Buffett Makes Bid for Constellation

Buffett Makes Bid for Constellation

Location: New York
Author: Ken Silverstein, EnergyBiz Insider, Editor-in-Chief
Date: Monday, September 29, 2008

The turmoil in the financial sector is now rattling the utility world. Constellation Energy was about to become the first such casualty, but Warren Buffett's MidAmerican Energy Holdings came to the rescue, finding a fundamentally good company at a garage sale price.

In an unprecedented set of negotiations, the deal took just 48 hours for the respective corporate boards to approve. Constellation, which had been an industry gem with $21 billion in sales revenues last year, was pushed to the verge of bankruptcy because it had underestimated the collateral it would need if its credit ratings were downgraded. Essentially, the crisis underlying the financial sector had severely affected the Baltimore-based company's ability to fund its trading operations. Altogether, it has lost about 70 percent of its value since that emergency had peaked in July.

The company has been especially battered in recent weeks, notably after announcing its ties to the bankrupt investment banking firm Lehman Brothers. Such firms provide the collateral that trading organizations need. In Constellation's case, it recently revealed that its collateral obligations more than doubled from July to August, to about $4.4 billion. It then sought to sell off certain assets in a last-ditch effort to raise capital.

It's the type of whirlwind activity that draws Buffett, the head of Berkshire Hathaway. He values those prized assets that are distressed and selling inexpensively. The Omaha-based company that reports more than $31 billion in cash has been on the hunt, particularly when there are a plethora of such propositions and so few suitors that can cut checks. Buffett, meanwhile, has said on multiple occasions that utilities are among the properties he would like to add to his portfolio.

In March 2000, Buffett bought his first utility, MidAmerican. "MidAmerican has been a wonderful steward of its energy assets and the acquisition of Constellation Energy, when completed, will prove beneficial to all constituents," says Buffett.

The agreement is expected to be finalized in nine months. It must first win approval from federal and state regulators, as well as shareholders. Buffett, through MidAmerican, said the entity would pay about $4.7 billion for Constellation, which will then issue $1 billion in preferred equity with an 8 percent yield to MidAmerican. Electricite de France, which bought a 9 percent stake in Constellation in 2007, also expressed interest. But the French company ultimately backed out, leaving Buffett the sole bidder.

What attracts Buffett to Constellation? According to James Halloran, Wall Street analyst for National City Bank in Cleveland, he sees an opportunity to cash in on Constellation's other assets that include about 9,000 megawatts of generation. With the country projected to be short generation in the decades to come, these assets will likely become increasingly lucrative.

"It's classic Buffett: Find valued assets and buy at the bottom of the market," says Halloran. "He got a heck of a deal."

Good Credit

MidAmerican Energy says that it will leave Constellation Energy fundamentally intact, although it will probably pare down its trading operations. The risk profile associated with that business has risen since the credit meltdown in financial markets that provides the good-faith money necessary to assure trades happen. Without such a safety net, it would be hard to attract counterparties -- all offshoots of the Enron debacle.

Much of the collateral requirements had been overkill, until now. But when its collateral nearly dried up and when Constellation faced a downgrade in its credit ratings as a result, the damage had been done. If far more capital is necessary to back trades, then the risk-reward ratio becomes too great and the business is much less attractive.

"You have to maintain a certain amount of creditworthiness," says Halloran. "Commodity prices can get pretty volatile and counter-parties need enough collateral on hand if -- for whatever reason -- they are unable to meet their end of the trade. If they need to put up more money but they can't get access to credit, no one will trade with them."

The eventual result could then be bankruptcy. Buffett, of course, is flush with cash, but Halloran says that this deal is unusual and does not represent a trend in the utility industry. That is, Standard & Poor's said that it would downgrade Constellation's credit ratings unless the company got additional and immediate funding, which forced it into a marriage.

If markets settle in early 2009 and Constellation determines that the full value of its assets has not been fully accounted for, then it has the right to back out of the deal. This is a fundamentally different set of circumstances than the fate which had beset the unregulated marketing and trading organizations. They had built too much generation and were unable to sell their power at prices high enough to cover their debt obligations.

What does all this portend in terms of Buffett's participation in the utility segment? "He has a good war chest and is always looking for a deal," says Halloran. "But I don't see him doing any more utility deals until this one with Constellation gets resolved."

Utility mergers have typically been premised upon combining two companies that are geographically aligned or that are complementary with one another. MidAmerican's potential buyout of Constellation is uncommon not just because it was consummated in just two days but also because of the circumstances surrounding it. The chaos in the financial world has crept into the utility sector.