Since the enactment of the National Energy Policy Act of 1992, there have been
approximately 90 announced mergers between, or acquisitions of, publicly traded
gas and/or electric utility companies. This consolidation activity has reduced
the number of independent, publicly traded utility companies during the past
decade from approximately 160 to 100 (pro forma for pending Exelon-PSEG merger).
The reduction would have been even greater but for the fact that a number of
announced mergers ultimately did not close and that, during this period, there
were a number of new, independent companies, such as Mirant, NRG Energy and
Reliant Energy, formed via spin-offs from utility parents.

Further, during this period there have been approximately 200 additional transactions
involving the purchase of utility transmission and distribution (T&D) or electric
power generation assets. The acquirers of these assets have ranged from traditional
utilities to industrial companies and conglomerates to financial investors.

The Phases of M&A

This 13-year period of consolidation activity can be broadly categorized into
three phases, each predominated by a certain type of merger transaction and/or
participant.

The first phase, covering the period from the end of 1992 through 1997, was
characterized largely by stock-for-stock mergers of neighboring utilities, typically
involving observed merger premiums of 20 percent or less. Most utilities during
this period suffered from an excess of generation capacity and a lack of new
opportunities to invest in their regulated base of assets (rate base). They
viewed consolidation with neighbors as an opportunity to reduce costs, create
scale efficiencies and increase growth in earnings per share (EPS). In addition,
many companies believed that the pending deregulation (and potential forced
divestment) of the electric power generation side of the business would result
in a much smaller residual T&D company. Mergers were viewed as an opportunity
to “bulk up” in advance of any potential separation or spin-off or sale of generation
– in order to ensure that the residual T&D entity would have sufficient critical
mass to compete in a post-deregulation environment. Many of the combinations
entered into during this period were “mergers of equals” (MOE) or “modified
mergers of equals” (MMOE) transactions in which two companies of similar size
joined together to jointly manage the combined business, and the 100 percent
stock consideration that predominated was consistent with – and indeed necessary
for – the mergers not to be characterized as change of control (i.e., sale of
the company) transactions. Few companies during this period, in fact, viewed
themselves as “sellers”; and few, if any, of the transactions involving larger
premiums were “shopped” to multiple potential acquirers, as would be the case
when a company was trying solely to realize the highest short-term value for
shareholders. The pace of consolidation during this period was moderate and
deliberate, averaging roughly six to seven combinations per year.

The second phase of utility industry consolidation commenced in late 1997/early
1998, as industry participants became convinced that the industry was indeed
undergoing a radical transformation – and that simply maintaining the status
quo was not an option. The period from 1998-2000 witnessed a major shift in
both the type and number of transactions announced annually. On the corporate
utility front, the number of annual transaction announcements jumped into the
double digits (peaking at 27 announced transactions in 1999). Equally noteworthy,
however, was the shift observed in the form of consideration being used to effect
these combinations. In the five years (1993-1997) preceding this 1998-2000 feeding
frenzy, there were a total of 34 corporate utility transactions – 30 of these
were all-stock combinations, while just four involved all cash or a cash/stock
mix. Over the three-year period spanning 1998-2000, the industry witnessed no
less than 45 announced utility merger/acquisition transactions (roughly 15 per
year – or more than double the pace of the 1993-1997 phase). Of these 45 transactions,
only eight were 100 percent stock-for-stock combinations; 37 of the 45 involved
some use of cash as part of the merger consideration.

Using Cash

The increased use of cash in utility merger and acquisition transactions resulted
from the increasing acceptance of the inevitability of continuing industry consolidation
– particularly on the part of many smaller companies, as well as certain larger
companies whose CEOs were nearing retirement age or which were otherwise considered
attractive by one or more of their larger neighbors. Anxious not to let the
parade pass them by, and realizing that there weren’t enough (or often any)
neighbors who could be legitimate MOE partner candidates, they elected to enter
into a “sale of the company” transaction with a third party which could offer
the highest price to their shareholders (often representing a significant premium
to the company’s then-current market value). In an industry in which few companies
enjoy much of a P/E multiple advantage relative to their neighbors, potential
buyers, anxious to not be outbid for the rapidly disappearing universe of potential
targets, were very willing to begin using cash as part of the acquisition consideration
mix. Cash was viewed as beneficial by selling companies interested in preserving
a certain (known) sale price per share (and minimizing the risk of value variability
inherent in many stock transactions) and also viewed as necessary by many acquiring
companies who needed to be able to pay a full and competitive premium to the
target company while minimizing the otherwise earnings-dilutive effect of paying
a large premium using a significant amount of common stock.

