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Building a Utility Roll-up Machine

How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

Imagine that you are C. John Wilder, chairman and CEO of TXU Corp., and before you sit several bankers wearing French cuffs. They want to buy your company for cash, with a sweet premium for shareholders. How do you advise your board? Will the bankers be able to close the deal or will they leave TXU tied up for a year or more while regulators, politicians, ratepayer groups, and public-interest advocates take potshots at the deal? What will be your ongoing role in this enterprise? And, if you’re not C. John Wilder but would like to be in his shoes, how would you enhance the curb appeal of your company to attract similar suitors?

With more than 3,000 electric utilities in the United States today, much thought has been given to how this fragmented industry could be consolidated to reduce costs and more efficiently deploy large amounts of capital in new plant. The bankers leading the TXU acquisition consortium, Texas Pacific Group (TPG) and Kohlberg Kravis Roberts (KKR), have had previous failures with utility acquisitions. Their success in acquiring TXU will depend on whether lessons have been learned from those failures. Their model also may set an example that utility management can replicate.

Warren Buffett claimed that Berkshire Hathaway would invest $10 billion to $15 billion in the utility industry if regulatory barriers could be removed. The industry has remained fragmented for decades because the Public Utility Holding Company Act of 1935 (PUHCA) limited utility mergers to regional markets where the combining companies’ operating assets could be integrated. PUHCA’s “anti-diversification” principle also limited utility acquirers to companies engaged in the utility and related energy businesses, and excluded Berkshire Hathaway from significant utility ownership.

Now that PUHCA has been repealed, private equity and infrastructure funds have become active in the market. The fund manager collects management fees, called the “carry” (typically 20 percent of fund earnings) and may earn additional fees from syndicating fund debt. The sponsor also may earn large profits on its equity investment in a fund. Like any fund manager, the more assets under management, the greater the fees. This powerful incentive has driven fund sponsors to develop an acquisition vehicle that, coupled with a capable utility management team, can be used to acquire and roll up several utilities.

But financial acquirers face a higher hurdle than traditional utility acquirers because their reputation for seeking out-sized returns on highly leveraged, short-term investments doesn’t play well in Peoria. They need to move beyond that reputation to be effective in consolidating the utility industry. It may be, therefore, that TXU has greater value to TPG and KKR than is apparent merely by looking at TXU’s financials, because TXU may serve as a hub from which to launch future utility acquisitions.

Serving Many Masters

The Maryland legislature’s recent attempt to fire its Public Service Commission members after they approved substantial rate increases shows that

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