SHEDDING LIGHT ON THE FINANCIAL STRUCTURE OF THE LIPA/LILCO PROPOSAL

The Long Island Lighting Company (LILCO) has reached an agreement in principle with the Long Island Power Authority (LIPA) on a corporate restructuring plan. Under the plan, LIPA would acquire LILCO through a leveraged buy-out, in which borrowed funds finance a takeover, and the cash flow of the acquired company is used to repay the debt. LIPA plans to issue tax exempt municipal debt to accomplish the transaction. The financial structure of the deal includes the following:

• LIPA would issue new bonds in the amount of $7.594 billion through multiple offerings. The financial deal, if issued at once, would constitute the largest municipal debt ever issued in the nation.

• LIPA's initial debt profile would be $8.07 billion, which includes $476 million in debt assumed, but not refinanced, from LILCO. LIPA also plans to issue bonds for capital expenditures over the next ten years. LIPA will either assume without refinancing or issue new debt totaling over $9 billion.

• If LIPA elects to purchase LILCO's generation assets, LIPA's total debt would rise further.

• Over the term of the bonds issued during the first 10 years, debt service payments would total $23.446 billion, including $14.301 billion in interest and $9.145 billion in principal.

• Each customer would pay approximately $23,000 in total debt service over the life of the bonds, including $14,000 in interest and $9,000 in principal. Each of LIPA's customers would effectively pay an average of $400 in interest per year over the next 35 years.

• LIPA effectively borrows $502 million in its first two debt issuances to be repaid over the next 35 years to subsidize rates over the first ten years.

• LIPA's obligations are projected to exceed its revenues by over $1.322 billion in the third through the tenth year. Covering this deficit requires utilizing funds that would otherwise have reduced the need for borrowing.

• On average, LIPA will only finance 20 percent of its total capital improvement needs over the next 10 years with internally generated cash. In contrast, LILCO has funded all of its capital improvement needs over the last few years with internally generated cash.

• The value of the fixed assets to be purchased by LIPA represents only a quarter of the overall purchase price. Consequently, bondholders will be unable to secure their position with collateral, as is generally becoming commonplace in the industry, and will look for alternative forms of security.

DESCRIPTION OF LIPA PROPOSAL

The major components of the proposed purchase transaction include the following:

• LIPA would initially issue $7.594 billion in tax-exempt municipal bonds (see Table 1 for details related to the use of bond proceeds), in multiple offerings.

• LIPA would use $2.837 billion in bond proceeds to acquire LILCO's common and preferred stock.

• Acquisition of stock by LIPA would represent ownership of transmission and distribution, nuclear, regulatory and other assets. LIPA would settle the Shoreham property tax certiorari litigation as part of the deal.

• LIPA would assume $3.684 billion of LILCO debt, of which $3.208 billion would be refinanced with bond proceeds.

• LILCO would receive $2.5 billion in cash from the transaction.

THE SIZE OF THE LIPA PROPOSAL

Many different numbers have been used to describe the magnitude of the proposed LIPA buy-out of LILCO. Public discussions and press accounts of the deal have revealed numbers in the range of $6 billion to $8 billion, with $7.2 billion and $7.3 billion among the most commonly quoted amounts.

Table 1 provides the reader with a detailed description of the amounts LIPA proposes to borrow over the next ten years to effectuate the deal and provide rate savings through the new capital structure.

The Table first identifies the uses of LIPA's initial new borrowing of $7.262 billion (the number most commonly referred to in descriptions of the deal), which would take place through three bond issues and would allow the initial purchase transaction to take place. The bond proceeds would be used to purchase common and preferred stock of LILCO, as well as to refinance $3.208 billion out of the $3.684 billion debt which LIPA would assume from LILCO. In addition, the proceeds would finance the first payment related to the Shoreham tax settlement and capital expenditures for the first year. Table 1 also includes future borrowing necessary for the functioning of the transmission, distribution and nuclear assets to be acquired by LIPA.

