July 25, 2008
Tight credit won't prevent utility asset sales. The expected increase in power demand coupled with the need for more investment in infrastructure will continue to drive domestic and foreign enterprises to seek opportunities in North America.
The objective is to leverage assets and to increase earnings growth. Today's environment, however, differs from what it was a couple years ago when some megadeals such as Duke Energy and Cinergy were consummated. The lack of liquidity that now exists has trimmed the list of would-be suitors. As such, the firms with the strongest balance sheets that can still get access to debt financing will guide the process.
"To get the returns that are most attractive, you need to have lower equity and more debt," says Michael Rogan, a partner with Skadden Arps in Washington, D.C. who works on mergers and acquisitions. "If the debt is not available, then you can't make these acquisitions. An investment grade energy company that wants to do a deal will still be able to borrow if it has a good balance sheet. That's why mergers and acquisitions will continue but it will not be as busy as it has been."
Repeal of the Public Utility Holding Company Act of 1935 that restricted utilities' business activities has attracted more investor interest. But it has also drawn added scrutiny from state regulators who want to assure that no company is able to exercise undue influence over the market. That's why the trend overall will be for companies to acquire strategic divisions -- ones that fit nicely with corporate missions.
Regulatory pressures won't stop acquisitions in their tracks. And neither will tight credit. According to PriceWaterhouseCoopers, activity within the utility sect in all of North America climbed to $95.2 billion in 2007, a 34 percent jump from 2006 and a 56 percent growth from 2005. North American deal value in 2007 represented 26 percent of the global value, up from 24 percent in 2006. The $43.8 billion buyout of TXU, Corp. by Kohlberg Kravis Roberts, Texas Pacific Group and Goldman Sachs Capital Partners was the year's biggest.
In 2008, North American power deals are likely to be influenced by the need to replace aging infrastructure and the ongoing implementation of renewable portfolio standards at the state levels. Along those lines, concerns over climate change and the opportunities presented by such challenges will create more activity in non-carbon ventures.
"Looking ahead, the election year creates more uncertainty as it is likely to prompt potential regulatory and legislative actions, particularly impacting carbon emissions," says John McConomy, who spearheaded the PriceWaterhouseCoopers utility study, adding that the weak U.S. dollar will attract global suitors. "Energy companies will be assessing the impact of satisfying environmental and renewable energy mandates, and may look to private capital for assistance."
Aging Infrastructure
Private companies can range from hedge funds to infrastructure funds to venture capital firms and may choose to seek minority or controlling shares. U.S. energy assets are appealing because they are steady revenue producers, which is a huge bonus if companies are to pay down their newly acquired debt.
Besides the private takeover of TXU last year, another closely-held consortium led by Australia-based Macquarie Infrastructure Partners is now acquiring Washington State-based Puget Energy for $6.8 billion. For its part, Puget says that it needs to attract $5 billion so that it can upgrade its wires system.
It's all about the need to attract capital. Utilities, in particular, must build expensive power plants and transmission lines. In the last three years, the cost of those investments has risen by 50 percent, says Standard & Poor's. In the last 12 months, utilities have anteed up $6 billion toward infrastructure -- an amount that is expected to keep climbing as the demand for electricity increases and necessitates more generators and wires.
The North American Electric Reliability Corporation, in fact, says that by 2015 the country will need an additional 141,000 megawatts to accommodate an expected 19 percent increase in electricity usage. So far, there's only 57,000 megawatts on the board.
By going private, utilities are be able to avoid quarterly reporting pressures while having potentially quick access to parents flush with cash. But skeptics question the benefits of such arrangements and ask whether private investors are dedicated to the businesses or whether they are more concerned with getting quick returns. Among the most common complaints with private owners is that assets are flipped before promises are fulfilled.
But future transactions will involve non-traditional entities. It then becomes the job of regulators to assure that such deals meet the smell tests. Domestic private investors and international infrastructure funds want in on the action. So do sovereign wealth funds, which are set up by national governments and which have already pumped billions into ailing U.S. investment banks. They now hold nearly $3 trillion in assets.
Foreign enterprises, meantime, are expected to continue to pursue U.S. power and gas assets. Last year, Spain's Iberdrola bid $7.8 billion for Energy East -- a deal which must still get approval from New York State regulators. European companies also sought U.S. renewable assets, including Energias de Portugal's $2.3 billion buyout of Horizon Wind Energy and E.ON's $1.4 billion purchase of the North American operations of Airtricity.
"The bottom line is that companies need to invest in infrastructure and to diversify their assets to get away from their reliance on fossil fuels," says Skadden's Rogan. "Their goal is to increase earnings growth. Until the credit crunch eases, the volume of mergers and acquisitions is expected to be down. But in the meantime there will still be transactions."
Deals will get done. But the scope of buy-outs and asset sales is expanding. They don't just involve traditional enterprises vying for greater market share. They also include newer players such as private equity and foreign interests. If the bids are properly scrutinized, then the outcome should be positive.
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