[BETA] Fortnightly

When will utilities see the next round of deals?

With the substantial decline in utility mergers and acquisitions (M&A) activity since the heady days of 2000, it's time to ask when M&A activity might return, if at all. Business combinations provide a potentially important means for a utility to enhance its earning and growth prospects, and one of the few alternatives available to achieve these objectives at an acceptable risk.

The elements conducive to an increased level of activity are either coming into place or, in the case of regulatory clarity, have the prospect of coming into place within the next 12 to 18 months. One reason we at Morgan Stanley expect M&A activity to increase over the next cycle is the increasing level of meaningful dialogue among senior management of companies in the industry (. 58).

In the future, transactions likely will shift in form compared with the previous cycle, with more emphasis on moderate premium acquisitions or no/low premium MOE (merger of equals)-type transactions, in contrast to the higher premium deals of the past cycle. Also, while we expect the level of M&A activity to increase, a return to the pace of 1999-2000 is unlikely.

The significant decline in M&A activity since 2000 was not unique to utilities. Overall M&A activity in the United States fell from more than $1.9 trillion in 2000 to about $830 billion in 2001 and $540 billion in 2002. It was not until 2003 that activity started to increase, and then only gradually. The decline in overall M&A activity was due to a number of factors, including the low-growth economic environment subsequent to the market "bubble," the reduced level of confidence among CEOs, and the fragility of the financial markets with the concurrent reduction in equity values. Many companies across varied sectors of the economy became inwardly focused and put their strategic agendas on hold.

Utility companies encountered most of these issues, as well as several specifically related to the sector, including a sharp contraction of the principal growth engines (the merchant generation and trading businesses); the impact of the Enron meltdown and the deterioration of credit quality of companies in the merchant business; the tightness of the credit markets; and the ever-changing status and outlook for deregulation. As a result, many companies in this sector-similar to their industrial counterparts and perhaps more so-turned their focus inward, putting strategic plans on hold.

During this period, the utility sector has focused on other matters, such as:

Improving operations;

Reducing costs;

Stabilizing credit quality;

Increasing the transparency of earnings; and

Generally pursuing a "back-to-basics" strategy.

With these priorities, it is not surprising that M&A activity by potential acquirors has taken a back seat. Of the more recent utility transactions, most have occurred as a result of sales processes motivated by the financial considerations of the target utility or its parent company (e.g., Illinois Power, Portland General, NUI, TNP, and Mountaineer Gas) ().

Changing Developments

A number of developments have begun to enhance the environment and prospects for M&A transactions.

The call for growth. For the last several