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Building a Utility Roll-up Machine

How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

financial and regulatory risk, for example, increase risk-adjusted returns for investors, even if the book return on equity remains unchanged.

Once Burned, Twice Shy

Regulators, with their varied responsibilities, cannot monitor and understand a particular utility or holding company group nearly as well as its management. Regulators usually learn of serious problems after the damage is done and it is time to clean up the mess. When NUI Corp.’s failed diversification threatened its utility subsidiary Elizabethtown Gas Co. (ETG), New Jersey regulators understandably were frustrated:

ETG enters the process with credit ratings below investment grade, restricted access to capital markets, very high interest rates on existing lines of credit, significant prepayment burdens under its gas procurement arrangements, and a serious need to re-establish the trust and confidence of ratepayers, bondholders, and investors. The board must note and strongly emphasize that NUI Corp. caused these problems. 1

Increasingly cautious, regulators are wary of the pressures on management to improve returns by aggressively cutting costs and increasing financial leverage. They may impose a spider’s web of commitments, audits, and reports to protect consumers’ interest in long-term, reasonably priced service. Regulators recognize the limits of their supervisory powers and want utilities to be owned and operated by investors and management they can trust—trust based in the knowledge that investor and management interests are aligned with the consumers’ interest in reliable, low-cost utility service for years to come.

The lack of “institutional trust” was key to the failure of the proposed acquisition of UniSource Energy Corp. by KKR and co-investors J.P. Morgan Partners and Wachovia Capital Partners. The investors promised to improve the capital structure and liquidity of UniSource’s subsidiary, Tucson Electric Power Co. (TEP), and to retain local management and a local presence. The investors also built a “ring fence”—a collection of terms and commitments designed to safeguard the integrity of the utility—around TEP.

In this case, the Arizona Corporation Commission (ACC) reviewed the deal under a “net-benefits” standard. An “in-the-public-interest” standard merely requires a showing of “no harm” from the transaction, but “net benefits” requires investors to demonstrate that the public interest will be advanced by the transaction. The ACC faulted the non-investment-grade rating of the acquisition debt, stating that high leverage would lead to increased utility cash flows and expense cutting, resulting in negative effects on service quality and safety. The ACC also faulted the general partner’s lack of utility experience and questioned the investors’ commitment to preserving service quality. The ACC also was troubled by the lack of transparency of the limited partnership acquisition vehicle. “The investors’ refusal to disclose certain materials does not give us confidence that the relationship between the commission and the investors would enable the commission to retain the same level of oversight that currently exists.” 2

We cannot quantify the risks from a utility change in ownership. But it can be said with certainty that their perceived magnitude to regulators increases with their level of distrust of the investor group. The perceived risks must be more than offset by benefits to satisfy the net-benefits standard. Tangible benefits