(February 2012) ITC Holdings agrees to acquire Entergy’s electric transmission business; Constellation agrees to acquire ONEOK Energy Marketing; Duke Energy acquires two solar power plants...
The Devil in the Deal: Notes From an M&A Practitioner
A look at due diligence for energy transactions, and at what’s driving them.
a key consideration in the analysis should be the business mix of the group being evaluated.
Marketing and trading businesses might engage in a wide spectrum of activities. These include proprietary trading, hedging, market-making, asset optimization, and energy management. There are very few marketing and trading businesses in existence today that have significant and balanced levels of activity across all of these areas. Instead, most groups tend to focus on a small subset, and this largely is a function of industry. For example, most investment banks focus primarily on market-making, or “customer-flow” business, while hedge funds engage mostly in proprietary trading.
Risk and expected returns vary considerably across these trading activities. Providing customers with energy management services typically is a business with more stable cash flows than might be expected from an operation that is heavily dependent on proprietary trading. The lower risk should come with lower expected returns as well, however. The multiple used should reflect the particular risk-reward profile of the organization being evaluated. The due-diligence process therefore should assess each trading activity’s individual contribution to overall risk and return. The valuation and risk assessment also should project how risk-reward performance might change with anticipated changes in the business mix, because trading groups often are acquired with the intention of shifting their business mix toward activities that better complement and support the buyer’s strategic objectives.
A Final Word
A recurrent theme should be apparent just beneath the surface of each issue we have highlighted: the importance of risk assessment when evaluating a transaction. Valuation analysis alone is not a sufficient basis upon which to base a bid or justify a transaction. There needs to be a firm understanding of the riskiness of the asset as well. These types of assets require sizeable commitments of capital, not only to acquire the asset, but also to support their operations. Unless the asset can generate required returns on all of the capital it consumes, both before and after the acquisition, the transaction will be difficult to justify. For a due-diligence process to be most beneficial, it therefore should provide a balanced assessment of both value and risk.