IN UTILITIES YOU DON T HAVE TO BUY BIG TO SCORE

ENERGY POINT OF VIEW MARCH 20, 2017 IN UTILITIES YOU DON T HAVE TO BUY BIG TO SCORE MORE THAN 100 SMALLER UTILITIES REPRESENT ATTRACTIVE ACQUISITION CANDIDATES AUTHOR Gerry Yurkevicz, Partner

The utility business in the United States is a good business to be in, just ask Canada s AltaGas which agreed to purchase WGL Holdings in a deal valued at $8.4 billion at the end of January. The reasons are straightforward. Electric and natural gas utilities (1) represent attractive infrastructure businesses, (2) are supported by a constructive, improving regulatory environment, (3) generally follow focused business strategies, (4) offer significant opportunities to expand their rate base, and (5) offer growth upside with continued low natural gas prices. Solid and predictable cash flows and earnings growth often follow. Utility consolidation is sure to continue as energy consumer preferences change and firms search for investment opportunities. If $8.4 billion seems pricey, potential buyers can check out more modest options among smaller operations. Despite competitive acquisition prices, smaller utilities continue to represent a yet to be fully realized investment opportunity. Oliver Wyman projected in 2012 that the acquisition potential in the smaller utility segment was about $30 billion. Recently, buyers have scooped up smaller targets such as Delta Natural Gas, Gas Natural, Mobile Gas, Wilmut Gas, Pike County Light and Power, and Arkansas Oklahoma Gas. Today, Oliver Wyman estimates the opportunity to still be worth around $15 billion, capable of delivering annual earnings exceeding $700 million. But buyers will have to pay to play as utilities in general have continued to be hot takeover targets including 2016 s big deals: Oncor (Round 2), Westar, Empire District Electric, and Questar. Mega deals for Pepco Holdings, AGL Resources, Piedmont Natural Gas, and Cleco also closed last year. The aggregate value of these eight transactions totaled $75 billion. Exhibit 1: Utility M&A opportunities and recent EBITDA transaction multiples SMALLER VERSUS LARGER UTILITIES: STILL PLENTY OF SMALLER OPPORTUNITIES AT MARKET PRICES # OF UTILITY ACQUISITION OPPORTUNITIES RECENT EBITDA TRANSACTION MULTIPLES, ENTERPRISE VALUE TIMES EBITDA 120 100+ realistic opportunities 16.0 100 80 15.0x 10.0x 14.0x 10.0x 14.0 12.0 10.0 60 40 20 6.5x 15 25 realistic opportunities 6.5x 8.0 6.0 4.0 2.0 Median EBITDA multiple Lowest EBITDA multiple Highest EBITDA multiple 0 LARGER UTILITY OPPORTUNITIES SMALLER UTILITY OPPORTUNITIES 0.0 # of opportunities Source: S&P Global, Moelis & Company, Gabelli & Company, company reports and filings, Oliver Wyman analysis 1

Oliver Wyman believes that there are still more than 100 potentially lucrative small utility acquisition opportunities throughout the US, with more small natural gas utilities than electric. Some are whole companies, others are unloved or orphaned among big corporate parents, while still others represent carve outs and unique situations. Sure, a buyer can still consider mega-deals, but going forward, there are only about 15 to 25 realistic options to consider a narrow menu that will almost assuredly command premiums. Additionally, some of these larger deals will also be fraught with negotiation, approval and management risks. Achieving synergy savings and earnings growth projections is often challenging with mega-deals, especially those deals involving a difficult regulatory approval process. With smaller utilities, focusing on growth and improving performance is just much easier. Our updated analysis shows that these often less complicated takeovers are more likely to yield incremental rate base growth and significant improvement in earned return on equity. The same cannot be said about mega-deals where improvement in performance is much more difficult to achieve, given the scale and complexity of the business. With utilities these days, the deal flow favors the seller. Recent larger and smaller acquisitions on average were done at similar multiples, according to Oliver Wyman s most recent analysis. Both the median EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples and range of transaction multiples are about the same for both sizes. Good assets, no matter what the size, tend to be priced competitively, with a mean EBITDA multiple of about 10. So what should a wannabe utility buyer do? For larger utilities, a small utility acquisition program should be an important part of their development strategy. To have the best chance of success, attention must be paid to certain critical elements: Knowing the locals well: Larger utilities should develop a thorough understanding of potential smaller utility targets, including both local and parent management, in order to be able to act quickly. Senior management should establish quality relationships with their counterparts in smaller organizations. Laying the groundwork with regulators: Larger incumbents can set the table by understanding customer, business, and regulatory issues facing targets and informally testing the waters on potential ratepayer benefits that could be offered with an acquisition (such as lower rates, higher reliability, and better service). Building internal acquisition capabilities: Large deals grab headlines and can move the needle. Smaller acquisitions often demand time and thinking. A capable and dedicated business development team can make small deals work. In the acquisition game, utilities generally have a competitive edge over infrastructure funds, private equity firms, and other energy companies that may want to invest in smaller utilities. Larger utilities may have a longer investment horizon, lower return expectations, better perceived ability to close, local operating and safety reputation, and regulatory relationships. However, Oliver Wyman believes non utility buyers can also be successful: 2

Developing targets proactively: While there are lots of small utility opportunities, funds and private equity firms cannot just wait for the next teaser or auction. If private money is serious, it must do its homework and devote some boots on the ground time. There are a number of unique and special utility acquisition situations out there that require legwork. Going where they aren t: Not all large incumbent utilities are created equal. There are markets where a new non-utility face is welcome for customer, rate, business, regulatory, or local job creation reasons. Paying market or more: Any sale will most likely command market prices. Funds and firms may have to pay market or more. Premiums can be justified and recouped. The key to keeping investors happy is not just good but superb pre-acquisition planning and analysis plus a focus on putting in place the right management team post-acquisition with the right incentives. Thinking creatively and differently: A smaller deal flow requires new thinking. There is big opportunity for creativity if one wants to enter or grow in a market (such as thinking real small, considering how public utilities might be part of the equation, and exploring how other types of assets like water utilities could be part of the creative mix). Benefiting from improving exit options: The lower risk, more stable cash flow infrastructure market will continue to represent solid investments even if interest rates tick up. The new US administration could embrace policies that would make future exit options even better. The bottom line on utility acquisitions: While large utilities will continue to attract lots of suitors and generous offers, the universe of small targets should not be overlooked. Small utilities are indeed worthy of a buyer s time, money, and effort. Gerry Yurkevicz is a Partner in the Energy Practice at Oliver Wyman, focusing on utility strategy, mergers and acquisitions, performance improvement, and transformation. He can be contacted at gerry.yurkevicz@oliverwyman.com. 3

About Oliver Wyman Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. About Oliver Wyman s Energy Practice Oliver Wyman s energy practice helps companies address strategic and operational challenges through proven, results-oriented approaches across all sectors of the utility market. The practice offers deep industry expertise across the energy sector, informed by decades of work with industry leaders. The energy team has worked with leading international and domestic utilities operating in the Americas, Europe, and the Middle East. www.oliverwyman.com All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.