-of-favor assets with attractive turnaround potential. In the case of merchant power, private equity sees a rare chance to make bargain acquisitions and reap huge profits once energy rebounds (as it has already begun to following OPEC’s latest output reduction deal).

No one foresaw all this four or five years ago, when merchant assets were popular with regulated utilities. Through ownership of some non-regulated plants, these utilities planned to juice earnings by better profiting from high energy prices.

But because wholesale markets are so volatile, merchant assets often didn’t pan out as hoped and the crash in energy prices only made a bad situation worse.

Now, regulated utilities with merchant power are often happy just to cut their losses on these ventures and focus on more reliable regulated generation. And they’re finding many willing buyers for distressed merchant assets in the private equity space.

Deals Aplenty

Merchant power and private equity are an excellent match, as the latter is usually adept at risk-taking and willing to wait years for investments to reach their full potential.

In the latest major match-up a few months ago, private equity giants The Blackstone Group LP (NYSE: BX) and ArcLight Capital Partners announced a joint venture to buy four merchant power plants from Midwestern utility giant American Electric Power Co. Inc. (NYSE: AEP).

The four plants, located in Ohio and Indiana, have about 5,200 megawatts (MW) of combined capacity. The $2.2 billion acquisition is expected to close in early 2017.

Thanks to low energy prices, private equity’s merchant buying spree has accelerated over the past few years. In 2013, for example, the private equity firm Energy Capital Partners paid Virginia-based utility giant Dominion Resources Inc. (NYSE: D) $450 million for three non-regulated power plants.

Several sizable merchant power acquisitions closed the following year, such as Rockland Capital’s $140 million buyout of three gas-fired plants in Illinois from regulated utility Ameren Corp. (NYSE: AEE).

Around the same time, The Carlyle Group LP (NSDQ: CG) paid $490 million to take over the Rhode Island State Energy Center, a large gas-fired facility previously owned by diversified utility Entergy Corp. (NYSE: ETR).

In two of the biggest transactions this year, New York-based Riverstone Holdings took independent power producer Talen Energy private for $1.8 billion, while Starwood Energy Group Global announced plans to buy 840 MW of merchant capacity from the Florida-based utility giant NextEra Energy Inc. (NYSE: NEE) for $760 million.

Although private equity’s recent merchant power acquisitions involve some hefty-looking price tags, takeover costs are likely much lower than they would have been only a few years ago when energy prices were much higher.

A Golden Touch

While further energy price gains would likely buoy the broader merchant power industry, the outlook is especially bright for private equity-owned merchant assets. For instance, Blackstone and ArcLight are good bets to turn the plants acquired from AEP—three gas-fired and one coal-burning—into winners.

Both firms have the financial strength to weather further energy price weakness. And both are experienced energy investors, having owned and operated a combined 38,000 MW of capacity worldwide.

Blackstone is especially successful in the sector, historically achieving a 34% average annual return on its energy investments. Major private equity rivals such as Carlyle and KKR & Co. LP (NYSE: KKR) have also done well, typically earning 15% to 25% annually on such ventures, according to the investment research firm Market Realist.

These investments often outperform because private equity has the expertise to spot the best energy sector deals (as well as the capital and connections to get in on them).

For instance, Carlyle’s stake in the Rhode Island State Energy Center could yield outsize profits as energy prices rebound because of the Center’s potent competitive advantages. These include regional dominance coupled with rising demand for gas-fired generation as older coal-fired plants close.

Riverstone’s Talen Energy acquisition should prove lucrative, too, as Talen is one of North America’s largest merchant generators, with total capacity of approximately 16,000 MW in the Northeast, Mid-Atlantic and Southwest.

Over the past year, the company diversified significantly by adding gas-fired capacity in New York, New England and Arizona. Through non-core asset sales and plant cost cuts, among other measures, Riverstone plans to reduce Talen’s operating outlays by $100 million annually.

Aside from direct investment through a private equity firm, which typically involves investment minimums in the millions, there are few ways to benefit as private equity scoops up merchant power assets on the cheap.

However, risk-tolerant investors can at least get some exposure to the trend by owning stock in publicly traded private equity firms with energy expertise, such as Blackstone. Shares of the company boast an excellent five-year track record—gaining nearly 22% annualized—and currently yield 5.9%.

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