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BEN COLLINS: Generally speaking, 2010 was a relatively slow year for transactions. But at Constellation, you were extraordinarily active on the acquisition front. Why was 2010 such an opportune time for you to buy?
JOHN PAFFENBARGER: The big picture prior to 2010 is that 2008 was a very, very difficult year for us. We had to sell a number of businesses and agreed to sell half of our nuclear business. At the end of 2009, as a result of our agreement to sell half of our nuclear business, we received a large payment of cash from the buyer, Électricité de France. The total purchase price was $4.5 billion. Cash paid at closing was $3.5 billion, and then after other corporate uses, we had over $1 billion in cash on our balance sheet. That facilitated our acquisitions in 2010. We were able to act. Others in our sector were actually building cash during this period so they were unable to take advantage of the situation we were in, in terms of the ability to buy.
We have a fundamental belief that, over time, long-term commodity prices will recover from their lows in 2009 and 2010. As commodity prices recover, values of assets are going to increase. Furthermore, the fact that asset prices are typically less than one third of replacement cost also suggest there will be pressure on asset values to increase. We said, now is the time to buy because other people see only today’s commodity prices and their valuations are lower. You’ve got to believe that during the commodity price trough is an opportune time to buy and that you’re going to get a good price on assets. Then the challenge is finding someone who’s willing to sell, because many were waiting until valuations recovered. The transactions Constellation executed were based upon sellers who were looking for an exit and had a reason to sell their business.
Were these transactions primarily auction processes?
The large power plant deals we did were somewhere between negotiated deals and auctions. We started the conversation in both cases by contacting the owners. In the case of the two Navasota plants in Texas, that process really turned into more of an auction with an investment bank intermediary. In the case of Boston Gen, a $1.1 billion acquisition we closed in January, we saw early on that they were headed toward restructuring. Ultimately an auction process ensued in which Constellation was the winning bidder and those auction results were confirmed in the bankruptcy process.
In the case of the retail power business we acquired last year, it was a negotiated transaction.
What’s the typical timeline for these kinds of transactions?
The Boston Gen deal was a long, slow process. We started working on it in late summer of 2009, so the process took nearly a year and a half. We put in a lot of time and effort throughout, and just hung in there. We had to feel our way around which external groups to work with. There were many constituents, not all with the same objectives. Usually our timeframe is much shorter, more like three months. With the Navasota transaction, we were talking about it in early 2010, and went back and forth with the seller. They provided enough information for us to do a valuation, and at that point they realized they wanted to do an auction. They cranked up the machinery and that took a period of time where our focus was to reconfirm our price. But then once we reached a certain point, they decided they were going to bring things to a close quickly. From the point where they accepted our bid to signing was a really compressed period. It was less than a month—a really fast process once we both fully engaged.
There’s a lot of work that goes into these deals; a lot of internal resources and external advisors are involved. Are there any recurring pain points that you’ve noticed?
They don’t exist as pain points. There are certainly challenges to overcome in every deal. One challenge is that when you’re outside of the formal auction process, the flow of information is sometimes difficult to control at the pace you’d like. Typically the seller will not want to tell you everything because they’re afraid you’ll misuse it and either compete against them or steal their people. On the other hand, they’re asking you for a firm price. They are asking you for a valuation that they can move on to the next round with. That was very challenging in two of the deals we did last year.
Perhaps the challenge that’s most important to deal with upfront is the issue of support within the company. You have to make sure you’ve got an opportunity that will be supported by your team and company. We said corporately at the beginning of the year that we wanted to buy generation assets in some specific regions. That made it easy to ensure that we would have support. It’s important to make sure that everyone in the company who needs to be is on board with the idea.
How do you keep C-level and board-level input aligned with what you’re seeing in the business units?
It starts with the heads of the business units. Business unit managers are members of our senior management committee, which sets the company’s overall strategy. The business unit has to want to do the deal and they have to say it looks like an interesting business that they’d like to own and grow. Business unit managers will participate in discussions about the opportunity with corporate executives and the board of directors. The discussions at all levels of management ensure that our overall objectives are being addressed in pursuing specific acquisitions. That active dialog internally also helps us make sure all parties are aligned as challenges and observations arise during the course of a deal.
Do you have annual or quarterly sessions with the C-level execs or board of directors to make sure that what you’re evaluating is in line with their strategic vision?
The volume of our deals is not so high that we need to be that formal about it. For power plants, the strategic direction was set out very clearly—we were looking to grow our generation in a number of specific regions. For others, such as the retail business, we have an objective to grow but it’s rare that you have any more than one or two acquisition opportunities in progress at a time. We start each deal with an internal process to create an indicative bid. Before you can give any potential seller an indicative bid, you’ve got to go to the senior managers and say, “Here’s what we’re doing. Does everyone find this acceptable?” That’s part of the consensus-building and approval process that needs to be done.
How do you organize and manage these cross-functional teams?
Staffing is driven by the business and functional units. They are interested in having really engaged people on the team, so staffing follows the specific product. In the case of power plants, we’re working with the generation team. We generally have a point person for generation who participates in every process. In the retail business, there’s a person from the business unit who will always participate in the due diligence team and the acquisition team. For the functional units such as tax, HR, or accounting, it’s a little more variable, but it tends to be the same people. The accounting group, for example, has a person whose main responsibility is just M&A. That’s a great help for us. The modeling is generally done at corporate strategy but with huge input from the business unit.
