A Record Buyout Turns Sour for Investors
Struck at the peak of the buyout boom five years ago, the $45 billion acquisition of the Texas energy giant TXU — the biggest leveraged buyout in history — has been a painful investment for its private equity owners.
They did not need Warren E. Buffett to remind them how bad things were.
America’s most famous investor, in his annual shareholder letter on Saturday, highlighted his $2 billion wrong-way bet on the bonds of the company, which its new owners have renamed Energy Future Holdings. He called the investment “a big mistake” and said it was at risk of losing all of its value.
“In tennis parlance, this was a major unforced error,” Mr. Buffett wrote.
Mr. Buffett’s grim view of his Energy Future Holdings position underscores the troubles facing the Texas utility, which is owned by a group of private equity firms led byKohlberg Kravis Roberts, TPG Capital and the buyout arm of Goldman Sachs.
Last week, Energy Future Holdings reported a 2011 loss of $1.9 billion amid record low natural gasprices. Its retail business has lost about 17 percent of its customers over the last three years to cheaper rivals. Worsening the company’s weak financial performance is its prodigious debt load of $35 billion, most of which was added to the balance sheet to finance the buyout.
Energy Future Holdings was the biggest of the so-called megabuyouts — huge deals struck during the market boom of 2005 to 2007. After the financial crisis hit, it seemed that these deals were destined for bankruptcy.
Instead, most of them — a group that includes and Caesars Entertainment — have made it through the downturn, though the investment returns on these deals are expected to be modest. A few, like the hospital chain H.C.A., have earned big profits.
Not so with Energy Future Holdings. For now, the $8.3 billion in equity invested in the deal by the private equity owners has been all but wiped out on paper. K.K.R. is holding its Energy Future Holdings investment at 10 cents on the dollar, or down 90 percent, according to its latest securities filing.
Allan Koenig, a spokesman for Energy Future Holdings, defended the company. He said it was operating extremely well across all of its businesses, had increased its employment by 25 percent under private equity ownership, and was hedged against low natural gas prices this year. The company’s weak financial performance won’t cause any defaults on its debt obligations, he said, because it has restructured its balance sheet so the first maturities on its bonds do not come due until 2014.
Yet a growing chorus of analysts and bond investors is skeptical of Energy Future Holdings’ ability to survive under its current debt-heavy capital structure. The company’s bonds are trading at deeply distressed levels that suggest a high likelihood of default. Energy Future Holdings bonds due in 2015 recently traded at 28 cents on the dollar, offering a yield of 60 percent.
“If natural gas prices remain low, there is no way this can work in the long run,” said Peter J. Thornton, an analyst at KDP Investment Advisors.
Energy Future Holdings has avoided deeper problems by tapping the hot market for high-yield debt, or junk bonds. With the Federal Reservesignaling low interest rates into 2014, investors are shunning Treasuries and pushing into riskier bonds that pay higher yields.
This has allowed troubled companies like Energy Future Holdings to raise money in the bond market. In recent weeks, the company raised about $1.1 billion in high-yield bonds in part to repay loans that it owed to one of its subsidiaries.
But Mr. Thornton, the KDP analyst, said that repeatedly tapping the bond market to raise new funds was a Band-Aid solution to a larger problem.
“It seems to us that they’re effectively borrowing more now to increase cash and be able to pay interest in the future,” he said. “That’s not a good long-term strategy.”
The TXU takeover, which was announced in February 2007, was not supposed to turn out this way. A storied century-old business originally called Texas Power & Light, TXU was one of the most profitable utilities in the country. It operated in the large and deregulated Texas electricity market, with holdings that included the state’s biggest power-generation business and largest electricity retailer. And as the economy boomed, demand for electricity rose.
It was such a promising deal that several of Wall Street’s largest banks — Lehman Brothers and Citigroup among them — invested alongside K.K.R. , TPG and Goldman .
The new owners recruited several Texas power brokers to join Energy Future Holdings and help the heavily regulated utility with government relations. They named as chairman Donald L. Evans, the former commerce secretary under President George W. Bush. James A. Baker III, a senior official in the Reagan and Bush administrations, was named advisory chairman.
While Mr. Evans and Mr. Baker have assisted the company on political and regulatory issues, they have no control over the price of natural gas, which has fallen since the buyout, putting pressure on the price of wholesale electricity.
U.S. Natural Gas Exploration
Natural gas prices dropped to a 10-year low of $2.32 per million British thermal units last month, from about $13 during the summer of 2008, mainly because of an unusually warm winter. Andrew DeVries, an analyst at CreditSights, estimates that natural gas needs to reach a price of at least $6.15 for Energy Future Holdings to break even after its interest payments and other expenses.
Consensus expectations put long-term natural gas prices between $4.50 and $5, according to the futures market and an average of Wall Street analysts estimates as compiled by Bloomberg.
“The low price of natural gas provides a significant challenge for the company,” John F. Young, the chief executive of Energy Future Holdings, acknowledged in the company’s earnings call last week.
One reason for the plummeting price of natural gas has been the sharp rise in domestic natural gas exploration, which has created more supply. Extracting natural gas from shale, through a controversial process called hydraulic fracturing, or fracking, has created a drilling boom in the United States.
K.K.R. and TPG have benefited from the shale exploration boom in other areas of their private equity portfolios. K.K.R., for example, has had success investing in so-called shale plays. Beginning in 2009, the company placed two bets on natural gas exploration companies. It has since sold those investments, making billions in profit that offset the paper losses in Energy Future Holdings.
Those profits will not help the owners of Energy Future Holdings bonds, who would normally be among the first in line to recouping their investments in a restructuring. But given the company’s dim prospects, even bondholders are worried. Mr. Buffett, the company’s most prominent bondholder, said in his annual letter that unless gas prices rose substantially, the company’s ability to pay interest on its bonds would soon be exhausted.
“Before the leveraged buyout, this was a highly profitable utility,” said James Hempstead, an analyst with Moody’s Investors Service. “Five years later, the company finds itself in deep financial distress with an untenable capital structure. The game may not be over just yet, but the prospects don’t look so good.”