United States: Power Distribution - A Growing Investment Target

Over the past decade investors in the power industry have focused their attention on acquiring generation companies, but more opportunities now are arising in the power distribution (disco) sector. In the mid-to-late 1990s there was a wave of power distribution deals, both privatizations and sales of already-private companies, especially in Latin America and the U.K. However, in the past few years, with the exception of Brazil, nearly all disco activity has been in the U.S., Australia and Europe as their respective power sectors have consolidated. What can investors learn from these deals, and what does the future hold?

Investment Trends

PricewaterhouseCoopers Securities (PwCS) has identified the key investment trends and criteria that companies have used to determine whether and how much to invest in discos. Statistically, distribution deals are catching up with generation. From 1992 through September, 125 companies entered into 183 disco deals, worth a total purchase price of $115 billion (average price of $628 million). PwCS also highlighted the following trends:

• Most of the action has taken place in developing and middle-income countries, but most capital has poured into developed countries. The former has seen 118 transactions worth $41 billion (average price, $347 million), while there has been 65 deals costing $74 billion (average price, $1.14 billion) in the developed world.
• Complementing this trend, buyers have paid on average about $1,000 per customer to buy discos in developing and middle-income countries and $2,200 per customer in developed countries (with prices up to $5,000 in Australia). With the average U.S. per capita utility bill being about $1,000, buyers are paying more than twice their annual revenues for such discos.
• Investment is geographically unbalanced, with 94 deals in Latin America, 65 in North America and Europe, 18 in Eastern Europe and the former Soviet Union, and just six in Asia.

This last set of figures is instructive. Until now, Asian power restructuring has largely minimized the privatization of discos, but several countries, such as India and Korea, are now on the verge of witnessing much greater activity. In other forums, PwCS has contended that developing countries should consider privatizing their discos before or with generation. This approach puts discos on a firmer financial footing, with operators that can make them profitable and that can purchase generation without using local or national government guarantees and multi-lateral insurance. A number of Latin American privatizations such as those in Brazil, Bolivia and the Dominican Republic have followed this approach.

Investment Criteria

Clearly, companies must weigh up a host of complex factors when making investments in discos, for distribution is much closer to the customer and the success of the deal depends on different skills. When they evaluate a deal, how are disco investors deciding where and how much to bid?

It's generally a two-step process. They first develop a consensus on whether to invest by addressing a series of "threshold" questions regarding the country of investment. Such questions include:

1. Are the economic conditions and political system sufficiently stable or attractive?
2. Is the regulatory framework reliable and flexible?
3. Are they confident in the sanctity of contracts, environmental laws and the legal system?
4. Is the country consistent with the investor's corporate strategy and capital availability? For example, some investors have eliminated countries, such as, Colombia and Peru as investment opportunities, because they perceive these countries as too risky. Further, investors tend to be wary of countries where regulators change incentives or break promises, such as the U.K. and Hungary, and seek countries where regulators will stick to long-term arrangements that reward good performance.

If the first set of criteria has been satisfied players tend to consider investment opportunities against a second set of criteria and generally evaluate them in this order:

1. The projected returns of the investment.
2. The tendering process.
3. Resource availability.
4. Condition of the target company. But why do investors evaluate the criteria in this order?

Firms must seek to raise shareholder value, and require minimum returns. Further, investors seek stability, since discos have a bond-like quality - some U.S. firms (e.g., Dominion) exited the U.K. market after the government imposed a windfall tax on utilities. Investors want to have good chance of winning the bid and of gaining control. Issues that will concern them are the ability to obtain majority control, which most investors consider vital, the availability of partners and the level of competition. The primary issue surrounding resource availability is whether the investor is confident it can obtain the inputs necessary to make a success of the deal, such as reliable transmission, sufficient generation, and the availability of fuel.

The target company's condition is also of critical importance. Issues include the level of investment required to improve performance and flexibility with regard to employment. Currently, many firms have re-focused on European and U.S. investments, as deals elsewhere have suffered from mixed results. Investments in these countries will continue as reforms in countries such as Italy, Germany and Poland continue.

However, as reforms take hold in more developing countries, we expect private investment in their discos to increase, and for regional investors to play a more prominent role (e.g., Endesa, Singapore Power). This will focus attention on raising capital in the local markets, as buyers seek to minimize currency risk. It will also emphasize the role of multi-laterals, which can help foster a climate under which buyers find discos an attractive investment.

In short, PwCS expects to see many more investment opportunities in power distribution in the next three to five year. Are you ready?