Outsized Returns in a Regulated Industry

Last post we talked about a 10 year investment, now we will look back 20 years!

In October 1999, Berkshire, Walter Scott and David Sokol agreed to pay a 27% premium to acquire MidAmerican Energy for $35.05 a share.

Initially, Buffett offered $35.00, but the bankers kept asking for more. This was probably the only public investment were Berkshire ceded to demands from the seller. It was only 5 cents, but still I think this is not the message Buffett wants to send.

The transaction had a complicated structure, since certain regulations prohibited Berkshire from gaining voting control over the utility.

So here it is:

Berkshire invested $1.25bn in common stock and convertible preferred stock plus $800mm in an 11% fixed-income security.

The investment gave Berkshire 76% economic ownership of MidAmerican, but less than 10% voting power. Walter Scott and David Sokol were co-investors. The Scott family brought their total investment to $280 million and became the controlling shareholder.

At the time of the acquisition, MidAmerican served 3.4 million customers electricity and natural gas in the Midwest and UK, primarily. The company also had other power generation assets.

The plan was to use this platform to keep growing, organically and through acquisitions.

MidAmerican was a possible solution to one of the problems Berkshire was starting to face, even back in 1999.

Berkshire needed to allocate excess capital and earn adequate returns. The utility industry provided a long runway.

It didn´t take long after Berkshire made its investment, for MidAmerican to start its expansion.

In 2002, MidAmerican acquired 2 gas pipelines, Kern River and Northern Natural Gas. Both investments were opportunistic as the sellers needed cash. In the case of Kern River the seller was Williams and in the case of Northern Gas it was Dynegy. The pipeline was actually an Enron asset that ended up in Dynegy´s hands in the middle of that mess…

To fund that acquisition, MidAmerican asked Berkshire for cash. Berkshire bought $1.3bn in an 11% FI security and $402mm in common stock (6.7mm shares for $60/share) bringing total economic ownership to over 80%.

There are many interesting aspects of these transactions.

MidAmerican was an opportunistic buyer that bought distressed assets at great prices. They were able to act quickly given the company had the financial support of Berkshire (it took Berkshire 3 days to sign a deal after receiving the call from Dynegy). Also, MidAmerican instead of paying dividends clearly became a place for Buffett to allocate additional cash, when the company found a deal and needed capital.

A similarly structured transaction occurred in 2006, when MidAmerican asked Berkshire for $3.4bn. This time the funds were used to acquire Pacificorp, a utility with 1.6mm customers in the West Coast.

MidAmerican also was opportunistic during the GFC when Constellation Energy ran into trouble. CEG had a commodities trading business used to hedge the company´s risks. As volatility in commodities spiked, trading partners asked for higher collateral requirements. The company ran into trouble with rising liquidity needs, credit downgrades, etc. MidAmerican came to the rescue, by offering a loan of $1.0bn (8% preferred stock) for a $25mm fee and also an all cash proposal to acquire CEG at $26.50 a share. 3 days later a consortium led by KKR offered $35/share, but CEG needed reliability and speed since the situation was deteriorating quickly. After agreeing to a deal with MidAmerican, a couple of months later CEG terminated the agreement. But they had to pay dearly for this breakup. MidAmerican got a termination fee of $175mm, 19.9mm shares of CEG (10% of S/0) and $1.0bn in 14% notes in exchange for their $1.0bn 8% preferred stock. MidAmerican sold its shares in CEG for approximately $500mm. After all, MidAmerican made more than $800mm from a failed deal. Excellent.

There have also been deals in which MidAmerican didn´t ask Berkshire for capital, as they were funded with available cash and new debt. In 2014, they acquired NV Energy for $5.6bn and Altalink for $3bn. Also, the company has been active acquiring realtors and expanding its real estate services business.

Fair to say, MidAmerican has been opportunistic and that has created value. They have been able to close deals faster than the competition since they had the financial backing of Berkshire and didn´t depend on the capital markets or banks. Also, the Berkshire sign of approval has been critical.

