Power sector beset by debt, other woes, Jefferies conference says

By Paul Deckelman

New York, December 11 - That the once-powerful U.S. power generating industry is in trouble is no secret, with Enron Corp. - once the leading energy trader - wallowing in Chapter 11 and the debt of such former high-flyers as Williams Cos., Dynegy Inc., Mirant Corp. and, most recently, El Paso Corp., having been beaten down to junk-bond levels, while their shares have all tumbled sharply from year-ago levels.

How did such a once robust industry get into such a mess?

According to participants at a Jefferies & Co. conference on the power industry's problems held Tuesday in New York, the industry was laid low by a combination of factors, including an overly aggressive industry-wide construction boom occurring just as overall power demand was slackening off, and legislative actions in various states that suddenly changed the rules in the middle of the game.

In California, government "legislated [the equivalent of] an S&L crisis," said M. Douglas Dunn, a partner specializing in power and energy issues for the international law firm of Milbank, Tweed, Hadley & McCloy LLP. This happened, he explained, because laws partly deregulated the energy market while leaving other regulatory structures in place.

As a result "you borrowed [i.e. bought power from wholesale producers] at a floating price and got paid [sold the power to retail customers] at a fixed price" that was almost always substantially lower than what utilities like Pacific Gas & Electric and Southern California Edison had paid for it. That caused the former to go bankrupt and the latter to almost follow along.

Besides over-building and government interference, the panelists at the conference noted the unfortunate consequences accruing to the power industry from the mountain of new debt that was borrowed from banks, bondholders and other sources to finance a torrid spate of mergers and acquisitions and asset purchases, as well as plant construction.

Lane Genatowski, managing director of Jefferies Global Power Group, pointed to what happened to Allegheny Energy, the Hagerstown, Md.-based regional electric power producer whose ratings were knocked down into the junk category earlier this year, even as its stock fell from over $40 a share this spring to as low as under $3 (it has since recovered slightly to current levels in the mid- $8 range.

After being put behind the proverbial 8-ball by some legislative decisions in its major territory of Pennsylvania - going, he said, "from the front to the back of the pack with the stroke of a legislative pen," Allegheny "increased their leverage through bridge loans to buy assets, in an effort to become a national energy player," including buying Merrill Lynch's energy trading business in March, 2001.

For a while, the strategy seemed to be working, as the revenues from the assets made the company more profitable and its shares doubled in price between March 2000 and May 2001. "That was what we called 'the happy time' for all utilities," said Genatowski.

But storm clouds were gathering on Allegheny's horizon. Genatowski said Allegheny had "paid high [prices] for the trading business and for the [power generating] assets." On top of that, its trading unit negotiated a big power contract with California which later turned cash-flow negative. Then "the wheels came off Enron and people started to look behind the screen" of the trading business.

Allegheny was put into a situation where it lapsed into a technical default in October and was downgraded by the ratings agencies, which caused it to get hit with a double-whammy. Not only did its lenders now demand that the company put up collateral on its loans - taking the revenue from those assets out of the profit stream - but its energy trading counterparties were calling for more collateral as well as part of the price of doing trades with them.

"The collateral went out faster than the company expected," Genatowski said. "They turned around and quickly found themselves in a large liquidity crisis, with very little money to run large enterprises - much less so than they thought they had." The company, he added, is now working with its bank group and its bondholders in an effort to reschedule its debt.

According to Gregory R. Imbruce, vice president, High Yield Research-Energy for Jefferies, the power sector has an industry-wide total of $188 billion of various kinds of debt outstanding, with at least $40 billion of it classified as current debt.

Genatowski noted that in some cases, energy borrowers such as Mirant Corp. were indulging in "triple leverage" - borrowing against assets at the project level, at a special-purpose holding company level and again at the parent company level. "Mirant has a lot of debt," he asserted. "Triple leveraging is clearly a warning sign" that a company might be too heavily levered.

As power companies continued to borrow more and more money, piling debt upon debt, at the insistence of the lenders much of that debt was booby-trapped with ratings triggers upping collateral requirements that kicked in as the ratings fell and drained away precious liquidity, just when the companies needed the funds the most.

"These guys [executives of fallen angel merchant energy providers and traders] grew up in what were then investment-grade companies, where writing ratings triggers into the indentures was like giving away the sleeves in your vest," declared Milbank Tweed's Dunn, meaning it was something they had no problem putting in, feeling that it would cost them nothing, since the provisions would never be put into effect anyway. As long as the companies remained profitable and the debt ratings held up, that proved to be the case.

But with Enron's fall from grace last year - which dragged much of the industry down into speculative-grade territory with it - "now those provisions are coming back to bite them," he said.

Scott Taylor of Standard & Poor's noted that rating triggers "hastened the fall of Enron." Aside from increases in interest rates, triggers might take the form of collateral calls - and the S&P analyst said that at many companies, "management doesn't even really know what the magnitude of the collateral calls may be," since the way they are written into most energy trading agreements leaves it up to the counterparty to decide what an appropriate level of collateral might be.

Describing the vicious cycle energy borrowers - and borrowers in general - get caught in, Taylor intoned that "companies are scrambling for their liquidity. As the credit quality begins to slip, and you most need liquidity, liquidity starts to disappear."

With one major player (Enron) already bankrupt and others in distressed situation, Genatowski of Jefferies noted that the banks are likely to tread very carefully. "They have a lot of money out the door, so they don't want to move against the companies [by foreclosing on assets] since they don't know how to operate power plants."

Instead, he predicted, the banks "are going to give them capital in an eyedropper, to keep them above water until the spark spreads [i.e. the difference between what it costs a utility to generate a kilowatt-hour of electricity and what it can sell that power to a customer for] come back. No one wants to write down a loan. "

Once workout negotiations with troubled energy companies begin (or almost any other kind of borrower), it would appear that banks have the upper hand over bondholders, since their debt almost always ranks higher in the capital structure.

"There is a lot of denial" on the part of managers of formerly robust energy companies that have fallen upon hard times, said Luc A. Despins, a managing partner at Milbank Tweed specializing in financial restructurings. "Many of those companies are fallen angels - and now they have to make hard choices, whether to file for Chapter 11 or provide additional collateral demanded by the banks. Companies often panic and give in to the banks' demands for collateral," in what he called "a knee-jerk reaction."

He said that bondholders looking to oppose the turnover of collateral to the banks could challenge such transactions as a preference (an illegal transfer of assets by a soon-to-be bankrupt debtor), but only if the deal occurs within a 90-day window before the filing.

But even if there is no preference, he said, there might be grounds to challenge a turnover of collateral, especially if the indenture on the bondholders' securities has a negative pledge clause, which keeps the debtor from giving assets to one creditor that he doesn't offer to all of the others.

Bondholders, Despins said, "may have to threaten to sue the company for breaching their indenture covenants."

The attorney advised disgruntled bondholders to scrutinize their indentures to "try to find a default. If you are in a default mode - you have leverage."

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