The Power of Private Capital: Managing market forces

by Joseph Fontana

Deregulation of the global utilities industry has resulted in an environment ripe for transactions, fueling merger and acquisition activity across the sector. With nearly 250 deals totaling $100 billion announced in the first quarter of this year alone, including more than 150 in the U.S. and Europe, transactions will continue to play a significant role in reshaping the electric and gas utilities space.

Today, a diverse group of market participants, each with its own set of financial goals, drives the market. Key players include regulated utilities, which are seeking growth in mature markets; independent power producers, which are driven primarily by greater scale and scope; and private capital investors, who continue to show strong interest in utility investments.

The power of private capital

Not long ago, the prospect of private capital generally foreshadowed a sale three to seven years after the transaction. Regulators historically misinterpreted private capital’s limited holding periods and desire to seek above-market returns as a danger to the long-term needs of the utility’s infrastructure and its customer base. As a result, regulators rejected several private capital deals, citing concerns over investment track records.

Today’s private capital players, as in the past, are looking more toward the future of the companies in which they are investing. In many cases though, they are holding onto assets longer, maintaining the existing business model and engaging key stakeholder groups, from the management team and employee base to legislators, regulators and grassroots environmental organizations, to ensure the long-term success of the business.

The emergence of infrastructure and private equity funds as a significant investor group is establishing an even more dynamic utilities marketplace. Private capital can create new opportunities to effectively maximize value for their companies and stakeholders in the following ways:

Liquidity Infrastructure and private equity funds are bringing additional liquidity into the sector, resulting in greater competition for assets and stronger balance sheets. Liquidity can positively impact large and small utilities alike, whether they are rationalizing their asset base through the sale of non-core assets or seeking capital investment for their retained business.

Stability Infrastructure and PE funds are entering into transactions with long-term investment goals in mind. For infrastructure funds, the focus is on maintaining long-term steady cash flows, while the goal of PE funds is to improve operations, thereby increasing the underlying value of the business. In both cases, private capital investors are retaining assets longer, adhering to the established business model, and working with existing leadership teams.

Investment On a global basis, construction in the utility industry is estimated to exceed $11 trillion by 2030, according to the International Energy Agency World Energy Outlook 2006. Utilities, power companies and transmission businesses acquired by private capital have access to certain capital that they may have previously lacked, thereby permitting these businesses to advance construction plans.

As the markets become more competitive, new private capital players provide greater opportunities for growth, but they also present challenges for utility industry leaders.

With every deal subject to scrutiny from regulators, customers, financial analysts and other key stakeholders, utility executives and managers must carefully weigh both the benefits and the risks of their decisions. Are current market forces creating opportunities for premium prices? Is the near-term need to raise capital through asset sales more important than the long-term value that the same assets could create? Has the utility established relationships with regulators through which it can convey the long-term benefits of private capital investment?

Access to inexpensive lending has helped fuel the sector’s M&A activity for the past several years but recent credit issues and their impact on the broader debt markets have caused lenders to reduce the number of transactions. Despite these challenges, it appears the availability of assets for private capital investors remains solid. The impact from the current credit environment will slow the number of deals, but it is not likely to reverse the investment trend.

The common denominator

Strategies in the utility sector have changed over the past decade, but one market driver has remained the same: value. From aggressive expansion into new business lines and markets in the mid- to late 1990s, to a period of restructuring in the early 2000s when companies refocused their strategies, to today’s partnerships with new market players, utility companies continue to look for ways to maximize their value. Wall Street wants it. Investors expect it. But regulators must approve it.

The key for utility companies to effectively manage and leverage market forces is positioning themselves for opportunities consistent with their objectives and obligations with future earnings growth, greater scale and scope, reliability of service or all of the above. Whether that takes the form of asset divestitures and deals or large-scale consolidations and combinations, private capital investors will continue to play an important role in utilities’ ability to capture value.

Author

Joseph Fontana is Ernst & Young LLP’s general utilities and power industry leader, transaction advisory services. Fontana has more than 20 years of corporate finance and transaction experience, with a focus on the utility and power generation industry. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP. Contact Fontana at joseph.fontana@ey.com.

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