By some measures, merchant power assets look like a bargain, selling for well below their replacement cost. But whether low prices signal a buying opportunity or a value trap depends on the...
A View on the TXU Leveraged Buyout
Is power a public good or a private goodie?
Although TXU’s board recently approved the Kohlberg Kravis Roberts (KKR) and Texas Pacific Group (TPG)-driven leveraged buyout (LBO), this vote does not address the looming and real public-policy issues. Is the public interest best served when the largest utility in Texas, which provides a vital public good—power—is taken private under a risky debt-laden scheme?
This LBO could have negative consequences for Texas consumers. An LBO, by its very nature, is risky because the post-LBO company is strapped with more debt at higher interest rates and then is forced to find ways to pay down this debt quickly.
While power demand in Texas is expanding, concessions made to get this deal done include scrapping eight sizable coal-fired plants, totaling 6,000 MW. If this shortfall in lower-cost generation is not made up quickly, there will be upward pressure on retail electricity rates.
Whether this LBO, potentially the largest in history, is successful will be an important utility-industry litmus test in determining if the floodgates should be thrown open for other private-equity, high-debt-driven deals.
In evaluating this transaction, it first is is important to understand what is motivating KKR/TPG to take on approximately $25 billion in additional junk-bond debt to acquire this utility. TXU bidders are giddy at the prospect of this deal, and rightfully so. TXU is a utility that is in the right industry, the right state, and at the right time. Wall Street views TXU as the cash cow with the potential of generating even more revenue. Whether by chance or by skill, this company sold most of its higher-cost gas-fired power plants and made a clear, strategic decision to place its future on less expensive coal-fired plants. To date, this strategy has paid off handsomely, as profit margins from power sales have continued to rise and now represent billions of dollars in quarterly cash flow. The critical part of the TXU LBO strategy is to tap into this deep reservoir of money and pay off the junk-bond debt quickly.
Cost of Capital: TXU and Junk Bonds
Since the LBO announcement on Feb. 26, 2007, TXU bonds and credit-default swap spreads have shot up, while major credit-rating agencies have lowered TXU’s bond ratings deeper into junk-bond status. For example, on March 5, 2007, Standard & Poor’s lowered TXU’s unsecured debt rating to “B+” from “BB+.” It also indicated that TXU’s plan to take on new junk-bond debt drove this three-notch downgrade. Such market indicators demonstrate that TXU’s default risk and the cost of raising capital have increased substantially. To close this transaction, the TXU bidders will need to raise more junk debt at higher risk-adjusted interest rates. To TXU consumers, higher debt could equate to higher electric rates.
TXU has indicated that this new debt will be structured to insulate the utility from default risk. However, the sheer size of the debt load cannot