The proposed acquisition of the Texas utility TXU Corp. by a private equity consortium led by Kohlberg Kravis Roberts & Co. Texas Pacific Group, and Goldman Sachs for $45 billion, the largest private buyout in U.S. corporate history, highlights the recent changing ownership of the utility industry in the United States as private equity firms invest heavily in the electric and gas utility sectors. Relatively steady cash flow, increasing demand for energy that is exceeding available power supplies, changing federal regulation, and the abundance of investment funds have made utility assets attractive investments for private equity sponsors. As a result, private equity funds have provided a new source of needed capital for the utility industry.

Private equity funds have, for some time, been investing in unregulated electric generation plants. Now, private equity funds may be moving into regulated utility operations.

Private equity investment in unregulated power plants and other utility assets has been steadily increasing

Since 2002, more than $25 billion has reportedly been spent by private equity firms to buy power plants and other utility assets, according to industry sources. These investments have become attractive due to the increasing demand for electric power in many parts of the country, which is outstripping the supply of generation capacity. Some of the major private equity investments that we have observed in industry news reports are illustrated by the following:

• Goldman Sachs formed its GS Infrastructure Partners Fund at the end of 2006 with more than $6.5 billion in capital to invest in electric, natural gas and water utilities as well as other infrastructure projects.
• Energy Capital Partners closed in late 2006 what it called the worlds largest debut fund for generation assets at $2.25 billion and made a $1.34 billion acquisition of the Northeast Utilities competitive generation assets. Northeast Utilities will use the proceeds to build transmission and distribution infrastructure over the next 5 years in Connecticut, Massachusetts and New Hampshire.
• ArcLight Capital Partners has raised $3.73 billion for three energy funds, a significant portion of which has been invested in generation assets.
• Tenaska Power Fund and an affiliate of Warburg Pincus announced in December 2006 that they have agreed to acquire three electric generation stations in Pennsylvania, West Virginia and Ohio from Dominion Resources.
• Wayzata Investment Partners completed the purchase of two Northern California power plants from NRG Energy in early January 2007.
• The Carlyle Group, Bain Capital and Thomas H. Lee Partners have also invested in power and natural gas assets.

In addition to purchasing existing assets, private equity funds have participated in building new greenfield projects. ArcLight announced in October 2006 that it had joined with Excel Energy to build a 550 MW gas-fired plant in New Mexico. The project company, Lea Power Partners is owned by ArcLight Energy Partners Fund III and is expected to be completed in the summer of 2008.

The Energy Policy Act of 2005 has encouraged investment in the electric utility industry

The Energy Policy Act of 2005 (EPACT) replaced much of the Public Utilities Holding Company Act of 1935 (PUHCA) and made the Federal Energy Regulatory Commission (FERC) the primary regulatory authority for public utility holding companies. FERC has implemented policies set forth in the EPACT that have had the effect of encouraging investment in the electric utility industry, such as:

• making it easier for private equity firms to invest in utility assets by repealing much of PUHCA that removed some previous Securities and Exchange Commission barriers to ownership of utility assets,
• allowing higher rates of return for transmission assets, and
• streamlining merger review.

As a result of the proposed acquisition of TXU Corp. more private equity funds may invest in regulated utility operations

In addition to its size, the proposed acquisition of TXU is unusual in that the acquirers sought the support of environmental groups and state government officials before announcing the deal. They obtained support from two leading national environmental organizations, the Natural Resources Defense Council and Environmental Defense, in part by agreeing to cancel all but 3 of the 11 coal-fired power plants that TXU had planned to build. The private equity sponsors hope to gain customer and legislative support in Texas for the proposed deal by offering a rate reduction for some customers and proposing approximately $400 million to fund renewable energy and energy conservation initiatives.

TXU Corp. was considered an attractive acquisition candidate because Texas has a deregulated market which, to some extent, is a captive market since it has few transmission interconnections to other states. Furthermore, market prices for power have generally been set by natural gas fired generating plants which can make lower cost coal-fired generation plants highly profitable.

Regulatory hurdles have blocked some previous efforts by private equity firms to purchase regulated utility operations. For example, in March 2005, Texas Pacifics bid for Portland General Electric was not approved by Oregon regulators. In 2004, an investor group led by KKR did not complete a bid to buy UniSource Energy Corp. after Arizona officials failed to approve the deal. Warren Buffett, however, was successful in buying the Oregon utility PacificCorp in 2006 for $5.1 billion only after agreeing to upgrade the companys infrastructure facilities.

Ownership of regulated utility operations requires a great deal of sensitivity to state legislators, environmental groups and customer interests. In addition, regulated utility operations may result in lower returns than private equity funds have experienced in the past and longer-term investment horizons than is common for private equity firms. Already there have been questions raised as to whether the KKR Group will sell off or retain the regulated utility operations of TXU Corp. TXU Electric Delivery, which is considered to have lower returns than TXUs merchant power plant operations. Private equity funds may, however, be interested in utility investments for the same reason given by Warren Buffet when he was reported to say that a utility investment is not a way to get rich, its a way to stay rich.

While there are many opportunities, investment in utility assets and operations should not be undertaken without a team of experts experienced in power markets, generation plant engineering and design, environmental issues that range from environmental permitting to global warming, legislative relations and customer expectations.