Energy and Private Equity, Part II
What prompts me to write about PE is its current relation to investments in the energy arena. According to one authoritative estimate by Cambridge Energy Research Associates (CERA — which has been so opposed to Peak Oil theory, but which also does quite good work in other areas), the U.S. electric power sector will require about $800 billion of new investment by 2020. By way of comparison, the current net book value of the U.S. power sector is about $700 billion. So right away, the discerning mind can figure out that it will require significant outside investment to keep the lights on in the U.S. over the next 15 years. Much of that new investment will probably come from PE.
Private Equity and Energy Investment
One large deal that is in the news is the proposed, $45 billion-plus takeover of the Texas utility TXU by a group composed of PE players KKR and Texas Pacific Group. The PE players want to take TXU private, and run the power houses and distribution channels themselves. The interesting angle of the takeover is an “environmental” play, as well as a financial offer for the stock. That is, the PE group is promising to cancel up to eight proposed pulverized-coal power plants that TXU has previously announced its intent to build. By changing TXU’s management and strategic direction, the proposed PE takeover will focus on using a mixture of conservation methods and new, more “green” generating capacity, to lower the impact of TXU power-generating activities on the environment in general and the atmosphere in particular. Will it work? I suppose that anything can work, if the management and funding are present. And anything can fail to work, where the will, ways, and means are lacking.
The point to keep in mind is that PE is recognizing some ominous energy trends in the U.S., and beginning to do what smart money often does best, which is to take advantage of the situation. That is, some really big money is now stepping up to the plate. Here is a summary of what is going on.
For the past two decades, there has been strong demand growth in the U.S. for electricity and natural gas, both of which are considered relatively clean and convenient energy sources at the point of use. But due to chronic underinvestment in the U.S. energy infrastructure over the same past two decades and more, reserve margins for electricity and natural gas have been tightening. There is very little in the way of “spare” capacity at the lower-cost, “base-load” level, and in many instances, the spare capacity that does exist lacks the transmission facilities to move it from where it is to where it is needed. (This is true even with renewable energy supplies, such as wind power. Almost all wind farms are located in rural areas, far from the urban load. So there is a need for new transmission infrastructure to move the electricity from the point of generation to the area of use.) The bottom line is that on both the hottest and coldest days of the year, the U.S. power system is stretched to its limit as was, for example, demonstrated so dramatically by the cascading power outage that affected the Northeast U.S. and Ontario in August 2003.
Thus, there are looming requirements in every region of the U.S. for new-build decisions in the fields of basic energy supply and power production, plus generation, transmission, and distribution, as well as overall requirements to upgrade systems for safety and reliability. But capital costs for construction are soaring due to worldwide inflation in the prices of many basic elements such as cement and steel, machinery and pipe, copper wire and welding rods, and, of course, the basic engineering and project management talent that brings it all together.
This situation dovetails with a large number of immensely complicated issues of environmental regulation, rate-base calculations (necessary for determining appropriate ROI), and design and technology assessments. And through it all, the past few years have also been ones of severe commodity and price volatility, both due to improper market manipulation (such as what Enron did with electricity in California early in the decade), and geological factors such as Peak Oil and Peak Gas in North America. Add to this the growing scientific and political concerns about the emission of greenhouse gases, which is leading to calls to burn less carbon. Things are just plain complex. No, make that really complex.
The View of Private Equity
I do not propose to speak on behalf of all private equity, nor to praise PE more than it deserves. But in general, the situation that we are describing lends itself to some of the self-described advantages, if not virtues, of PE.
The convoluted situation in supply, new-build decisions, construction, and overall regulation is causing many existing players in the energy business to re-evaluate their stakes and revise their business strategies. Recently enacted regulatory and accounting rules are forcing many publicly held companies to bear costly burdens that they would just as soon avoid (Sarbanes-Oxley reporting requirements come to mind.) On the best of days, many firms face a shortage of capital, yet they are held accountable by the public and the regulatory agencies for any failings or lack of results. So there are incentives simply to, as the saying goes, “monetize assets,” and certainly to get rid of unnecessary or underperforming assets.
The “For Sale” signs for energy infrastructure are beginning to come out, publicly and, on numerous occasions, not so publicly. And PE is standing there, with checkbooks in hand — after the obligatory due diligence, of course.
PE can afford to, and in many respects must, focus on cash return, as opposed to mere book income, and lacks the prurient fixation on quarterly results that drive many bad decisions by publicly held companies in other instances. Most of the funds that go into PE are locked up for terms ranging from five years to as long as a decade or more. So PE managers can be patient and deliberate in making their investment plans over time frames that approach a decade. PE can also accelerate development decisions, because it is spending its investors’ money, and not what is referred to as the “ratepayers'” money, and, when appropriate, PE can make efficient use of hedging.
Again, I am not making a blanket endorsement of any one investment method or another. But I believe it is worth discussing that PE advertises a focus on long-term value creation that is often absent in the quarterly driven world of publicly traded companies. My view is that whether a company is PE or publicly traded, much of any firm’s success depends upon the kind of people who are making the decisions. Your success or failure always depends on how the assets are managed and how the people perform.
One Great and Historic Success
One great historical example of a person who took a nest egg and, through a then-prevalent form of PE, turned it into the foundations of a fortune was Andrew Carnegie and his investment in the Columbia Oil Co. in the early 1860s. I wrote about this in another article in Whiskey & Gunpowder, entitled “Columbia, the Gem of the Oil Patch.” Carnegie took his earnings from his job with the Pennsylvania Railroad and, in an early form of PE, bought into an oil company near Titusville, Pa. The Civil War era gains and dividends from the Columbia Oil Co. provided Carnegie with the money he used to change careers and get himself into the steel business. The rest is history. You can look it up.
Until we meet again,
Byron W. King
March 21, 2007