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Investors see value in El Paso deal, but will regulators?

El Paso Electric Co.'s June 3 announcement that it has entered into an agreement to be acquired by the Infrastructure Investments Fund, an investment vehicle advised by J.P. Morgan Investment Management Inc., is not a complete surprise, as the company has been discussed at industry financial conferences and other public venues as a possible target given the dearth of large-scale merger candidates in the sector. Nor is the concept of an infrastructure fund or private equity firm purchasing a utility considered beyond the pale.

The transaction has been well received by investors, although it appears that some of the initial euphoria has worn off as concerns regarding the regulatory review process have come to the forefront.

In the view of Regulatory Research Associates, a group within S&P Global Market Intelligence, this concern is justified, as the transaction will face a number of regulatory hurdles. In addition, there may be some pushback from activist investors. According to a Form 8-K filed by El Paso Electric, or EPE, Rowley Law PLC is investigating potential claims against the company and its board of directors for "breach of fiduciary duty" concerning the transaction.

The deal must be reviewed by state regulators in New Mexico and Texas, states known for intense regulatory scrutiny, as well as the City of El Paso. While the agreement is also subject to approval by federal regulators, including the Federal Energy Regulatory Commission, RRA believes it will be at the Public Utility Commission of Texas, or PUC, where the rubber will really meet the road.

In a climate where regulatory scrutiny has intensified in general, merger-related activity has been particularly controversial in Texas in recent years. From 2014 until 2018, regulators grappled with serial proposals to acquire Oncor Electric Delivery Co. LLC in the aftermath of the bankruptcy filing of Energy Future Holdings Corp., or EFH, which had acquired a majority stake in Oncor as part of a leveraged buyout of what was then TXU Inc. in 2008. Even after the acquisition of EFH's stake in Oncor by Sempra Energy was completed in 2018, the PUC was faced with and has only recently signed off on subsequent transactions under which Sempra and Oncor acquired a large portion of the transmission and distribution assets of Sharyland Distribution & Transmission Services LLC and affiliate Sharyland LP from Hunt Consolidated Inc.

Notably, one of the suitors for Oncor was Hunt Consolidated, but Hunt walked away from the deal over PUC conditions related to the make-up of Oncor's board and uncertainty concerning the future regulatory treatment of tax benefits associated with the proposed real estate investment trust, or REIT, organization structure for Oncor.

While three transactions may not constitute a "trend," there appears to be a clear preference in Texas for ownership of the utilities to reside with a utility holding company. That being said, RRA notes that Berkshire Hathaway Energy had also thrown its hat into the ring to acquire Oncor and appeared to have secured buy-in from the key stakeholders, which boded well for the success of that proposed transaction. Even so, that transaction faced opposition from Elliott Management Corp., EFH's largest debt holder that was reportedly putting together a competing transaction. Berkshire walked away when the Sempra offer was announced.

While there is no way of knowing how Berkshire would ultimately have fared at the PUC, in RRA's view, the firm's reputation and track record of acquiring well-run, well-managed utilities, including MidAmerican Energy Co., PacifiCorp and NV Energy Inc., leaving incumbent management teams in place, allowing each to play to its respective strengths and holding them for the long term, helped Berkshire gain support from stakeholders — as was Berkshire's strategy of meeting with these stakeholders prior to announcing the transaction.

It is unclear at this time, whether Infrastructure Investments Fund, or IIF, took a similar approach with this transaction, but it appears that the upfront commitments offered in the transaction announcement are designed to mimic those that have found favor with the PUC in past transactions, including a commitment to retain EPE as part of IIF's portfolio for a minimum of 10 years.

In Texas, the City of El Paso must also sign off on the transaction, and the company has historically had a contentious relationship with the city. In RRA's view, the city is an unknown quantity when it comes to merger proceedings, but the team's inclination is to view the city as a possible stumbling block, as the city council will be more focused on what is good for the city and is not charged with balancing the interests of shareholders and ratepayers as the PUC is.

Merger activity in New Mexico has been less robust in recent years than it has been in Texas, with the most recent proceeding involving Emera Inc.'s acquisition of New Mexico Gas Co. Inc. in 2016. This was the only transaction to come before the commission in recent years, in which a utility in New Mexico is being acquired by a nonutility entity. That proceeding was not particularly contentious.