The team leader is from corporate strategy, assisted by an associate in corporate strategy. The team leader manages all aspects of the process, including due diligence, interface with the seller, internal approvals, negotiation of transaction documents, and, after an agreement is signed, closing. There are lead team members from the business unit and each functional group who are responsible for ensuring their respective organizations have signed off on their relevant areas.
The essential process in developing an indicative bid is having a small core of people who can evaluate the key issues, problems, and opportunities and get you to the point where you’re ready to put a price on the table. Once you get past the indicative bid, suddenly the scope of your job increases dramatically. The next big challenge is making sure you have the right people on the team willing and able to contribute. How do you get their time? Some companies have a pretty large core team to draw from. In our case, it’s an analyst on the corporate strategy team, and then everyone else is from the business or a functional unit.
Where does legal fit into this process?
Our legal team plays an important role in due diligence. The commercial folks are really focused on whether the deal makes commercial sense. They need to understand the commercial aspects of the business and associated contracts, but they don’t have the time to go through thousands of pages of legal documents. In the case of buying a distressed asset in bankruptcy, there are hundreds and hundreds of documents to go through. The legal team coordinates all the evaluation of the other issues that show up in the business and contracts. They help create the bridge between due diligence and integration because they identify the issues early in the transaction, documenting the issues found during due diligence, and then afterwards they help resolve any issues which arose as a part of that. They’re not subject to as many distractions as other team members might be because they are solely dedicated to the deal team. We are typically using an outside law firm to augment our internal legal staff, and we rely on them quite a bit. Among the support functions, legal is most important in terms of deal mechanics. They’re integral to the process.
Do you leverage any technology tools for managing the various people and responsibilities involved in each deal?
Not really. It’s just good old-fashioned project management. We make sure the team knows what’s expected of them. At the beginning of each process, once we’re past the indicative phase, we hold a meeting where we give people a roadmap that tells them the schedule and their responsibilities. We make it very clear at the start what we’re expecting. We go through the requirements of covenants. For power-plant deals, we have a playbook, a template that outlines team members, schedules, roles, confidentiality, and some other things. For retail businesses, it’s generally more variable.
We do take advantage of electronic data rooms and shared network locations to share due diligence information and planning documents. And of course email, conference calls, and electronic meeting management are ubiquitous in managing deals, as they are in all aspects of the business.
With C-level and board oversight increasing, they may ask for updates on whatever deals are in process. What’s your process for reporting on the status of deals?
It’s driven by specific reporting requests and scheduled senior management or board meetings. If there’s a formal request for an update, the deal coordinator in the corporate strategy group would check with the functional leads to provide the latest status on specific issues. But generally, we’re not trying to formalize the process as much as to make sure we know that there are no loose ends. At that initial team meeting we make clear when our final bid is due, so everyone is working towards that same date. That’s typically about a month. We don’t have an electronic system for entering this information in a formal way. We have weekly meetings where the coordinator or the deal lead will go around the table and solicit the latest status on open items. He or she will ask, “Are you going to be ready for our due date? If not, what are the issues holding you up?” We have a good idea of status as we go along with the process, but it’s not formalized and tracked electronically.
When it comes to the actual bid date, you need to go to the board of directors. For that, there is a formal presentation and discussion. We ask every functional lead on the due diligence team to sign off that they are either done or have issues that they want to highlight for the board and management team. We have a series of due diligence slides in our presentations that outline issues that have come up. We’re never going to be 100% certain about every single issue, but what we’re presenting to the board is that we think the risk is manageable.
How do you manage performance after the deal is closed?
We may have more of a traditional model here. The corporate team brings the transaction up to close and we’ll remain involved through several months afterwards, but then it’s really up to the business unit to make sure that it meets expectations. We don’t have a formal process where we put companies into a system and map their performance, but we have gone back and looked at specific transactions to see how they did compared with our expectations.
Determining where integration begins depends upon the asset. For a business that’s going to be more complicated—a lot of people issues, sales and marketing, more intangible values—we try to get the integration leader involved as early as possible, well prior to close. It’s really the business unit leads who have that overall vision of what the acquisition is going to entail. The role of the integration personis to make sure that project management flows as it should. They ultimately work for the business unit. You’re giving responsibility to the business unit but making sure they have someone who’s going to watch the details of project management. For acquisition of power plants, the people who perform the due diligence are generally the ones doing the integration, so there’s no real need to designate a special team. On the Boston Generation acquisition we closed at the very beginning of 2011, the lead integration person is a very senior manager who is well respected in the organization. He was involved in the due diligence and at a certain point he was designated as the formal integration lead.
Do you have quarterly calls with the business units as a form of status check?
I don’t want to give the impression that we hand over the baby and say, “It’s all yours. Figure it out.” But on the other hand, we do make the clear distinction that the responsibility for execution lies with the business units. We’ll assist in any way possible, and we certainly always assist through the working capital true-up, which is usually a several-month process. But all the projections and viewpoints are controllable by the business unit and really in their realm to follow through on. In the series of acquisitions that Constellation has made over the years, this has worked out well.
What are Constellation’s goals for 2011?
Our corporate strategy relative to power generation is to increase generation in areas where we serve load and don’t have generation to match. That was our goal last year, and we were very successful in New England and in Texas at increasing our generation presence by over 4,300 megawatts. We will continue to grow our solar business. We’re also looking to grow our retail businesses both for commercial and industrial customers as well as selling directly to household consumers. Our business-customer base is continuing to grow, but we’re putting more emphasis on developing or acquiring retail businesses to serve individuals. Cost consciousness and cost reduction remain important as we pursue our primary objective.