Apr 24, 2006 -- Datamonitor

 

Standard & Poor's is concerned that a continued flurry of debt-financed takeovers in Europe will damage the credit rating of the sector as a whole, as financial gearings grow. The combination of high financial gearing and market risk exposures has already caused some bankruptcies and could easily cause more.

PricewaterhouseCoopers has released figures showing that global M&A activity has grown 59% in the energy sector in just one year to $196 billion. Much of the M&A activity has been domestic, with cross border deals in Europe making up a $40 billion minority of the total $105 billion worth of its power transactions. Much of the domestic activity was driven by energy companies seeking to grow their national customer base through acquisition, whereas cross-border deals were more likely to be initiated by financial institutions.

In the absence of the development of a true pan-European market place, cross-border deals are much more likely to be regional, a point noted both in the PWC report as well as previous Datamonitor research. Another common feature of EU M&A is the support by governments of "national champion" utilities by taking steps to block their acquisition. Both the Spanish and French governments in the last couple of months have taken steps to protect, respectively, Endesa and Suez from foreign takeovers.

In a market where the potential for substantial organic growth is relatively limited and acquisitive growth is favored, managing debt levels should be a principal area of concern. There is significant risk of being drawn into a cycle where increased financial gearing (debt-equity ratio) degrades the credit rating in turn raising the cost of servicing debt to unsustainable levels for the company.

This is magnified by the continuing liberalization of EU energy markets which exposes energy companies to ever greater levels of market risk. TXU went bankrupt in the UK when the market turned against it, customers churned away and the revenues from energy sales were not high enough to cover their interest payments.

For businesses such as transmission and distribution that continue to be regulated, gearing is less critical as their level of market risk is very limited. However for utilities in liberalized markets, managing the transition from regulated or non-competitive business practices will require a careful evaluation of their exposure to market risk to decide upon an acceptable level of debt.

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