Prior to the mid-1990s, the power industry in the US was dominated by regulated, geographically focused monopolies. State public utility commissions told the monopolists what they could charge and allowed for modest profit levels. With the onset of deregulation, some form of which was instituted in about half of the states, a new breed of non-regulated company emerged, via spin-offs, mergers, or from the ground up with the sweat of ambitious entrepreneurs.

All of these non-regulated, or merchant, energy companies were designed to wheel and deal in the new wholesale marketplace. Enron was the largest and most aggressive of the merchants, whose ranks also included Dynergy, El Paso, Williams and Mirant Corp. The energy merchants faced greater risks, but had potentially rosier upsides, and were prepared to borrow to the hilt to finance their acquisitions.

Predictably, the market overheated (no pun intended). According to some estimates, the large independent power producers' combined debt is now somewhere between $30bn and $50bn. Furthermore, the frenzy of speculation created massive oversupply in the energy market. Approximately onethird of all of the power produced in the US now comes from merchant generators, which don't have a captive audience of ratepayers to absorb their output.

“Too much money came into the space – which is a Wall Street issue – and obviously there was some misbehaviour on the part of these entities,” Jeffrey Harris, a managing director at private equity firm Warburg Pincus says. “Now the pendulum is swinging back the other way, with a lot of pressure from the regulatory agencies and shareholders and tremendous scepticism from the capital markets.

The merchant players are over-extended, and are now being told they are over-extended, and they have to clean up their balance sheets. So they will sell assets to the extent that they can, and that does create some opportunity.”

The opportunities are not lost on private equity firms that prowl the energy space. One recent deal highlights the desire among energy merchants to sell off assets. Last month, Chicago-based Madison Dearborn Partners and The Carlyle Group's Carlyle/ Riverstone energy investment group jointly acquired a 54.6 per cent stake in the private equity assets of Williams, a post-deregulation energy merchant that has fallen on hard times. The secondary deal was valued at $1.1bn.

Complexity is good
Some market observers draw parallels between the outcome of deregulation in the energy and telecommunications sectors. In both instances, deregulation led to rapid capacity expansion.

But a key distinction must be highlighted: whereas deregulation of the telecommunications sector was a federally decreed reform that established a single national standard, deregulation in the energy sector has occurred incrementally, with tremendous variation by state and even locality. This has added multiple layers of complexity for private equity investors.

Harris divides the various regulatory layers into “deregulation at the generating asset level, deregulation at the transmission level, deregulation at the consumer price level. Most of the world thinks deregulation means consumers will have a chance to pick their supplier of power, just as after deregulation of the telecommunications sector you got to pick who your long distance carrier was. It didn't quite work out that way.”

“Regulation is not just federal or state,” Pierre Lapeyre, Jr., managing director of energy investment specialist Carlyle/Riverstone, says. “It's federal, state and local.

Buyout opportunities are determined market by market, asset by asset, as to whether regulation is a good thing or bad thing for the assets you're looking at.”

The pitfalls of deregulation were exemplified by the energy crisis in California. But this crisis was more of a perfect storm than a long term indicator that the US was massively short of power production capacity.

The overreaction to this short-term confluence of factors – low hydro, flawed regulation, corporate opportunism, high gas prices and a hot summer – created substantial excess capacity in energy markets across the US.

The shakeout has begun
All this has culminated in a number of over-leveraged merchant energy superstars desperate to unload assets for whatever cash they can get across the table. And this in turn creates the opportunity for private equity players to make counter-intuitive plays for vastly undervalued assets. In many instances the merchants have been forced to sell businesses they wouldn't otherwise have wanted to sell because they are liquid, they are high quality, and they can be moved relatively quickly.

We're in the early stages in the power shakeout

The sheer scale of the opportunities available in the energy sector was revealed last year, first in March, when Berkshire Hathaway's Warren Buffett, through his MidAmerican Energy Holdings, snapped up gas pipeline company Kern River Gas Transmission from Williams for $450m, then in July, when MidAmerican acquired the Northern Natural Gas pipeline from Dynegy for $928m in cash and the assumption of $950m in debt. The 16,600-mile pipeline had been Dynegy's consolation prize after its fumbled merger with Enron.

