Bankers hope that still-rare utility leveraged buyouts could experience a burst of activity in the upcoming year, even though top utilities with strong fundamentals have been tarred by the likes of Enron Corp.
CIBC World Markets has assembled a senior utilities banking team to further explore the financing of utility LBOs, and although the bank was not specific about pending deals, the team is working on several transactions at this time. Since 1997, CIBC originated, financed and invested in the first LBO of a public electric utility and has financed three of the only four utility LBOs completed to date.
CIBC utilities banker Paul Kovich is working with colleagues Michael Masselli and Jon Larson to transact utility LBOs, and the officials believe these deals would make worthwhile investments, especially for high-yield investors who typically don’t have the opportunity to buy regulated utility risk.
Utilities tend to pay large dividends, so the debt structures of the operating or utility company usually provide for a much larger dividend payout than the norm. “There’s no regulatory concern on high levels of dividend payments, and whatever restriction concerns there may be, they don’t kick in until well beyond what is necessary to service the debt,” Kovich said. “There’s almost always ample dividend protection for the bondholders at the top.”
Of the few utility LBOs done so far, TNP Enterprises and Intermountain Gas are both quite successful stories, said Ed Tirello, a power strategist at Berenson Minella. TNP restructured and put in progressive management changes and innovative operating techniques, which have made the company substantially profitable, he said. CIBC was the lead on the deal-the bank arranged the financing and was a major equity buyer of that particular utility.
Still, as the CIBC team admits, utility LBOs are not easy transactions to put together, not least because of the sheer amount of money and the long lead time necessary to close the deal. These impediments are among the reasons so few utility LBOs have ever seen the light of day.
Despite the hopes of some players, utility LBOs are no easy sell these days, given general sector fears driven by a bevy of bad press.
Not only are banks reluctant to lend to companies with large exposure to independent power production or power marketing, but bondholders in any potential LBO would find themselves last in the payback line, because utilities are regulated and investors that are financing a takeover have to do so through a holding company.
In a utility LBO, the operating company cannot be tampered with and the public utilities commission structures the capital on a 50-50 basis. In order to get returns, the holding company is leveraged via 80% debt and 20% equity, and dividends are then moved from the operating company to the holding company, a utility analyst explained. By lending to a holding company, the bondholder essentially becomes a stockholder of the utility.
Still, most utilities rated BBB and higher are fiscally sound, and it’s unfair that such players should be lumped in with the bad apples, sources said. Bankers argue that such utilities represent a stable industry with predictable returns and are regulated by the public utilities commissions. Fund managers, though, remain wary.
The CIBC team, however, is banking on its experience in and knowledge of structuring such deals to work on upcoming opportunities. The first rule is to go for a utility that is focused on its core business. An LBO for such a company would benefit management, as it would enable them to “cash out, keep their jobs and have a much clearer set of goals for the business,” Masselli said.
By contrast, utilities that have veered away from core businesses in an attempt to generate earnings growth have run into problems, Kovich said. “They’ve taken excess cash flow and invested them in the wrong areas. We have no interest in unregulated cash flow: We want regulated cash flow and want to use that excess cash flow to pay down debt,” he said.