Jeremy's Take on the PwC Quarterly Power and Utilities Deals Report

Each quarter, the PwC Deals Report analyzes mergers and acquisitions activity — including all transactions of greater than fifty million dollars — for the U.S. power and utilities industry. It breaks out strategic versus financial deals, corporate versus asset deals, and inbound versus domestic deals.

Here, PUF asks PwC's U.S. Power and Utilities Deals Leader, Jeremy Fago, about the Deals Report for this year's first quarter. There were sixteen transactions in the first quarter. Total deal value declined to 7.9 billion dollars. This was the lowest value quarter since the second quarter of 2017 and the lowest first quarter since 2015. 

Looking ahead to this year's second quarter, the Deals Report forecasts that renewables will continue to drive deal momentum. The basis, certain states continue to boost their renewable targets, while federal incentives phase down.

PUF's Steve Mitnick: What does this new report say?

Jeremy Fago: We saw a lot of what we expected starting to play out. In some previous reports we highlighted that we thought that we would start to see some changes in the types of deals that we're seeing.

To level-set, it's important to note that in 2016 we had over one hundred fifty-six billion dollars in deal value, as we quantify it, driven by some mega-deals on the regulated utility side. That year alone was the size of the previous three years added together. So that was a significant year with some big dollar deals.

We saw a big drop off in deal value in 2017 to a little bit more than half that of 2016 and then a little bit less in 2018 but even those two years were bigger than each of the three years prior to 2016. So, there was a drop off since 2016, but it's relative.

It's not that the fundamentals have changed since 2016 per se but it's important to remember that because of the strategic rationale behind a lot of those deals that were announced in 2016, coupled with the limited number of mega-deal players in the industry we've experienced a relative slowdown in mega-deal announcements. 

For example, in recent years, including the big one with 2016, we saw a lot of infrastructure plays on the natural gas side with midstream and LDC deals. In some cases, regulated electrics were diversifying into new customer growth profiles on the natural gas distribution side or vertically integrating into midstream because of their, and broadly the industry's, shifting generation mix, and the infrastructure needs to support that shift. This garners significant opportunity to build out that infrastructure to support the shift in generation make-up from mostly coal and nuclear in some cases to a mix of renewables and natural gas.

This opportunity to deploy capital into these growth platforms yielded some big deal announcements from a value perspective. There was significant competition for several of these deals and as a result a big uptick in valuations with premiums for deals moving from low double-digit levels to, in some instances, 40+%.

There is a different synergy to assess when you're paying a premium of that significance than those we traditionally thought of eight to ten years ago, when premiums were around ten percent. The synergies must go beyond traditional cost take-out, back-office cost efficiencies and other types of operating efficiencies, for example.

There is a significant strategy around recent deals focused on the growth aspect of being able to buy/merge these platforms that were ripe with opportunity, but maybe needed capital to grow and realize their full potential in the current fast changing environment.

So we saw folks willing to come in and pay up for the opportunity to get in earlier on a platform and then be able to deploy, in most cases, rate-based capital into those businesses over the long-term and therefore grow those businesses to a significant degree over the longer term.

The reason we've seen a drop in deal value is there is a lot of effort by those folks that announced deals in 2016, '17 even '18 to execute on the integration and growth strategy that was the underpinning of the values that were paid for those deals. The focus has therefore shifted to organic deployment of capital to grow those platforms. And with a limited number of mega-deal players in the space, that's why we are feeling a shift in the types of deals we expect to see in 2019.

PUF: Is that continuing? Higher premiums?

Jeremy Fago: We continue to see higher premiums than say ten years ago and even in cases where premiums appear to be lower than recent past years, it's not because valuations are down. We did see, with some of the initial announcements, a lot of the speculated targets for acquisition, start to trade up. So even though one-day premiums in some cases appeared to be softening, it was really a result of increases in market capitalization and not because valuations were coming down.

That's why we're seeing a little bit of a shift as these mega deal participants in past recent years focus internally on the strategic platform underpinning those mega-dal announcements. 

