Utilities regulation & PE boom?.

This change will allow parent companies to sell utility assets while still retaining a long-term operating role. Also, joint bids for utilities assets could be made by financial and strategic buyers with the post-acquisition operating role being assured for the strategic partner. The Utilities Directive, penned by the UK and published in June, looks set to be implemented by all of the European Union member states by the end of January 2006.

However, what impact the new legislation is likely to have in each of those 25 countries is largely going to be dependent on how utilities are regulated in each state. Not surprisingly, some of the attention is focusing on the most recent accession countries in the EU, many of which have by-passed burdensome and politicised approaches to regulation still lurking in some Western European states.

“It occurs to me that this directive will generate some interesting opportunities,” says Steven Bryan, a partner at Lovells in London. “There seems to be an interesting play in terms of a divestment strategy for selling down their equity but retaining a long-term operational role.”

“I think there’s more appeal for the utilities sector, but I think this is less based on legislative changes and more on investors’ appetites and the availability of funds they have to invest,” says Michael Bryceland, a partner at Clifford Chance in London. “The utilities sector is not always the most natural environment in which to invest from a private equity perspective,” he adds.

A number of UK-based and pan-European private equity players with exposure to various utilities sectors have reacted to the new legislation with what appears to be a “wait-and-see” approach. Also, few companies and law firms have so far had a chance to examine the details.

To grasp the proposed new regime, a basic understanding of the old rules is helpful. Under EU-inspired legislation, known as the regulations, there have been formal tendering procedural requirements, known as the procurement rules, which apply where a utility seeks offers in relation to proposed works, supply or services contracts above certain monetary thresholds, unless one of the exemptions in the regulations has been applicable.

For the sake of definition, a utility includes a public authority, public undertaking or a private undertaking that carries out a utility activity listed in the regulations; broadly covering water, gas and electricity services. However, the new directive will also cover aspects of the transport industry.

“The question of whether a contract is subject to the procurement rules depends on the content of the individual contract, but the key material operating or management services contracts which are likely to be of interest to strategic players tend to be subject to the procurement rules,” Lovells stated in its latest private equity newsletter.

It also states: “Currently an exemption to the regulations applies where a contract is awarded by a utility to an affiliated undertaking which satisfies certain tests including that the affiliate has generated at least 80% of its turnover from providing services of the type proposed under the contract for the past three years.”

Steven Bryan is confident the new directive will encourage a greater flow of deals in the market. He is working with corporates looking to release equity from existing holdings in utilities and has seen interest from the investment banking community, which he reports as “strong” and could set the ball rolling for more awareness among private equity houses.

“The old rules were rather artificial in terms of requiring a three-year track record. The main change is that if you’re an affiliate you are treated as part of the same entity and therefore it was unnecessarily restrictive to have the additional requirement of a three-year track record,” says Bryan.

“You do have to jump through various hoops in terms of demonstrating the affiliate relationship, but it is about control rather than about economics. Even if you have this control relationship with the utility, there are things you can do around that in terms of support services, support contracts and secondment of personnel, which can give a significant degree of influence over the operating company,” says Bryan.

The new Utilities Directive retains the affiliated undertaking exemption but, in recognition of increasing liberalisation in the utility sector in Europe, relaxes the criteria for its application in certain ways, including relaxation of the three-year rule. This is

provided it can be demonstrated that a newly created affiliate would prospectively derive at least 80% of its average turnover from

providing relevant services to affiliated

undertakings.

The need for three years of historical

data has been relaxed to the point where a financial investor bidding with a trade buyer can secure a deal by showing a three-year

forecast. “If you can forward plan, you don’t need to go through the public procurement rules,” says Bryceland. The effect of the

relaxation of the three-year requirement

is that a new affiliate may be created

specifically with the intention of being

awarded a contract. This outsourcing arrangement could be combined with a transaction involving the acquisition of equity in the utility.

As the contract is treated as intra-group between affiliated companies, the usual competition law requirements, which apply in relation to a contract between unrelated undertakings, do not apply so that the operating or management contract could potentially be granted on a long-term basis in excess of the usual five-year period expected for such contracts.

A number of issues need to be considered in implementing the structure, based on the new regulations, depending on the particular sector in which the utility operates and the legal and regulatory regime affecting the utility in its relevant jurisdiction. Other issues generally relevant to outsourcing arrangements, such as tax and employment, would also need to be considered. The change in the procurement regime gives rise to significant opportunities for financial investors in the utilities sector of Europe. Private equity has managed to make inroads in the UK, there have been a few water utility deals in Italy and interest in the gas distribution sector in Portugal.

“It’s not just the legislation that is encouraging these investments,” says Clifford Chance’s Bryceland. The role of the regulator is also playing an important part of the equation, he adds. For example, some issues have raised hurdles in the French market where water deals have not been progressed because the regulator just hasn’t been able to offer the same amount of comfort to investors and pricing remains politically motivated. “They didn’t seem to have non-political intervention in the pricing and didn’t display a good approach to good governance and the regulatory framework,” explains Bryceland.

By contrast, some of the new EU member states have, in a sense, overtaken the approach of the older member states by more recently introducing non-politically motivated regulatory regimes. Essentially, the regulatory environment has to be secure before an investor will go ahead with a project. Terra Firma’s ongoing discussion over a proposed and significant regulatory change by the Northern Ireland Authority for Energy Regulation (NIAER) could deal investments in the province an unfortunate blow.

Terra Firma was looking to buy East Surrey Holdings, an integrated gas and water utility, active in Northern Ireland. However, NIAER took an unprecedented move to ask for an amount of money, thought to be in the region of £55m, to be taken out and paid back to customers. According to market commentators, this has never been done before in an investment process. Terra Firma since abandoned its bid. Some see that it will put off private equity investors in utility companies with an exposure to the Northern Ireland market, should the regulator uphold its demand. One observer called the process “extraordinary, in the true sense of the word.”

Bryan at Lovells says: “There may be cases where you would have to look very closely at the license terms. There may be other market-testing issues you have to look at, for example for water, there may be licensing conditions where you have to demonstrate the fact that you have a long-term contract or arrangement, which probably would be benchmarked. So, you have to look at each opportunity on a sector-specific basis.”

“It’s a structure that needs to be tested against a real situation. No one’s done it yet, but I have received some enquiries,” he says. “You need to work out, for example, where the stress points are. When you talk about control you need to work out how much control you can confer as a strategic partner, while keeping it within the affiliate relationship without breaching the spirit or the intent of the procurement regulations, while giving commercially a high degree of comfort to the partner who has a minority stake in the operation but who wants to be assured about the long-term strategy of the business.”