Utility Mergers will Continue, Focusing on Synergies and Access to Capital

Industry Challenges

Utilities today continue to face considerable challenges in the marketplace:

• Rising commodity prices are applying upward pressure to rates
• Regulators are continuing to press for slow rate growth and cost savings
• The cost of debt is rising because of the current real estate and credit crisis
• Pressures are increasing to update aging infrastructure and build to meet strong demand for renewable technologies, from customers and regulators alike

Not surprisingly, many utilities are looking to engage in merger and acquisition (M&A) activity to address these challenges, providing them the opportunity to expand the system and support growth while constraining cost increases across the enterprise.

Our Perspective on M&A Activity

Activity has certainly picked up over the last few years, most likely as a result of the repeal of PUHCA (the Public Utility Holding Company Act of 1935) in 2005 –which ostensibly made it easier for utilities to pursue acquisitions by reducing federal oversight of these transactions. While the industry is certainly not seeing the same volume or magnitude of mergers as in the late 1990s, utilities seem to be emerging from the “back-to-basics” strategies they adopted in the early 2000s that focused on improving their internal operations and processes. This will lead to more acquisitions and structural changes.

Our perspective is that recent (and future) activity is marked by the following traits:

• International activity is in play. The weak U.S. dollar makes U.S. companies more attractive for international acquisitions and the industry may see increased merger activity from foreign investment.
• Regulators remain a prominent force. While the repeal of PUCHA may have eased federal hurdles, state regulators remain a prominent force. Case in point: six of the ten mergers withdrawn in the past six years were due to the state regulatory process (Table 1).
• Failed or sub-optimal mergers have occurred. The regulatory hurdles combined with other factors have halted some significant mergers that would have changed the industry landscape.
• The nature of transactions may change. Many industry observers believe merger activity within the industry will continue, although the nature of transactions may change from large-scale mergers to smaller acquisitions of assets and to foreign investment.
  In summary, it seems clear – given the current financial and regulatory environment, utilities will continue to pursue strategic acquisitions that provide synergies to increase scale, constrain cost increases, and manage rate base and regulatory pressures.

Table 1: Withdrawn Utility Mergers (2002-2008)
Acquirer	Target	Date Announced	Date Withdrawn	Reason Withdrawn
MidAmerican Energy Holdings	Constellation Energy Inc.	9/19/2008	12/17/2008	Mutual decision to terminate; subsequent investment by EDF Development, Inc.
PNM Resources	Cap Rock Energy Corp. (Subsidiary of Continental Energy Systems)	1/15/2008	7/22/2008	To focus their joint efforts on completing the pending acquisition by Continental of PNM’s natural gas business
Babcock & Brown Infrastructure	NorthWestern Corp.	4/25/2006	7/24/2007	Montana Public Service Commission rejected the merger, asserting that rather than benefitting rate payers it would put them at greater risk
FPL Group	Constellation Energy Inc.	12/19/2005	10/25/2006	Uncertainty with the Maryland state regulatory agencies
Exelon Corp.	Public Service Enterprise Group	12/20/2004	9/14/2006	Uncertainty with the New Jersey Board of Public Utilities, including among other things, issues related to rate concessions and market power mitigation; pulled after 19 months at NJBPU
Saguaro Utility Group LP	UniSource Energy	11/24/2003	12/30/2004	Arizona Corporation Commission rejected the transaction
Exelon Corp.	Illinois Power	11/3/2003	11/22/2003	State general assembly did not enact legislation required to facilitate merger
Aquila Inc.	Cogentrix Energy Inc.	4/30/2002	8/2/2002	Uncertainty in the power market, particularly surrounding Enron’s collapse
Northwest Natural Gas	Portland General	10/8/2001	5/16/2002	Issues related to buying Portland General from a bankrupt Enron
PNM	Western Resources	11/9/2000	1/8/2002	Kansas Corporation Commission rulings rejecting rate increases and reorganizations prevented merger

Source: Archstone Consulting Analysis

M&A Challenges Typically Result from Inadequate Planning and Execution

Let’s face it – across industries, mergers have a very high rate of failure. Following a merger, only 42% of companies outperform their peers in shareholder value, and only 29% realize an increase in aggregate profitability! The reasons have been well circulated in business media – the most common reasons that executives give for this are cultural divides and poor planning and execution.

