The volume of utility merger and acquisition transactions declined precipitously
in North America over the last two years following what was an extremely active
period. However, the pace of M&A is likely to pick up in the near term,
if certain regulatory and market hurdles do not arise.

As Figures 1 and 2 show, M&A volume in the US utility sector fell dramatically
from approximately $80 billion in 2000 to $16 billion in 2002. A number of
factors ended this prolific period of M&A activity that stretched from
1996 to 2001, during which a total of $382 billion of regulated strategic transactions
were announced.

In 2002, many of the large utilities that were touted as the natural consolidators
of the sector retrenched strategically to focus on their own operations. Trading
and accounting scandals combined with even more complex business models resulted
in an unwillingness of acquirers to pay for black-box earnings or cash flow.
Failed investments in wholesale generation and other unregulated investments
began to challenge the financial performance of a number of companies.

These
unexpected trials encountered by the US utilities became front page news
in Europe and Asia, slowing cross-border M&A as foreign managements became
leery of committing to US transactions.

As efforts to deregulate the US utility sector fell away in light of problems
in high-profile states such as California, the need to acquire companies to
remain competitive also disappeared. Utilities became less concerned about
adding products and customer relationships to their portfolios to be more competitive
in the face of diminished prospects for deregulation.

Finally, the capital markets rewarded stable cash-flow stories
while earnings growth obtained through M&A activity was met
with skepticism in the markets. Rating agencies also became more
critical of highly leveraged transactions and became less tolerant
and credit rating stability became the noted attributes for utilities that
obtained premium valuations in the markets.

The End of the Tunnel?

While there have been relatively few recent announcements, the behind-the-scenes
strategic dialogue between companies has picked up dramatically. Why have companies
begun to turn back to M&A as a
way to create shareholder value? Will we see a vibrant M&A market over
the next several months?

The broader equity markets have begun again to reward growth stories, just
as the utility sector has seen a slowdown in expected growth rates. The average
five-year expected earnings growth rate for the utility sector as tracked by
Morgan Stanley has dropped significantly from 11.6 percent to 4.9 percent over
the past
28 months. Having spent the last two years internally focused, many companies
have exhausted opportunities to take costs out of their operations and to refinance
their balance sheets.

In addition, with the poor historical track record of value creation outside
of the core regulated business, as well as the rating agencies’ continuing
criticism of non-regulated investments, managements are wary to move too far
outside of the regulated arena. Managements again are looking toward regulated
utility M&A to provide growth through new cost-cutting prospects or to
supply additional refinancing opportunities by improving the credit quality
of the company.

While there has been a notable reduction in expected growth rates, paradoxically,
thus far utility stock prices have not followed suit, with the S&P utility
index up over 20 percent for 2003. Potential acquirers may now be more confident
using their own equity as currency, and possible targets may no longer believe
they are selling near the bottom of the cycle.

Managements themselves have also seen dramatic turnover in
the past year. Fifteen separate utilities, including many of the nation’s
largest companies, have changed their CEOs or announced plans to do so. With
this void or transition in leadership, important social obstacles may have
been removed that previously might have prevented M&A activity.

Another important trend is that private equity capital has stepped up efforts
to pursue transactions in the utility sector. Overall, the private equity universe
has grown significantly from only four funds greater than $1 billion in 1990
to 80 funds with similar characteristics and almost $200 billion of buying
power in 2002. These financial investors are attracted to the basic necessity
attributes of the utility products, the steady cash flow from the core businesses,
and the opportunity to add leverage above the operating utility company.

The Kohlberg Kravis Roberts/UniSource and Texas Pacific Group/Portland General
acquisitions, as well as the previous deals completed by Berkshire Hathaway
and Laurel Hill Capital Partners, will
be important test cases to determine if the financial sponsor model
can be applied more broadly to the sector.

The private equity investors are of particular interest to smaller utilities
as a number of smaller companies are finding it more challenging to remain
public. Because of the downsizing and expense cutbacks on Wall Street, a number
of smaller utilities are finding it difficult to attain equity research from
Wall Street houses and have seen limited trading volume, which has limited
interest from certain institutional investors.

In addition, boards are increasingly tested by the requirements under new legislation,
such as the Sarbanes-Oxley Act, which has made their duties progressively more
complex. Many boards and managements are questioning whether the go-it-alone
strategy as a public company is better than looking to sell to a private equity
investor or a larger public company to create shareholder value.

Finally, the long-awaited repeal of the Public Utility Holding Company Act
of 1935 (PUHCA), if implemented, will eliminate important obstacles to increased
M&A activity for regulated utilities. PUHCA’s effect on the US utility
industry has been to limit the geographic expansion of US electric and gas
utilities, discourage ownership of utilities by US industrial and financial
institutions and non-US institutions more generally, and finally, restrict
utility companies’ focus to businesses incidentally or functionally related
to their core business.

The geographic requirement forced utilities to prove the two merging companies
could be interconnected, which prevented companies that were separated across
large geographies from merging. A utility holding company from the Southeast
such as Southern Co. could not acquire a company in the Pacific Northwest such
as Portland General because their service territories could
not meet this interconnection requirement. With the removal of this stipulation,
utilities are no longer obligated to look for regulated opportunities near
their existing geographic platform.

The main deterrents under PUHCA for many nontraditional buyers, such as
financial investors or foreign companies, centered on the requirements that
the investor
become a registered holding company, fully regulated by the SEC, if those buyers
owned a significant stake (usually greater than 10 percent)
in a multistate utility. Warren
Buffet was noted as saying with
the removal of this stipulation he could easily foresee investing an additional
$10 billion to $15 billion in the space.

Finally, with the removal of the business line requirement,
the door will be opened to a variety of external players to bring new business
models into the utility space. Could a major cable company or local phone company
look to further lock in customers
or lower their costs by providing multiple products through a new multi-utility
platform? Having one provider manage all of the essentials around the home
has
yet to be a proven model in North America, but with PUHCA’s removal,
a number of new players external
to the industry may attempt to implement the one-supplier model.

The Potential Hurdles

The greatest variable to any strategic transaction in the utility industry
is the reaction of the state and federal regulators to the proposed transaction.
Overly zealous state regulators asking for significant merger concessions that
prevent merger synergies from being achieved have been the root causes of a
number of failed mergers. With the removal
of PUHCA, a number of state and federal regulators and legislators may look
to step into the regulatory void that has been created and try to implement
their own agendas that may severely curtail M&A activity.

Could more states pass laws and regulatory stipulations, like the Public
Utility Holding Company Act of Wisconsin, which could limit out-of-state ownership
of utilities? Could the Federal Energy Regulatory Commission become the new
federal reviewer of transactions and determine it is in the
best interest of industry reform to use its approval process to implement what
it views as needed reform such as transmission divestitures, which the companies
may view as overly punitive?

Other market factors may also dampen interest. Most market pundits are expecting
an increase in US Treasury rates over the coming year. A run-up in interest
rates would have two important effects on the utility industry. The rise would
likely put downward pressure on stock prices as investors attracted to utilities
for their dividend yield shift capital back to treasuries for their higher
fixed return. With lower stock prices, utilities are less likely to sell their
companies and to use their own stock as currency in the transactions. In addition,
as interest rates rise, transactions become more expensive for financial investors
that use significant leverage to finance their proposals.

The utility sector in the US is positioned for a dramatic increase in M&A
activity. Due to a number of significant factors including the expected repeal
of PUHCA, the entrance on new nontraditional buyers, and the need for growth
among existing utilities, the utility sector should experience a resurgence
of M&A activity in coming months.