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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

ultimate regulatory tool: the power to reduce rates if he or she feels there is abuse. Furthermore, he believes that regulators should be primarily focused on the regulated utility. "Most LBO entities are not expert operators: They are financial investors. The regulator doesn't care if you mortgaged your house to buy shares in the regulated utility, or whether you inherited your stock from your grandfather Rockefeller. How you financed the stock that you purchased is irrelevant to the regulator as long as the equity structure of the [regulated] utility is appropriate," he says. "There is, of course, the issue of 'control' when a single stockholder owns the utility, but once again the regulator in most states has a full array of regulatory tools to protect the public interest."

Jim McGinnis, managing director at Morgan Stanley, says that targeted returns in the order of 20 percent are anything but guaranteed, especially as there is more to worry about than just the regulator.

"The regulator might be motivated by perceived excess leverage to reduce rates, but negative regulatory impact can come from other sources: a serendipitous change of rulemaking framework on the timing of recovery of fuels, the pricing of fuel inputs, the willingness to extend rate freeze agreements or engage in prospective rate stabilization discussions. So, regulatory rate actions are not only linked to excess leverage," he says.

Furthermore, debt is not necessarily a bad thing, McGinnis says, explaining that regulators often encourage added leverage at the regulated utility level in an effort to lower the cost of delivering electricity to customers who otherwise might have been charged a higher amount.

"The concern dating back to the 1930s was that if a holding company used excessive leverage, there was the potential for undue risk being shared by the utility that was not apparent to the local regulator. And this heightened risk of financial distress at the parent was a burden that the utility was inherently bearing, completely outside the scope of regulation. This extra-jurisdictional risk was one of the primary reasons why the federal government began regulating holding companies. In today's market, we have effective structuring techniques applied to today's ring-fenced utilities that are protective and which ensure against that kind of credit deterioration from above, and investor constituencies -lenders and shareholders-who carefully monitor these inter-creditor issues," McGinnis says.

Some regulators council that if KKR or any other highly leveraged company is perceived to be taking advantage of the regulated utility and earning a "windfall," the double leverage standard may be applied. Double leverage is the use of debt by both the parent company and the subsidiary, in combination with the company's equity capital, to finance the assets of the subsidiary. The purpose behind the double leverage adjustment is to account for the parent's accessibility to lower cost debt to purchase equity in its subsidiary, upon which it may earn a higher rate of return than it pays for the debt.

Alliant Energy's Interstate Power & Light and MidAmerican Energy, which itself was taken private, recently protested the use of double leverage by