Mergers and Acquisitions: A Changing Landscape?

Major shifts in the global economy have had a significant impact on many aspects of the renewables sector since the last KPMG survey into renewable energy mergers and acquisitions, ‘Turning up the heat’, was published in May 2008. While respondents last year were clearly worried that a bubble was developing, their concerns today focus much more on how the renewables mergers and acquisitions (M&A) market will react to the new financial landscape.

Without doubt, the global financial crisis has made access to capital for even the largest players in the sector difficult. Nevertheless, the fundamental drivers which have made renewables such a dynamic sector in the last few years remain: notably the climate change agenda, dwindling fossil fuel stocks and concerns over the security of energy supply. Despite the financial difficulties, our respondents – more than 200 executives across the global energy industry – agree that renewable energy projects will continue to be economically viable.

The Market Lives

Digging down into the detail, the research unearths some interesting insights into where many energy companies are planning to invest their cash in the coming year, how much they are seeking to commit and the underlying factors motivating their ambitions. Understandably, we are witnessing step changes in who is investing, how much is being invested, and how deals are being financed. A significant change from last year is that buyers appear to be less willing to pay a premium for development pipelines, evidence perhaps that some of the froth in valuations last year may have dissipated. Yet the M&A market is by no means dead, the report suggesting instead that activity is likely to continue through 2009 and beyond, as potential bargain opportunities arise for those who have both the will and the means to invest.

Respondents have also identified how changes in the political climate could affect the industry. As governments seek to reinvigorate national economies through a series of fiscal stimulus packages, one of the key beneficiaries is clearly green energies. Nowhere is this more evident than in the United States, the country that respondents see as by far the most attractive for investment in the next 12 months. A key factor is the election of Barack Obama, with respondents from across the globe having faith that he will be able to deliver on his green promises.

The world has seen immense financial turmoil in the last year, and the renewables sector has been no exception. A white-hot, if not overheated, M&A environment changed dramatically in the space of several months in late 2008, with more speculative premiums paid to undeveloped projects disappearing overnight. Multi-billion dollar deals in early 2008, such as the acquisition of Airtricity by Scottish and Southern Energy for US $2.2 billion, have so far not been evident in 2009. In tandem with the rest of the global economy, the momentum shifted dramatically as the financial crisis worsened sharply in September, with the fourth quarter of 2008 recording the lowest volume of corporate M&A in renewables for over three years.

What is the outlook for the year ahead?

Despite the global economic meltdown, 78% of respondents believe renewable energy projects continue to be economically viable, a key indicator of the sector’s ongoing importance amid the general economic gloom. Similarly, despite the financial turbulence, executives believe M&A continues to prove valuable for many of those engaged in it. In considering their last acquisition, 37% of executives experienced an increase in shareholder value, compared with just 8% who suffered a decline. More important for the long term, is that two of the underlying reasons for the substantial growth in the sector over the last few years – climate change and energy security – remain as pertinent as ever.

The US, India and China are being targeted as key countries for investment in M&A. The US is likely to be the most popular target for M&A deals in the year ahead, with 42% of all respondents saying they will be investing there in the next year, notably heading the list of destinations for European respondents. India, China and Canada are also popular, with 24%, 22% and 21% of respondents respectively, earmarking them for investment (respondents could be investing in more than one country). This interest is very likely to be closely linked to stimulus activity in these countries. The US government’s stimulus funds targeted at the renewables sector, for example – which include both grants and tax credits – are certainly attracting attention. China, too, will direct more than one-third of its stimulus spending towards environmental initiatives, including renewable energy projects. Meanwhile, nearly two-thirds (63%) of respondents expect growth in government subsidies during the year ahead (up from 37% in last year’s survey).

Investors are switching their attention to productive operating assets, at the expense of undeveloped ones. Given the tougher operating environment, executives are focusing their attention on deals considered lower risk. Direct asset acquisitions nearly doubled in 2008 compared with 2007. The big losers were companies that had been obtaining planning permission for projects or only developing them to a very early stage and then selling these off at a premium. Such activity has now dried up, which is probably a healthy sign.

Despite these positive signals, however, the typical size of M&A deals is far smaller than a year ago, with overall activity in the sector remaining muted. More respondents to this survey expect a further decline, rather than an increase, in the size of transactions over the next 12 months (37% compared with 30%). About half (49%) foresee a drop in the volume of transactions worth over $1 billion (compared to just 13% expecting an increase) and, of those who expressed an answer, 58% say that their companies would be spending less than $50 million on M&A in the coming year. Even once things pick up again, some of the conditions which helped to stimulate the growth of recent years are likely to be absent, such as intense competition for development opportunities and easy credit.

Large corporates with strong balance sheets and well established banking relationships are likely to be the main beneficiaries. Other interested buyers may struggle to find financing. More companies are expecting to make purchases in the coming year than actually did last year, but in an opportunistic way. One recent example was the $477 million acquisition by Valero Energy of assets from VeraSun (which entered Chapter 11 bankruptcy filing in October 2008) in April 2009 – less than a year after VeraSun’s larger merger with BioEnergy.

However, those in need of finance should expect to work hard to secure funds. Many banks are showing little interest in one-off deals that do not support an on-going relationship. Smaller companies are encountering particular troubles: 70% of those with annual revenue of under $500 million are finding financing harder to obtain. Larger companies are also squeezed: 57% of those with sales of over $10 billion complain of the same problem. Instead, where possible, companies are turning to balance sheets and cash reserves, while also making greater use of deferred payments in funding investments.

A Changing Culture

The new balance of risks and opportunities in the renewables market is likely to create a different M&A picture. Companies will be looking for opportunities, sometimes as those facing bankruptcy hold fire sales, but will be unlikely to take big gambles, especially in an environment where access to funding is severely constrained.

Survey respondents believe that M&A in the near future will be on a smaller scale and opportunity driven. The key to being able to exploit opportunities, however, will be financing. A vast gulf exists between those buyers with the cash on hand to pursue deals versus those without. Just under 40% of respondents say they are having a significantly harder time securing funding for renewables projects, with a further 25% finding it moderately more difficult. Along with other investments, this has a direct impact on M&A: bank financing is the most common means of funding, cited by 32% of companies as the one they would rely on most heavily. The growth in the use of banks reflects the even bigger problems in the stock and bond markets. The number of companies likely to issue shares to fund investments is down from 17% in last year’s study to 7% this year, and those using corporate bonds from 10% down to 6%.

Larger companies benefit not only from presenting a lower risk, banks are also interested in the long-term business they can represent. At the same time, larger companies are turning to other sources of finance. Among the biggest companies in the survey, 34% expect to rely on financing through the parent company for renewables investment, the most common means of funding for that group. Nearly one in four (23%) will either tap cash reserves or turn to their banks. For the smallest companies, however, about a third (32%) will need to head to the bank, while only 17% have cash reserves and 16% access to group financing.

The better position of larger companies is relative rather than absolute. Among other things, banks want parties involved in a deal to have single A credit ratings, and are unwilling to take technology risk, to the point of favouring onshore wind projects to offshore where risks are considered much lower. Sellers themselves may need to provide funding: 55% of respondents expect an increase in the number of deals with delayed or contingent payments rather than up-front money. An ability, where necessary, to find creative arrangements may well differentiate the winners from the losers in the new M&A environment.

Andy Cox is energy partner at KPMG.

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