We also highlighted a little over a year ago that we expected tax reform to impact the deals' environment in a variety of ways. We expected to see some pressures on cash flow for certain regulated businesses due to lower tax rate give-backs to the customer and expected to see some slowdown in mega-deals as a result. We also expected to see some portfolio rationalizations/divestitures as a strategic focus but also to shore up balance sheets and we did in fact see that play out over the past year or so.

We expected to see a few asset deals and portfolio deals, and we are.

We also continue to think that renewables are going to drive deal-making in 2019.

PUF: Acquisition of renewable portfolios, that's going to continue?

Jeremy Fago: We believe so, particularly on the wind side as we are in the last year of production tax credits at least as it stands today and we expect that as folks look to getting their wind farms online over the next couple of years, some deal activity will result as we've historically seen when tax credits get to expiration. We expect that's going to be a trend so keep an eye on that in the near-term.

Also, with the production tax credit going away after this year, we think there will be a renewed focus on solar as the investment tax credit starts to get closer to full step down to ten percent in 2022.

Tax benefits aside, we continue to see renewables as a key focus for the industry given continued and even increasing state standards and incentives, the desires and demands of the customers, as well as the cost and efficiency gains renewables continue to make. So, we do still expect a lot of movement on the renewable side. 

PUF: What about the merger of two large utilities?

Jeremy Fago: There's a couple of them potentially out there both rumored and in the public domain. It's not going to be like it was in '16 due to the reasons we have talked about, at least in the near-term. However, even though total annual deal value is down, volume is still robust and the fundamentals for continued deal activity in the industry broadly are still extremely good.

Things we watch include macro pressures like interest rate increases that can obviously increase cost of capital and potentially lower valuations, which may in fact increase the bid-ask spread in what people are willing to sell for versus what people want or are able to pay. We see this as potentially slowing the velocity of deal activity if that spread gets too wide. Regulated utilities are particularly exposed to rising interest rate pressures in the current low interest rate environment as investors have found safety and solid predictable returns in the asset class.

That said, we've been in this low interest rate environment for some time, so we'll see how that plays out. As we sit here today, we are still in a very low cost-of-capital environment, so, you can finance a lot of these deals with relatively cheap debt and valuations have still held up despite the interest rate increases the Fed has done so far. 

The other point I highlighted earlier is that the industry frankly isn't that big from the perspective of the number of players out there that can do mega-deals on a recurring basis and we've experienced significant consolidation over the past several years, so that has definitely impacted the annual announced deal values again in relative terms.

PUF: As you look forward what do you and your team look for?

Jeremy Fago: I'd like to say that it's an exact science but there's obviously a lot more to it. There are things like the macro impacts. Then you look at the number of players in this industry, particularly from a mega-deal perspective. From a player's perspective it's relatively small as I mentioned.

From a dollar's perspective it's a big industry because it's so capital intensive. We watch that. How many people can digest multiple acquisitions of size? Obviously, the macro stuff we talked about where you think about a low interest rate environment and low risk-free rate and what does the cost of capital look like as we step forward. Does that create some headwinds? 

The other aspect is that the regulatory environment is going to be a huge driver of what gets announced and ultimately done. We've seen, historically, that certain deals haven't gotten done. Other deals have changed as a result of the regulatory environment whether that be more concessions, structural changes, or synergy justification, to name a few. 

Things like that certainly have an impact, particularly when you talk about the types of premiums that we've seen. Managing, quantifying and articulating the growth aspect in addition to the traditional cost/efficiency gain aspects of those synergies is critical. 

In addition to the regulatory environment, we have to look at various state policies and incentives and market structures in general, as well as the federal landscape in thinking through what might get announced when. 

Then of course you have to layer on all of the change we are going through as an industry from a generation and supporting infrastructure perspective, customer wants and needs and how technology is playing into it all in thinking through what might happen for deals.

PUF: Also, we're entering a political cycle.

Jeremy Fago: It's not just at the national level but state government, state legislatures, open seats on public utility commissions, all of those are going to have an impact on how people are evaluating things. 

We've seen an intense focus from our clients on that regulatory environment and how to manage through that when they think about doing a deal, particularly if you're looking at a major merger or acquisition sitting in multiple jurisdictions. That gets exponentially more complicated as you evaluate and execute a deal.