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Business & Money

Experts debate whether KKR's leveraged buyout of UniSource Energy is right for the industry.
Fortnightly Magazine - February 2004

Still, Williams says the real test will be how this company will be able to become profitable, given that it is financing $970 million, including new debt of $660 million.

"While the purchase price is approximately $885 million in cash to shareholders plus assumed debt, total consolidated debt will exceed $2 billion. To meet these debt payments, any additional income generated will have to come from the cost side, not the revenue side, as utility rates are highly regulated. Additionally, costs related to plant and line maintenance are closely scrutinized to ensure that adequate capital is spent for reliability.

"In a sense, the fact that existing management has not been successful in turning this company around, as measured in stock performance, the LBO is at least acknowledgement that radical changes needed to occur. Shareholders are now able to cash out at a premium and reinvest their money elsewhere," Williams says.

Daniel More, head of utility M&A at Morgan Stanley, who advised Unisource Energy on the deal, says it was precisely because the company was not being paid attention to in the public equity markets that privatization is a compelling alternative.

"Let's face it; Wall Street research is getting to be harder and harder to come by. Mid-size to smaller utilities are often not covered by any sell-side analysts. It's also difficult to have adequate trading liquidity in the stock of such companies, both of which contribute to lack of institutional investors' interest. With lack of interest in your stock, if you don't have clear avenues for growth, you start to think about the world out there and potential pools of capital. There is public equity and there is private equity," More says.

Furthermore, many advocates of the deal point out that it strengthens the capital base of the company's regulated utility. But opponents point out that the leverage is moved from the utility subsidiary to the holding company. "KKR is not putting equity into the utility out of the goodness of their hearts. They're providing that equity to overcome restrictions on the dividend amount paid to the holding company to further leverage the holding company," says another.

The equity that will be attributed to Tucson Electric Power Co. (TEP) is $260 million, including the retirement of a $95 million inter-company loan from TEP to UniSource Energy. According to Kevin P. Larson, vice-president, CFO, and treasurer of UniSource Energy, "The Arizona Corporate Commission limits dividends (from TEP to UNS) to 75 percent of TEP net income if TEP equity is less than 40 percent of total capitalization (excluding leases). Today TEP's equity represents approx 25 percent of capitalization per Arizona Corporation Commission calculation. Following the merger it is anticipated that TEP equity will be equal to or greater than 40 percent. At that point, TEP could pay 100 percent of net income as a dividend, provided no other restrictions exist," he says. At press time, the application to the Arizona Corporate Commission for the acquisition of UniSource Energy by KKR had not been filed, neither had the proxy statement, but both were expected