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Negative outlook for mergers could turn around


Analysts were unanimous in agreement at the Edison Electric Institute International Utility Conference back in March 2008 that there would not be much cross-Atlantic merger and acquisition activity in the US power sector this year.


Despite what can only be described as exchange rates favorable to European companies, it has been the credit crisis which has hit banks on both sides of the Atlantic that has made it difficult to finance large acquisitions in 2008, either in Europe or the US.


It's not a very rosy picture....M&A has a spotty track record in the US at best.
--Gregory Gordon, Citigroup Investment Research


Gregory Gordon, managing director, US power and utilities, Citigroup Investment Research speculated at the conference that this economic scenario could lead to renewed interest in US deals among European companies, but commented: "When does that happen, I'd like to ask the European analysts?"


"I'd not be surprised to see European groups looking more seriously [at US acquisitions], but the market is not looking favorably at big trans-Atlantic moves," added Carine Salvy, portfolio manager and senior European utilities analyst at London-based Ecofin.


Regulation has also been cited as a key factor in the scarcity of acquisitions. Gordon said that "several big transactions that made sense did not close due to regulatory interference. There are very few pairs left that make a whole lot of sense.... It's not a very rosy picture." He added that "M&A has a spotty track record in the US at best."


Two notable transactions which failed to close were Exelon's attempt to buy Public Service Enterprise Group and FPL's plan to buy Constellation Energy Group.


Big utilities in these precarious financial times seem unwilling to acquire other companies right now.


Take Exelon, for example. John Rowe, chairman, president and CEO of Exelon told financial analysts during an April conference call that Exelon could not identify a potential transaction that would not dilute earnings. Rowe said that instead of going for a big splash, Exelon will settle for now for a smaller ripple through asset acquisitions or swaps or potentially adding new generation to its fleet.


Carbon concerns could provide a stimulus to power sector M&A activity


Despite the economic gloom, and the reticence of many companies to become embroiled in M&A transactions, there are those who see a brighter picture for M&A activity in 2008.


According to Lazard Freres Director Greg Donat, mergers and acquisitions in the power industry could increase as companies adjust generation portfolios to address the uncertainty associated with carbon regulation.


In the near term, the uncertainty about the form pending carbon dioxide mitigation legislation will take, and what that will translate into in terms of costs, will likely have a chilling effect on mergers and acquisitions, Donat said April 15, speaking at Platts 23rd annual Global Power Markets conference.


But longer term, as power companies try to figure out their appropriate portfolio configuration in preparation for expected carbon legislation, Donat said he expects to see more M&A transactions. "Carbon will drive portfolio decisions, and portfolio decisions will drive M&A."


Those decisions, among other things, could include considerations such as whether or not to buy wind power assets in order to offset coal-fired plants, he said.


Another driving factor will be the scale of companies relative to the scale of the projects that are going to need financing, said Donat. He noted that power companies are faced with taking on projects that are as large as some that oil companies take on, but that oil companies are exponentially larger than power companies in terms of market capitalization.


That could result in transactions that merge companies with strong cash flows with companies that have a strong project development pipeline.


"The capital gap will only be filled by consolidation," said Donat, referring to the capital that needs to be raised to fill the expected baseload gap, the gap between the amount of baseload capacity that is being proposed and built to fill long-term demand growth needs.


David Albert, managing director, project and structured finance, at Morgan Stanley, said that private equity is still looking at acquisitions, but they are faced with putting up significantly more equity, sometimes twice as much as the 20% that was put up for the TXU private equity buyout by a consortium of Kohlberg Kravis & Roberts and TPG. That puts constraints on their returns, he said. So except for a small band of players that have access to financing outside the US, the financial players are not likely to be very aggressive.


Referring to the prospects of foreign money coming into the US to buy up assets -- and bolsters asset valuations -- Donat said that many people are looking for that "mythical being."


He noted that the US market can look attractive to a European firm. "There is load attrition in Europe," he said, while the US enjoys load growth and a stable economy. But bear in mind, said Donat, "the US is a scary place to do business for us let alone a European company." He said he expects to see "a slow creep up, not a massive flood" of European investment into the US because of "general prudence."


And Douglas Dunn, a partner with Milbank, Tweed, Hadley & McCloy, noted that of 82 utility companies targeted in mergers in the past few years, 60 deals were completed. The failed deals usually were caused by problems with the state regulatory process, he said.


Sixty-one of the attempted deals were utility-to-utility acquisitions, nine were from foreign companies, eight from financial institutions and four from merchant generators, Dunn said.


While a weak dollar may be inviting more foreign investment in utility and generation assets, the panelists agreed that a large influx of foreign investment probably would not arrive until carbon regulation uncertainty is resolved.


In terms of global capital flows, Eric Blank, executive vice president of Iberdrola, said there is a huge investment opportunity in the United States. If the US is going to get to Spain's 20% level of wind power in its generation mix, it would require $10 billion over the next five or six years.


And Juan Kruetz with Barclays Capital said that while there is some slow down in M&A into the US, the overall trend remains positive.


"We are seeing a lot of interest in the US from Japan and Australia and Europe, particularly in the unregulated sector" where investors can side step regulatory concerns that have held up other investments.


Andrew Reicher, CEO of Globeleq Advisors Ltd., pointed to an even larger opportunity. By 2015 demand for electricity in the emerging markets will overtake electricity demand growth in the developed countries, he said, and it will take about $10 trillion of investment in power sector infrastructure to meet that demand.


"You can make good money in emerging markets," he said, "but it is not easy money" and it is fraught with risks.


Created: May 8, 2008


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