Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

The Rich Get Richer: How Hedge Funds Are Making Millions Tearing an Energy Giant Apart

NRG Energy is selling renewable energy assets in an effort to appease hedge funds invested in the company.

It's easy to pick sides when a hedge fund takes a position in a stock. Sometimes they want to oust terrible management, making them heroes to the retail investors who wish they had the same power. In other instances, hedge fund operators push for financial engineering that may drive short-term gains but distracts management from running the business for the long term.

No matter what the circumstance, make no mistake: Hedge funds are involved to make money.

What's worse, oftentimes the long-term interests of a business may run counter to what makes the most money right now. And that conflict can create a situation like the one NRG Energy(NYSE:NRG) is in after hedge funds Elliott Management and Bluescape Energy Partners took big stakes in the company and were given board seats to agitate for change. As a result, NRG Energy is making a strategic shift that the market is happy about right now -- and, in the process, making millions for hedge funds. But it may end up in bankruptcy betting on these older assets.

Image source: Getty Images.

The situation

NRG Energy is planning to sell up to $4 billion in assets, including its entire renewable energy business, 6 GW of unnamed conventional assets, plus anywhere from 50% to 100% ownership of NRG Yield(NYSE:NYLD)(NYSE:NYLD-A). The end result of this will be a far-less leveraged balance sheet.

Once the restructuring is complete, NRG will have a retail electricity unit in Texas and fossil fuel assets that operate in the wholesale power markets. It will also have about $6.5 billion in debt on the balance sheet, down from $19.5 billion today.

Short-term gains

Should NRG Energy complete these divestitures, it very well could unlock value for shareholders (at least in the short run). That's what Elliott Management and Bluescape Energy are betting on. They estimate that the sum of the parts is worth more than what NRG Energy is trading for. If that's true, then selling some assets might make sense.

However, as with most things in life, it's never that simple.

If it were indeed true that all of NRG's fossil fuel assets and renewable assets are worth more separately in the long term, it would make sense to split them up. What one can't help but notice is that renewable energy assets are easy to sell these days.

There are scores of buyers (pension funds, other utilities, investment funds) bidding for renewable assets in today's marketplace. NRG could easily get full value for renewable energy assets while holding on to fossil fuel assets that may not get the value management wants.

One has to wonder why NRG's fossil assets are harder to sell than its renewable businesses.

Corporate history is replete with examples of situations where it was advantageous for all stake holders to separate business units. Sales can make sense if you're trying to extract value from a mispriced stock. And splitting a company in two because the segments would be worth more separately is a common justification for restructuring. But in this case, there's a long-term reason this makes no sense for NRG Energy.

Missed opportunities

Short-term traders may think that selling NRG's renewable assets makes sense, as indicated by NRG Energy's temporary stock jump. Alas, this is a fleeting boost. It ignores what NRG Energy was doing buying renewable assets in the first place: building a business for tomorrow.

There is trouble brewing beneath the surface.

The wholesale power market that NRG Energy happens to have a major presence in is in financial trouble because rates have been dropping across the country. The reason is that wind, solar, and nuclear energy have first dibs on supplying electricity to the grid. As these energy sources have grown, they've pushed demand for coal and natural gas out of the market, which used to be NRG Energy's bread and butter.

Many utilities have started to adjust to this shift by buying the wind and solar assets, as NRG Energy did.

Renewables come with long-term contracts, and if you can buy them with low-cost capital (the entire rationale behind NRG Yield) then returns on invested capital can easily be in the range of the 12% to 15% that NRG's management wants to buy projects at in the future. Near as we can tell, long-term, NRG Energy was making the right moves betting on renewable energy.

But when the stock market doesn't value the sum of the old fossil fuel assets and the new renewable energy assets at a level at or above their core value, it makes sense for a hedge fund to come in and sell the company for parts -- even if it means that NRG Energy goes bankrupt a decade from now.

Which brings us to today.

Throwing the baby out with the bathwater

The important part of the strategic change isn't the 6 GW of fossil fuels NRG Energy is selling, it's that it's hoping to sell ALL of its renewable energy assets. Long-term, the company will be betting on the wholesale market that's leaving companies in financial distress across the country.

Given the industry's struggles, it's not out of the realm of possibility to say that NRG is throwing away its best bet on the future.

None of the now bankrupt power generators thought wholesale power rates would fall as much as they have. Worse, some companies are writing off power plants they thought would generate money for decades to come. Without a core of renewable energy assets to fall back on, NRG Energy is making a big, risky bet on aging fossil fuel technology that's working against where the market is headed.

What's a business for, anyway?

Hedge funds trying to extract value from NRG Energy shouldn't surprise anyone. It's likely that Elliott and Bluescape saw assets that were mispriced based on their underlying value. And from a shareholder standpoint, it makes sense to sell some assets for full value (renewable assets) and hope that the market then reprices the stock higher, giving what you think is full value to the assets the company keeps (fossil fuels and retail).

While the move makes sense today, I don't think this transition is a wise one for NRG Energy long-term. The aging fossil fuel business is almost certainly not a growth business. The best management can do is suck as much cash out as possible. The one bright spot, the retail business in Texas, is competitive but running up against new competition from the one thing Texas is guaranteed to have -- the Sun. Investors simply can't count on consistent returns in Texas as this competition grows.

These long-term risks probably don't matter to the hedge funds pushing for change at NRG Energy. They'll have moved on to their next investment target. They're in it for the money now -- no matter what happens to a company later.