As North America’s energy landscape shifts, transaction due diligence will be even more critical.
Key takeaways
Technological advancements and sustainability considerations also underscore this focus.
We zero in on financial model validation, revenue and gross profit analysis and other key areas.
As the North American energy landscape continues to shift because of the evolving energy mix, regulatory changes and market volatility, thorough due diligence will become even more paramount for deals in the power generation sector. Investors must carefully assess the financial and operational viability of power generation assets to ensure their resilience and profitability in a competitive and uncertain environment.
Technological advancements coupled with sustainability considerations further underscore the need to validate assumptions, contracts and compliance frameworks to mitigate risks and identify growth opportunities effectively.
Below we’ve highlighted 14 key diligence areas to help investors assess power generation businesses, broken into three categories:
Financial model validation
- Assumption validation: Compare key assumptions in the financial models such as heat rate, generation output and availability with historical actuals to assess reasonableness and understand the drivers behind any discrepancies.
- Contract review: Analyze key agreements with service providers, including long-term service agreements (LTSA), operations and maintenance (O&M) contracts, and asset management agreements, to understand historical and go-forward fee structures. Confirm that all recurring and anticipated costs are properly reflected in the model.
- Power purchase agreements/tolling agreements: Review contractual volumes and pricing structures. Identify any use of levelized revenue recognition in the historical period and assess the implications for future cash flow projections.
- Capital expenditures: Evaluate the company’s accounting policies for capital expenditures, including treatment of major maintenance and LTSA costs. Understand the forecasted maintenance and growth of capital expenditure needs and confirm these are appropriately captured in the financial model.
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Revenue and gross profit analysis
- Revenue streams: Assess revenue sources across regional independent system operators and wholesale energy markets, including merchant energy revenue, capacity payments, power purchase agreements, renewable energy credits and other environmental attributes. Understand the pricing mechanisms, contractual terms and market dynamics.
- Scheduled vs. unscheduled outages: Evaluate the impact of planned maintenance and forced outages on generation and profitability. Assess operational reliability and the financial impact from outages on capacity and energy payments, including penalties.
- Seasonality and weather impacts: Analyze how seasonal resource availability affects the generation and revenue including wind speed, river flow and other weather conditions.
- Hedging strategy: Review historical and forward hedging strategies for both revenue and fuel costs. Analyze the historical impact of hedging on earnings and cash flow and understand how hedge accounting (including effective vs. ineffective hedges) is reflected in the financials.
- Energy margin and other cost components: Assess historical margin trends and understand how fuel price, asset performance (e.g., heat rate, capacity factor) and O&M costs affect the margin profile.
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Other key due diligence considerations
- Cash flows: Understand the main drivers of changes in year-to-year cash available for distribution (CAFD) with a focus on operational fluctuations and any potential pro forma areas or other issues that could affect future CAFD.
- Minority investments: Understand go-forward operating structure and cash flows to properly value the business for minority investments.
- Renewable energy credits: Understand accounting policies surrounding renewable energy credits, which are often generated off the balance sheet and recorded as income when sold. Consider including working capital targets for any off-balance sheet amounts.
- Off-balance-sheet exposure: Determine the existence of any unrecorded liabilities or potential liabilities, claims asserted or unasserted (e.g., environmental exposures, asset retirement obligations) or contingencies not otherwise disclosed.
- Regulatory environment: Understand the impact of local, state and federal regulations, both historical and contemplated, including emission targets and tax incentives. Monitor potential changes in policy or compliance costs that could materially affect the cost structure going forward.
Assessing the points outlined above can provide investors with a holistic view of a given transaction target and enable them to make more informed decisions. In many cases, working with an external advisor to conduct these due diligence assessments can help ensure the process is thorough and complete.