Our perspective is that the three largest challenges utilities face while integrating organizations are:

1. Inadequate or Unrealistic Planning
2. Underestimating Regulatory Hurdles and Costs
3. Failing to Realize Planned Benefits

1. Inadequate or Unrealistic Planning
Most organizations undergoing a merger retain strong advisory support from a variety of experts to successfully execute a transaction. Planners must realistically assess the major challenges to the process, most notably regulatory approvals and cultural integration. Additionally, data indicates that as utilities grow larger, they generate less market value-added (MVA) per dollar of capital invested, most likely because large companies insulate managers from the pressures of accountability and incentives of ownership. In addition, large combined energy companies may attract more regulatory attention and denied the opportunity to earn a high return on large capital bases. Finally, cost savings often don’t materialize because many companies underestimate the costs to get regulatory approvals, to terminate leases and employees, and to operate in a multi-state regulatory environment, all of which result in unrealized benefits.

2. Understanding Regulatory Costs and Hurdles
Over the past few years, some leading utilities (most notably Exelon/PSEG) have withdrawn merger applications, primarily due to a rigorous regulatory approval process. Our perspective is that these utilities likely underestimated the power of the Public Utility Commissions (PUCs) as well as the consumer advocacy groups. At some point, the give-backs became unpalatable and the deals needed to be halted. Clearly the number of constituents to manage is significant–PUCs, consumer groups, the Federal Energy Regulatory Commission (FERC), the Department of Justice (DOJ), shareholders, etc.–however, perhaps most surprising is the significant power and resistance of the state regulatory groups. Acquiring a utility in another state adds even more complications to the process. As regulators evaluate potential mergers in their jurisdictions, they are looking to minimize monopoly power, to ensure that consumer protections are in place (e.g., rate reductions, choice of energy suppliers, investment in the community), and increasingly to look for environmental investments (e.g., wind).

3. Failing to Realize Planned Benefits
In short, once the acquisition is consummated, many organizations simply can’t overcome the cultural hurdles or simply had not assembled a clear merger integration execution plan. As far as cultural challenges, employees of the acquiring and acquired companies will both face uncertainty about the future of the merged organization, including leadership, operations, and locations, as well as their own personal future. This uncertainty may lead to lower morale, decreased productivity, and attrition, and must be countered with clear communications. Additionally, many pre-merger communications focus on short-term goals, benefit, and profit.

Add to this the reality that as with any significant transformational initiative, the merger integration effort can lose steam over time, especially if a clear integration team and plan isn’t established. While most acquisitions start with a series of “quick hits,” most companies fail to address the processes and systems needed to achieve full integration of the merging businesses. To compound this, utilities are not typically nimble organizations accustomed to quickly enacting change, so the change effort to achieve these synergies can likely not be overestimated

Merger Success can be Achieved by Following Five Key Tips

So what should companies due to mitigate these challenges? Put simply – plan well, manage the regulatory process, and execute mercilessly.

In our experience, companies that experience the most success with merger efforts follow the following five steps:

1. Fully articulate the rationale for the merger in terms of its strategic importance
2. Apply a rigorous process to identify the economic value of the acquisition
3. Anticipate and manage the regulatory approval processes
4. Develop and follow an M&A Playbook
5. Begin integrating as early as possible, maintaining momentum until target benefits are realized

1. Fully articulate the rationale for the merger in terms of its strategic importance
Acquisitions should support the utility’s long-term strategic objectives and ultimately add value for shareholders. This value can come from a larger geographic footprint, a better power-generation and asset mix, and a more efficient cost structure.