As part of its deal with LILCO, LIPA would settle the Shoreham property tax litigation. The Shoreham property tax settlement would involve additional bonding over the four years following the initial debt issuances, bringing the total new LIPA debt to $7.594 billion¹. Also, as part of the $3.684 billion in debt assumed by LIPA from LILCO, $476 million would not be refinanced. As Table 1 demonstrates, the addition of this assumed debt increases LIPA's initial debt profile to $8.07 billion.

The total proposed LIPA debt, as depicted in Table 1, would rise to $9.145 billion, due to LIPA's plan to issue $1.075 billion in bonds over the next ten years to finance capital expenditures. Additional debt would be incurred by LIPA, if it decides to exercise its option in the fourth year to purchase LILCO's generation plants. LIPA might also incur debt if, as part of its fifteen year power supply contract with LILCO, it chooses to reduce the amount of power purchased from LILCO in year seven, in which case LIPA would be required to pay a percentage of the present value cost of the remaining capacity charges.

DEBT SERVICE COSTS OF THE LIPA BONDS TO RATEPAYERS 

Figure A depicts the debt service profile on the initial $8.07 billion in LIPA debt, necessitating revenue requirements be charged to ratepayers over the next 35 years. LIPA's ratepayers will pay a total of $12.94 billion² in interest on this initial debt over the life of the bonds. This initial debt service profile translates into each customer on Long Island paying almost $13,000 in interest and approximately $8,000 in principal.

Under LIPA’s financing proposal, which structures the repayment schedule to produce levelized annual payments, annual debt service would plateau at $625 million after the tenth year on the initial $8.07 billion in debt. The profile indicates that no principal would be repaid in the years 1998 and 1999, limiting debt service payments to $492.5 million in interest only. Between years two and three, debt service increases by over $78 million, reflecting the repayment of principal. During the ensuing years, LIPA's rates will reflect even higher debt service requirements as a result of the delay in principal repayment.

Under the LIPA plan, additional borrowing would occur at a faster rate than the repayment of principal during the early years. Even after the second year, when LIPA starts to repay principal, total outstanding principal continues to increase due to the issuance of bonds for the Shoreham property tax settlement and capital improvement expenditures. Under this plan, a total of $9.145 billion in bonds would be issued over the initial ten years.

Figure B shows the total proposed LIPA debt service profile for $9.145 billion in bonds. This profile includes the $1.075 billion in debt to be issued for capital expenditures as noted above and in Table 1. Figure B provides a more complete picture of the annual debt service requirements of LIPA’s plan in the first ten years, showing annual debt service will exceed $700 million in the tenth year.

Furthermore, the debt service profile presented in Figure B does not include additional bonds that may be issued for capital expenditures over the following 25 years. To service LIPA's total proposed debt, each customer would effectively pay an average of $400 in interest per year over the life of the bonds.

DEBT SERVICE REVENUE REQUIREMENTS

The proposed LIPA transaction attempts to support reductions in rates for the service territory over the next ten years. To a certain extent, it appears that this results in LIPA issuing more debt than is absolutely necessary during the period. LIPA’s documents include a projected ten-year "revenue requirement schedule" consistent with these rate reductions, which indicates that LIPA's obligations will exceed its revenues by over $1.322 billion in the third through the tenth year (see Table 2). LIPA avoids revenue shortfalls in the first and second years by shifting the repayment of $150 million in principal on the bonds to the remaining term of the bonds.

Source: Long Island Power Authority

Part of the financing of the fund comes from diverting $284 million in cash receivables and $40 million in operating surpluses, generated at least in part, by not repaying principal on LIPA’s debt in the first two years. Much of the revenue in the fund comes from cash made available from debt service coverage requirements that are collected from ratepayers, but presumably will not be required to meet debt service payments. These revenues serve to cover the deficit which would otherwise require LIPA to charge higher rates.

In its first two bond issuances alone, LIPSA borrows slightly over one-half billion dollars for such items as working capital and capital improvements that could have been funded with cash assets accumulated in the fund during the first two years. As a result, LIPA effectively borrows $502 million to be repaid over the next 35 years to subsidize rates over the first ten years.

