hedge funds and private equity funds active in energy markets

Private equity funds and hedge funds have been steadily investing in the U.S. energy market for the past several years.

Equity funds and hedge funds have helped to strengthen liquidity in both the debt and equity markets in the U.S. energy sector. As the number and types of investors continue to diversify, traditional investors, such as independent power producers and investor-owned utilities, will likely respond to these evolving strategies.

profile: private equity funds

There’s been a great deal of prognostication in the wake of the Energy Policy Act of 2005. Because the Act repealed the regulatory regime imposed under the Public Utility Holding Company Act of 1935, many expect that this legislation will create opportunities for mergers and acquisitions and new investment in electric generation and transmission. However, even without encouragement from Congress, investment by private equity funds and hedge funds has now reached a crescendo of activity.

Initially, private equity investments were often made by boutique energy-focused funds or larger diversified funds with a limited mandate for the energy sector. With strong performances and the return of confidence in the energy sector-and a lack of attractive alternative sectors such as telecom-participants across the private equity market, including most major investment banks, have committed large amounts of capital and resources to energy investments.

Private equity investors typically view their ownership in power investments up to a seven-year time horizon, which gives them sufficient opportunity to provide added value to the structure of a project. Exit strategies optimize return and usually involve an outright sale of the project interest, some kind of going-public transaction or recapitalization in which the private equity firm is taken out. The focus for most private equity funds has been on acquisitions of quality assets involving offtakers with acceptable credit ratings or merchant assets strategically located in the dispatch curve in a regional transmission organization like PJM Interconnection. These purchases have often been very competitive because of the high quality and consistent cash flow of the assets and the resulting ability to leverage the projects.

During the last several years, private equity firms have been very active in terms of the number and profile of the deals. The most recent private equity coups include the $1.75 billion acquisition of InterGen by AIG Highstar Capital II, L.P. and its partner Ontario Teachers’ Pension Plan; and LS Power’s successful bid to acquire Duke Energy North America’s assets for approximately $1.5 billion.

Given the life cycle of private equity funds and current valuations, many equity funds are also seeking more current returns and are selectively selling assets. In October 2005, Kohlberg Kravis Roberts & Co., Blackstone Group, Texas Pacific Group and Hellman & Friedman inked a deal with NRG Energy, selling Texas Genco for a cash and stock price that is more than $2 billion higher than the $3.65 billion cash price paid by the private equity consortium in July 2004.

profile: hedge funds

It is not clear exactly how many hedge funds are dedicated to the energy sector. Most analysts believe the number is at or near 100 and climbing. As returns in the energy sector reportedly approached 40 percent for some hedge funds during the past several years and as returns elsewhere tended to be lagging, yield-hungry hedge funds have been increasingly turning toward energy investments.

Hedge funds tend to hold assets that are highly liquid. Unlike private equity firms that are obligated to return money to their limited partners every five to seven years or so, many hedge funds return money to their investors yearly. Typically, hedge funds have acquired interests in projects via distressed debt purchases as banks and other institutional investors holding interests in defaulting projects have sold interests. Hedge funds, along with the private equity funds, are also the principal investors in and contributors to the explosion of the Term Loan B market that has become an attractive alternative to the long-term fixed rate institutional debt market. Hedge funds have also committed significant resources and capital to energy trading.

However, in the search for higher returns in a competitive market, hedge funds are looking not only to distressed debt, the Term Loan B market and trading desks, but are pursuing more illiquid investments. In October 2005, Harbinger Capital Partners (formerly known as Harbert Distressed Investment Master Fund) acquired from Bechtel Enterprises Energy and Royal Dutch Shell all of the equity of InterGen (North America), Inc., a private company with 3,300 MW of combined capacity.

John Hawkins is chair of the project finance practice group at Paul, Hastings, Janofsky & Walker LLP, an international law firm. His practice is primarily focused in the areas of project finance and leasing including energy facilities. Michael Madden represents clients in various aspects of commercial law, including general corporate matters, corporate finance, and mergers and acquisitions.

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