A View on the TXU Leveraged Buyout

Deck: 

Is power a public good or a private goodie?

Fortnightly Magazine - April 2007

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 be ignored. Whether the LBO-related debt is held at the parent, moved away from the utility, or sophisticated ring-fencing techniques are applied, this approximately $25 billion in debt still has to be repaid. And the primary source of repayment is the cash generated from the utility.

Logically, the parent will upstream as much money as it legally can to pay down this debt. This debt load also decreases financial flexibility. Although market interest rates are closer to historic lows, should such rates spike up, this significantly could constrain the utility’s ability to access needed capital. The end result could be that TXU is unable to obtain adequate capital to meet its growing long-term customer obligations.

TXU bidders have only three primary ways to pay down its LBO debt load: 1) increase revenues; 2) sell assets; or 3) decrease costs. Recently, TXU has indicated it would not increase short-term consumer rates or sell certain assets in the next five years. Assuming this statement is true, how will this mountain of debt be paid down? Cost cutting, if not done prudently, could come at the expense of dependable and reliable service to customers. This is another critical element of the proposed LBO structure that the Public Utility Commission of Texas (PUCT) will need to explore in more detail.

Texas Economics and LBO 101

The health of the Texas economy will have bearing on the financial strength of TXU. Power companies tend to prosper most in a growing economy as energy consumption expands. In good economic times, and with companies such as TXU that throw off sizable cash flow, leveraged buyouts appear to be financial alchemy. However, should the economy turn south and anticipated earnings growth not materialize, this newly acquired LBO debt can reduce TXU’s financial flexibility substantially, causing more harm than good.

Don’t forget that less than five years ago, TXU was close to bankruptcy, and it was questionable as to whether it would survive. As we learned through the bankruptcy of California-based PG&E (2001), big utilities can and do go bankrupt and customers are the ones that are impacted immediately.

In the last five years, Texas has moved forward with deregulation, lifting rate caps, and the result has been sizable increases in the rates charged to its power customers. TXU retail consumers are paying 14.5 cents per kilowatt,1 substantially above the national average (the price per kilowatt is based on 1,000 kW per month and includes a monthly service charge). While the LBO deal-makers have offered a 10-percent rate concession to a small sub-group of consumers through September 2008, is this concession meaningful given where rates currently stand?

Where Are the Regulators?

TXU has made comments suggesting that the Public Utility Commission of Texas (PUCT) has limited authority to review this transaction. Texas lawmakers feel differently, and have proposed expanding the PUCT’s mandate. If Senate Bill 896 is passed in part or in full, the PUCT will be sitting front and center in this debate.

The PUCT will need to incorporate numerous questions into its assessment. Will 2.4 million TXU power customers potentially be harmed if this LBO transaction is permitted? Is this sale truly in the public interest? Should the largest public utility in the state, with the obligation to provide safe, reliable, and competitively priced power be allowed to overdose on debt in an attempt to be taken private?

It also is important that the PUCT assess whether KKR/TPG are planning to be only short-term owners or long-term partners. If the latter, will they make capital investments that tangibly bolster the utility’s infrastructure, including transmission lines, generation capacity, and a strengthened distribution delivery business? If the answer is yes, then KKR/TPG might be forced to invest more money into this transaction than it had initially planned. Such a capital investment could go against the basic tenant of an LBO: to quickly pay down debt, turn a profit, take out money, and sell.

Companies such as KKR and TPG are large private-equity firms in the business of seeking profit. Is having them control a vital public good—power—appropriate? What expertise does this TXU bidder group bring to the utility, and do they have a successful track record in running power companies?

Is KKR/TPG going to focus primarily on finding creative ways to pull money out of TXU in an attempt to quickly pay down LBO debt? If the economy were to tank and TXU cash flow were not adequate to service or pay down LBO debt, would the TXU bidders be forced to sell power plants that otherwise were meant to support the future demand needs of its retail customer base?

Lastly, taking this utility private would significantly diminish the level of financial scrutiny and oversight that public investors and Securities and Exchange Commission reporting requirements tend to create. Can we then leave it up to KKR/TPG to look out for the best interest of its utility customers? Simply stated, can these TXU bidders be trusted to do the right thing? TXU and similar utilities across the United States have been given monopolistic power to serve a defined customer base in exchange for making sizable capital investments in delivery infrastructure and generation assets. These utilities have enjoyed this special relationship with the implied understanding that they have a responsibility to provide a vital public good.

In an LBO scenario, TXU will have a debt burden at higher interest rates that will decrease its financial flexibility. This potentially will have ramifications for Texas consumers in strong as well as in weak economic cycles. Critical to any LBO strategy is to pay down debt quickly using three methods: increasing revenue, decreasing costs, or selling assets. Unfortunately, all three alternatives could jeopardize the fundamental agreement between utility and customer—to provide safe, dependable, and competitively priced power, and above all else, to keep the lights on.

The last two battles over smaller but similarly proposed LBO utility buyouts, Unisource Energy in Arizona (2004) and Portland General in Oregon (2005), were not approved. The public utility commissions in both states, after asking many hard questions and evaluating the facts, viewed the increasing risk associated with junk debt as the main deal killer. The true Achilles heel for KKR/TPG, which cannot be quantified effectively by using sophisticated financial models, is the risk of not obtaining state regulatory approval. This is the one uncertainty that should keep KKR/TPG executives up at night.