A Review of the Risk Premium Method for Regulated Electric Utility ROEs

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A Review of the Risk Premium Method for Regulated Electric Utility ROEs

Energy ROE

In utility financial economics, the cost of capital, or rate of return, is the cost of an electric utility’s invested funds, both debt and equity. The cost of equity capital is the rate of return that common shareholders require on their investment, commensurate with the risks they assume and the expected returns from other similar investments (opportunity cost). In the regulatory process, the principles established in the US Supreme Court Bluefield1 and Hope2 decisions guide most state regulatory commissions in establishing returns. In particular, the Bluefield decision noted:

A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.

From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also to pay a return on bondholders and stockholders providing the capital for the utility to invest. These funds are required to service debt and pay dividends on equity (common and preferred stock and retained earnings).

From both the investor and company point of view, it is important that there be enough revenue not only for covering operating expenses, but also for the capital costs of a regulated utility.

By that standard, the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit rating and to continue to attract capital.3 A long-term comparison of the rates of return on different sources of capital is shown in the Capital Market Line Figure 1, with data calculated by Morningstar. As shown, the data plots the realized rates of return from different investments versus their risk, as measured by the standard deviation of their returns. The resulting line demonstrates the relationship and positive correlation between risk and rates of return; investors require higher rates of return for an investment with more risk.

The return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit rating and to continue to attract capital.

Energy Roe


The Risk Premium Methodology, or analysis, is based on a comparison of allowed rates of return on equity from decided rate cases, as compared to various sources of debt capital and their corresponding costs. Like the Capital Asset Pricing Model, the risk premium methodology is an example of a build-up approach used to estimate a utility’s ROE. The cost of equity for a regulated utility (or any company) is composed of the following components:

The real rate of return
+ Inflationary return
+ Industry risk/return
+ Company-specific risk/return
+Other risks

Return on equity (ROE)

The examples in Figure 2 compare authorized ROEs of electric companies to long-term utility debt rates, between 2000 and 2018. As shown, the authorized rates of return on equity from various commissions are summarized into a quarterly authorized ROE on the vertical axis and are compared against the cost of utility debt (represented by Moody’s Utility BAA yield (“Triple B”) on the horizontal axis of the graph. In the lower right corner of the graph, the regression calculation is shown as a reference for all of the figures in this article. The first item of interest is that with a slope of approximately 35 percent, a utility’s allowed rate of return moves up and down at a slower pace as compared to changes in interest rates/debt costs.

Energy Roe

Although the data above illustrates the correlation between authorized equity rates of return and the cost of debt, it ignores “regulatory lag.” Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year. Therefore, it is more appropriate to compare the authorized ROEs from commission decisions with interest rates as of one year prior.


In Figure 3, the timing has been shifted to compare authorized rates of return with debt costs from one year prior.

Energy Roe

Regulatory lag reflects the fact that a utility will file a rate case at a certain point in time but will not receive a final decision, with an allowed rate of return, for a period of time, approximately one year.

Making this change to the “regulatory lag” timing assumed improves the coefficient of variability, or R-squared, of the analysis. In a “perfect world,” the R-squared from the analysis would be 1.0, indicating that 100 percent of the changes in authorized ROEs are due to changes in interest rates, but many other financial and economic risk factors exist. Considering the build-up approach mentioned earlier, a risk premium approach based on authorized rates of equity returns and utility debt costs would address the following return components:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes


Another debt index to consider is the cost of long-term US Treasury Bonds with a maturity of 30 years.4

Figure 4 is similar to the one based on Moody’s utility bonds, but it is “higher,” meaning it has a y-intercept that is 1.2 percent higher to account for the risk differential between risk-free Treasury bonds and a Triple- B utility bond index. The following are the build-up components for this analysis:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

Energy Roe

Although Figure 5 could be used to simply look up an implied ROE for a certain level of interest rates, some additional precision, and better correlation, can be gained by calculating the implied “premium” (the amount the authorized ROE exceeds the cost of debt) for each quarter and comparing that to debt costs 12 months prior. While the downward slope may look odd at first, recall that this is the equity premium, which is added to the cost of debt, to determine an implied return on equity. The downward slope reflects that as interest rates increase, the corresponding authorized returns on equity also increase, but at a lower rate.

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

A similar relationship is seen in the comparison of authorized rates of returns and utility bond yields in Figure 6:

A Review Of The Risk Premium Method For Regulated Electric Utility Roes


Combining the two methodologies above with current interest rates, these models suggest an equity rate of return in the range of 9.7 percent to 9.9 percent. As previously discussed, the risk premium approach is one of the methodologies considered to determine a fair return on equity for regulated utilities. However, it is important to note that this methodology has relative strengths and weaknesses, like all simplified financial models taught in academia. The risk premium analysis does a reasonable job of capturing real interest rates, inflation, and industry risk factors. However, to determine a credible conclusion for a fair ROE, more analysis is required.

