Building a Utility Roll-up Machine


How private-equity firms may consolidate the utilities industry.

Fortnightly Magazine - May 2007

Imagine that you are C. John Wilder, chairman and CEO of TXU Corp., and before you sit several bankers wearing French cuffs. They want to buy your company for cash, with a sweet premium for shareholders. How do you advise your board? Will the bankers be able to close the deal or will they leave TXU tied up for a year or more while regulators, politicians, ratepayer groups, and public-interest advocates take potshots at the deal? What will be your ongoing role in this enterprise? And, if you’re not C. John Wilder but would like to be in his shoes, how would you enhance the curb appeal of your company to attract similar suitors?

With more than 3,000 electric utilities in the United States today, much thought has been given to how this fragmented industry could be consolidated to reduce costs and more efficiently deploy large amounts of capital in new plant. The bankers leading the TXU acquisition consortium, Texas Pacific Group (TPG) and Kohlberg Kravis Roberts (KKR), have had previous failures with utility acquisitions. Their success in acquiring TXU will depend on whether lessons have been learned from those failures. Their model also may set an example that utility management can replicate.

Warren Buffett claimed that Berkshire Hathaway would invest $10 billion to $15 billion in the utility industry if regulatory barriers could be removed. The industry has remained fragmented for decades because the Public Utility Holding Company Act of 1935 (PUHCA) limited utility mergers to regional markets where the combining companies’ operating assets could be integrated. PUHCA’s “anti-diversification” principle also limited utility acquirers to companies engaged in the utility and related energy businesses, and excluded Berkshire Hathaway from significant utility ownership.

Now that PUHCA has been repealed, private equity and infrastructure funds have become active in the market. The fund manager collects management fees, called the “carry” (typically 20 percent of fund earnings) and may earn additional fees from syndicating fund debt. The sponsor also may earn large profits on its equity investment in a fund. Like any fund manager, the more assets under management, the greater the fees. This powerful incentive has driven fund sponsors to develop an acquisition vehicle that, coupled with a capable utility management team, can be used to acquire and roll up several utilities.

But financial acquirers face a higher hurdle than traditional utility acquirers because their reputation for seeking out-sized returns on highly leveraged, short-term investments doesn’t play well in Peoria. They need to move beyond that reputation to be effective in consolidating the utility industry. It may be, therefore, that TXU has greater value to TPG and KKR than is apparent merely by looking at TXU’s financials, because TXU may serve as a hub from which to launch future utility acquisitions.

Serving Many Masters

The Maryland legislature’s recent attempt to fire its Public Service Commission members after they approved substantial rate increases shows that 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 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 attributable to the transaction, such as rate credits and commitments to future utility investments, generally are required. Financial investors, with reputations for highly leveraged capital structures and aggressive cost cutting, have a particularly high “trust hurdle” to overcome.

In the TXU transaction, leverage again has become an issue, and the acquirers are attempting to sidestep concerns by pointing out that none of the additional debt will be placed on TXU Delivery, the rate-regulated utility. Acquirers with a trust deficit generally must offer more tangible benefits than other acquirers to establish that a proposed transaction results in net benefits. Indeed the hurdle may get so high that it kills the deal. In contrast, utility management with a track record of sound utility operations, community responsibility, and financial prudence will help the financial acquirer to bridge the trust gap if regulators can be ensured that the utility management team will continue to be fully involved in decisions affecting operations and capital allocation.

Although yet to be completed, NorthWestern Corp.’s acquisition by the Australian fund Babcock and Brown Infrastructure provides another illustration of efforts to address the trust hurdle. Made wary by NorthWestern’s recent bankruptcy, the regulatory reception has not been warm. “The deal will receive severe scrutiny. [Babcock and Brown] is a company we know nothing about. … This is an attractive deal to shareholders, but it may not be the most attractive alternative for Montana,” noted Ted Schneider, a member of the Montana Public Service Commission.3 Babcock and Brown has emphasized its commitment to long-term ownership, retention of NorthWestern’s employees and management, and its desire to provide capital for utility infrastructure additions.4 Its CEO has met with employees, retirees and community leaders and has stressed his firm’s intentions as a good steward.

“We want NorthWestern Energy’s customers and regulators to be assured of our commitment to being a long-term investor. We understand the importance of maintaining infrastructure and ensuring that NorthWestern continues to provide safe, reliable electricity and natural gas service at reasonable prices.”5

Bringing Management And Labor Together

No matter how polite the euphemism—“operating synergies,” “workforce reductions,” “terminations,” “pink slips,” or “firings”—state regulators will consider the impact on labor when determining whether a transaction furthers the public interest.6 A high-performance company relies on its workforce for success, and even if labor is not legally a stakeholder in a merger proceeding, investors cannot afford to fumble their approach to labor.

