A Signal of Potential Investment Opportunities for Private Equity Investors and Expanded State Regulatory Powers

"The Texas Legislature's reaction to the merger follows on the heels of several other states that have sharpened their regulator's control over mergers...."

--- Earle O'Donnell

Head of the White & Case Energy Markets and Regulatory Group

Quote from Competition Law 360 (March 2007)

Conditionally, the board of directors at TXU Corp., the largest provider of power in Texas, recently agreed for the company to be taken private by a group of investors led by Kohlberg Kravis Roberts (KKR) and Texas Pacific Group. If regulators were to approve the KKR/Texas Pacific deal, which is valued at nearly $45 billion, including the assumption of about $13 billion in debt, the transaction would not only be the largest leveraged buyout ever in the United States – it may be the breakthrough development that opens the traditional utility sector to a wave of new capital from private equity and other investors, while providing them with more potential investment opportunities.

The announcement of the buyout has also prompted the introduction of new legislation in Texas that seeks to clarify and expand the powers of the Public Utility Commission of Texas (Commission), which may be a harbinger that other states may likewise consider changing the role of their local regulatory authorities when reviewing mergers of utilities. The Federal Energy Regulatory Commission (FERC) is also considering what role it should play with respect to the transaction because the vast majority of TXU's business is located within the Electric Reliability Council of Texas (ERCOT), an area that FERC has little jurisdiction to regulate. Further complicating the situation, press reports suggest that other non-traditional investor bids for TXU may be forthcoming.

Deal Triggers Legislation to Clarify Local Regulator's Powers

The KKR/Texas Pacific deal has ignited debate in the Texas Senate as to whether the Commission should have expanded powers in reviewing and acting on mergers. Although the state regulator can investigate how proposed mergers and transactions involving utilities may impact the state's local market, the law fails to spell out how and when the Commission should intervene in the process.

In response to these concerns, a bill was introduced on the same day the deal was announced (February 26) that could broaden the Commission's power and clarify procedures when reviewing proposed mergers. Maryland also recently passed a law to toughen the criteria for allowing mergers to proceed, and two other proposed mergers were rejected last year as a result of actions taken by states. While these accounts do not imply that the KKR/Texas Pacific deal will not be approved, they may suggest that this and similar deals may come under more scrutiny in the future. This may prompt companies seeking to merge in the future to acquiesce to certain conditions in order to get their deals approved.

Broader Participation From Private Equity Funds May Revolutionize the Industry

The structure of the traditional electric utility industry, with its heavy regulation, relatively protected local markets and close political relationships at the state level, has tended to limit financial institution opportunities to own integrated electric utilities. While the outcome of the KKR/Texas Pacific deal remains to be seen and despite the fact that utility deals may be subject to more scrutiny by local regulators, if the KKR/Texas Pacific deal or a similar private equity deal were to be approved, it may signal that private equity funds will play an increasingly important role in the future of the utility business, providing a new well of capital for utilities to modernize and grow.

Considering these potential benefits going forward, smart utility managers may be more receptive to investment from non-traditional buyers such as private equity funds. New management ideas may foster a more entrepreneurial, customer service-oriented culture that brings innovation and service enhancement on line faster than in the past, thereby benefiting the industry as well as its customers.

The KKR/Texas Pacific deal reportedly is projected to close in the second half of this year. In the meantime, TXU may solicit other bids from third parties through April 16.