But considering the time, energy, and resources required to pursue an acquisition, along with historical success rates, executives should also consider whether the transaction is the best avenue to achieve these goals. It may be possible to achieve operational improvements and cost reductions by investing in existing assets or conducting focused improvement efforts, rather than tying up company resources for months or years pursuing an acquisition.

Before committing to an acquisition, companies should also ensure that groupthink is not a factor. This can be done by testing assumptions analytically to understand scenarios/ranges, and also by obtaining an outside opinion from firms who have worked through M&A processes for peer companies. That said, the key is to conduct “realistic planning” and truly look at the future merged organization with “open eyes.” Dealmakers need to honestly examine the planned benefits – to paraphrase Jim Collins, we must “confront the brutal facts,” yet still retain an unwavering confidence to successfully execute (if that is the right course of action).

2. Apply a rigorous process to identify the economic value of the acquisition
Utilities face a complex regulatory environment, and economic benefits must be realized quickly. The most successful acquirers rigorously examine each business unit, function, and process to determine the most efficient way to combine the two organizations. This approach needs to be pragmatic and geared toward driving tangible headcount and other cost savings. These projected savings should be the yardstick to measure integration efforts progress.

Measurement of the actual results is a key success factor of the merger – we suggest a long-term (3+) year reporting process should be developed to track synergies against the original deal model. The true synergies and value are typically realized much longer-term; therefore, a process should be in place to measure an acquisition’s success against the original projected model. This provides data for feedback to individuals internally (regarding priorities and accountability), as well as to Wall Street analysts (“Hey look how good we did”).

3. Anticipate and manage the regulatory approval processes
The number of constituents involved in the process is significant – PUCs, Consumer Groups, FERC, DOJ, Shareholders, etc. – and as mentioned before, perhaps one of the most significant is the state PUC. The regulatory process differs in each jurisdiction – not only from a procedural standpoint, but also in terms of priorities. Regulators may be focused on achieving rate reductions, improving reliability, enacting environmental concessions, or avoiding monopoly power. Understanding the process and priorities of each jurisdiction of the combined organization will help to focus companies on the types of benefits to pursue and the messages that need to be crafted.

In the end, concessions will need to be made – you should also be prepared to walk away from a merger if the concessions and agreement rise to a level that is too complicated, too costly, or in conflict with your strategic objectives for the merger.

4. Develop and follow an M&A Playbook
As with any effort, a repeatable methodology with standard templates can help improve efficiency. Investing time in creating an M&A Playbook can help improve M&A evaluations and integrations by documenting processes, evaluation criteria, and tracking mechanisms that allow employees to focus on evaluating and implementing the transaction, rather than reinventing the wheel each time. In addition, the Playbook can be updated with lessons learned from prior integrations (from both inside and outside the company), helping to ensure they do not happen again (e.g., extra costs from terminating contracts and leases).

However, even with the Playbook guiding activity, executives should make practical, pragmatic decisions without overanalyzing information, which may not always be perfect during a merger process.

5. Begin integrating as early as possible, maintaining momentum until target benefits are realized
The CEO and Senior Executive team should champion and drive the process to help ensure that benefits are realized quickly. A PMO can be useful to help track progress, benefits, issues, and risks, using standards outlined in the M&A Playbook. Working with Senior Management, the PMO can also be effective in keeping the focus after quick hits are achieved. In order to quickly realize benefits, executives should make key decisions early, hard decisions with conviction, and make no excuses.

Integration plans should be designed by business unit or function to ease implementation, and change management should be a core component to help avoid cultural issues.

Conclusion

In conclusion, it is fairly safe to say utilities will continue to pursue mergers to counter rising commodity prices, maintain rate stability, achieve economies of scale, and improve their asset bases. As these are pursued, utilities will likely encounter the typical challenges common across all industry, most notably cultural integration and stakeholder approval; while facing the unique hurdle of regulatory approval of the intended transaction.

Note: This is a re-post of an article I co-authored for Archstone Consulting that was submitted to EnergyPulse.