In the late 2004 acquisition by AGL Resources Inc. (AGLR) of NUI Utilities, the New Jersey Board of Public Utilities observed:

While petitioners do anticipate the elimination of redundancies … petitioners will honor all existing NUI bargaining agreements. Petitioners also assert that employees will benefit from the merger due to AGLR’s financial strength and stability, particularly with respect to the employee pension plan and in the form of enhanced professional opportunities and training.7

The case provides insights into managing labor issues during a utility merger.

• Job reductions should appear even-handed. AGLR explained that the elimination of redundant employees would be focused at the executive and management levels.

• 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” has a lot to do with his plain-talking Midwestern character and his buy-and-hold investment style.

Changing perceptions is largely the acquirer’s job. It begins with straightforward public statements about the motives and objectives for the particular transaction. The acquirer’s private actions, such as assumptions made in financial models (e.g., exit strategy), must be consistent with its public statements; there is a good likelihood that transaction work papers will be discovered during the regulatory approval process. Acquirers with long-term investment horizons and an interest in reasonable and predictable, if unspectacular, returns from infrastructure investments should find this easy to do. Acquirers with venture capital expectations should not be shopping for utilities.

Utility management can help by developing utility service quality commitments that demonstrate tangibly the acquirer’s intention to operate the target to measurable levels of service (e.g., outage frequency and duration, number of customer calls unanswered, etc.). The commitment should include consequences if the service objectives are not met.

Assuage regulators’ fears that they cannot monitor all the decisions that affect long-term service quality. Use performance benchmarking to evaluate service quality and share the results with regulators. Institute procedures to share basic financial and operating information with PUC staff on a real-time basis, thereby increasing transparency and trust and lessening concerns about utility under-investment and holding- company diversification. Regulators are most in fear of being surprised by deteriorating financial conditions after it is too late to take corrective action. Provide regulators with brief, confidential real-time reports of basic operating and financial information to lessen that worry.

The selection of directors for the utility and holding company boards is another opportunity to demonstrate a long-term commitment to the community and to improve trust. As with any company, a utility’s board should be comprised of people of varied backgrounds, breadth of experience, and opinions. State regulators prefer directors who have utility expertise and who also are state residents. Regulators favor board members who are independent of the acquirer and its affiliates, and see them as guardians of the utility’s interests when they conflict with the holding company’s interests. In the TXU transaction, the acquirers have identified Donald Evans, former U.S. Secretary of Commerce, James Huffines, chairman of the University of Texas Board of Regents, and Lyndon L. Olson Jr., former Texas state representative and former U.S. ambassador to Sweden, as new members of the board. Former Secretary of State James Baker also has agreed to serve as “advisory chairman” to the investment consortium.

Diagramming the Roll-up Machine. A utility ownership structure that, because of its inherent incentives, automatically protects the financial soundness of the utility will lower the trust hurdle. The elements of this structure are: (1) separation between utility and nonutility businesses; (2) separate credit ratings and financing capacity for the utility business; and (3) a securities structure that gives “passive” shareholders a preferred claim to the earnings of the business, and managing shareholders an incentive to increase risk-adjusted returns. A structure that achieves these aims is outlined below.

In Figure 2, non-utility and public utility subsidiaries in the same holding company group are held by separate intermediate holding companies. At a minimum, public utilities should not have non-utility subsidiaries. Separation keeps non-utility businesses from directly impacting utility financial health. Locating several small utilities under a pure utility holding company may improve their ability to efficiently issue securities. A pure utility holding company would have first claim to the shares and earnings of its utility subsidiaries, and may earn a better credit rating than the one assigned to a higher-level holding company. Financial wizardry in this case benefits consumers and investors rather than placing them at increased risk and provides a tangible benefit from consolidation.

HoldCo’s securities are held by managing and non-managing members. The interests held by non-managing members entitle them to a preferred distribution of HoldCo’s earnings. If HoldCo’s earnings exceed the hurdle rate set for the non-managing members’ interest, the managing member’s interest will earn a premium return. Non-managing members also have limited rights to participate in the management of HoldCo, including full access to books and records, and veto rights for transactions that fundamentally affect their investment interest. However, curtailment of distributions to the non-managing members, or a drop in Utility HoldCo’s credit ratings to less than investment grade, should trigger greater management participation by the non-managing members. This encourages the non-managing members to influence the managing member to promote sound management of Utility HoldCo and its subsidiaries given that Utility HoldCo will be a substantial, perhaps dominant, source of the group’s revenues. Last, the managing members’ incentive structure should be designed to maximize risk-adjusted returns, while discouraging undue risk taking with the utilities.

