The German energy market is currently experiencing a tremendous upheaval which is set to change the dynamics of the market. Key issues include the unbundling requirement under EU law, privatization of municipal power suppliers, fluctuating governmental promotion of renewable energy and the creation of a new regulatory authority. Flexible and progressive players may well benefit from the creation of new business opportunities in restructured markets. The need for funding to implement the restructuring measures creates the capacity for a considerable increase in shareholder value which, in economically difficult times, provides the basis for profitable private equity investments.
The German private equity market has often failed to live up to expectations and the German energy sector was hitherto not considered to be suitably en vogue for private equity investments. Now, however, in an accelerating economic environment and with a stabilized German private equity practice, pacesetter private equity houses are taking a new look at a market that suddenly inspires and accommodates new business ideas. The following examines how unbundling, privatization and public support are conducive for private equity investments in the German energy market.
Key factors: unbundling, political support and privatization
Unbundling as a Gateway
Legal unbundling and the resultant need for corporate restructuring paves the way for innovative business solutions to break into existing market structures.
Under EU Directive 2003/54/EC, “transmission and distribution systems” must be separated from “vertically integrated undertakings.” In essence, this means that the operation of grids must be isolated from generation and supply, i.e. run by different legal entities and management teams. In many cases new corporate structures are required. Any kind of controlling influence exerted over the grid operator’s management by the energy supplier will be prohibited, thus excluding domination agreements. Furthermore, it remains to be seen whether, in relation to the most common German corporate entity, the private limited company (GmbH), shareholders’ controlling influence and right to direct the management under corporate law will be deemed to be in violation of the unbundling requirement and, if so, how this can effectively be excluded.
Most key players in the German energy market have already addressed the unbundling requirement by setting-up a new, independently managed net-operating subsidiary, the shares of which are held by a holding company. A second subsidiary runs the generation and sales business. Smaller suppliers may hope to fall within the exemption for suppliers “serving less than 100,000 connected customers.” This depends, however, on a number of factors such as the specific implementation of the directive, the calculation of the threshold, and the expected increase in business. The customer threshold may potentially already be exceeded by capital interests or by virtue of exerting a decisive influence over other energy suppliers.
It is generally mid-sized energy suppliers that have yet to comply with the new unbundling rules that will become binding on July 1, 2004 for transmission system operators and-at the latest-on July 1, 2007 for distribution system operators. In addition, time will tell whether undertakings exempt from the legal obligation to unbundle will conclude that economic needs for efficiency requires that comparable measures be taken. In any case, time is running out to take preparatory measures. Any advantage in know-how and experience puts pacesetter equity houses in a good position.
There may be instances in which the bulk of the consequences stemming from the unbundling process are detrimental to an energy supplier. However, given the fact that German energy suppliers will probably be unable to circumvent unbundling requirements, it is worthwhile assessing the many business benefits that can be reaped as a result of the successful implementation of the requisite restructuring.
A spin-off of grid operations may enable a concentration of core capabilities and strategic re-positioning. Successful sales allow for the repayment of debts, improvement of balance sheets and replenishment of coffers for investments in core business areas. Restructuring may result in increased efficiency via greater internal transparency of costs, cash flows and revenue. Specialist units are able to react more flexibly to market developments and facilitate operative turnarounds if necessary. Unbundling coupled with cost efficiency measures may accelerate the development of a market for shared customer-, accounting- and/or maintenance services, most efficiently rendered by spin-offs entering into horizontal co-operations, joint ventures, mergers or take-overs. Finally, energy specific long-term grid lease models can be envisaged, reducing the outlay of initial investments required of grid operators.
Time to reconsider
German energy has never before been a core area for private equity investment. This was due to the demand for riskier, but, at the same time, potentially highly profitable investments allowing an exit scenario through public offering, which the German energy sector was ostensibly unable to offer. With low volatility and strong, predictable cash generation, it could not meet the sometimes unrealistic expectations placed in the new economy.
The situation appears to be changing and, accordingly, thinking along traditional lines can result in missed opportunities for a profitable investment in a generally slow economic environment. Recent blackouts in the US and Europe have focussed additional public attention on the energy sector. Cash-strapped municipalities, small renewable energy companies, expanding technology ventures or service providers recently created as a result of unbundling all offer investors the opportunity of taking advantage of sound investments at reasonable prices. Investment opportunities are enhanced by strict Federal Cartel Office monitoring of municipal acquisitions by incumbent utilities. One must also factor in the EU Emissions Trading Scheme and Kyoto compliance, which will encourage a further shift away from carbon intensive energy production towards renewable energy.
Hard assets typical in some parts of the energy industry make an investment relatively conservative and less risky, and the constant cash flow resulting from long-term energy supply or wheeling contracts, shields investments from a dramatic variation in cash flow. This, however, is not necessarily the case for “shared services” which allow a more robust investment approach. Moreover, the possibility to operate leased electricity networks may even enable investors to invest in grid operating businesses without having to invest huge amounts of funds in hard assets.
Finally, the economic conditions for investment in energy are healthy. According to European Commission estimates, a 44% increase of energy consumption is expected in Europe by 2020. In Germany, Europe’s largest market with consumption running at 500TWh/yr and an annual turnover of EURO53 billion, the addition of some 40,000MW at a cost of EURO40 billion is forecast to be needed by 2020.
If deregulation of telecommunications is any indication, it would appear that the German energy sector offers a great opportunity for investments at low prices in an industry that few private equity houses are targeting.
Operational knowledge of the power sector is crucial, and procuring managers with the right skills and expertise is equally important as formulating a good business concept and sound legal advice. Although investment cycles in the energy sector are likely to be considerably shorter than in the past, one must nevertheless bear in mind that the average minimum investment period is between 58 years, thus increasing the likelihood of a profitable exit scenario.
As is characteristic for private equity investments, not every opportunity is profitable especially when the majority of houses are focused on the same market. However, given the anticipated market restructuring and the hitherto relatively small number of potential investors in the energy field, pacesetters with carefully chosen investments should have a good chance of achieving the revenues they desire.
Markus Strelow (Markus.Strelow
@ashurst.com) is a partner and Daniel Schmachtenberg (Daniel.Schmachtenberg@ashurst.com) an associate in Ashurst’s Frankfurt office, both dealing with general corporate law, M&A, private equity and energy law and members of Ashurst’s ETI Group.