M&A in the energy & utilities sector
March 2014 | TALKINGPOINT | MERGERS & ACQUISITIONS
financierworldwide.com
FW moderates a discussion examining M&A in the energy & utilities sector between Colette Lewiner, Energy and Utilities advisor to the chairman of Capgemini, Todd Giardinelli, a managing director at Morgan Stanley, and Allen C. Barron, president of Ralph E. Davis Associates, Inc.
FW: What are some of the major trends you have witnessed in energy & utilities M&A over the last 12-18 months?
Lewiner: In Europe, many utilities divested from network activities. The acquirers were mainly investment funds, infrastructure funds and pension funds. These acquirers were lured by recurrent revenues and insured yields. For example, in May 2012 the German large utility E-ON sold its gas distribution network company Open Grid to a consortium led by private equity firm Macquarie. In June 2013, the French oil and gas major Total sold its south-west gas network to a consortium including the Singapore sovereign fund. More recently, in December 2013 the Finnish utility Fortum sold its electricity distribution business in Finland to Suomi Power Networks, which is owned by a consortium of Finnish pension funds. In the oil and gas sector, M&A was aimed at acquiring reserves and entering the shale gas business. For example, in early 2012 Total purchased a minority stake in the Chesapeake Energy Ohio shale discovery for $2.32bn.
Giardinelli: The market continues to reward smart, strategic transactions. In the IPP space, acquirer prices have risen following announcement, signalling that the market is willing to capitalise a meaningful portion of the expected synergies. Given the low interest rate environment, cost of capital has been a critical enhancer. In recent M&A processes involving contracted generation assets, we have seen parties bid with some of the lowest cost of capital in recent memory. Buyers are hungry for yield and are willing to pay for stable cash flows. At the same time, ‘yieldcos’ and MLPs have emerged as a new class of publicly traded, low cost-of-capital buyers with attractive acquisition currency that allows them to achieve accretive deals, even at significant premiums. On the regulated side, large players with access to low-cost capital, such as MidAmerican and Fortis, have been successful using their balance sheet to consolidate smaller utilities.
Barron: There has been a general slowdown in the number of global deals, down 16 percent in 2013, and in the value of deals, down 49 percent, according to PLS Inc. In the US, a similar deal slowdown is evidenced by a reduction of about 17 percent in the number of deals with a decrease of some 42 percent in value. Many of the major companies have become followers of trends or the types of properties being acquired and the geographic areas in which the primary acquisitions are being made, rather than being the leaders generating these acquisition opportunities. There has been a large sell-off of assets as companies have started a focus on portfolio optimisation rather than a reaching out and expanding; companies are focusing on their core assets.
FW: What factors are driving deals in today’s market? Are there any segments or regions that seem to be offering a wealth of M&A opportunities?
Giardinelli: The key factors driving deals today are low gas prices on the unregulated side and a search for growth on the regulated side. For many hybrid utilities, the market is giving little to no value to embedded generation businesses. Hybrids are trading at an increasing discount to their sum-of-the-parts value, and the P/E multiple discount versus regulated utilities continues to widen. As a result, many hybrids are considering alternatives for their generation businesses. At the same time, power assets continue to change hands, as companies pare non-core assets. Sponsors have been active buyers of power assets, accumulating scale comparable to strategics. On the regulated side, M&A is all about growth. With P/Es trading above historical means and interest rates expected to rise, regulateds must grow EPS to offset potential P/E multiple contraction in order to maintain share price growth.
Barron: There are several factors driving deals in today’s markets. Many companies are reporting flat or lowered earnings so they are redirecting capital to enhance development of existing areas; again, the concept of focusing on core assets. Exploration companies have started to give the appearance that they have become risk averse and are reducing their exposure in higher risk areas. Capital requirements, political instability and environmental pressures are being used as reasons internally in the decision making process for companies to pull back from major projects that may still have major reward potential that exhibit long lead times. Major M&A opportunities still exist in Russia, countries in Africa and those areas with unconventional plays, including those that are not exclusively shale plays, in several established countries.
