Report Slams TXU LBO

Deck: 

Consultant Roger Gale concludes that the TXU leveraged buyout does not provide inherent or long-term advantages to the customer.

Fortnightly Magazine - August 2007

Just when everyone thought the dust had cleared on the highly contentious leveraged buyout of TXU by Kohlberg Kravis Roberts and Co. (KKR), new challenges have sprung up from the most unexpected place.

The publisher of the Dallas Morning News retained consulting firm GF Energy LLC, led by Roger W. Gale, to produce an independent assessment of the consumer impact from the proposed private-equity buyout of TXU. In late June, the newspaper ran a three-part series highlighting the report’s conclusions, as well as responding to reader feedback. (The report and the news coverage of the report can be found at www.dallasnews.com/investigativereports/txu/.) This may come as a surprise to many industry watchers who believed the deal was as good as done, and therefore likely exempt from continued criticism. But given the deal’s importance to the Texas economy, the newspaper felt an independent analysis of the deal was needed. The paper had conducted a similar investigation several years ago into how well Dallas city government was serving its citizens.

“That study—published in 2004—set in motion numerous and profound changes at City Hall, changes that continue to play out today,” wrote Dallas Morning News Editor Bob Mong in introducing the series on TXU’s LBO. Whether the GF Energy report affects the deal will depend largely on whether the regulators reviewing the buyout read the report and follow its recommendations. Many of the report’s suggestions also could prove instructive when considering future LBO offers. In this case, however, GF Energy’s recommendations are based on the conclusion that there “are no material advantages to the customer if the transaction proceeds.”

The consulting firm believes that any benefits will have to be sought by the Public Utility Commission of Texas (PUCT) on behalf of customers. GF Energy concludes that the buyers are offering the customer what TXU would probably have offered anyway. Therefore, there is no net gain for the customer in the deal as currently described.

GF Energy’s specific recommendations are that the Texas PUC should:

• Test the TXU transaction against public-interest criteria used elsewhere in the United States to determine if this transaction offers definite net benefits to customers;

• Consider negotiating commitments from the buyers that will ensure adequate oversight. These commitments may include:

• Safeguards involving transparency, shifting of profits, cross- market power mitigation, and financial stability;

• Operational and customer performance guarantees that allow the PUCT to fine the companies if their performance falls below prescribed or pledged levels, such as when there are excessive power failures;

• Assurance that the new operating companies continue for significant periods of time existing labor contracts and commitments to community-related support;

• Commitment to a specified investment budget, schedule, and plan for renewable energy sources—wind, solar, etc.— as well as to advanced coal, including integrated gasification combined-cycle (IGCC) and nuclear plants;

• An effective, customer-controlled, demand-response program for reducing electricity demand and the commitment to specific targets, including consequences for not meeting them;

• A requirement that TXU establish a global climate working group with a six-month to one-year charter to develop specific policies and programs for the holding company and its subsidiaries;

• Tough “change-of-control” provisions, including approval processes and penalties, if the buyers decide to sell control of the businesses to others; and

• Assurances that there will be no change in the cost of capital because of the transaction that would result in higher interest costs being passed on to customers.

• Launch a formal collaborative process involving a broad range of public-interest organizations representing low-income customers, retirees, labor, public-power, and cooperative customers, as well as environmental stewards to ensure that a final decision on the buyout is credible and legitimized by key stakeholders.

Not surprising, TXU and its future owners have disagreed publicly with GF Energy’s critique. In an e-mail to the Dallas Morning News, TXU wrote:

“The GF Energy report commissioned by the Dallas Morning News contains significant factual errors and makes unfounded sweeping assertions directly related to the transaction proposed by KKR and TPG. Therefore, we feel those assertions are more appropriately addressed by the investor group proposing to buy TXU and through the ongoing PUC review.”

The group separately sent the paper another e-mail asserting that the GF Energy report endorses its plan if read in its entirety; KKR objected to the report casting doubt on its intentions. Furthermore, KKR highlighted its commitments, namely its promise of “a 15-percent price reduction, price protection through December of 2008, low-income support, strong environmental stewardship, and protection of TXU’s regulated utility business.”

The key criticism of the report is that the new buyers are not sufficiently being held accountable for future capital investment in the company. “The core issue in the proposed buyout is the extent to which the transaction would diminish state oversight. Texas has moved faster than any other state to make the electricity business more competitive, but Texas has also retained significant state control over the rules of the game,” the report states.

GF Energy concludes that if the transaction proceeds, the separate companies into which TXU would be carved, although headquartered in Texas, would be owned by privately held companies located outside of Texas, with fewer disclosure requirements than publicly traded companies like the existing TXU.

The State of the Deal

After Texas politicians, who had threatened to block the buyout, were persuaded to sign off on the deal a few months ago, many believed the only challenge remaining to the TXU LBO was from the bond market.

The recent meltdown in the sub-prime market has raised concerns about the viability of a number of proposed high-yield debt sales that are tied to company buyouts like TXU.

In fact, junk bonds sold in early July soured an already fragile financing market after ratings warnings on billions of dollars of sub-prime, mortgage-related bonds snuffed out appetite for risky debt, according to a Reuters report. A number of deals already had been pulled by early July because of poor market conditions or balking investors. And adding to the challenge of financing the deal, some believe the TXU buyers may have to pay more. On June 1, Citigroup analyst Greg Gordon released a research note that suggested the possibility that KKR and TPG Capital would have to raise their $69.25-a-share buyout offer for the Texas utility to get the deal done. (At press time, the stock was at $67.40.) At $32 billion, the deal already was the biggest proposed leveraged buyout in history.

According to a Wall Street Journal analysis, a number of analysts and investors believe that, based on how comparable utilities trade, TXU is worth more. “That has helped narrow the annualized spread between the offer and the current TXU share price to 6.5 percent from 14 percent in the past five weeks,” the report states.

According to Citigroup, that’s not a lot for a deal that isn’t expected to close for six months. That’s probably why KKR and TPG may have to bump up their offer, perhaps to $71 per share, Citigroup concluded.

TXU has yet to file the proxy statement for the deal that will set a date for the shareholder vote on the transaction, but according to Gordon, the vote could take place in August or September. The analyst points out that an affirmative vote of two-thirds of TXU’s shares will be needed.

But if the Texas PUC commissioners are Dallas Morning News readers, the deal may end up being about more than just money.