the buyout of energy future holdings

8/13/2019 The Buyout of Energy Future Holdings

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The biggest buyout in the history of Finance – Today a Bankruptcy

Saga



What’s an LBO? An LBO is way to buy a company with funds that are nearly all borrowed, either through

debts or bonds. In many cases the assets of the companies acting as a collateral to those

debts.

E.g. If Nestle wants to buy Amul , but does not have enough money it can raise debts from

the market and later sell Assets of Amul to pay-off those debts in case when it cannot pay

them through the combined cash flow of both the companies. Thus Amul will essentially be

the one to go bankrupt.

What’s a Private Equity?

It consists of investors and funds that make direct investment into private companies or

buys majority shares of public companies from the eventually results in a delisting ofpublic equity. Capital for private equity is raised from retail and institutional investors,and can be used to fund new expansion and growth strategies or to strengthen itsbalance sheet.

Once a balance sheet is strengthened the Private Equity players exit from the companyselling its assets and pockets the profits.

There is no emotion involved, no buzzwords like consumer-focus or brand equity, it ispure capitalism.

What is the Difference between a Buyout and a leveraged Buyout?

In a buyout or a management buyout the management of the company retains its control

and rather takes it away from the public. They usually do this when they see that the stock



market is not doing enough justice to the fundamentals of the company and this is a good

time to consolidate control and rejuvenate the business.

In a leveraged buyout however the PE firm that arranges the funds also aims to take control

of the company. While a MBO is done to rejuvenate the company, a LBO deal is done with

the relentless pursuit of profit and can even mean liquidation of the company to pay off thedebt obligations that were procured during the buyout. Most PE investments are highly

leveraged and raise money from high risk instruments and junk bonds.

Major players in the PE business

Private equity companies hire the best brains and continue to attract the best talents. They

hire fresh graduates from top B-Schools and experienced professionals from top investment

banks.

The biggest players in the PE market are, Kohlberg Kravis and Roberts (KKR); Blackstone;TPG Capital and Carlyle Group to name some major ones.

Now comes the deal

Who are TXU CORP.?

TXU Corp or Energy Future Holdings as it is known today is an energy utility company,

headquartered in Texas. The company derives bulk of its profits from coal and nuclear

power plants and was instrumental in pegging the utility prices to the natural gas prices.

Why TXU Corp. went for a LBO?

TXU Corp. carved out its main energy producing subsidiary, TXU Energy back in 2002. After a

series of deals in Europe that did not pan out, TXU Energy and its parent company found it

hard to carry their debt. DLJ Merchant Banking came in with a $750 million investment in

TXU Energy. A few months after the transaction, Warren Buffet bought one-third of DLJ's

stake for $250 million, a clear testament to the value proposition in the energy sector. At

some point, DLJ exited this investment and earned a pretty penny for bailing TXU out.

In 2007 TXU was again faced with a crisis keeping the companies financials in place and thusstuck the LBO deal under which the CEO of the company John C. Wilder will continue to

manage the company. Although TXY Corp had a problem with managing its finances its

overall business prospect was fine. Not many healthy companies want to sell themselves;

most would prefer to use their capital to buy other companies. However, in TXU’s case, CEO

John Wilder’s compensation package is maximized if the company shares are acquired at a

premium. Moreover at the time of buyout the market cap of TXU Corp. was $27.5billion

with $12.3 billion in debt. A $47billion bid for the company was nothing but a money

machine for the existing shareholders.

Why Goldman Sachs came into the picture?



The size of the TXU Corp, LBO deal was around $47Billion. It is impossible for any individual

player to arrange for so much of funds. Thus any LBO deal is initiated by a PE player and

backed by an investment bank. In this case it was collaboratively initiated by KKR and TPG

the PE players and Goldman Sachs as the investment bank. LBO deals require a lot of hedge

funds and junk bonds and Goldman Sachs was the leader in hedge funds in general and fuel-

price hedging in particular.

The deal also indirectly involved Citi, JPMorgan Chase and Credit Suisse who sold loans of

TXU corp. to help finance the private equity. Thus in a way the deal involved the very best

and brightest of Corporate America.

Why KKR and TPG were interested in buying TXU?

Energy is a classic buyout category and being highly value driven has always attracted the

eyes of investors. Although TXU Corp had a problem with managing its finances its overallbusiness prospect was fine, the generation business of TXU was highly promising and under

the leadership of its CEO the stock prices moved from $5.44 in Oct 2002 to $60 in 2007.