Lewiner: European utilities are in a very difficult situation. As an illustration, the average net income of the six largest utilities in 2012 was only half of what it was before the financial crisis. They also carry high debt. In order to improve their balance sheet, they are divesting their networks but also their renewable energies units. As a consequence of this deterioration, governments are keen to divest from state owned utilities. For example, the Danish state is finalising a controversial agreement with Danish pension funds ATP and PFA and Goldman Sachs to divest 24 percent of Dong Energy, the state utility. Independent oil and gas companies that were successful in finding reserves – in Ghana and the Mediterranean Sea, for example – are selling shares in their new projects in order to be able to continue to invest. This is great opportunity for the majors that need to increase their own reserves.
“Major M&A opportunities still exist in Russia, countries in Africa and those areas with unconventional plays, including those that are not exclusively shale plays, in several established countries.”
FW: Are you seeing different M&A strategies adopted in developed versus developing countries?
Barron: Those companies operating in developing countries appear to continue to have difficulty in raising capital. The general move for the major capital investor has been to the more favourable areas of the world, with many factors going into the decision making process. The developing countries are also generally burdened with a long lead time from projects being announced or offered to being started to being completed. In addition, a poor infrastructure hampers the overall development of many projects and opportunities in getting the finished product to market. Many of the international plays requiring large amounts of capital have to compete with the US shale plays for similar financing. Joint ventures among M&A participants are generally better positioned in developed countries as these agreements are better directed at specified areas with large holdings, whereas in developing countries these areas are usually less defined.
Lewiner: European utilities are divesting from Europe and are keen to acquire energy businesses elsewhere, mainly in the developing world. For example, GDF-Suez, the Franco-Belgian utility, produces more electricity outside Europe than in. It is the largest power producer in the Middle East and number two in Brazil. It is now focusing on India. The Italian utility ENEL has also expanded aggressively abroad. Some 40 percent of its business is now in emerging countries and the aim is to increase that to 50 percent. The German utility E-ON is catching up and has pushed investments into Brazil and Turkey following an earlier move into Russia. Shale is attracting oil and gas companies in Eastern Europe, such as Chevron’s explorations in Poland. But investment funds are also present; San Leon Energy, a gas explorer backed by billionaire George Soros and Blackrock, announced recently that testing at one of its Polish wells had been successful.
Giardinelli: The United States and Canada have seen increased interest in investment by foreign companies and state-owned entities. The attractiveness of stable and contracted cash-flows from both renewable companies and regulated businesses continues to command interest. Concerns of the approval process surrounding CFIUS in the United States and the Investment Canada Act in Canada have given many foreign investors pause. However, to date both countries have historically been receptive to foreign investment and acquisition with little or no need for added mitigation. In contrast, we have seen little interest from US power and utility companies to invest outside of the United States. Tax issues surrounding repatriation of cash forces companies interested in foreign investments to make a permanent strategic decision to keep investments overseas – which few have decided to do.
FW: What general advice would you give to parties on negotiating and closing energy & utilities deals? Are there any sector-specific nuances that require a particular approach?
Lewiner: My advice to parties on negotiating energy and utilities deals would be the classical general points. Perform a thorough business assessment, review carefully supply and sales contracts, evaluate the right price and perform due diligence. Overall, the deal has to be attractive to both parties and the collaborators of the acquired company and its clients have to feel comfortable. Moreover, country stability and the economic environment have to be examined. Energy and utilities are highly regulated businesses, so in addition to the above recommendations, an in depth knowledge of the different regulations, including prices and tariffs, competition, environmental laws, and their possible evolution, is required. In Europe, EU legislation and approval procedures must also be taken into account.
Giardinelli: The key nuance for M&A in the regulated utility space is, not surprisingly, the state regulatory environment. While regulators have generally been more receptive to M&A than they were in the early 2000s, they remain focused on the impact of a transaction on ratepayers and jobs in the state. Parties to a transaction must understand the impact of their deal and plan for regulatory scrutiny. In addition, despite the more accommodative posture of the regulators, the process still generally takes 12-18 months, making the time between signing and closing significantly longer than in most other industries. As a result, interim operating covenants in transaction documents need to be a point of emphasis – sellers need the ability to operate their business between signing and closing, while buyers need certainty that they will receive the expected benefits of their transactions.
