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Dial M for Merger

When will utilities see the next round of deals?
Fortnightly Magazine - October 2004

second quarter of 2004. Although a high number of companies remain on negative outlook or credit watch negative, prospects for improvement are on the horizon, as certain credit ratios monitored by the agencies are starting to improve. Better quality credits will allow the possibility for acquisitions to be funded in part or in whole with debt, and will allow acquirers to more readily consider the acquisition of lower credit-quality companies.

Potential shift in premiums required. In today's more disciplined financial marketplace, which recognizes the difficulty of achieving meaningful intrinsic growth, there likely will be additional focus on acquisitions with more moderate premiums and no/low premium MOE-type transactions than in the previous cycle. This shift already is reflected in the overall M&A marketplace, where premiums have fallen from an average of more than 40 percent for the past 15 years to 38, 35, and 26 percent for 2002, 2003, and the first half of 2004, respectively (). Anecdotal evidence suggests boards of potential utility company acquirees may be more receptive to considering a lower premium transaction under the right circumstances.

Active financial players, flush with cash. Financial sponsors, which include both general funds and specialty utility/energy funds, have been purchasers of approximately half of the recently announced utility transactions. Recent announcements include purchases by ArcLight (Mountaineer Gas), KKR and JPMPartners (UniSource), and TPG (Portland General).

The funds raised by financial sponsors continue to expand. Morgan Stanley estimates that the largest 25 funds control approximately $100 billion, or about $300 billion of buying power if levered 3:1. In addition, more recently, some of the large investment fund managers and hedge funds have become increasingly interested in the power sector and may also become active in acquisitions of utilities.

Smaller company issues. While bigger is not always better, some smaller utilities have decided that maintaining independence is not necessarily the best path for maximizing shareholder value. Smaller companies often find it more difficult to attract institutional ownership given recent trends by institutions to prefer investments in larger companies with greater liquidity. Additionally, it has become more difficult for smaller companies to attract research coverage, especially given the contraction in the broker and analyst community.

Regulatory considerations. On a federal level, FERC market power issues and the 1935 Public Utility Holding Company Act (PUHCA) often have been significant impediments to merger transactions. Although energy policy has been deferred until after the 2004 presidential election, many believe it will be tackled early in the next legislative term. Clarity in federal energy policy would certainly be a significant help in fostering an environment conducive to mergers in the industry.

In particular, increased clarity regarding FERC's treatment of market power, and how it will be measured and potentially mitigated, would reduce potential obstacles to transactions between larger companies in nearby geographical regions. Also, any additional clarity in the application of PUHCA (or its continued existence) would serve to reduce uncertainty as to the ability to merge utilities in different geographical regions.

The potential repeal of PUHCA also would be constructive for a more active M&A environment because it would