Alice in Powerland
by Roger Feldman -- Bingham, Dana L.L.P.
Something there is about the prospect of European investment in the U.S. power industry that makes the bankers go giddy, and the cross-border strategic consultants break into songs from The Producers: “Springtime for Germany in Louisville. . .” Will it be a real hit?
We were led recently to look down this particular “Alice in Wonderland” rabbit hole by the proclamation in a recent news article of “The Return of the Double-Headed Merger,” which turns out to be not hype for Austro-Hungarian Empire double-eagle war bonds but for cross-border deals that, while establishing a single economic entity, enable the merging parties to keep separate stock market listings, boards and headquarters in their home countries. Bankers love not only the fees achievable through reconciliation of the monumental egos of merging CEOs, but also the opportunity it may afford to head off post-merger stock market “flowback” (think Daimler shares being dumped post-Chrysler). Three small business problems with this idea for electric power deals: no acquisition premium; norelief from Public Utility Holding Company Act regulatory requirements; no apparent enhancements in operational management from the resulting corporate structure.
But if mogul ego-salving provides insufficient rationale for trans-Atlantic power deals, lusty dreams may yet. One foreign utility finance director at a recent conference reportedly cooed that: “The girl I’m going to marry is vertically integrated, probably [does] not own a lot o of merchant energy, and lives West of the Rockies.” His ardor and that of similar would-be continental swains was unctuously stoked by a Wall Street MD, who assured his audience that European utilities might have an easier time wooing American investor-owned utilities because, as foreigners, they seemed more, well, exotic (like debonair foreign exchange students appealing to domestic Alices, distracted from their looks by their charm).
Still, there may be some economic logic to this still mostly hypothetical mating game, if, as has been suggested, European suitors prove willing to accept 12-14percent on equity (higher than available at home); adopt a never-forgiving, long-time return horizon (15 to 25 years); and are willing to use their available big bucks to sweep America’s full-figured, “plain Jane” Alices off their feet, just so long as they make a contribution to suitor earnings. Certainly, there are five or six European utilities with an equity value of $20 billion or more that tower over potential American mates and can pay the required premiums, given their PE ratios.
But will the Europeans come? That would seem to depend on the interplay of several variables: the choice of business models of “Euro-globalization”; the impacts on such choice of acquisition lessons learned to-date; and the influence on it of the market structure of the American power scene, as the FERC and Congress currently are remaking it.
The business models in play to choose from seem to be of three basic types: (1) mega-globalization; (2) global multi-utility holding companies comprised of power and other public services; and (3) opportunistic value creation through exploitation of acquirer operating management skills developed at home.
The globalized business model is one of oil and gas majors taking over the power industry as the delivery point for their commodities. To the consolidating but still-fragmented industry in Europe and America, this model seems both abstract and passť, as they themselves pursue the new growth opportunities needed for stock price support by seeking to become something slightly different – large multi-fuel, multi-national holding companies. The con-sultants to these global venturers have advised them to foresee three stages of growth: first, random growth to achieve size; second, purchase and sale of assets to obtain locale-specific strategic value; and finally, the summum bonum, achievement of “focus” to go with scale, leading to portfolio rationalization. It all sounds like a soaring hymn to rational strategic planning, till we read that the exemplars of this strategy of sectoral focus (e.g., asset-backed trading; consumer products; wires) and global scale, until recently, were said by the consultants to be Enron and AES.
Once noted, this observation has driven empirical managers to examine what has happened to date in actual cross-border acquisition.
There’s Scottish Power that arguably overpaid its premium, and has wrestled with state regulators using a newly-substituted management team, which has achieved mixed results to date. There’s Power Gen, acquirer of LG&E Energy (now gobbled up by E.ON), where some traditional merger savings/cost-cutting has been achieved, which may or may not have offset the 27 percent premium paid. LG&E may, of course, yet prove the first hoof print of a larger E. ON, US Trojan Horse, or it could be a one-trick pony.
Finally, there’s National Grid’s market entry, which perhaps may suggest a generic, third category of Euro-penetration: focused growth on focused targets with particular characteristics, e.g., skillful, home-grown management held over and able to deal with regulators; acquisitions where specific management skills and techniques developed in homeland operations can be applied to achieve more than generic cost savings; and concentration on contiguous U.S. geographic regions, which are compatible with the focused strategy. Yet even in the National Grid case, hiccups have begun to crop up – as in the Middle West, where proposed continued expansion, accompanied by management control, has encountered the aversion of regulators to the putative harmful effects of a concentration of market power.
Which leads us to this bottom line on choice of business models: the bankers and counselors of any Euro Queen of Hearts can be no wiser in their advice than the local white rabbits regulating the local utility markets they desire to enter will allow them to be. There are two facets of this observation. First, the treatment afforded by regulators to power and/or transmission commodity prices and, second, the extent to which regulators’ concerns with market power of any type gained by any person – European or American – may interfere with a consolidation strategy designed to create properties large enough to have an investment impact. Paradoxically, these two concerns may be perceived by regulators as pulling in opposite directions: price deregulation may be perceived as consumer friendly only if the “market power” of individual players has been squeezed out of it by special oversight regulation. This perceived adversarial nature of deregulation and the exercise of market power also may continue to fuel the ongoing State-Federal mad tea party contest for jurisdictional control of electric utility market structures, notwithstanding the Supreme Court’s recent upholding of Order No. 888. In short, not only will investors face market uncertain-ties, but regulatory ones as well.
Specifically, therefore, before sending too many Euros down the rabbit hole, shrewd continental investment planners should check out the final profile in the U.S. of the RTO governance issues, the treatment of incentive transmission rates, the regulation of trading securities derived from bilateral trading contracts and, above all, the extent to which concern with denying market-based rates to parties with geographic market power may cut down the levels of cash flow available as a result of acquisitions. While in the first instance these deci-sions will be FERC decisions, increasingly on individual subject areas, they are becoming the province of special-purpose congressional legislation as well. It is, in short, desirable to main-tain one’s head in developing asset acquisition structure.
It is the Euro buyer – not the U.S. target – that’s really “Alice” in this fable. And the question is: What regulation is in the bottle marked “DrinkMe” that Alice has stumbled upon at the bottom of the rabbit hole? Will it make the buyer very large, very small, or simply give it a headache?
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years. In particular, he has analyzed and executed a wide variety and substantial value of project financings. He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration. He is a graduate of Brown University, Yale Law School and Harvard Business School.