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Building a Utility Roll-up Machine

How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

has a lot to do with his plain-talking Midwestern character and his buy-and-hold investment style.

Changing perceptions is largely the acquirer’s job. It begins with straightforward public statements about the motives and objectives for the particular transaction. The acquirer’s private actions, such as assumptions made in financial models (e.g., exit strategy), must be consistent with its public statements; there is a good likelihood that transaction work papers will be discovered during the regulatory approval process. Acquirers with long-term investment horizons and an interest in reasonable and predictable, if unspectacular, returns from infrastructure investments should find this easy to do. Acquirers with venture capital expectations should not be shopping for utilities.

Utility management can help by developing utility service quality commitments that demonstrate tangibly the acquirer’s intention to operate the target to measurable levels of service (e.g., outage frequency and duration, number of customer calls unanswered, etc.). The commitment should include consequences if the service objectives are not met.

Assuage regulators’ fears that they cannot monitor all the decisions that affect long-term service quality. Use performance benchmarking to evaluate service quality and share the results with regulators. Institute procedures to share basic financial and operating information with PUC staff on a real-time basis, thereby increasing transparency and trust and lessening concerns about utility under-investment and holding- company diversification. Regulators are most in fear of being surprised by deteriorating financial conditions after it is too late to take corrective action. Provide regulators with brief, confidential real-time reports of basic operating and financial information to lessen that worry.

The selection of directors for the utility and holding company boards is another opportunity to demonstrate a long-term commitment to the community and to improve trust. As with any company, a utility’s board should be comprised of people of varied backgrounds, breadth of experience, and opinions. State regulators prefer directors who have utility expertise and who also are state residents. Regulators favor board members who are independent of the acquirer and its affiliates, and see them as guardians of the utility’s interests when they conflict with the holding company’s interests. In the TXU transaction, the acquirers have identified Donald Evans, former U.S. Secretary of Commerce, James Huffines, chairman of the University of Texas Board of Regents, and Lyndon L. Olson Jr., former Texas state representative and former U.S. ambassador to Sweden, as new members of the board. Former Secretary of State James Baker also has agreed to serve as “advisory chairman” to the investment consortium.

Diagramming the Roll-up Machine. A utility ownership structure that, because of its inherent incentives, automatically protects the financial soundness of the utility will lower the trust hurdle. The elements of this structure are: (1) separation between utility and nonutility businesses; (2) separate credit ratings and financing capacity for the utility business; and (3) a securities structure that gives “passive” shareholders a preferred claim to the earnings of the business, and managing shareholders an incentive to increase risk-adjusted returns. A structure that achieves these aims is outlined below.

In Figure 2, non-utility and public utility subsidiaries in the same holding company group are