A lot of banks and big investors got burned in the bankruptcy last week of Energy Future Holdings, a Texas electric utility that in 2007 had been acquired for $45 billion in one of the largest leveraged buyouts ever. ¶ But the private-equity folks who put the deal together, thanks to fees and tax deductions, will walk away virtually unscathed and possibly slightly ahead. ¶ This leveraged buyout bust is partly an age-old tale of crushing debt. To seal the deal, three high-flying private-equity firms — KKR, TPG Capital and Goldman Sachs Capital Partners — piled about $25 billion of new borrowing on top of the utility’s existing $13 billion of borrowings. Now Energy Future is staggering under a mountain of debt, even though the company’s assets are worth far less. ¶ “In the 12 months ended in September, 46 percent of Energy Future’s sales went to pay debt interest,” Bloomberg news reported, based on data Bloomberg had compiled. ¶ The leveraged buyout is also a tale of impeccably bad timing and poor judgment about the energy business. The private-equity firms used information from the past in looking at Energy Future. And when the deal was done in 2007, the future was about to change for utilities.
The now well-known explosion of shale gas discoveries was just beginning that year, and some of the most prolific shale formations turned out to be in Texas. The boom in cheap natural gas undercut the company’s coal and nuclear power plants. A collapse in the economy and gains in energy efficiency lowered electricity consumption, even though industry experts had forecast modest but steady growth. And a growing number of wind farms in Texas provided stiff competition, as well.
“While Energy Future Holdings is a complex story, the reasons that it did not work out are pretty simple,” said Terry Pratt, director of Standard & Poor’s U.S. utilities and infrastructure. “The price of natural gas in 2014 is $4 a thousand cubic feet, rather than about $8 to $9 that was a common view back in 2007.” In addition, Pratt said, the company expected the retail electricity business to grow, but instead it lost ground, and “that market was much more competitive than expected.”
It looks foolish today, but some smart money got taken, too.
“Most of you have never heard of Energy Future Holdings,” Warren Buffett said in his annual letter dated Feb. 28 this year. “Consider yourselves lucky; I certainly wish I hadn’t.” Buffett’s Berkshire Hathaway bought about $2 billion of the debt issued in the 2007 buyout. In 2013, he sold the debt and, even after counting interest payments received, suffered a pre-tax loss of $873 million.
One set of players managed to walk away in decent shape: the private-equity firms that engineered the buyout in the first place.
For arranging the deal, the firms shared a $300 million transaction fee, according to Bloomberg News. They also kept about a quarter of the more than $1 billion in management fees paid over a period of seven years, experts estimate. And they received as much as $57.3 million for consulting on debt deals, the 2012 Bloomberg report said.
In addition, the private-equity firms will reap tax benefits by writing off their losses in Energy Future Holdings against profits in other companies. That will help contain the damage.
These are some of the biggest names in the private-equity world. KKR’s Henry Kravis won the legendary 1988 battle to take over RJR Nabisco, which was immortalized in Bryan Burrough and John Helyar’s book “Barbarians at the Gate.” David Bonderman, who co-founded TPG in 1993, celebrated his 70th birthday in 2012 with 700 friends at a Las Vegas bash featuring Paul McCartney, Robin Williams and John Fogerty.
“Truly, this private-equity game is just a game the rich play with the world’s productive assets for their own benefit at everyone else’s expense,” said one of the scores of financial professionals involved in negotiating bankruptcy terms, who spoke on the condition of anonymity to preserve his working relationships. “There is no social or economic value to this activity.”
Though investors put $8.3 billion of equity into the Energy Future deal, private-equity firms generally put in little of their own money, typically investing about 5 percent. That would come to $400 million in Energy Future. The rest of the $8 billion came from money under management, much of it from pension funds.
So, at the end of the day, the three private-equity firms walk away without losing money, but the ambitions of private-equity firms are much greater than that.
Tax policy has played a part in the buyout craze ever since the days of Michael Milken, the 1980s junk bond king and leveraged buyout pioneer who eventually paid $1.1 billion in criminal fines and settlements of civil claims and went to jail for violating securities laws.
Because interest payments on debt are deductible, borrowing money to buy assets often makes sense. The money borrowed by Energy Future created what experts call non-operating losses that offset any profits the firm made. Those profits would have been taxable. Some critics say that the Treasury essentially subsidizes leveraged buyouts, though the Treasury also collects a capital gains tax when the takeover takes place and shareholders declare capital gains.
If the buyout had succeeded, the private-equity firms would have been given 20 percent of increased value of the investment and reported that as “carried interest,” which means the payments would have been treated as capital gains with a lower tax rate than ordinary income.
At an April 24, 2007, panel discussion held by the Milken Institute at the Beverly Hilton, then-Dallas mayor Laura Miller said she was worried that the huge debt taken on by Energy Future (then known as TXU) could lead to excessive cost-cutting measures that might hurt the quality of service in parts of Texas.