The net cost of this additional borrowing to ratepayers will exceed $560 million in accumulated interest charges over the term of the bonds after subtracting $138 million in interest earnings that are deposited in the fund for rate relief. These interest charges are included in the total $12.94 billion in total interest charges on the initial issuance.

To minimize revenue requirements for capital improvements to plant and equipment in the first ten years, LIPA will issue over $1.075 billion in additional bonds, as shown in Table 1. Consequently, LIPA will only finance, on average, 20 percent of its total capital improvement needs over the first ten years with internally generated cash.

In contrast, LILCO has funded all of its capital improvement needs over the last few years with internally generated cash. Absent the proposed deposit of cash freed from debt service coverage requirements into the rate stabilization fund, LIPA could fund its capital improvement needs without additional borrowing. As a result, ratepayers will pay $1.361 billion in interest on the issuance of $1.075 billion in bonds over the 35 year life of the bonds, placing upward pressure on rates after the rate stabilization fund is depleted in year ten.

In addition, LIPA's rate reduction based upon reduced capital costs will decrease the amount of cash available to retire outstanding bonds. Over the past four years, LILCO has reduced its debt on average by $250 million per year. In contrast, LIPA will stop repaying principal on its bonds in the first two years, with principal repayment only rising to $250 million twenty years later.

THE SIZE OF LIPA'S DEBT COMPARED TO OTHER MUNICIPAL DEBT

The ability for the municipal bond market to absorb the issuance of $7.262 billion over twelve to eighteen months has been noted by many financial experts as problematic. A single large bond deal has the potential of crowding out other municipal bond issuers, driving up interest rates and increasing costs to taxpayers. Investors could also be adversely impacted by such a large issuance, as the influx of bonds from the massive issue drives down the price of other currently outstanding municipal debt from the influx of supply. LIPA does propose to address this problem by issuing the debt in three offerings.

In perspective, LIPA's $7.594 billion in initial debt, if issued at one time, would dwarf all other long-term municipal bond issues ever sold in this country. Figure C compares the new LIPA debt required to effectuate the leveraged buy-out of LILCO to the five largest long-term municipal bond issues in the history of the nation. This total initial financing level would be four times larger than the average of the five largest municipal issues ever sold.

Additionally, the $7.594 billion in new LIPA bonding would represent almost five percent of the total $159 billion municipal volume for 1995, the most recent year for which complete data are available. Compared to other electric power issuers, the proposed LIPA financing level exceeds the $5 billion total financing amount for the entire industry in 1995 by 50 percent and exceeds the largest issue for a single utility company in that year by a factor of seven.

In an effort to ensure that the municipal bond market is able to absorb $7.594 billion in new bonds without significant difficulty, LIPA would sell three separate bond issues and spread the issuance of bonds for the remaining $332 million related to the Shoreham property tax litigation over four years.

RATEPAYERS BEAR THE RISKS IN THE LIPA DEAL

Bondholder Protections

The heavy reliance on debt by LIPA and the overall structure of the LIPA deal increases the underlying risk. Because the value of the fixed assets to be purchased by LIPA represents only a quarter of the overall purchase price, bondholders will be unable to secure their position with collateral, as is generally becoming commonplace in the industry. As a result, LIPA includes in its initial bond issuances $674 million to provide bondholders with the following protections that limit their risk exposure:

• bond insurance on $1.3 billion of the initial $4.3 billion issuance costing LIPA $34 million; and,
• a debt service reserve fund, which is common practice with public authority bond issues, totaling $640 million.

LIPA will also commit to bond covenants requiring the collection from ratepayers of an additional 20 percent of both annual debt service payments and payments in lieu of taxes to insure repayment of the bonds. In addition, bondholders may require bond covenants that restrict LIPA's operating or financial activities over the life of the bonds to limit potential out-year risks.