Last month's Madison Dearborn/Carlyle deal may have indicated merely the beginning of a fire sale.

The steady pace of investment opportunities entering the market shows no sign of abating. “We're in the early stages in the power shakeout,” Lapeyre says. “Many of the troubled situations that exist in the merchant energy, and particularly in the electric power area, we believe are at the front end of the difficulty. There are many banks that are holding loans to troubled assets or troubled situations. As those loans get either marked down or get moved to the work outside of the house you'll start to see the pace of transactions pick up.”

Despite the vast number of potential deregulation-fallout energy deals on the horizon, not many have been finalised, says Bill Macaulay, chairman and chief executive officer of energy investment specialist First Reserve.

One reason for this is the sheer dollar value of the assets becoming available is prohibitive to all but the largest buyout players, especially during a period when debt financing is elusive.

“For the most part, the dollars are large because the generating assets are very expensive,” Harris at Warburg Pincus explains. “Even when their bonds are selling at cents on the dollar, you need an awful lot of money to take control. And when you take control, it's unclear what you have.”

Buyout specialists differ in their approaches to the new energy market opportunities.

“You've got a number of new entrants in the business among the major diversified buyout players that are focused on acquiring utilities; from our experience that's about the hardest thing to do,” Macaulay says.

According to Macaulay, First Reserve's focus is to own the companies that supply the oil and gas companies with what they need to conduct their business. “If this were the California gold rush, our strategy would be to sell the picks and shovels, as opposed to looking for the gold.”

“A couple of groups have bought transmission assets,” Harris says. “That opportunity exists because of a shift in the regulatory environment. Most people would say those are low risk, relatively low return investments.”

Re-regulation risk
Further complicating the picture is the prospect for re-regulation of the energy market. Democrats in California are now looking to do exactly that by phasing out competition, capping profit margins for utilities, and incorporating laws approved last year that set minimums for how much electricity must be produced by renewable sources, such as wind, solar and geothermal energy.

“Regulation risk is an element of investing in power today. Anyone who's looking at it is contemplating the probability of re-regulation, or a change in regulation that's adverse,” one energy merchant executive says. “Re-regulation obviously would be an unattractive structure for people who wanted to acquire these assets and market the power in a free and competitive environment.”

Re-regulation “is a risk and we analyse it all the time,” Lapeyre says. “There are plusses and minuses to owning regulated assets. It depends on the type of regulations.”

Regulation risk is an element of investing in power today

“What you find attractive as a private equity firm is that regulation provides some minimum return for you – if you are able to effect a series of efficiencies or other synergies or acquisitions you can generate substantially higher returns. In other instances, regulation substantially caps your return.”

Major recent US energy sector buyouts
April 2003: Madison Dearborn Partners and Carlyle/Riverstone acquired natural gas company Williams' 54.6 per cent stake in publicly-traded energy investment subsidiary Williams Energy Partners in a buyout valued at $1.1bn.

March: CSFB Private Equity and AIG Highstar Capital acquired a 50 per cent stake in Duke/UAE Ref-Fuel from Duke Energy for approximately $306m.

February: Morgan Stanley Capital Partners agreed to acquire ethanol manufacturer Williams Bio-Energy from Williams for approximately $75m.

December 2002: One month after investing $750m in TXU Energy, the retail electricity provider and electricity producer of energy conglomerate TXU, CSFB Private Equity sold $250m of exchangeable subordinated notes in the company to Berkshire Hathaway.

December: AIG Highstar teamed with Southern Union Co. to acquire the CMS Panhandle Cos. from CMS Energy Corp. for a total of $1.8bn. AIG Highstar paid approximately $158m for its stake.

December: First Reserve Corp. acquired all of the North American assets of bankrupt gas pump maker Tokheim Corp. in a $42m deal.

November: First Reserve Corp. acquired the remaining coal operations and businesses of Coastal Coal from El Paso Corp. in a $53m deal.

September: AIG Highstar bought out Williams Cos.' pipeline assets in a $555m transaction.

August: Natural Gas Partners acquired two pipeline systems and 50 per cent of Oasis Pipe Line Co. from Aquila for $265m.