Now, MidAmerican has been renamed Berkshire Hathaway Energy. BHE has a series of assets including electric distribution, 27,500MW of generation capacity, gas pipelines, and real estate services.

That was a quick summary.

The reason why I decided to dig deeper into BHE is because it has become a large and significant subsidiary of Berkshire. Results here matter. This might be due to the combination of good performance, no dividend policy and Berkshire investing additional capital throughout the years into BHE.

Once I started looking at the numbers I was amazed.

I was expecting ~10% type returns since this is a regulated industry with allowed returns in that range. Here are the allowed ROEs:

I think Buffett also expected returns in that range. At various times, he has invested in junior subordinated debt of the company with an 11% coupon. In an annual letter he stated the following: “By charging 11% interest, Berkshire is compensated fairly for putting up the funds needed for purchases, while our partners are spared dilution of their equity interests.” A junior subordinated fixed income security in this industry is very similar to equity so there is a reason to think something in the range of 11% was the expected return for the equity.

So I am not alone in this camp. Buffett also thought 11% was adequate.

Let´s look at EPS growth.

I know EPS is not the best measure to calculate value creation, but it is helpful. I was impressed by this chart. When Buffett decided to invest in MidAmerican in 1999, EPS were $2.59 and that number has increased 14x to $37.19 in 2017. That is 16% per year. Way higher than the ~10% type number we expected.

I initially thought something was wrong, but fortunately we got help from our man at Omaha. There are some data points that are very helpful:

  1. Berkshire has bought shares in 2 different transactions, besides his initial investment. The shares were issued at what was considered “fair value”
  2. Berkshire has acquired shares from the Scott Family at “fair value” in certain years.

So we know what was considered “fair value” per share through the years:

BHE has not paid dividends since Berkshire became a shareholder, so it´s easy to calculate the return from the initial investment 20 years ago at $35.05 per share. Surprisingly, “fair value” per share growth was the same as EPS growth, 16%!

The obvious question is, how has BHE generated 16% returns if the allowed ROE on its subsidiaries has been in the 10-11% range?

I have a couple of reasons why I believe this has been such a success, but I obviously might miss some.

Distressed Investments: BHE has closed deals when sellers where desperate for cash and needed quick execution. The company was able to close many of these transactions because it had the financial backing of Berkshire. For example, the acquisitions of Kern River and Northern Gas summed $1.3bn and these assets were soon earning more than $200 million per year. Another example, is when MidAmerican came to save Constellation Energy and ended up making more than $800mm even after failing to close the deal. These investments at low prices have bossted returns.

BYD Investment: In 2008, MidAmerican acquired 10% of the shares outstanding of BYD for $230mm. That investment has been a success and now is worth almost 10x what the company originally paid for.

Holdco Leverage: BHE has used its low cost of funds to improve its equity returns. The company has constantly employed parent company debt, in addition to subsidiary level debt, to increase the return profile. Given the Berkshire name and the various stream of assets, BHE is able to issue at the parent level at low costs. This is a big benefit.

There are many other reasons including tax credits/efficiency, management, luck, etc…but that will take us forever.

I think this investment has been even better for Berkshire than the 16% headline number suggests. I know the number alone is impressive, but…

BHE has not paid a dollar in dividends since 1999, so Berkshire has “reinvested” all its earnings. This reduces the pressure at headquarters to allocate excess cash. BHE has even asked Berkshire for additional capital when it found large deals. So Berkshire has invested additional amounts at great returns. Besides the equity returns of 16%, Berkshire has also invested in 11% fixed income securities in a high quality issuer.

Berkshire also found Greg Abel, which will likely be an important figure at Berkshire…hopefully for a long time.

Buffett has guided to ~10% type returns for Berkshire in the next decade, let us hope we get a similar surprise…crossing fingers.

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