Sector is ripe for M&A activity – but will regulators play ball?

The UK utilities sector remains an attractive market for potential investors. But as the CMA’s former director of mergers explains in this article for Utility Week, the bar for approval of deals by the regulator has grown ever higher. Joel Bamford, now a director at Fingleton, and his colleague, Simon Oates, look at what’s on the regulatory horizon for investors in infrastructure

It doesn’t take a soothsayer to see that more bids for regulated UK infrastructure assets are on the cards, in particular for pipes and wires networks. Investors are looking for safe havens from the economic fallout of Covid and the Russia / Ukraine war. With their predictable returns, and clear inflation hedge, infrastructure businesses offer just that. Add in the UK’s track record of a stable regulatory framework as well as the government’s drive to decarbonise the energy and water sectors, and UK infrastructure offers an attractive investment story. Even after the government’s recent windfall tax, which focuses on the profits of oil and gas companies, the network businesses retain their sparkle.

Private equity giants including Blackstone and KKR have said they will invest billions in the UK infrastructure, with KKR recently raising $17 billion for its biggest ever infrastructure fund. Their timing could hardly be better.

Ofgem has just signed off its five-year pricing review for gas distribution and electricity / gas transmission businesses. Later this year it will do the same for electricity distribution. These reviews give investors invaluable insight into what they can expect in the coming years. In fact, the Pennon bid for Bristol Water came three months after the appeal to the Competition and Markets Authority (CMA) on water price controls was concluded, while Macquarie sealed its bid for National Grid’s gas transmission unit in March, three months after the relevant Ofgem price review.

But successful bids don’t automatically translate straight into deals. Should the CMA get involved, any investigation will be invasive and costly, not just in financial terms but also management time. Companies may have to pass thousands of internal documents to the CMA as part of the process and even a ‘Phase 1’ investigation can take six-12 months including the initial information gathering stage. An in-depth ‘Phase 2’ investigation can add a further eight months. The Pennon / Bristol Water deal is a good example. It took nine months for the ‘Phase 1’ investigation to conclude, and Pennon only got the deal over the line after offering significant concessions to the CMA. These included separate reporting so Ofwat can maintain its benchmarking regime.

So what’s on the regulatory horizon for investors in infrastructure?

While the UK’s regulatory framework is stable, the markets themselves are changing. And the prevailing market landscape is all-important when it comes to determining the level of regulatory intervention. Looking to the energy market as an example, with the collapse of 28 UK suppliers last autumn, Ofgem predominantly stepped in to select a “supplier of last resort” – without any competition investigation. Speed was of the essence. But the effect on competition has potentially been significant. Today, the UK has fewer energy suppliers, particularly smaller, innovative ones, and of those remaining the big boys are bigger. Seen through this lens, the CMA may not waive through a deal in the same way as it did with SSE and Npower in 2018 – although the deal itself was ultimately abandoned.

Even before this the CMA had stepped up its willingness to block deals or impose conditions in recent years, notching up the risk for investors. Between 2019 and 2021, our analysis of CMA merger decisions reveals that 19 deals were blocked or abandoned at ‘Phase 2’ compared with just three between 2015 and 2017. The changes in the market make-up and the emerging cost-of-living crisis are likely to further fuel the regulator’s appetite for intervention.

For funds with positions in multiple assets within the same sector, it’s also important to note that the CMA doesn’t just look at deals where full, or even majority, ownership is involved. It has the power to intervene in deals where an investor acquires “material influence” across more than one business. For example, the CMA carried out an investigation of Amazon’s purchase of a roughly 15% stake in Deliveroo where Amazon also gained the right to a seat on Deliveroo’s board. .

What can acquirers do to up their chances of success? Too often, there is a perilous gap between their mindset and that of the regulators. But by expanding their deal preparation, investors can mitigate the risk of regulatory scrutiny or CMA investigation. They need to be able to see their deal in the context of the market, through the eyes of both the sector regulator and the CMA, at the pre-bid stage. This should be buttressed with an informed view of sector regulators’ reform agendas and policy priorities set within the broader government policy context. They also need to understand how various deal scenarios might influence the regulators. Forewarned is forearmed.

For a deal to proceed, a carefully considered deal narrative, with robustly evidenced arguments, is a must. Investors may need to go a step further and make clear commitments to satisfy regulators’ potential concerns – from divestments or transparency arrangements to separate business reporting (depending on the regulatory regime).

And when questions come in from regulators, interpreting these and determining how best to respond is a fine art that demands expertise and experience. A deep understanding of the way the system works and how best to influence the development of the regulators’ thinking – through providing the right evidence at the right time – can be the difference between keeping a deal on the track or it being derailed.

Given the global economic uncertainty and the safe-haven status of UK infrastructure, there’s going to be strong interest in dealmaking. We’re predicting that bidders could face intense competition for the assets and the path to deal completion may not end there. Putting a bid and strategy together that takes full account of today’s regulatory environment could be the difference between failure and success. It will also help keep down costs and protect value.

Joel Bamford and Simon Oates are both directors at the strategic regulatory advisory firm, Fingleton. Joel was Senior Director of Mergers at the CMA until February 2022 and advises on merger strategy, including pre-deal advice. Simon previously held executive director positions in infrastructure businesses and heads up Fingleton’s infrastructure practice.