While past mergers have not been as contentious as the above-noted Texas transactions, the New Mexico Public Regulation Commission, or PRC, and the regulatory climate in New Mexico is viewed as relatively restrictive from an investor viewpoint, and while the commission oversees a much smaller portion of El Paso's operations, could prove a difficult hurdle, with two of its five elected commissioner seats up for election in 2020.

Transaction overview

IIF will purchase EPE for $68.25 per share in cash, representing an enterprise value of approximately $4.3 billion, including EPE's net debt. The per share purchase price represents a 17% premium to EPE’s closing price on May 31, the last trading day prior to the announcement of the agreement.

EPE is a regional electric utility and, as of the end of the first quarter of 2019, was providing generation, transmission and distribution service to approximately 426,000 retail and wholesale customers in a 10,000-square-mile area of the Rio Grande Valley in West Texas and southern New Mexico. Its service territory extends from Hatch, N.M., to Van Horn, Texas, and includes two connections to Juarez, Mexico, and the Comisión Federal de Electricidad, Mexico’s national utility. The company serves Rio Grande Electric Cooperative as a full-requirements wholesale customer subject to FERC jurisdiction. The company owns more than 2 GW of electric generation, including an approximate 16% stake in the Palo Verde nuclear plant.

EPE's retail electric rates are set by the New Mexico PRC and the PUC of Texas. EPE's most recent rate case in New Mexico was decided in 2018, when the PRC approved a $1.1 million rate increase that reflected a 9.48% return on equity (49.29% of capital) and a 7.67% return on a rate base valued at $414.5 million. The company is expected to file a rate case in New Mexico by July 31.

RRA views the regulatory climate in New Mexico as restrictive from an investor viewpoint, as the commission has been slow to implement mechanisms designed to alleviate regulatory lag, even after legislative authority to do so has been granted. See the New Mexico Commission Profile for additional information.

In Texas, EPE's most recent rate case was decided in December 2017, when the PUC approved a settlement calling for a $14.5 million rate increase premised upon a 9.65% return on equity (48.35% of capital) and a 7.73% overall return. The rate base value reflected in the approved revenue requirement was not specified. The company has not indicated plans to file a base rate case in the near future but is permitted to seek adjustments to reflect incremental distribution and transmission investment through limited-issue rider mechanisms.

While these mechanisms are constructive from an investor viewpoint, RRA views the regulatory climate for electric utilities in Texas as slightly more restrictive than average, largely due to reliance on historical test years, use of hypothetical capital structures for certain companies and stringent stances on previous mergers. In addition, in Texas, original jurisdiction over utility rates lies with the cities. While in most instances the cities cede jurisdiction to the PUC, the City of El Paso has been known to take rate matters into its own hands (see the Texas PUC Commission Profile).

The FERC oversees EPE's wholesale transmission rates. EPE is not part of a regional transmission organization and does not operate under formula-based rates. Prior to the announcement of the instant transaction, the company indicated that it planned to file a general transmission rate case with the FERC in the third quarter of 2019.

IIF is an $11.3 billion private investment vehicle advised by a dedicated infrastructure investment group within J.P. Morgan Investment Management Inc. IIF’s 19 portfolio companies are located primarily in the United States, Western Europe and Australia and include 11 energy, utility and electric generation companies, such as Summit Utilities Inc. IIF also has invested approximately $3 billion in renewable power generation assets which collectively provide 3.4 GW of renewable capacity.

Commitments

The companies contend that the transaction will enhance EPE's ability to meet "growing service area needs," including renewable energy and sustainability programs. While the timing of filings with regulators has not been disclosed, the agreement contains a June 1, 2020, expiration date that is subject to a three-month extension if all regulatory approvals have not been received. In addition, the companies have outlined a series of commitments they plan to offer to regulators.

* Rate and investment provisions — EPE would provide electric bill credits totaling $21 million to customers over 36 months following the merger close. The company would refrain from seeking recovery of the acquisition premium in rates. The company would continue to make minimum capital expenditures in an amount equal to its current five-year budget for the five-year period beginning Jan. 1, 2021, subject to adjustments for unforeseen circumstances. According to an April 1 investor presentation, EPE's planned capital expenditures over the years 2019 through 2023 aggregate to $1.3 billion.

* Community outreach — Annual contributions of $1.2 million would be made under EPE's existing Community Partner Program; maintenance of the company's low-income assistance programs and creation of apprenticeship programs for technical professional careers and utility supplier diversity; and creation of a Community Economic Sustainability Fund through which the company will invest $100 million over 20 years to fund growth and economic development in its service areas.

