Negotiating Merger Premiums: Unregulated Business Divestment (5 of 5)


This merger analysis was first published on
the Seeking Alpha website back in April of 2017. The written article can be accessed for free
from the Seeking Alpha website using the first link under the video description and the PowerPoint
slides can also be downloaded using the second link under the video description. If we put aside for the moment the unlikely
scenario of an aggressive bidder who doesn’t feel bound by earnings constraints or who
isn’t worried about being downgraded to a sub investment grade credit rating, putting
those aside, there is an alternative scenario where SJI shareholders may be able to achieve
a higher merger premium. That has to do with the relatively large unregulated
business operations of both NJR and SJI. NJR’s unregulated operations are equal to
about 45 percent of its total operations and SJI’s is about 35 percent. This compares to an average US utility’s regulated
business of over ninety two (92) percent. Which means the average U.S. utility only
derives eight percent of its total economics from its unregulated operations. So it may be possible, at least in theory,
to divest some or all of the unregulated operations of NJR or of SJI and then use those post-tax
proceeds to pay down the merger acquisition debt, or to fund a higher merger premium payment
to SJI. Unfortunately, when we think through
the issues involved with divesting their unregulated businesses, it doesn’t really take us much
further. If there is a Merger Of Equals, the goal of
both sides will be to keep the merger premium relatively low. And the pro forma leverage with the Merger
Of Equals scenario is already quite low. Divesting the unregulated operations isn’t,
strictly speaking, necessary to maintain a quality credit rating. Under what scenario would you consider
divesting the unregulated businesses? Well, it could be useful under the ~30 percent
premium, 50 percent stock merger scenario. There are some complications though, even
under that scenario where you’re trying to fund a higher premium and you have high pro
forma leverage to contend with. The problems include the fact that many of
these unregulated businesses benefit from the “halo” effect of being associated with
the regulated utility. You are going to be more willing to “trust”
the unregulated businesses when they are associated with your local utility. That may mean that if the unregulated businesses
are sold to a third party, the third party may not value those assets as highly as the
regulated utility would value those assets. There is also a lot of execution risk involved,
obviously, in selling the unregulated operations. You would have to query whether the NJR shareholders
want to be burdened with that execution risk. They have already got to contend with the
fact that they are undertaking a massive merger with a similarly sized company. On the other hand, the SJI shareholders may
not want to provide what is called an “earn-out” where they would receive additional merger
consideration if, and when, the unregulated operations have been sold. They would want the operations
to be sold prior to the deal closing. It is true that SJI could use some of its
Net Operating Loss (“NOL”) carry forwards to offset the taxable gain on the sale of
its unregulated operations. This could be a useful strategy if there is
a reasonable chance that those NOLs will expire before they are utilized. That benefit would need to be weighed against
the increase in both deal execution risk and uncertainty and the possibility that the NOL
carry forwards might be utilized before they expire anyway. A pre-deal divestment of either
company’s unregulated operations would also impact a number of viable alternatives for
a tax-free merger. A number of the Section 368 tax-free structures
prohibit any asset divestments, while other structures would limit divestments to 30 percent
of gross assets and 10 percent of net assets. It is possible, potentially, to structure
a pre-deal divestment but it is not going to be easy. Certainly not a slam dunk. Other structuring alternatives such as, say,
a spin-off of the unregulated businesses might be viable. Even if they are viable alternatives, they
are not going to permit you to pay a higher merger premium. Each of these alternatives would impose their
own set of restrictions on the post merger operations and ownership of Newco. To summarize all of that… there are a number
of steps that NJR could potentially take to monetize the unregulated operations of either,
or both, of the merging companies. All those steps would involve more deal complexity,
execution uncertainty and general risk that may not be willing to be borne by either side. It is also reasonable to expect
that NJR would not look to share all of this valuation upside with the SJI shareholders. After all, if NJR takes all the execution
risk, they are not going to want to hand that all over to the SJI shareholders; who have
taken none of the execution risk. If NJR and SJI go down the route of a Merger
Of Equals, then there is no immediate need to de-lever the balance sheet and they would
not even be wanting to pay a higher merger premium to SJI. You cannot do a Merger Of Equals if one side
is getting a huge premium. That concludes today’s recap of
the merger analysis. If you would like to read more about the challenges
of negotiating merger premiums, you can download the written article from the Seeking Alpha
website and the PowerPoint slides are available from the Lateral Capital Management website. Links are provided below the video description.

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