A Southwest Power Play: TNP Goes Private

Electric utility investors received a wake-up call last week that may change the way consolidations are financed in this industry. An investor group led by former Long Island Lighting, or Lilco, CEO William J. Catacosinos agreed to a leveraged buyout of TNP Enterprises (TNP Quote), the parent company of Texas New Mexico Power.

The investor group, which includes CIBC World Markets, agreed to buy TNP for $585 million plus assumed debt, for a total price of about $1 billion. Current shareholders will receive $44 per share, which represents a 39% premium over the 30-day average price.

Although it's hardly surprising that smallish TNP is a takeover target, the structure of the deal is somewhat unexpected and prompts a couple of questions: Does the TNP LBO have greater implications for the industry as a whole? And will regulators sanction utility LBOs?

What's Next for Catacosinos?

Catacosinos isn't exactly beloved as a utility executive. Indeed, many utility investors and regulators harbor ill will toward him because of a personal $42 million severance package he received when Lilco merged with Brooklyn Union Gas to form Keyspan Energy (KSE Quote). He remained an executive of the successor company, but after a strife-filled two months at the helm, Catacosinos resigned, quietly taking his severance and retiring to the Hamptons.

Others, however, argue that without Catacosinos, Lilco never would have survived. "He took nothing and made something of it," says Ed Tirello, managing director of utility research at BT Alex. Brown. "If Lilco [were] in any other industry, his picture would be hanging on every shareholder's wall. His critics are third-rate politicians who resent his success and the fact he was the only one who could get the job done."

Indeed, Catacosinos' deal-making savvy probably saved Lilco, and led him to introduce an old financing mechanism -- the leveraged buyout -- to the power industry. "It's a shrewd move," says one buy-sider. "I always wondered why someone hadn't attempted an LBO sooner. I guess it took someone with Catacosinos' chutzpah to give it a go."

To be sure, Catacosinos has structured a deal that's largely in his favor: Sources tell TheStreet.com that he dictated all of the terms of the deal save the final price. Senior executives, for example, have a three-year commitment to stay on at the private company, even though they received no equity. And while the investor group can walk away from the deal without penalty, TNP spokesperson Valerie Smith confirmed that her firm is subject to a break-up penalty should it walk away from the deal: $30 million if the company accepts a competing bid, and up to $10 million if TNP is not able to gain the necessary regulatory approvals.

Not that a competing offer is likely to emerge: TNP is a relatively small utility that, earlier this decade, was considered troubled because of high generation costs and burgeoning debt. TNP has quietly shopped itself to other utilities in the past year, but even though its current management has completed a turnaround, the company's bigger brethren have largely ignored it. The offer from the Catacosinos group appears superior to any other interest.

For Catacosinos, this is likely the first step in a much larger strategy to create a powerful Southwestern utility. "TNP has become a great little company, but it's little," says Tirello. "Catacosinos will use it to create a larger company, purchasing others of similar size in the region." Future targets likely include El Paso Electric (EE Quote) and Public Service New Mexico (PNM Quote).

Electric cooperatives and municipalities also may be on the company's radar. Additionally, under the state's latest deregulation plan, the private TNP could pick up a number of customers from larger Texas utilities. "They will likely become a significant customer aggregator in Texas," Tirello speculates. "Catacosinos knows how to create value and this is a great vehicle to do just that."

Ultimately, however, Catacosinos will want to unlock and monetize his stake, which leads most industry watchers to suggest the private company will once again enter the public markets. "You'll see this group come public again some day," predicts the buy-sider. "Catacosinos always does a nice job for himself, and he'll do it again here."

Regulatory Roulette

The real uncertainty with any utility takeover rests in the regulatory process. And many observers of this deal appear unsure about its success, fearing Catacosinos' reputation may slow the process of approval by federal and state regulators.

The uncertainties caused Ron Tanner, head of Legg Mason's utility research group, to downgrade the stock from buy to hold. "We believe there is a high probability the transaction will be approved," he wrote in a recent report. "However, given uncertainty, our buy rating is no longer supported by the risk/reward relationship."

Although the stock traded sharply higher on the news, it now trades at more than a 15% discount to the offer price.

An additional uncertainty rests with the deal's structure. Regulators have never scrutinized a utility LBO, and its novelty may prompt a closer look. If they think the LBO could result in higher returns to the private investors, they may ask for rate concessions. If so, Catacosinos may walk. TNP says it plans no rate or operational changes from the transaction.

Still, the fact the concept has been floated is likely to increase interest in alternatives to traditional utility mergers. And, if Catacosinos is successful, it should spur greater interest in the industry as a private roll-up candidate. "LBOs make a lot of sense for many of the smaller utilities," according to the buy-sider. "It's a great way to unlock value."