* Local control and workforce continuity — The company headquarters would remain in El Paso, Texas, for as long as IIF owns the company. IIF would maintain its ownership interest for at least 10 years post-closing. EPE's senior management would remain in place and continue to reside in the company service area. For at least five years post-closing, the company will not implement any material involuntary workforce reductions or changes to wages, benefits and other terms and conditions of employment in effect prior to the transaction and will honor the terms of existing collective bargaining agreements.

* Composition of EPE's board of directors — The post-closing board would consist of 10 directors: the company CEO, two IIF representatives and seven independent directors as defined by the New York Stock Exchange. Of the seven, at least two would reside within EPE’s service territory and at least two would be individuals that either served on the board immediately prior to the transaction, are local business/community leaders or are from a university within the company's service territory.

* Renewable resources — EPE would support and adhere to state-based initiatives to expand renewable resources and alternative technologies, including electric vehicles, distributed generation and battery storage.

* Ring fencing — EPE would refrain from guaranteeing the debt or credit instruments of its parent or any affiliate, pledging company assets, revenues or stock for the benefit of any other entity, sharing credit facilities with affiliates, being party to any cross-default provisions in debt covenants, and entering into inter-company transactions or disposing of assets without approval of state regulators. EPE senior management would not hold any type of position within the IIF organization. IIF would obtain a nonconsolidation legal opinion that provides that, in the event of a bankruptcy of IIF or any of its affiliates, a bankruptcy court will not consolidate the assets and liabilities of the EPE with IIF or any affiliate of IIF. EPE would maintain the authorized equity ratio established by the PRC and PUC for ratemaking purposes and would suspend payment of dividends or other distributions, until allowed to resume by the PUC and PRC, if issuance of the dividend or distribution would cause the equity component of the equity ratio to fall below that level.

Regulatory approvals and review of prior transactions

Federal law grants FERC authority over mergers involving electric utilities and utility holding companies, and FERC must determine whether a proposed transaction would be "consistent with the public interest." FERC determines whether a merger is in the public interest by analyzing the transaction's effect on competition, rates and regulation.

In addition, the commission must determine whether a proposed transaction would result in cross-subsidization of affiliated companies and, if so, whether the resulting cross-subsidization would be consistent with the public interest. FERC must act within 180 days of the filing of a complete application but may extend the deadline another 180 days. If FERC does not act within this time period, the application is deemed to be approved.

The effect on competition receives the greatest consideration in deciding whether a merger is to be set for hearing and is determined through a market power analysis. To analyze market power, FERC uses a "competitive analysis screen," which examines: relevant products sold by the merging entities, customers affected by the merger, customers' potential suppliers, and market concentration statistics. In instances of significant market concentration, mitigation measures may be required.

In RRA's view, the current transaction appears unlikely to trigger vertical or horizontal market power concerns, as there does not appear to be much, if any, overlap between IIF's current holdings and EPE's service areas.

In New Mexico, state law calls for a transaction to be approved unless the PRC finds that it is unlawful or inconsistent with the public interest. The PRC considers four principal factors when reviewing a proposed merger or acquisition: whether the transaction provides benefits to utility customers, whether the PRC's jurisdiction will be preserved, whether the quality of service will be diminished and whether the transaction will result in the improper subsidization of nonutility activities. There is no statutory time frame within which the PRC must rule on a proposed transaction.

Transactions approved by the PRC in recent years have included rate credits, commitments to pursue shareholder funded economic development and service expansion initiatives and requirements that the utility maintain a certain capital structure and debt ratings, with restrictions on dividend payments if these metrics are not met. In addition, the transactions have called for the creation of an independent board of directors at the utility and commitments to retain ownership of the acquired entity for a minimum period of time.

The current transaction appears at first blush to largely align with the types of provisions that the PRC has required, with the exception that the instant deal has an equity ratio trigger precluding dividend distributions whereas recent deals approved by the PRC have included an investment-grade credit rating prerequisite for dividend activity.

Texas statutes require that before a transaction involving a transmission and distribution utility may proceed, the PUC must determine that the transaction is in the public interest after considering whether the transaction will adversely affect the reliability or cost of service of the electric utility or transmission and distribution utility. In addition, if the transaction involves an entity or entities that own electric generation assets in Texas, the PUC must determine that the transaction would not result in a violation of Section 39.154, which prohibits a power generation company from owning or controlling more than 20% of the installed generation capacity available to serve a specific power region. If the commission finds that the transaction as proposed would violate Section 39.154, the PUC may conditionally approve the transaction provided that the parties sufficiently modify the proposal to mitigate any potential market power abuses.