A Review Of The Risk Premium Method For Regulated Electric Utility Roes

As illustrated in Figure 7, most of the data points lie within an approximate 125- basis point (1.25 percent) range around the trend-line indication. For public utility companies, these risks would be expected to reflect company-specific risk factors from their geographical concentration, state and federal regulation, and potential mergers and acquisitions, among other risk factors. For a utility that is not public nor owned by a public holding company, additional risk factors not reflected earlier would also need to be considered. The common stock of smaller private utilities is considered to be a riskier investment than a public utility’s stock, commanding higher returns from investors. Some of the key factors affecting this are a small utility’s lack of liquidity, less access to competitive debt financing, and geographical concentration, as well as company-specific factors such as aging infrastructure or litigation risk.


In summary, the risk premium methods discussed earlier provide a reasonable starting point for a utility’s ROE, but other risk factors and other financial models must be considered in concluding a fair return on equity for a utility. The analyses shown earlier provide another insight into what investors expect and what commissions authorize for allowed returns. Like all financial approaches to estimating an appropriate rate of return, however, this data and analyses are best considered in addition to other financial models.

1. Bluefield Waterworks & Improvement Company v. Public Service Commission of West Virginia, 262 U.S. 679, 692, 693 (1923).

2. Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944).

3. Ibid.

4. Although 10-year Treasuries are sometimes referenced, given the long-lived nature of utility assets, the longer-term bonds better match a utility’s underlying assets.

For more information, contact:

Brad R. Currey, CEIV, CFA

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Middle Market Private Equity M&A Activity – Q3 2018

Middle Market Private Equity M&A Activity – Q3 2018

Executive Summary

Average Valuations are Slightly Down

The aggregate EV/EBITDA multiple of 7.3x for Q3 2018 is in line with the multiples observed over the last few quarters, but valuations have tapered off compared to the 7.5-8.0x seen in the latter half of 2017.

Leaning Towards Conservatism

It appears that private equity firms are preferring to use less debt in their acquisition efforts.  Despite plenty of capital available in the leveraged finance market, total debt/EBITDA has decreased, and the percentage of deals using less than the maximum amount of leverage allowed is rising.

Headwinds for Sectors Trying to Stay “In Favor”

Technology and health care were once again leaders in terms of highest average valuations, but their multiples in 2018 are lower compared to last year.

Also of note is the media & telecom sector.  This industry had an average EV/EBITDA multiple of 8.2x in 2017 (second highest among all sectors) but sharply fell to just 5.0x in 2018 (lowest among all sectors).

Based on our review of GF Data’s latest M&A Report, Q3 2018 was a mixed bag of indicators for the private equity transaction arena.  63 transactions were reported by more than 200 private equity firms in the quarter.  This is an increase over the 47 transactions reported last quarter and the 53 transactions reported in Q3 a year ago.  However, total transactions are slightly down from the 71 and 67 that were reported in Q4 2017 and Q1 2018, respectively.  Just 177 transactions have been reported for 2018 thus far, so we will need to see a slightly faster pace if we are to keep up with 249 transactions reported last year. Middle Market Private Equity.

We also note that multiples, in terms of total enterprise value (EV) to EBITDA, were slightly down.  While two sectors reported higher multiples in Q3 than in Q2, most sectors declined.  In aggregate, EV/EBITDA multiples averaged 7.3x for Q3 2018.  This is down from 7.4x last quarter, 7.5x in the same quarter last year, and a high of 8.0x observed in Q4 2017.  Not surprisingly, targets with larger enterprise values were acquired at higher multiples.  In Q3, companies with enterprise values in the ranges of both $50-100M and $100-250M were acquired at 8.6x EBITDA, whereas companies in the $10-25M range were acquired at 5.8x EBITDA and $25-50M companies were acquired at 7.1x EBITDA.

Middle Market Private Equity

Industry Analysis

To get a better understanding of the mixed M&A trends, we took a deeper dive into the report and analyzed the various industry classifications of the acquisition targets. 

Middle Market Private Equity


Manufacturing valuations have largely hovered in the low-to-mid 6x range since 2014, although they have trended upwards in the past two years.  Recent EV/EBITDA multiples observed include 6.8x in 2017 and 6.9x in 2018.  This is in comparison to an average of just 6.3x from 2014 to 2016.  However, there has been an apparent drop in recent deal volume.  Only 56 transactions have been reported in 2018 thus far, compared to an average of over 100 from 2014 to 2017.  Time will tell if Q4 activity will pick up and get manufacturing M&A volume back to historical levels. 

