Utility mergers present special challenges, consultant says, and probably will keep it up

Electric Utility Week
30 April 2007

Conditions placed on mergers in the utility industry are "going to become more and more intrusive over time," a former Illinois Commerce Commission member, now a consultant, told an Energy Bar Association annual meeting in Washington.

"I think that's just the nature of the beast," he said, because when it comes to mergers in the sector, "in some sense, the benefits and costs are more complicated. How are they being generated? Given that uncertainty, people are going to want to put more constraints on how the deal is structured so that they feel that they have certainty about what they're getting out of" a transaction, said Karl McDermott, a vice-president with NERA Economic Consulting and former ICC member.

"I think that legal/regulatory requirements are getting more and more stringent" on mergers "because I think that as the character [of mergers] has changed, the obvious benefits to customers aren't as clear any more."

McDermott, who participated on a panel looking at state regulatory issues and M&A, said that "ring-fencing" provisions are going to become "more and more important."

He thinks states will get "more refined in the level and detail" of ring-fencing provisions. "I don't know whether that's a good thing or a bad thing, but it seems to me that" the case involving the merger of Enron and Portland General Electric "started as a nice model, where it was very effective and very limited in number."

Oregon "did a really great job" on its approach to ring-fencing as it relates to the Enron-PGE combination, McDermott said. "With the failure of Enron, non of those effects ever were passed on to the PGE customers...They were insulated by those ring-fencing provisions" tied to the deal. He also pointed out that there "weren't many" ring-fencing conditions imposed by Oregon regulators tied to the Enron-PGE deal.

Meanwhile, McDermott said, "I don't know that there's a bias against private equity firms, but there's something that people find difficult to handle in the notion of flipping a company." The notion of private equity buying a utility has been creating some consternation in Texas, where Kohlberg Kravis Roberts and TPG are offering to buy TXU Corp.

In 2004, the Arizona Corporation Commission rejected a deal under which an investor group, including affiliates of Kohlberg Kravis Roberts, JP Morgan Partners and Wachovia Capital Partners, would have acquired UniSource.

In 2005, the Oregon PUC denied Texas Pacific Group's (now TPG) bid to buy PGE, saying the potential harm and risk to customers outweighed benefits. In its denial, the PUC cited two major source of risk -- a large debt burden and short-term ownership.

Another panel member, Joseph Sauvage, with the global power group at Lehman Brothers, said that "this is absolutely the most difficult industrial sector to structure, negotiate, much less close, M&A transactions."

There are several factors that explain why the utility sector has seen more failures than successes when it comes to M&A, he suggested. "First of all, I think it's obvious, you have multiple constituencies you have to satisfy, and at the end of the day, not all of those constituencies have interests that are perfectly aligned."

He also said that "in these transactions, unlike M&A in pure industrial sectors, there's generally only so much economics that can be shared."

Another challenge facing M&A in the utility sector involves the length of time to complete deals. "You have simplified the federal regulatory process, although you still have the normal FERC proceedings, et cetera, and you have what can be very lengthy state regulatory proceedings."

Sauvage said that colleagues of his in natural resources will close very large E&P and pipeline deals "in three months, four months. We're generally just kind of warming up to go to FERC in three or four months." Twelve months "would be a land speed record in utility M&A."

Despite these challenges, he believes there are "substantial shareholder and stakeholder benefits to consolidation."

Panelists were asked whether they believe there are too many electric utilities in the US and whether there would be benefits for customers from greater consolidation overall in the sector.

Frederick Butler, a commissioner with the New Jersey Board of Public Utilities, said he thinks there are too many companies, and said, "I think there can be benefits from having large utilities. The difficulty is getting from here to there."

Samuel "Jimmy" Ervin, a member of the North Carolina Utilities Commission, said that even if "consolidation as a general proposition is appropriate, that does no necessarily make a particular transaction one that ought to go forward." He said that even if consolidation "in the abstract is a good thing, that shouldn't be the end of the inquiry."

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