Revenue Risk Exposure for Ratepayers

Achieving investment grade rating on LIPA's bonds will not only rely upon the implied guarantee of a State public authority but will depend more directly on LIPA's ability to impose adequate rate tariffs on customers. The existence of a "true-up mechanism" will be the principle credit enhancement that will adjust rates to compensate for any shortfalls in revenues necessary to meet LIPA's obligations. LIPA's ability to collect amounts necessary to satisfy its financial obligations in the form of a line charge protects the bondholders, but exposes the ratepayers to "revenue risks" resulting from many factors. The following revenue risks may undermine the sustainability of any rate reduction.

Revenue Risk From LIPA's Capital Structure

Unlike LILCO or other electric utilities, LIPA's financial structure will consist entirely of debt. If for any reason, LIPA is unable to satisfy its commitment to bondholders to pay debt service on its bonds, LIPA will have no alternative but to raise rates. LIPA, unlike an investor-owned utility, will be unable to reduce capital costs by reducing stockholder dividends during periods of financial distress. Consequently, Long Island ratepayers will be vulnerable to volatile rates resulting from unforeseen business conditions.

Revenue Risk From Competition

Increased competition both within the electric industry and between gas, oil and electricity would enhance customer choice and reduce consumer energy bills. However, it will exacerbate the risk to electric ratepayers, because LIPA would not end up owning electric generation or gas assets. These assets remain with LILCO, and LIPA proposes only to contract for power from these sources. If a proposed merger between LILCO and Brooklyn Union Gas is achieved, expansion of natural gas as a competing energy source may increase the risk of revenue loss from reduced demand for electricity.

Not only would LIPA forgo enhanced revenues from the sale of natural gas by not owning the gas assets, but LIPA would also realize an erosion in its electric revenues as natural gas displaces electric use for certain functions, such as heating. The inability for LIPA to spread its fixed capital costs over a larger customer base could result in higher rates for electric ratepayers.

Revenue Risk From New Technology and Energy Conservation

The technology of electric power generation is continually evolving and the state-of-the-art power generation technology existing ten, twenty or thirty years from now cannot be reasonably predicted. Technological advances in electric generation offer potential environmental benefits and a promise of consumer savings. Although these represent positive developments, LIPA may be exposed to significantly increased incidence of customers getting power by means other than purchase from LIPA. This increased risk will place upward pressure on rates to cover LIPA's fixed costs.

In addition, aggressive energy conservation efforts offer an alternative way to lower total energy costs for consumers. LIPA's allocation of $33 million for energy conservation and advocacy (see Table 1) could provide substantial benefits to ratepayers. However, LIPA's success may inadvertently increase the risk of eroding LIPA's revenue base. A reduction in revenues from reduced electric demand may not be offset by the projected expansion of the customer base and the related increased electric sales. As a result, the rate tariff would have to be adjusted upward to make up for lost revenues in order to meet LIPA's financial obligations.

Taxpayer Risk

Statewide, New York State taxpayers may be exposed to a risk of paying higher costs of capital associated with other municipal bond issuances. The Wall Street Journal has reported that major municipal bond issuers have expressed concerns that the proposed LIPA bond issue could crowd out other municipal bond issues. "Taxpayers nationwide, but mainly in New York state, could have to fork over additional borrowing costs through higher interest rates on their debt in order to entice new investors amid the potential flurry of new issuance."³

In the out years, taxpayers may also be exposed to the risk of default in the event ratepayers cannot repay the bonds. This risk is true for any debt issued by a State public authority.

1. A plan put forward in Suffolk County to finance bonds through increased sales taxes would obviate the need for LIPA to issue bonds for the Shoreham settlement.

2. The debt service costs discussed in this paper are based upon repayment schedules provided by LIPA. The informatin provided by LIPA makes certain assumptions about interest rates which could either increse or decrease debt service payments depending upon market conditions at the time of bond issuance.

3. Charles Gasparino, "Muni Market Faces Turmoil from Megadeal," Wall Street Journal, April 22, 1997.