Can consolidation create sustainable long-term value, or will it prove seductive but, ultimately, disappointing to shareholders, employees, customers, and management alike?
Building a Utility Roll-up Machine
How private-equity firms may consolidate the utilities industry.
regulators, although normally independent, still must concern themselves with politics. As quasi-public entities, utilities are fully integrated into the community. South Carolina Electric and Gas Co., for example, was required to run the Columbia, S.C., metropolitan bus system on a subsidized basis as a condition of its franchise. Utility service to low-income consumers and energy efficiency programs may be subsidized through rate design. Charitable contributions to community causes are expected, and a utility’s large workforce, payroll, and tax payments provide important support to the local economy.
Regulators want reliable service, reasonable utility rates, and no surprises from their local utilities. Investors want returns that are at least proportionate to risks. Utility management seeks the flexibility to maximize profits, compensation, and benefits similar to unregulated industries, and the opportunity to advance in the organization. Labor seeks job security, competitive pay and benefits, and the opportunity for training and advancement. Gluing a merger together in this environment is tough.
Utility management has experience balancing these competing relationships, and offers an intimate knowledge of the local regulatory and legislative environment. Private-equity funds provide access to capital. They also have a deserved reputation as short-term profit maximizers. In January 2005, TPG and KKR closed on the $3.5 billion acquisition of Texas Genco from CenterPoint Energy. Barely a year later, in February 2006, they sold Texas Genco to NRG for $5.8 billion. Despite this reputation, some funds now are claiming to be interested in stable long-term infrastructure investments.
There may be truth to this claim. Former U.S. Treasury Secretary and former World Bank Chief Economist Lawrence Summers recommends that developing countries such as China, whose central bank holds billions of dollars in U.S. Treasuries returning about 2 percent after inflation, move some of their investment funds into higher-paying stocks. Holders of petrodollars invested in U.S. Treasuries are in a similar position. Don’t expect China’s central bankers, however, to leap into the stock market, either in China or the United States. They want to park money in high-quality infrastructure investments and to acquire other assets, such as oil reserves. The failed acquisition of Unocal Corp. by China’s CNOOC, and the fiasco involving the sale of several United States ports to Dubai Ports World, illustrate the difficulties in pursuing direct infrastructure investments in this country. Private-equity funds provide a measure of diversification and are a useful intermediary. Cue the bankers to develop a product for these wealthy investors.
Strong utility management and patient money form the basis of a utility roll-up machine. A roll-up machine propagates best utility operating and financial practices in a holding company system, addresses the inherent conflicts present in regulated utilities, and makes deals easier and faster to conclude. The roll-up model acknowledges that long-term performance in the consumers’ interest is the basis upon which regulators award reasonable returns on capital.
Because the objective of a roll-up machine is to generate the highest long-term risk-adjusted returns, as opposed to total returns, it follows avenues to improve returns that are aligned with the interests of regulators and labor, and consistent with environmentally responsible behavior. Reductions in