Bonderman, who was on the panel, said “there is nothing in this deal structure which is prohibitive or over-leveraged.” He said the reason for borrowing so much money for the takeover was simply that “cost of debt is less than the cost of equity,” according to a summary on the Milken Institute Web site. The worst-rated debt was still cheaper than equity, so concerns over how debt quality would affect profitability were unfounded, Bonderman said.
At that time, the future of TXU looked bright. The company had three separate businesses. One was a regulated utility, now called Oncor, that supplied electricity directly to customers. The rate of return on the utility’s investments, set by regulators, was modest but predictable.
A second part was a retailer, trying to compete with traditional utilities by lining up available power with residential and commercial customers.
The third and biggest part of the business, Luminant, owned a fleet of power plants but was not responsible for retail sales to consumers. Instead, that subsidiary sold power to regulated utilities on competitive electric-power markets run by the grid manager, the Electric Reliability Council of Texas. This model was widely hailed in the utility business as a way to spur greater efficiency, reward the best-run power plants and move toward the type of fuel most economical for customers. At the time, more than three-quarters of Energy Future’s cash flow came from competitive power markets.
Optimistic about demand, KKR and TPG told the Texas Public Utility Commission that they would build three new coal plants, double their number of nuclear reactors to four and later build two more coal plants with advance technology.
Vowing to be a more environmentally friendly company, the new owners reached an agreement with environmental groups to shelve plans to build eight other coal plants. (William K. Reilly, a senior adviser to TPG and a former Environmental Protection Agency administrator, was particularly pleased.)
Luminant, however, soon ran into trouble. At the time, electric power prices were high. Indeed, the private-equity buyers wooed consumers by pledging to cut electricity rates by 10 percent. Natural-gas prices had spiked after Hurricane Katrina in the Gulf Coast and hadn’t come all the way back down.
But the natural-gas boom was just starting. And because natural gas can easily be substituted for coal or nuclear, it tends to set electricity prices. Today, natural gas accounts for half of the electricity generation in Texas, more than in any other state, according to the Energy Information Administration. In retrospect, it’s doubtful whether any of those eight coal plants would have been built.
The natural-gas prices collapsed. In the past two years, the price of natural gas has averaged less than half the price it was in early 2007. And the fortunes of Energy Future collapsed, too.
Now a small army of lawyers and bankers are trying to clean up the mess. Just as in the original buyout, tax considerations are central.
Under the bankruptcy proposal filed Tuesday, the holding company would be broken up and it would sell its subsidiaries — the merchant power generator and the regulated transmission and distribution utility — to the company’s creditors.
There would be no taxes involved. The proposal requires written guidance, known as a “private letter ruling,” from the Internal Revenue Service.
The incentive for the IRS to offer guidance is great. The tax basis of each subsidiary is very low because the assets are old and have been depreciated. Under the proposal, the creditors would use that basis and someday in the future would pay a hefty capital gains tax when they sold the business.
In a foreclosure, by contrast, the creditors would be able to use the current value of the business as the basis for any future capital gains tax.
If the proposal fails and the creditors simply foreclose on the Energy Future assets, they would create a more than $6 billion capital gain at the parent company, Energy Future Holdings. But since the parent company would have no assets, the Treasury would be unable to collect any of it.
Meanwhile, the bankruptcy faces other hurdles. Public Citizen is pressing for the closure of the oldest and dirtiest coal plants in the Luminant fleet and for the payment of $1 billion for reclamation costs at old strip mines it ran.
“This shows the dangers of allowing a highly leveraged, Wall Street-led buyout of a public utility,” said Tom “Smitty” Smith, director of the Texas office of Public Citizen, which was founded by Ralph Nader.
And junior creditors are also unhappy with the plan put forward Tuesday. They say it gives the senior creditors “recoveries in excess of their claims.”
Many critics of leveraged buyouts say the government should act to discourage them. It could alter the tax treatment of debt, but many businesses use debt in productive ways.
The government could also try to discourage excessive leverage by making private-equity firms liable for more than they invest if a buyout goes bust. In the case of Energy Future Holdings, as in other bankruptcies, the private-equity firms that arranged the deal are protected and their liability is limited.
But others say that private-equity firms that do leveraged buyouts on average bring benefits.
“Whether a deal is good or not depends on, number one: Do you buy it at a good price? Number two: Do you finance it in a way that is sustainable? And number three: How much risk are you taking on?” said Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago’s Booth School of Business.
He added that “the evidence is pretty good that, in general, buyout firms operate the businesses more efficiently. When you pay a premium to buy the company, you better do something differently or you will not make your money.”
But, Kaplan said, “in this instance, they paid a high price, betting on natural-gas prices staying where they were or going up, and natural-gas prices went down.”
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