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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

perfectly insulated from the troubles at a holding company. Many often point out that the bankruptcy of Enron did not have a significant impact on utility subsidiary Portland General Electric because of tight ring-fencing measures.

But credit rating agencies caution regulators from overconfidence in the structural separation at the utility.

Fitch Ratings, in a meeting with state regulators last year, said there is no perfect ring-fence that can completely insulate a utility. According to Fitch, companies have an inalienable right to force a subsidiary into bankruptcy. A company cannot waive this right, according to the general counsel at Fitch. The National Association of Regulatory Utility Commissioners' (NARUC) Subcommittee on Accounting and Finance last year investigated the issue of ring-fencing in an attempt to identify best practices.

According to its analysis, the NARUC subcommittee found that "the regulator might also be proactive in encouraging a properly structured package of ring-fencing enhancements in any acquisition. That is to say, the regulatory entity might require the insertion of a special purpose entity between the utility and the holding company, structured in a way that reduces the risk to the utility… This could also require tightly drafted set of covenants subject to commission review."

Moreover, according to a presentation to the NARUC subcommittee, Standard & Poor's named three states that they believe have adequate regulatory insulation mechanisms. Of those states, Wisconsin, Oregon, and Virginia, the report noted that the first two rely upon state statutes for their regulatory insulation. The third relied on conditions in a merger that indirectly is dependent upon state authority over mergers.

The NARUC subcommittee suggests several ring-fencing measures (some are more strenuous forms of others):

  1. Commission authority to restrict and mandate use and terms of sale of utility assets. This includes restriction against using utility assets as collateral or guarantee for any nonutility business.
  2. Commission authority to restrict dividend payments to a parent company in order to maintain financial viability of the utility. This may include, but is not limited to maintenance of a minimum equity ratio balance.
  3. Commission authority to authorize loans, loan guarantees, engagement in money pools and large supply contracts between utility and affiliate companies.
  4. Commission authority over the establishment of a holding company structure involving a regulated utility.
  5. Expand commission authority over security applications to include the ability to restrict type and use of financing.

Panos Ninios, associate principal at consultants McKinsey & Co., says, "Whether a regulator should approve an LBO transaction really depends on the company he or she is dealing with.

An LBO is valuable only if the regulator and the company can negotiate an equitable distribution of value creation between customers and shareholders."

As far as the capital structure at the utility, Ninios says, "There is no magic debt/equity ratio for regulated businesses. What is appropriate is defined by the risk/return of the regulator and the shareholders. Assuming you know what this ratio is, you need to review the balance sheet and you also need to look at the contractual obligations of the regulated utility. You need to know how it buys and