Mergers And Acquisitions

Business Services

While the average EV/EBITDA multiple of 7.0x for 2018 dipped slightly compared to the 7.3x in 2016 and 7.4x in 2017, EV/EBITDA multiples for the business services sector are still higher than their 2014 to 2017 average of 6.8x.  As another positive, volume is up for this sector in 2018 with 48 transactions already reported through just three quarters compared to only 44 and 41 in each of the previous two years.

Mergers And Acquisitions

Health Care Services

Both M&A multiples and volume are down for the health care sector.  EV/EBITDA multiples have averaged just 7.5x so far in 2018.  This is lower than the 7.8x, 7.6x, and 8.1x multiples observed in the last three years.  Volume is also down, with just 19 reported transactions in 2018 thus far compared to an average of 24 over the past three years.  However, if Q4 can keep the same pace as the first three quarters, 2018 could finish in line with average volume. 

Middle Market Private Equity M&Amp;A Activity - Q3 2018


As of now, 2018 appears to be a lackluster year for M&A activity within the distribution industry.  The average EV/EBITDA multiple of 7.0x so far in 2018 is moderately lower than the 7.5x and 7.7x seen in 2016 and 2017, respectively.  Volume is also down thus far, with just 13 transactions reported in 2018 compared to twice as many (26) reported last year.  We still have one more quarter of data to digest, but with multiples and volume both appearing lower, we won’t be holding our breath for any magic in the distribution sector in 2018.

Middle Market Private Equity M&Amp;A Activity - Q3 2018


Retail showed signs of recovering with EV/EBITDA multiples of 7.0x and 7.6x in 2016 and 2017, respectively.  However, multiples have dropped to just 6.7x thus far in 2018.  On a positive note though, this is still higher than the EV/EBITDA multiples of 6.0x in 2015 and 5.5x in 2016.  Retail will be a key industry to watch regarding growth for the overall economy. 

Middle Market Private Equity M&Amp;A Activity - Q3 2018

Media & Telecom

At first glance, the media & telecom sector had a significant drop in its average EV/EBITDA multiple.  However, a closer look reveals that the average multiple of 8.2x for 2017 was largely inflated compared to the sector’s average EV/EBITDA multiple of 6.5x for 2015 and 2016.  This perhaps could have been influenced by numerous large mergers in the industry including Disney and Fox, AT&T and Time Warner, and others.

Middle Market Private Equity M&Amp;A Activity - Q3 2018


From 2014 to 2016, technology EV/EBITDA multiples averaged a respectable 7.7x.  Multiples then rocketed to an average of 10.2x in 2017.  It appears that this was not an anomaly as 2018 multiples have averaged 9.8x through Q3.  As “fin-tech”, cyber security, and data analytics continue to grow in popularity, we expect technology multiples to finish 2018 on a strong note and remain elevated into 2019.

Middle Market Private Equity M&Amp;A Activity - Q3 2018

Information in this article is based on the GF Data November MA Report dated November 19, 2018.  GF Data provides private equity sponsored merger and acquisition information for middle market companies with enterprise values between $10M – $250M.

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Maximizing Value Throughout the Business Life Cycle

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Maximizing Value Throughout the Business Life Cycle

Most business owners think about valuing their business and how to get the best deal when it’s time to sell.   While some owners consider their company’s value from inception, too frequently owners give no consideration to value creation until much later, often when it’s too late to affect value.  In fact, value is created from the design of the business plan all the way through the close of the final business sale.

This paper explores value creation and how valuation-centric analysis throughout the business life cycle not only maximizes value but compounds the effects of accelerating value. 

The graph below depicts the business life cycle and when cash flows are typically achieved. 

Business Life Cycle

Value is ultimately derived from the timing, amount, and risk of a business’s cash flows.  If an owner is able to shift the above graph, the rate of value creation is enhanced, improving and compounding the owners’ wealth both during and after the business is ultimately sold.

Cash Flow


I have seen untold business plans; some well thought out, some with massive holes, but few with good financial planning and modeling.  At the launch phase, valuations necessarily incorporate detailed projections of unit sales, pricing, cost, and infrastructure components.  This analysis helps answer many questions fundamental to a successful launch.  It also helps the owners understand the level of capital required, its likely sources, costs and possible dilution, and the timing and number of tranches that may be necessary.  A competent valuation will help attract capital, and at the lowest cost, in addition to “cleaning up” the plan and focusing Management on the most value-maximizing strategies.

