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Size Matters: Consider teh Alternatives

For small to midsize utilities, the costs and burdens of being a stand-alone investor-owned utility merit considering the alternatives.
Fortnightly Magazine - May 15 2003

for smaller utilities would be the sale of the company to a larger utility. Shareholders could receive stock from the acquiror, which would allow them to continue enjoying the benefits of owning equity in a utility. They also should receive a strategic price premium in the sale process.

Another possibility is to seek a similar-sized merger partner. The combined company might be more able to justify the costs of being public, or result in a company that attracts more strategic interest and, therefore, a higher premium.

For midsize utilities, the scenarios are similar. However, it is more important for these companies to focus on finding a similar merger partner to achieve the scale benefits of being a larger public company.

Alternatively, a "going private" transaction may merit consideration. Morgan Stanley estimates that about $150 billion of private equity funds is currently available for investment. With typical leverage levels, that translates to about $500 billion of potential acquisitions. More importantly, the returns required by many private equity investors have come down significantly, with risk-adjusted returns for regulated utilities currently as low as the mid-teens.

For small to midsize utilities, the current conditions in the private equity market are favorable. Although going private will not make sense if a strategic buyer would pay more for the company, in today's displaced market, there are fewer strategic acquirors, and those that exist may not be willing to pay large strategic premiums.

A larger company will require substantially more private equity and have more complicated regulatory issues, all of which make a going-private transaction less likely. In 2000, TNP Enterprises, the holding company for Texas-New Mexico Power Co. went private. Its shareholders received a 33 percent premium to their pre-announcement share price. More recently, Citizens Communications sold its Hawaiian gas division to K-1 USA Ventures for $115 million in cash.

Is There a Role for Public Sector Ownership?

Though anathema to many industry participants, there may be a role for public sector ownership (municipal, public authority, etc.) of purely regulated, monopoly utility businesses. If one looks primarily at cost of capital and capital structure, the lower-cost financing and 100 percent debt structure available to a public sector owner can lead to much lower rates for consumers. However, the overall level of difficulty of selling, on a commercial basis, to a public sector owner is high, and the process is always subject to political currents and public sentiment.

Nonetheless, successful examples exist. The Long Island Power Authority (LIPA), a municipal entity formed in New York, acquired the transmission and distribution assets of the Long Island Lighting Co., which suffered significant financial difficulties, for $2.5 billion in cash and $3.6 billion of assumed liabilities. The transaction was funded by municipal bonds, and LIPA began operation with an immediate 20 percent reduction in rates to its 1 million customers.

The water utility sector has an effective model for contracted operation, resulting in the best of both worlds-efficient financial ownership and professional management. Operational contracts let private sector companies earn greater returns by allowing them to focus solely on applying their