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Building a Utility Roll-up Machine

How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

held by separate intermediate holding companies. At a minimum, public utilities should not have non-utility subsidiaries. Separation keeps non-utility businesses from directly impacting utility financial health. Locating several small utilities under a pure utility holding company may improve their ability to efficiently issue securities. A pure utility holding company would have first claim to the shares and earnings of its utility subsidiaries, and may earn a better credit rating than the one assigned to a higher-level holding company. Financial wizardry in this case benefits consumers and investors rather than placing them at increased risk and provides a tangible benefit from consolidation.

HoldCo’s securities are held by managing and non-managing members. The interests held by non-managing members entitle them to a preferred distribution of HoldCo’s earnings. If HoldCo’s earnings exceed the hurdle rate set for the non-managing members’ interest, the managing member’s interest will earn a premium return. Non-managing members also have limited rights to participate in the management of HoldCo, including full access to books and records, and veto rights for transactions that fundamentally affect their investment interest. However, curtailment of distributions to the non-managing members, or a drop in Utility HoldCo’s credit ratings to less than investment grade, should trigger greater management participation by the non-managing members. This encourages the non-managing members to influence the managing member to promote sound management of Utility HoldCo and its subsidiaries given that Utility HoldCo will be a substantial, perhaps dominant, source of the group’s revenues. Last, the managing members’ incentive structure should be designed to maximize risk-adjusted returns, while discouraging undue risk taking with the utilities.

The company that comes closest to operating under this model is MidAmerican Energy Holdings Co. (MEHC). MEHC distinguishes itself from other acquirers by leveraging Warren Buffett’s reputation for long-term, buy-and-hold investing and Berkshire Hathaway’s ample capital reserves. For example, MEHC has committed substantial funds for capital improvements at its new PacifiCorp subsidiary. Many acquirer’s promise rate freezes or reductions only when pushed to demonstrate the benefits of an acquisition. But in the PacifiCorp transaction, MEHC demonstrated its long-term vision to improve PacifiCorp’s infrastructure through needed investments in generation and transmission facilities. It also appealed to utility commissions in Oregon and Washington with its demonstrated commitment to building renewable generating facilities. The commitment is plausible because Mid-American Energy Co. is recognized as a leader in installed wind generation among regulated U.S. utilities. MEHC also has adopted ring-fencing protections for its utility subsidiaries, and has a corporate structure that separates utility and nonutility businesses. These factors give MEHC credibility with regulators and other stakeholders, and provide Berkshire Hathaway with an effective corporate and management structure to quickly and efficiently deploy capital for utility industry consolidation.

TXU’s acquirers are making similar efforts. They have committed to invest $400 million in demand-side management programs, and have sought to exemplify environmental leadership by reducing the number of coal plants that TXU will build and by supporting a mandatory cap-and-trade program to regulate CO 2 emissions.

Roll It Up

Managing and building trust is key to a successful acquisition. Trust can bring a utility’s