Barron: General advice for successful negotiations doesn’t change from year to year, and includes knowing the local country nuances as to the political atmosphere toward foreign company ownership or control of domestic assets, the competitive atmosphere from existing companies, the economic stability of the country, the legal sanctity of contracts, and so on. The successful company entering a foreign country must have a comprehensive pre-acquisition plan in place, a knowledgeable negotiating team that may be supplemented with local talent, and commitment to the due diligence process with a team that has been give full support of management to a thorough investigation of the assets being acquired.
“Despite the more accommodative posture of the regulators, the process still generally takes 12-18 months, making the time between signing and closing significantly longer than in most other industries.”
FW: Could you highlight some of the risk-related issues that need to be considered when undertaking an M&A transaction in the energy & utilities sector? How can acquirers manage those risks to enhance future value?
Giardinelli: Two of the biggest risks are failing to achieve promised synergies or to execute a path for regulatory approval. Achievement of synergies can determine whether a transaction ultimately creates or destroys shareholder value. In the IPP space, shareholders continue to reward transactions with identifiable synergies. NRG’s stock price climbed 8 percent on the day it announced its acquisition of GenOn, as the market applauded the synergistic nature of the transaction. In addition to a focus on synergies, regulated combinations require a clearly executed plan to receive regulatory approval in a timely fashion. The announcement of any power and utility combination requires companies to carefully explain the plan to create value through benefits to all stakeholders.
Barron: In foreign countries, especially in developing countries, both political risk and sanctity of contracts are always issues of concern. The economic stability of the region and the history or stability of its currency, along with guarantees associated with repatriation of profits, are further issues. Assets being considered for acquisition should be subject to an independent assessment and valuation – for example, an independent oil and gas reserves report, a third party assessment of a power generation project or distribution network. The acquiring company should have a pre-deal assessment of the project with set goals to be achieved in negotiations. There should be a planned period for complete and extensive due diligence and representation not only by in-house counsel but local area counsel with full knowledge of local and country requirements.
Lewiner: Several risk related issues have to be considered. The first is consumption evolution, as it is directly linked to revenue. Past years have shown that electricity and gas consumption, which used to grow steadily year after year, declined during the crisis and, in Europe, has yet to reach their pre-crisis levels. Selling prices are the second revenue component. In a liberalised market it is competition that sets the final price. So the competitive position and the relative base cost of the company to be acquired have to be evaluated and compared to existing actors. In regulated regions tariffs are mostly set by regulator or governments. Some assurances from those bodies must be sought. For example, the UK, in order to stimulate investments in de-carbonated energy, has accepted a selling price guaranteed over the long term. For developing countries, political stability and exchange rate fluctuations are key points to be assessed.
FW: To what extent are partnerships and joint ventures a viable alternative to M&A?
Barron: Joint ventures may offer a better alternative when designating specific areas within an overall play or large acreage holding in an oil and gas exploration and production activity. A JV between participants may offer an opportunity to combine various types of technical expertise in the pursuit of a project. Many times a partnership may be the better mechanism for entry into a new country where the host country lacks capital and expertise to develop major projects – for example, power generation or distribution projects. In developing countries, M&A may offer a better opportunity for a company to increase shareholder value and sustain growth through total control of a project by not having to share value growth or profit with a partner.
Lewiner: Different types of partners can be considered. Usually, a contribution from financial institutions in terms of equity or debt is needed. The covenant ratios required by banks in the case of significant loans have to be simulated over long periods of time and in different scenarios, in order for the acquired asset to be compliant with them in all cases. If part of the equity is brought by financial institutions as funds, clear governance has to be established and the role of those institutions in the management of the acquired company (if any) has to be set, on day one. A JV with a local partner, notably in developing countries, is a good way to learn about the country’s practices and establish the right connections. Again the ‘rules of the road’ have to be clearly established and exit conditions, for one or the other party, defined as early as possible.
Giardinelli: JVs are extremely viable alternatives to corporate M&A. JV negotiations tend to be complicated, because a JV is effectively two transactions – a combination and a plan for an exit. The key considerations are management, governance and exit mechanics. It is important to hope for the best, but plan for the worst, as the interests of the parties can diverge over the life of the partnership. JVs can serve a number of purposes. For example, a generation JV would allow for increased scale and dispatch optimisation, offering substantial synergies. JVs can also provide access to alternative funding sources, as in the case of Dominion and Caiman’s Blue Racer Midstream LLC. Particularly for long-term projects, public companies may be less inclined to issue equity when earnings realisation is long-dated, but may be unable to issue sufficient debt to fund the project without an adverse ratings impact. JVs can offer a customised capital solution.
