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Building a Utility Roll-up Machine

How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

• Make clear your commitment to honor collective-bargaining agreements. Acceptance of these contracts sets the right tone for subsequent discussions.

• Be honest about reductions in rank-and-file positions and contrast those losses with planned improvements in service quality and technology.

• Provide job training for employees of the acquired company to demonstrate increased opportunities within the combined company.

• Fund programs to assist those that are terminated. Design the program with the input of employee representatives.

• Demonstrate the acquirer’s corporate responsibility. A target’s underfunded pension plan is a good opportunity to demonstrate tangibly that the acquirer’s strong credit will benefit the company and its employees.

Union leaders talk to each other. The reputations of utility management and the potential acquirer are subjects of discussion. Utility management in good standing with labor is valuable to an acquirer because it eases the acquisition process and drives future productivity.

Structural Trust

There are other aspects of a roll-up machine that address regulators’ concerns while creating the high-quality investment sought by infrastructure investors. Utility management has a role in implementing these features:

• Ring-fencing best practices;

• A long-term investment strategy; and

• An ownership structure designed to protect the financial soundness of the utility.

Build a Ring Fence. Adopt ring-fencing “best practices” to insulate utilities from the risks of nonutility businesses and promote that ring fence with regulators and other stakeholders. This point of differentiation will distinguish your management team from most utilities and holding companies. Just as investors find comfort in a company with the best corporate-governance practices, regulators will be reassured by a solid ring fence. Both increase credibility with stakeholders.

A ring-fencing program communicates to regulators that utility management and the acquirers have no intention of using the public utility to cross-subsidize non-utility businesses. Ring-fencing commitments nearly are universal in utility acquisition transactions, especially now that PUHCA protections are no longer in effect. Proactively designing an effective ring-fencing program for a group of affiliated companies may avoid a more onerous program imposed by regulators or consumers’ counsel.

An effective ring fence should: (1) monitor affiliate transactions; (2) maintain separate credit ratings and bank accounts for utility subsidiaries; (3) restrict inter-affiliate financings so utilities pay no more than market rates for loans, do not loan funds to affiliates, and do not use utility assets to raise funds to support non-utility businesses; (4) restrict diversification so utilities cannot conduct nonutility business either directly or through utility subsidiaries; and (5) set minimum utility equity levels and dividend limits to maintain sound capitalization and operating liquidity. Ring fencing required by the Oregon Public Utility Commission at the time Enron Corp. acquired Portland General Electric Co. widely was credited with protecting the utility when its parent collapsed spectacularly (and unexpectedly) into bankruptcy.

A Long-Term Investor, and Proud of It. In Warren Buffett’s view, utility investing is “not a way to get rich. It’s a way to stay rich.” 8 Although financial acquirers generally are thought to have institutional incentives fundamentally at odds with long-term sound utility ownership and management, Buffett is a notable exception. His “halo”