A New Vintage of Investor

Deck: 

Rothschild investment banker Roger Wood explains why those new infrastructure funds are hot on utilities.

Fortnightly Magazine - March 2007

He was quite literally the toast of last year’s EEI Finance conference. Using his bank’s diverse resources (Rothschild vineyards in France), he arranged an unforgettable wine tasting that was a big hit with utility executives.

And utility execs should raise a glass for another reason. Roger Wood, the head of Rothschild’s Power & Utilities Group in North America, is one of the few true white knights on Wall Street. Whereas many banks have developed businesses that can conflict with their utility clients’ interests, Wood says Rothschild’s bankers “live and die by providing long-term independent advice.”

British born and Oxford educated, and bearing a slight resemblance to Sean Connery’s James Bond, Wood in 2005 joined Rothschild, the legendary investment house that funded Wellington’s armies, the Gold Rush, and the Suez Canal, for starters. He previously was a banker with Citigroup and J.P. Morgan.

Based in New York for 10 years, he’s had extensive transaction experience in both Europe and the United States. One of his toughest deals, he recalls, was the forced sale in a difficult market environment of British Energy’s North American nuclear assets, in two separate transactions; Bruce Power to a Canadian consortium, and AmerGen to Exelon. More recently he has been spending time on both sides of the deal table with a new class of financial buyer, called Infrastructure Funds, which are making a play for the utilities industry.

What do utilities and regulators need to know, and should they embrace or spurn these new deals? Rothschild’s Wood gives us his view on the matter.

 

 

Fortnightly: From an infrastructure funds perspective, why do some investors want to invest in particular segments of the industry? What do they seek?

Wood: The theory from the infrastructure investors, which I’m sure you’ve heard, is that they have long-term liabilities (typically pension but sometimes insurance as well) and what they want is some long-term, stable, low-risk assets so they can make the classic matching of liabilities with assets. It’s a nice theory. It works especially well in the low-risk, regulated monopoly parts of the industry, but less well in the commodity-sensitive parts. But I think where the theory potentially falls down is the risk that investors are not getting the portfolio diversification which most people would say that they should be looking for. You either need to do lots and lots of deals, or you need to effectively underwrite and then syndicate down your position in order to end up with a smaller piece of the deal, if you are to get real diversification. Otherwise, there is a risk that you are taking a huge bet on a sector, even a particular company, and if it doesn’t work out, then your long-term liabilities are even less likely to be covered than they would have been if you were investing in regular financial securities.

 The other issue, which I think is particularly topical at the moment, is what price you are paying. You are seeing some very heady multiples being paid both for utility types of assets and broader infrastructure types of assets (including things like ports, roads and airports) which are in turn supported by high levels of leverage. 

Fortnightly: Why would a utility consider selling its infrastructure as a standalone or spinning it off?

Wood: I think there is two reasons why they might do it. Firstly, they may deem it to be non-strategic. And the interesting area where that is happening with some companies is in transmission. You probably saw the recent announcement from Alliant about selling their Iowa transmission to ITC. Particularly in transmission, there has been a lot of discussion around the implications of operational control being taken away from the utilities. So, utilities could persuade themselves, “We have a lot of capital tied up in this investment, we cannot control it now, that control is being taken out of our hands, therefore we will deem it non-strategic and if someone pays us a good price than we’ll sell.” But I have to say that this is a tough discussion with many utility executives who have been brought up to believe that transmission is at the core of what they do, the link that binds their systems together.

The other reason is simply financial. There may be shareholder-oriented management teams and boards who would say, “I like this asset. I would like to continue to own this asset, but someone is offering me a price that I can't resist.”

Fortnightly: Are infrastructure funds generally negative or positive on utility management?

Wood: Positive. In a number of situations, for example with Macquarie and DQE, and the same with Babcock & Brown and Northwestern, the approach is to say, “We like management, they have been good at running the business, we want them to continue to run the business.” That’s also important from a regulatory perspective. They want the state regulators to feel comfortable that they are dealing with the same people in the same way. People who understand how regulation works. They can pick up the phone and call them and get an answer. Regulators also may like management being accountable to only one shareholder, so management is not distracted by worrying about how the Street is going to respond to the next quarterly earnings call.

Fortnightly: But when they invest in just the transmission asset as opposed to taking a financial stake in the utility itself, what does that say about utility management?

Wood: The view might be that they have an ability to make a bigger impact on the management of a transmission business or transmission assets than they would as a 5 percent shareholder in a publicly held company where management feels that they need to be responsible and answerable to shareholders as a whole. And they are not going to do anything which might benefit one 5 percent shareholder potentially to the detriment of the other 95 percent of shareholders. So, [infrastructure funds’] voice as a sole owner of an asset always will be larger than as one of many shareholders, even if they end up being the largest shareholder. In addition, they can take advantage of incentives from regulators that are not available to existing utility owners of transmission assets.

Fortnightly: Given that there is a limit to the number of assets available on the market, are restructuring funds contemplating purchasing whole utilities outright and then selling the segments to other infrastructure funds interested in only specific pieces?

Wood: I don’t think anyone has explicitly said that, but part of what you are seeing with funds trying to buy whole utilities (like Macquarie and Babcock & Brown buying DQE and Northwestern, respectively), is it gives them the potential to do that. And these particular institutions are set up as deal machines—they act as advisors, as underwriters, as asset managers. If they were to break up and sell off businesses after they own them, they would have another way to make money off these transactions that may not be available to investors as a whole. Now, if they end up getting a great price for an asset that they sell, obviously the outside investors get a piece of that, so that’s fine. But it’s a bit like the hedge fund math. The fund managers always will do better than the end investors because of the fee structure that they have. 

Fortnightly: What kind of returns do the infrastructure funds expect, and what is their holding period?

Wood: I would say most of the infrastructure funds are looking at low-double-digit returns on equity. The funds almost all would say that they are looking at longer time periods than the 5 to 7 years normally associated with private equity. If you take Warren Buffett as an example, I think he defies categorization, because some people would think of him as private equity, some people would think of him as an infrastructure investor, and some people would think of him as a saint. But his view when he was buying PacifiCorp was, “I never intend to sell this. I intend to own this for the rest of my life.” People may or may not believe that. Same with Goldman Sachs, which just raised a $6.5 billion infrastructure fund. They have said that they intend to hold for the long term, and that may very well be their intention. But I think they would have no hesitation selling if someone made them an attractive offer.