Emerging Trends: Hybrid Securities

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Emerging Trends Hybrid Securities

• 2006 AGA Treasurers Workshop October 2, 2006
• Ralph Pellecchia, Senior Director

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Emerging Trends

• Hybrids
• Utility Mergers and Acquisitions

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Equity Credit for Hybrids is Derived From

• Financial flexibility the hybrid affords the
  issuer under periods of financial distress
• Flexible coupon payments
• Long maturity
• Absence of covenants
• Loss absorption/Subordination

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Debt to Equity Continuum

• Equity Debt
• Class E 100 0
• Class D 75 25
• Class C 50 50
• Class B 25 75
• Class A 0 100

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The Role of Subordination Corporate
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The Role of Maturity
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Credit Measures Using Hybrid Capital

• Leverage
• Adjusted debt/cash flow and adjusted debt/EBITDA
• Limit of 30 of adjusted equity from hybrids and
  preferred
• Interest Coverage
• Fully loaded Includes all interest
  preferred dividends
• Alternate case Deferrable payments are deferred

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Caveats on New Hybrid Products

• New types of instruments incorporate features
  that may lead to excessive rigidity or complexity
• Examples are
• Binding replacement covenants not a Fitch
  requirement
• Mandatory dividend deferral financial ratio
  triggers not a Fitch requirement
• Alternate settlement with stock
• not a Fitch requirement
• New hybrid instruments are more suited to the
  capital needs of insurance companies and banks
  than to corporate issuers.
• Quality of business and cash flows is more
  meaningful for corporations than leverage and
  capital ratios.

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Fitchs Outlook on MA Activity

• Consolidation is overdue and fewer impediments
• Opportunities to rationalize costs and enhance
  strategy competitive genco, energy marketing,
  and risk management. Less burdensome capex impact
• Favorable capital markets environment Interest
  rates remain near historic lows, and strong
  equity valuations Hybrid securities offer new
  options
• PUHCA repeal not expected to accelerate activity,
  but rather change the partners
• Emergence of a new class of financial buyers
  Macquarie, Brookfield, Babcock and Brown, GE
  Financial, ArcLight
• Mega-deals still facing intense state scrutiny
  particularly given overall tariff pressure
• Debt covenant considerations KMI

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Recent Trends In MA Whos Selling

• MA Activity has picked up in the last few years
  driven by several internal and external factors
• Changing business strategy Southern Union
  divestitures, Duke spin-offs
• Corporate Restructurings Allegheny, Aquila, and
  Kinder Morgan
• Turnarounds Cascade Natural
• Departing Foreign Owners Scottish Power

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Recent Trends in MA Whos Buying

• The repeal of PUHCA has opened up the potential
  base of ownership or merger pairings
• Funds Macquarie, Brookfield, Babcock Brown,
  ArcLight
• Financial Institutions Berkshire Hathaway, GE
• Foreign National Grid, Gaz Metro
• Small In-market Consolidators UGI, MDU, Empire
  District
• Geographic Not yet

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General Rating Considerations

• Adoption of IDR/Recovery Rating methodology
  places greater emphasis on the regulated utility
  standalone financial profile (AES, Allegheny,
  CMS)
• Ownership by financial sponsors does not
  necessarily imply more leverage at the regulated
  utility
• Initial rating considerations at the regulated
  utility will center on existing dividend
  practices, pro-forma servicing and distribution
  requirements, and regulatory or other
  ring-fencing mechanisms
• Parent company leverage tolerances may be higher
  for financial owners/sponsors with deep pockets
  and strong access to the capital markets
• Corporate and financial strategies for financial
  sponsors simpler and less vulnerable to strategic
  decisions acquisitions, treasury share buybacks,
  etc.
• Leverage tolerance reflective of overall interest
  rate level/financing costhigher interest rate
  environment and/or floating rate acquisition debt
  problematic

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MA Rating Implications

• Merger of Utilities
• Generally credit neutral events
• Rating differential among partners has typically
  been modest, and Fitch has generally affirmed
  ratings on announcement
• Strategic benefits modest, and transaction
  financing is the dominant credit factor
• More often financed with stock as currency rather
  than leveraged, but back leveraging may occur
• Impediments to consummation may affect ratings
  Tariff reductions, divestitures

• Purchase by Financial Buyer
• Considered on a case-by-case basis
• Generally no strategic benefits or synergies
  directly related to the transaction
• Transaction financing is the dominant credit
  factor
• Typically entail debt leverage at an
  intermediate holdco
• Fitch also considers regulatory ring-fencing
  provisions, which may provide greater credit
  separation from leveraged parent