Indeed, the increased use of cash as part of the mix of merger consideration
resulted in an increase in the premiums paid in acquisitions during the period
from 1998–2000. The average premium paid during this period was 27 percent (and
ranged as high as 120 percent) compared to an average premium of 16 percent
during the period from 1993–1997.

The Unbundling Effect

The period from late-1997 though 2000 also witnessed the onset – in a number
of regions of the country – of the long-awaited “unbundling” of electric generation
assets from their host regulated utilities. Many utilities took advantage of
this one-time opportunity to divest some or all of their generation assets in
order to quantify and secure financial recovery of their “stranded costs” in
this asset class (stranded costs typically being defined as the differential
between the depreciated value of the capital invested in the assets to date
and the then-current – and often much lower – market value of those assets).

While many followers of the industry expected that the auctioning off of so
much of the industry’s generation capacity would attract a number of new buyers
and capital from outside the industry, actual results confounded these expectations.

The first significant divestiture of an entire generation portfolio by an integrated
electric utility was announced in August 1997 and involved the sale by New England
Electric System (NEES) of approximately 4,000 MW of generation and 5,000 MW
of purchased power contracts to an unregulated generating affiliate of California’s
Pacific Gas & Electric (an electric utility) for $1.6 billion in cash, plus
the assumption of a number of high-cost power purchase contracts. From the date
of this watershed announcement through December 2000, there were in excess of
80 sales of generation assets by U.S. utilities involving total (cash) consideration
of over $44 billion. Virtually all of this generation capacity was purchased
by unregulated affiliates of other U.S. utilities that had made the strategic
decision to build a presence in the emerging unregulated generation sector.
The names of the acquirers of these divested generation assets reads like a
“Who’s Who” of the U.S. utility industry and included affiliates of: FPL Group,
Southern Company, PG&E Corp., Edison International, Dominion Resources, Duke
Energy, Entergy, Reliant Resources, Northern States Power (NRG Energy). The
list goes on. Virtually all of these purchases were made for 100 percent cash,
and very few of these acquiring companies chose to issue parent company common
stock to help fund these purchases.

The effect of the shift to more cash consideration in the corporate utility
merger arena, coupled with the massive debt-financed acquisition binge in the
generation sector, caused a significant increase in the consolidated debt leverage
of the industry, and a corresponding decline in average credit rating[1]. Consolidated
debt leverage (as a percentage of total capitalization) in the industry peaked
in 2001 at approximately 63 percent, just as many of these acquisitions – which
were announced in the 1999 and 2000 time frame – closed. The higher balance
sheet leverage and rising business risk associated with nonregulated generation
activities, combined with a worsening overall economy and falling power prices
(deteriorating generation economics) in turn produced a record number of credit
rating downgrades by the rating agencies during the 2002-2003 period as shown
in Figure 1.

Perhaps not surprisingly, as power prices and trading profits plunged, P/E
multiples in the sector – which had risen gradually from 1995 through early
1999 – also began declining and reached single-digit lows in late 2002, as shown
in Figure 2.

Special Effects

With stock prices depressed and balance sheets over-leveraged, many companies
(or their nonregulated generation affiliates) began to suffer the very real
downside consequences of their miscalculations and misfortunes: They had overbought,
overpaid and were experiencing markets with overcapacity and falling prices.
Debt rating downgrades, falling trading profits and large cash collateral calls
all created further balance sheet and liquidity stresses. Further, the Enron
bankruptcy and other U.S. corporate scandals – which prompted the passage of
the Sarbanes-Oxley Act – caused most of corporate America (including the utility
sector) to enter a period of extreme caution and introspection.

The effects of all this on utility industry M&A activity were pronounced and
predictable. There was a virtual cessation of corporate level utility M&A activity
in 2001 through 2003. But even as the utility industry began eschewing corporate-level
M&A, many companies were nonetheless realizing that they had to take a step
back and reassess where they had come from – and the difficulties they had gotten
themselves into – and do the best they could to retreat gracefully. And although
this largely ruled out corporate-level M&A, many companies were left with no
choice but to pursue the divestiture of many of the assets they had acquired
over the previous four to five years in order to refocus their business strategy
and repair badly damaged balance sheets. (Those that were less fortunate sold
off these assets in the context of bankruptcy proceedings of their unregulated
affiliates.)