In reaching its determination, the commission is to consider the reasonable value of the property, facilities or securities to be acquired, disposed of, merged, transferred or consolidated and determine whether the public utility will receive consideration equal to the reasonable value of the assets when it sells, leases or transfers assets. The PUC must also consider whether the transaction will adversely affect the health or safety of customers or employees, result in the transfer of jobs of citizens of this state to workers domiciled outside this state or result in the decline of service. The PUC may impose conditions in order to correct any violations of these standards.

The law calls for the PUC to act on a request for approval of a transaction within 180 days, but the PUC may extend the time period by 60 days. If a decision is not rendered within this time frame, the transaction is deemed approved.

As noted earlier, merger activity has been robust in Texas in recent years, largely because of the EFH bankruptcy and the desire to find a more stable parent for Oncor.

In 2016, the PUC conditionally a proposal under which Hunt was to acquire the majority stake in Oncor held by EFH. Among the conditions were provisions designed to flow the tax benefits of the proposed REIT structure for Oncor to ratepayers, require PUC review and approval of the specifics of the lease transactions between the operating company and the asset company created as part of that structure, and require the operating company and asset company to file joint rate cases. Certain parties sought rehearing of the commission order, and the ensuing litigation led certain participants in the bankruptcy reorganization plan to withdraw from the deal. In May 2016, the proceeding was terminated by the PUC at the parties' request, and Hunt withdrew the offer.

The next suitor was NextEra Energy Inc. In April 2017, the PUC rejected an agreement under which NextEra was to acquire EFH and its 80% stake in Oncor. The PUC found that the "sole tangible and quantifiable benefit" offered by NextEra is a commitment to share 90% of the interest-rate savings on Oncor's cost of debt with ratepayers until new rates reflecting the lower debt costs are implemented. The PUC opined that other benefits cited by NextEra had either not been quantified or were not exclusive to this transaction. In addition, the PUC found that the existing ring fence, which NextEra sought to remove, was "critical in protecting Oncor from the bankruptcy of its indirect parent company."

As noted earlier, Berkshire Hathaway made an offer for EFH/Oncor after the NextEra deal collapsed. With the two failed deals in mind, Berkshire offered a series of commitments designed to address the PUC's concerns regarding the earlier proposals and with the apparent blessing of several key stakeholder groups. This was a key consideration, as the prior Texas merger proceedings involving Oncor were somewhat unique relative to most other utility-related mergers in that the parties were unable to reach a settlement and the commission was forced to render a fully litigated decision. Nevertheless, Berkshire withdrew its offer following the announcement of a competing offer by Sempra Energy, which was ultimately successful.

In approving the Sempra acquisition of Oncor, the PUC imposed a virtual laundry list of conditions as specified in a settlement among the various stakeholders. Included among the conditions were bill credits designed to guarantee the flow-through to ratepayers of interest rate and other merger-related cost savings. There were also provisions regarding the level of debt that could be held above Oncor in the corporate structure, the maintenance of minimum equity ratio metrics, lending arrangements, cross-subsidization protections and specific provisions regarding the make-up of the Oncor board. There were also provisions regarding management structure, worker retention and local presence.

The commitments proposed with respect to the EPE/IIF transaction are largely consistent with the conditions outlined above. However, there are a couple of notable differences. First, as mentioned in the discussion of New Mexico, the mergers approved by the Texas PUC have included commitments to maintain investment-grade debt ratings as well as a certain capital structure, with restrictions on dividends in the event those metrics were not met, while current transaction ties dividend activity solely to the utility equity ratio.

In addition, there was a strong ring-fence around Oncor, in the form of a special-purpose entity that held EFH's share of Oncor, thus rendering it bankruptcy remote. While the EPE/IIF commitments include pursuing an opinion regarding EPE's security in the event of a bankruptcy, it does not appear that this is as tight a ring fence as that applied to Oncor. This could prove to be a major concern for the PUC in light of its experience with Oncor.

Charlotte Cox, Jim Davis and Jim O'Reilly contributed to this article.

Regulatory Research Associates is a group within S&P Global Market Intelligence.

For a complete, searchable listing of RRA's in-depth research and analysis, please go to the S&P Global Market Intelligence Energy Research Library.

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