The company that comes closest to operating under this model is MidAmerican Energy Holdings Co. (MEHC). MEHC distinguishes itself from other acquirers by leveraging Warren Buffett’s reputation for long-term, buy-and-hold investing and Berkshire Hathaway’s ample capital reserves. For example, MEHC has committed substantial funds for capital improvements at its new PacifiCorp subsidiary. Many acquirer’s promise rate freezes or reductions only when pushed to demonstrate the benefits of an acquisition. But in the PacifiCorp transaction, MEHC demonstrated its long-term vision to improve PacifiCorp’s infrastructure through needed investments in generation and transmission facilities. It also appealed to utility commissions in Oregon and Washington with its demonstrated commitment to building renewable generating facilities. The commitment is plausible because Mid-American Energy Co. is recognized as a leader in installed wind generation among regulated U.S. utilities. MEHC also has adopted ring-fencing protections for its utility subsidiaries, and has a corporate structure that separates utility and nonutility businesses. These factors give MEHC credibility with regulators and other stakeholders, and provide Berkshire Hathaway with an effective corporate and management structure to quickly and efficiently deploy capital for utility industry consolidation.

TXU’s acquirers are making similar efforts. They have committed to invest $400 million in demand-side management programs, and have sought to exemplify environmental leadership by reducing the number of coal plants that TXU will build and by supporting a mandatory cap-and-trade program to regulate CO2 emissions.

Roll It Up

Managing and building trust is key to a successful acquisition. Trust can bring a utility’s management and regulators closer to creative regulatory solutions, such as performance-based rates that allow the acquirer to capture synergies from consolidation. Reducing the risks that worry regulators (and other stakeholders like environmentalists) increases an acquirer’s credibility and speeds regulatory approvals, allowing faster growth. Resolving competing interests builds trust equity, and that means giving up less value to demonstrate a net benefit from a proposed acquisition. The TXU deal has made headlines because the acquirers and TXU’s management have been innovative in gaining environmentalists as allies rather than opponents.

The bankers courting C. John Wilder and TXU Corp. are self-aware. They know what they don’t know about running a utility. KKR’s Henry Kravis said that while working with Wilder, the acquirers “have developed a new vision … of how we can turn TXU into a more innovative, customer-centric, environmentally friendly company, and we plan to work with management to implement it.” Institutional Investor magazine has bestowed multiple honors on Wilder, including naming him the best CEO in the electric power sector in 2004 and 2005. He has completed a turnaround plan for TXU ahead of schedule, the company’s generating units perform at high capacity factors, and TXU is well on its way toward its goal of “industry-leading, customer-focused financial and operational performance.”

Venture capitalists follow the maxim that you don’t buy the technology, you buy the management team. Wilder has not committed to stay on. He avoids conflicts that way. But it seems clear that bankers are backing C. John Wilder and his management team as much as TXU. They are nurturing a seedling that will someday grow into a utility roll-up machine.



1. In the Matter of the Petition of NUI Utilities, Inc. (d/b/a Elizabethtown Gas Co.) and AGL Resources, Inc. for Authority Under N.J.S.A. 48:2-51.1 and N.J.S.A. 48:3-10 of a Change in Ownership and Control, Docket No. GM04070721 (Nov. 17, 2004) (“NUI Utilities”) at 14-15.

2. In the Matter of the Reorganization of UniSource Energy Corporation, Arizona Corporation Commission, Decision No. 67454 (Jan. 4, 2005).

3. “NorthWestern Explains Why it Took BBI Offer,” Electric Utility Week (May 8, 2006) at 12.

4. Id.

5. NorthWestern Corp. Press Release; NorthWestern Energy, Babcock & Brown Infrastructure Receive Transaction Approval From Federal Energy Regulatory Commission (Oct. 19, 2006).

6. See e.g., N.J.S.A. 48:2-51.1, which provides in relevant part, “In considering a request for approval of an acquisition of control, the board shall evaluate the impact of the acquisition on competition, on the rates of ratepayers affected by the acquisition of control, on the employees of the affected public utility or utilities, and on the provision of safe and adequate utility service at just and reasonable rates.”

7. NUI Utilities at 17.

8. Electric Utility Week, Nov. 20, 2006 at 2.