Thus was “born” the third phase of the utility industry’s consolidation history.
By any measure, the 2001–2003 period was a slow one, with transaction activity
diminishing significantly. As P/E multiples and debt ratings fell, there was
a severe shortage of buyers capable of maintaining the historical pace of consolidation.
As corporate-level merger activity virtually disappeared, the market came to
be dominated by sales of generation assets. With few strategic utility buyers
aggressively pursuing these assets, unregulated generation asset valuations
became severely challenged. It had become a buyers’ market (see Figure 3).

Many Players

It was in this relative vacuum of strategic buying interest that a number of
new industry entrants, (i.e., asset acquirers – primarily financial buyers,
but not all LBO firms) began to experience some of their first acquisition successes.
Examples of some of these new entrants include ArcLight Capital, GE Commercial
Finance, AIG Highstar, KKR, Matlin Patterson, Brascan and Texas Pacific Group,
as well as other less-well-known names. While most of these new entrants experienced
their successes acquiring generation assets, a few of these names have been
involved in the pursuit of T&D acquisitions as well – namely KKR with UniSource
(announced Nov. 24, 2003) and Texas Pacific Group with Portland General Electric
(announced Nov. 18, 2003). Many of these financial players had been studying
the industry for years; in some cases, they had even managed to make some large
structured investments (e.g., KKR into Dayton Power & Light) but few outright
corporate-level acquisitions.

Indeed, KKR’s attempted acquisition of UniSource was rejected by regulators
Dec. 30, 2004 (prompting a termination of the merger agreement), and TPG’s planned
purchase of Portland General was similarly denied by the Oregon Public Utility
Commission on March 10, 2005, and was also mutually terminated. The reason cited
by regulators for denial of these requested acquisition approvals was similar
– namely, the financial buyers failed to demonstrate that the acquisition would
be in the best interest of utility customers. Financial buyers have fared far
better in their pursuit of generation and FERC-regulated transmission assets
(at least in terms of successfully closing on contracted purchases). It remains
to be seen what level of long-term returns they will ultimately earn on these
acquisitions.

What’s Next

Looking ahead to the next phase in the evolution of the industry’s consolidation,
we expect a gradual resumption of corporate level M&A activity between and among
the utility industry players. Following the recent unsuccessful experience of
KKR with UniSource and the difficulties being encountered by TPG with Portland
General, financial buyers are unlikely to want to invest the time, money and
energy to attempt to acquire regulated utility T&D companies (or assets). Indeed,
with utility industry companies generally on the mend and healthier financially
than they have been in many years, we expect peer (strategic) utility companies
to be the consolidators of choice for the foreseeable future. Financial buyers
(to the extent that any are still interested after the KKR and TPG experiences)
will find potential sellers skeptical at best, and strategic utility buyers
will be the preferred buyer for a neighboring company, owing typically to a
lower cost of capital and a greater potential to realize and retain synergies.

Healthy, integrated T&D-oriented gas and electric utilities will have the means,
motivation and strategic rationale to prevail over most nonindustry participants
as the next round of (corporate-level) industry consolidation plays out. This
next round of consolidation is likely to be heavily driven by stock-for-stock
combinations, typically involving low to moderate premiums (e.g., in the single-digit
to approximately 20 percent range). Few companies will want to risk impairing
their balance sheets (and credit ratings) when a stock acquisition is feasible.
But we are unlikely to see a return to the “feeding frenzy” mentality of the
late 1990s, as utility management (and their boards) have become far more selective
and disciplined in their approach to potential merger transactions.

Finally, as the ongoing reshuffling of the unregulated generation asset base
continues its slow wind-down, we do expect to see a mix of industry and nonindustry
players competing for these assets, with the nonindustry acquirers winning at
least a fair share of the contestable asset auctions. As strategic industry
players continue to be highly selective and sensitive to EPS dilution in determining
what assets they will (and will not) pursue, there will be buying opportunities
in this asset space for those acquirers who are willing and able to take a longer-term
view regarding power prices and generation asset value recovery.

Endnote

1. While the transfer of cash from one industry participant to another should
   not create an increase in total industry net debt, generation acquirers were
   concurrently also heavily investing in new (greenfield) generation plants,
   repurchasing common stock or investing in other ventures, thereby further
   contributing to the increase in industry net debt levels.