Thus it proved to be a sound investment plan for a PE firm. These firms usually stay invested

in highly volatile securities thus having a low-risk profitable firm like TXU would only hedge

them against bad times. This is what made them agree to pay so much for the company and

go ahead with the deal. TXU Corp was bought at 15% premium above its share price and 8.5times EBITDA (earnings before interest, tax, depreciation and amortization).

The deal was blessed by the regulators

TXU Corp. had plans to go ahead with opening of 11 new coal plants to meet the growing

needs of power and this decision faced huge backlash from the environmental activists as

well as regulators. The LBO deal promised to close down eight of these plants and

supported the mandatory emission and production limits as per environmental safeguard

thereby environmental activists pushed and even lobbied for the deal. The deal also

proposed to reduce the utility charges by 10% thus earning the blessings of the regulators as

well who saw high value in public cost saving.

Never before had an LBO earned so much support from the government that it appointed JamesBaker III, the former secretary of State as the advisory chairman.

As the saga unfolded

The deal agreed to split the original company into three units, power generation will be handledby Luminant Energy, transmission and distribution will be developed by Oncor Electric deliveryand TXU Energy would manage the company’s retail electric business.

The structure of the deal includes a $33billion buyout of TXU equity and $12 billion in existingdebts. To finance the same the buyers contributed $8.5billion in equity and $24.5 billion in debtthus the deal had around 80% in debt and 20% in equity.

Although this kind of structure is very common in a LBO and even in some cases the debt-equityshare is 90%-10%; for a company like TXU Corp. which was already operating at 0.85 debt to



equity ratio, such a move raised questions like where these loans will be placed in a companythat is already overleveraged.

How the credit rating agencies viewed the deal?

Immediately after announcement of the deal the credit rating agency S&P downgraded the TXU

debts to below investment grade expressing concerns over the highly leveraged structure. It alsoput it on a credit watch with negative implication.

The primary reasons cited were the promise by the buyers to reduce prices which would reducecash flow and exposure to huge amounts associated with the plan to drop eight coal-poweredplants and along with it a declining customer base of TXU.

Moody argued citing compromise on bondholder’s interest and found the deal risky and viewed itwith scepticism.

Fitch argued that that resulting company would cause a substantial indebtedness and alsoquestioned the strategic direction of the company as well as likely changes in the corporate

structure and how the firm would continue its financial practices after the deal.

Usually PE firms employ a massive cost cutting strategy after acquiring a company, in the energyutility sector however such a strategy may imply a compromise on safety and dependability of thedelivery.

Investment objectives of all PE firms are with an objective to maximise the investment and profitfrom the company and is believed to have no respect for values. Even the cost saving to thecustomer which was promised was required till 2008 after which the firms were free to raise theprices, many saw it as a ploy by the buyers to increase the customer base and the hiking theprices. The electrical utility industry is crucial to the growth of the economy and thus operating iton a soul motive to drive profits can have major repercussions on the society, thus the regulators

should have been prudent in ensuring that such a play not only benefits the buyers but is in theinterest of society’s long term interest.

Because of the sheer size of the deal, the largest PE buyout in history the deal should haveinvolved a lot of other stakeholders who should approved agreements reached between theCommission and the buyers.

In order to ensure that the buyers actually delivered on their promise, it was mandated to remainunder the public utility company of Texas.

What drew Warrant Buffet into the deal?

As stated earlier, despite the size of the deal investors saw the company as an extremely good

investment option. Berkshire Hathway had earlier purchase stocks in TXU when it appearedclose to bankruptcy and the sold it at hefty profits in 2004.

This time Buffet was offered two bond issues, one was $1.1 Billion purchase of 10.5% bonds at95 cents on the dollar and another $1 billion of PIK-Bonds for 93 cents on the dollar. The drawingof Berkshire Hathway generated huge confidence among the investors and helped in furtherprocuring of cheap debt.

What’s so much about these Junk Bonds?

Junk bonds are bonds issued by companies whose ratings are lower than BB, the high return isattributed to the weak underlying fundamentals of the company that makes it highly susceptible

to defaults and hence investing in bonds is referred as junk investment and the bonds as junkbonds.



LBOs use junk bonds as a cheap source of raising capital and it is specifically because of thishigh exposure to junk bonds that acquisition by a PE player is viewed with a great scepticism andcaution.

