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Real Power Plays On Wall Street


Nestled along a highway in Linden, N.J., a nondescript power plant sends hundreds of megawatts of electricity to New York City daily. It's a mundane task, but someone has to light and heat the city's skyscrapers. What's surprising is that the someone at this complex is one of Wall Street's most prestigious investment banks -- Goldman, Sachs & Co. (GS).

Goldman has been on a power plant shopping spree. In a little over 12 months, it has picked up 30 of them stretching from North Carolina to Minnesota at a total cost of $4 billion, including debt. Goldman's reasoning is simple: The knowledge of energy prices gleaned from its plants gives it a big advantage in cashing in on rising prices and running one of the world's busiest power-trading desks.

These days, bankers and traders are posing as power guys. Saddled with lackluster growth in their other businesses, many financial firms are doing the same as Goldman. Investment banks, buyout firms, hedge funds, and even giants such as American International Group Inc. (AIG) are scouring the energy landscape for potential earnings gushers in everything from oil and gas to electricity futures. "We now have petroleum and pipeline engineers on retainer," says Joe Colonnetta, a partner at private equity firm Hicks, Muse, Tate & Furst Inc. in Dallas. That's a reversal from the time when executives at Enron Corp. and other power companies scrambled to make big bucks by masquerading as moneymen in the go-go '90s. Then, they dreamt up new ways to trade everything from electricity to bandwidth to weather-related hedges.

What's attracting buyout firms and hedge funds to energy are the potential gobs of money to be made from buying power plants at dirt-cheap prices. In May, MatlinPatterson bought for $475 million eight state-of-the-art power plants from Duke Energy Corp. (DUK) that were originally valued on the company's books at $2.6 billion. "Our cost basis is substantially lower," says Mark Patterson, a founding partner of the private equity firm MatlinPatterson Global Advisers LLC. In addition, there's a chance that some day private equity firms will be able to sell the plants back to corporate buyers at a profit.

SWAP AROUND THE CLOCK

For investment banks, there's the added benefit of tapping markets that are an arbitrager's mecca. Swapping contracts for natural gas, coal, and other forms of power, Goldman's traders operate around the clock, just as its power plants now do. "Understanding the physical infrastructure makes it possible for us to immediately analyze the market and more effectively deploy our [trading] capital," says Richard Ruzika, head of global commodities. It's a heavily regulated business that the Federal Energy Regulatory Commission (FERC) has tried to make more transparent. Owners of power plants and transmission facilities are required to make public most information about the energy they make or deliver and the prices they charge.

Widely fluctuating demand for electricity throughout the day and inefficient distribution offer huge opportunities for trading profits. Dominant players such as Goldman and Morgan Stanley do not break out their energy trading results. But Sanford C. Bernstein & Co. (AC) estimates that Goldman and Morgan Stanley (MWD) each collect about $1 billion annually in revenues from their commodities-trading operation, much of which is energy-related. It expects these businesses to grow by at least 15% a year and bring in as much as $2 billion in revenue for each firm by 2007.

Wall Street is transmuting electrons into big money. In September, Merrill Lynch & Co. (MER) bought the energy-trading businesses of Entergy-Koch LP for $800 million. Newly formed private equity firm Diamond Castle says it wants to invest in energy-related businesses. And after it announced that it had bought a natural-gas company for $405 million in November, Hicks Muse got about 50 phone calls from financial firms, including a dozen hedge funds, that wanted in on the deal, too. The firm turned them all down. Adding it up, over the past 20 months financial firms have announced or closed deals for power plants worth nearly $15 billion, according to estimates by Platts Global Power Report (MHP).

The torrent of money from Wall Street is manna for a cash-strapped power industry that has been in chaos since Enron filed for bankruptcy in 2001. Financial firms have their pick of assets largely because most potential corporate buyers are still struggling. "We have an industry that has to move on and new sources of capital will help," says Jeffrey R. Holzschuh, head of utility and power investment banking at Morgan Stanley. So financial firms are emerging as significant producers of the nation's electricity. Texas Pacific Group will supply 44% of Oregon residents with power once it receives regulatory approval to buy one of the state's utilities. Goldman produces 6.5% of the power Consolidated Edison Inc. (ED) delivers to New York City. If all their deals are completed, financial firms will control an estimated 4% of the nation's power by some point next year, says Platts.

But is a new breed of Wall Street power brokers desirable? Regulators are closely watching to see how financial firms manage what some see as potential conflicts of interest between making hay trading electricity and supplying it. For now, financial firms' money, strong credit ratings, and expertise in managing financial risks are considered a plus. "But we are trying to make sure that what they're doing is within the rules," says William F. Hederman, director of the office of market oversight and investigations at FERC. Goldman says nearly 99% of its power is sold on long-term contracts.

Critics worry that bankers, with little operational experience, could end up leaving high-maintenance power plants in bad shape. And there's a fear that they'll borrow too heavily against these assets as energy prices soar, leaving the companies' balance sheets debt-laden once again. "New investors often don't recognize the risk during periods of high commodity prices," says Cameron O. Smith, senior managing director at Cosco Capital Management LLC. "They may have taken on unanticipated downside risk."

CLOSING WINDOW

Some energy assets are already starting to look expensive. In September, Credit Suisse First Boston (CSR) decided to back out of its plan to enter an energy marketing and trading joint venture with TXU Corp. (TXU) in part because it decided it could build up energy-trading operations more cheaply on its own. A senior banker at another major Wall Street firm, who asks not to be named, says: "We're probably a day late and a dollar short" to buy such a business.

Energy profits could quickly fizzle out if new supplies hit the market any time soon and skyrocketing prices fall back to earth. That would give quite a shock to today's power-crazed traders and bankers. But for now, they're fired up.

By Emily Thornton in New York


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