Mistakes at this stage are costly, as restarting or re-engineering leaves investors and lenders with little confidence and ability to fund further.  The track record of the owner is negatively affected and often difficult to recover from.

Additionally, getting the capital structure right is critical at the start; there are no second chances here.  Options, warrants, preferred equity, and debt with privileges and features all have values and associated costs.  There is no way to understand the economic ramifications of these decisions without sophisticated modeling as component parts of the financial forecasts and expected ultimate sale.


Execution is critical during the growth phase as this is when a business model is perfected affecting many future years of financial performance.  The value drivers of the business start to come to light and modeling the effects of those drivers helps optimize strategies and the allocation of finite resources.  Scenario and sensitivity analysis aids in understanding the cash flow and value impact of dollar or percentage changes in investment and performance.  Anything short of detailed and creative modeling is guess work.  While intuition has its place, financial modeling offers a more consistent framework on which to build and understand value.

Strategic and growth planning is a dynamic process.  Marketing econometrics that lead to better and optimal strategies at this stage often have the highest return.  Additional capital raises may be required or desired.  Management planning, incentives and compensation analysis are often helpful during this phase.  Understanding the market price of these decisions is important to maximizing value.

Growth can be achieved many ways, but there are only two basic paths:  organic and acquisitive.  Both need to be examined as the “build versus buy” decision is almost always in play.  While investing and building operations is always a viable option, so is acquiring other companies that could accelerate growth or play a strategic role.  Valuation analysis is multifaceted here.  Value creation needs to be assessed based on the tradeoffs of the build versus buy decision.  By growing organically, an owner might take less risk, and better control growth and operations.  By acquiring, an owner hastens the growth of the company, creating business synergies and often bolstering investor returns.  The acquisition method, though, is somewhat riskier as each acquisition must have a strategic fit and be acquired at the right price.  Sometimes a single poor-acquisition can leave a young firm struggling not only to grow, but to survive.


This phase is often characterized by the entrance of new competitors, and while sales may be increasing, margins are sometimes squeezed.  As investments decline, cash flow may improve, and the owners may enjoy enhanced distributions.

The goals of valuation analysis in this phase are to tweak the business model, help in the planning process, and provide ongoing visibility via better decision-making tools.  This can be accomplished through updated valuations (typically yearly), capital structure optimization, and business optimization that often involves detailed data analysis of operations, pricing elasticity studies, or other metrics that can improve cash flow.

Additionally, financial planning and analysis (FP&A) tools and support are very useful in helping Management budget, plan, and make informed daily decisions.  The visibility gained by using this “dashboard” model has been quite instrumental in lowering risk and managing cash flow for many companies.


This life cycle phase may be the most relaxing but the least rewarding.  Too many competitors, too little growth, and declining profits often accompany this phase.  Cash flow is often flat as major investments are in the rear-view mirror.  Not a bad place to be unless you’re the type who needs to reinvent yourself, which sometimes happens.  Even so, valuation modeling can help extend the life cycle through better planning.

There may be transactions during this period with managers, outsiders (maybe taking a few chips off the table) or family, such as with children working in the business.  Valuations are needed for all these circumstances, and the IRS is keenly aware of “gifts” to children based on undervalued stock.

The maturity phase is also a good time for succession planning; predominately to understand the alternatives and the wealth ramifications of different strategies.  These strategies include leveraged recapitalizations, private equity investments, management buy-outs, and ESOPs.  No matter which strategy is selected, an analysis of exit-timing is instrumental to generating the greatest sale price for the business.


Few owners want to think about the exit because it triggers negative thoughts, not the least of which is one’s own mortality.  That said, leaving a legacy to its stakeholders is usually important.  But self-interest also dictates that owners receive the maximum benefits for their decades of hard work.  Performing analysis of value and understanding strategic value to acquirors may be the most important valuation undertaking over the life cycle.  Often, it’s the last chance to get it right.

Understanding strategic value is best accomplished through detailed valuation and synergy analysis, presentation decks, and effective financial and legal representation throughout the sale process.  Adjunct analysis can be informative as it includes an understanding of the after- tax wealth differences between various deal structures.  Hopefully, some of the measures during the earlier phases have been completed making the exit more effective and rewarding.  The sooner owners understand the drivers of value and how to promote those assets most efficiently, the greater the value seen at exit.

Hopefully, this paper has highlighted that valuation is far more than appraisal.  It’s about value creation and its many forms.  Utilizing these tools over the business life cycle can accelerate and improve the business, while creating additional wealth to its owners and stakeholders.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.


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