Raising money through junk bonds mean two things:

1) The company is highly risky and can default on its bond payments , thus at the outset ofthe purchase the PE firms project the company as risky

2) Even if the PE firms are able to turn around the company they need to pay big interestamount from the cash flow of the company to its bondholders thereby lowering its profits

In most of the cases however PE firms exit the company before the repayment period is reachedand thus save themselves from the burden of paying the returns to the bondholders.

This entire junk bond thing thus places the LBO market on a morally wrong footing.



A SPELT Analysis of the deal

The giant deal as it stands today:

Unfortunately the deal materialised in Oct 2007 and in the very next year the world was to seethe greatest financial crisis after the Great Depression of 1929.

Despite involving the best brains of corporate America, KKR, TPG and Goldman Sachs couldonly recover 3% of their investments and the company as it stands today would file for theChapter 11 Bankruptcy next month.

The deal was primarily based on rising gas prices instead the gas prices fell post 2008 crisis anda hydraulic fracturing created a surge in US Gas supplies. The company registered 10 straightquarterly losses since 2011 and Warrant Buffet was to quote the investment as one the biggestmistakes of his company. The bankruptcy filing would be the fifth biggest non-financialbankruptcy in the world.

What is the insight from here?

The best brains of corporate America took a company that was started in 1882, soon after theinvention of incandescent light bulb to a bankruptcy. It is a lesson for all of us as buddingmanagers to see where our goal lies in striking an investment deal. There was no question on

the planning and execution of the deal but what it lacked was care for the society and was thusnot sustainable. Sustainable leadership in the world of Finance is hard to learn given the models

Social: The new owners were the PE buyers who are unlikely to invest in transforming the assets of the

company and further opening it to public for an IPO and therefore long-term interest of the society is nevera consideration in the deal

Political: Government and regulators would need to prove their reliability by sticking to the commitmentsof scrutinising the company. Many political players were not in favour of splitting the company howevermassive lobbying by TXU and the buyers helped defeat all bills that were passed in this regard. Perhapsseen with a clarity of hindsight the lawmakers lacked the political motivation to have a fight with thelobbyists.

Environmental: This deal was hugely favoured by the environmental activists seeing the benefits from theenergy savings associated with closing of coal plants. In fact the buyers took some major initiatives like joining the US Climate action partnership, supporting a mandatory cap and trade system of carbon

emission, tying up executive compensation and performance goals to climate protection goals that laterwent on to become the benchmark of the industry.

Technological: TXU was attractive for its large fleet of power plants and having technological systems inplace to run them at low cost. Technological innovations post buy-out were mainly directed in a way so asto maximise profits and create cost reduction and synergies. Further technological developments wereimplemented on the suggestion of energy advisory board.

Legal: Legally the deal was made full proof by splitting the business into three, although it was done onthe pretext that the customers would be saved from market manipulation and the new system wouldenhance transparency and accountability, the underlying idea was to provide the buyers with a flexible exitstrategy that would help them to sell the business in parts as and when they intend to realize return fromthe LBO investment.



and case studies we learn are mainly developed out of the Game of Greed practiced inCorporate America. But as Dylan said the’ times they are a changing’ , there will be a changewhere Finance caters not only to the 1% but to the whole 100% of the Globe.

References:

http://www.fortnightly.com/fortnightly/2007/04/view-txu-leveraged-buyout?nopaging=1

http://www.thestreet.com/story/10383767/1/txu-debt-sale-set-for-monday.html

http://understory.ran.org/2007/02/26/txu-buy-out-and-what-happens-next/

http://www.purevc.com/pure_vc/2007/03/the_txu_buyout.html

http://money.cnn.com/2007/02/26/news/companies/txu/index.htm

http://news.bbc.co.uk/2/hi/business/6397365.stm

http://www.marketwatch.com/story/txu-agrees-to-45-billion-buyout

http://www.intelligentinvestorclub.com/news/warren-buffett-buys-2b-worth-of-txu-bonds

http://salon.glenrose.net/?view=plink&id=12483

http://www.reuters.com/article/2007/02/26/us-txucorp-takeover-kkr-idUSWNAS203120070226

http://www.nytimes.com/2007/09/07/business/worldbusiness/07iht-txu.4.7423643.html?_r=0

http://www.cnbc.com/id/17302992/





































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