“Reserve replacement will still be a key objective for the majors and they will continue to acquire independent oil and gas companies.”
FW: Looking ahead, how do you expect energy & utilities M&A activity to unfold throughout 2014 and beyond? What major developments do you predict will shape the industry?
Lewiner: The difficult situation facing European utilities at present is expected to continue in the coming years. They will continue to divest from their European traditional activities creating opportunities for new type of investors – mainly funds or non European utilities. In Europe, utilities will continue to diversify in energy related services, notably energy efficiency services, taking advantage of their large customer base. To accelerate their penetration in these new markets, they should acquire electricity or heating service companies, as did French EDF at the end of last year when it acquired Dalkia France. Finally, European utilities will continue their investments in developing countries. Energy hungry Chinese companies will seize every opportunity to buy oil and gas companies or reserves. Reserve replacement will still be a key objective for the majors and they will continue to acquire independent oil and gas companies. In the future, M&A in the energy and utilities sector will continue to flourish.
Giardinelli: In the regulated utility space, the search for growth will continue to drive M&A. With interest rates expected to rise and P/E likely to compress, EPS growth is critical to stock performance. We would expect some hybrids to continue the shift towards a regulated business model, as the market is attributing little value to embedded generation businesses. These separations could take the form of spin-offs, sales or JVs. In addition, hybrids and regulateds will look to shed non-core assets, making asset sale processes a big part of M&A in the power space. Even with the threat of rising interest rates, companies have had and will continue to have almost unrestricted access to capital. Investment grade bond issuance in the utility sector hit $48bn in 2013, topping the previous three years, and non-investment grade term loan and bond issuance for the IPPs reached $17bn in 2013, up nearly 50 percent from 2012 levels. We expect this trend of capital availability to continue into 2014.
Barron: The world energy supply will continue to be influenced by the increase in oil production in the United States. The potential for increased exports of refined products will affect trade between countries. The possible addition of LNG exports from the US will also affect the balance of supply going into countries requiring the imported fuels and refined products. The major growth in many countries of green energy and the reduction of nuclear and coal generated electricity has begun to have dramatic increases in the cost of supplied power to the consuming populace. Consumer pressure on the political decision makers to reduce energy costs may swing the generation of electrical energy back toward fossil fuels in certain European countries and other areas that have increased their dependence on alternative fuels in recent years. This could reduce obstacles to the development of unconventional plays in countries that have placed moratoriums on industry in recent years.
Colette Lewiner is the Energy and Utilities advisor to the chairman of Capgemini. After an academic career in physics, Colette Lewiner joined EDF and became Executive Vice President in 1998. She joined the Areva Group in 1992 becoming Chairwoman and CEO of SGN (an engineering company). In 1998 Ms Lewiner joined Capgemini Group to create the Global Energy, Utilities and Chemicals practice that she managed as Corporate Vice President. In July 2012, she moved to her role as Energy and Utilities advisor to Capgemini Chairman. Ms Lewiner can be contacted on +33 6 07 28 68 10 or by email: colette.lewiner@gmail.com.
Todd Giardinelli is a managing director at Morgan Stanley and Head of North American M&A for Morgan Stanley’s Global Power and Utility Group. He has worked on Wall Street for 18 years and has executed transactions in multiple industries. Mr Giardinelli has an MBA from the University of Chicago Graduate School of Business and graduated cum laude from Kenyon College with Distinction in English. He can be contacted on +1 (212) 761 4271 or by email: todd.giardinelli@morganstanley.com.
Allen C. Barron is president of Ralph E. Davis Associates, Inc., a worldwide energy consulting firm located in Houston, Texas. Mr Barron has evaluated energy properties throughout North and South America, Europe and Asia. A large portion of his time is spent in economic analysis of energy assets for regulatory and financial reporting, and he has prepared Competent Person’s Reports for several IPO filings. Mr Barron can be contacted on +1 (713) 622 8955 ext 313 or by email: acbarron@ralphedavis.com.
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