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Largest LBO In History Looks Like Black Eye For PE Industry

(This story first appeared in Buyouts magazine, a peHUB sister publication.-Ed.)

The largest buyout of all time is fast becoming an embarrassment for its investors and for the private equity industry as a whole.

In the latest development, Energy Future Holdings Co. said on April 1 that it was negotiating a deal with creditors that could give it more time to pay back $20 billion of its debt.

The development is the latest fissure in what increasingly looks like a gargantuan failure for the Texas utility’s sponsors, led by Kohlberg Kravis Roberts & Co., TPG Capital and Goldman Sachs’s buyout arm. The PE firms bought the Dallas-based energy company, formerly known as TXU, for around $45 billion in 2007. (The utility still does business under the TXU brand, among others.)

Perhaps more importantly, the company’s struggles come at an inopportune time for the industry, to say the least. Private equity professionals seemed to be making some progress in repudiating their reputation as freewheeling, short-term investors who burden companies with debt. And Energy Future’s failings can’t help buyout firms that increasingly promote themselves as responsible stewards of utilities, roads, bridges and other critical infrastructure. Still, a strong financing market could help the firms eke out a recovery or at least put the company in a position to go public, which could generate some much needed cash.

What could end up as a public relations disaster actually started off as a public relations coup for KKR, TPG and GS Capital Partners when they inked what still stands as history’s largest leveraged buyout.

The firms proactively sought guidance from the Natural Resources Defense Council and the Environmental Defense fund to see how they could make the deal more palatable. Partly as a result, the company, then called TXU Corp., agreed to abandon eight of 11 coal-fired generators it had planned to build, and it tapped William Reilly, the chairman emeritus of the World Wildlife Fund and former Environmental Protection Agency administrator, to lead a “Sustainable Energy Advisory Board” to represent the interests of environmentalists, customers and economic development in Texas. The company also committed more than $150 million over five years to assist low-income customers.

But the firms bought the company at the height of the buyout bubble, when cheap financing lured buyout shops to take over ever-larger companies. Scads of other companies bought during the buyout binge have also struggled or gone bankrupt, including casino operator Caesars Entertainment Corp., bought by Apollo Global Management and TPG in early 2008 for around $30 billion; Chrysler Automotive, the iconic car maker that Cerberus Capital Management bought in 2007 for $7.4 billion, two years before filing for bankruptcy; and media conglomerate Clear Channel Communications Inc., bought by Bain Capital LLC and Thomas H. Lee Partners in 2008 for $18 billion.

For all of the good will the firms invested to get the TXU deal done, they reportedly only put up about $8.5 billion of equity, financing the rest of the deal with debt. That factor has been critical in recent years as prices for natural gas have plummeted, making it increasingly difficult for the company pay down more than $35 billion debt, including more than $20 billion that matures in 2014.

Last October, Moody’s Investors Service downgraded what it called the “financially distressed” company’s corporate family rating to Caa2 from Caa1, declaring, “Its capital structure appears untenable, calling into question the sustainability of the business model.”

To make matters worse, most experts don’t expect a rise in natural gas prices any time soon.

Nonetheless, Jim Hempstead, a senior vice president with Moody’s infrastructure finance group, said the company could avoid a bankruptcy. “While the low natural gas prices and heat rates are affecting its cash flow generation, they have some time on their hands to manage their liabilities and hope for better market conditions tomorrow,” Hempstead said. “They have to get through the refinancing in 2014, and if they can, these are good solid assets that produce a steady amount of annual [electricity] volume.”

Energy Future CFO Paul Keglevic told Buyouts in a written response to questions that the company and its sponsors “have the tools, capacity and time necessary to improve our balance sheet.” Through a refinancing program it started in 2009, Energy Future has reduced its net debt by about $2 billion and extended the maturity of another $5 billion, he said.

KKR, TPG and Goldman Sachs have committed to hold a majority of the company for at least five years, and they are providing the company with “invaluable counsel and guidance,” Keglevic said. “EFH and its sponsors continue to take the long-term view that investment in key internal and external infrastructure projects are necessary to foster future growth and sustain a strong overall enterprise.”

Management at Energy Future has not asked the sponsors to inject more equity and the company is not planning on divesting any assets to help pay down debt, Keglevic said.

The company continues to expand under its private equity owners, Keglevic said, pointing to plans to build 1,500 circuit miles of transmission lines to bring wind from West Texas to the state’s growing population centers and plans to launch the largest smart-meter deployment in the United States, among other investments. The company employs 9,400, an increase of 1,900, or 25 percent, from the 7,500 people the company in employed in 2007, according to Keglevic.

Should Energy Future go bankrupt, the problem for its owners and the private equity industry is primarily one of public perception. Either way, its subsidiaries will still produce energy for consumers in Texas. And though KKR and TPG could lose money on the deal — KKR has reportedly written down the investment by 80 percent — Energy Future is ultimately only one of dozens of investments in the PE firms’ portfolios. The firms will be buying and selling companies long after Energy Future sorts through its issues.

The problem is what will happen the next time a consortium of private equity firms offers to buy a critical utility like Energy Future. In recent years, many large firms have raised funds dedicated to investing in utilities, bridges, highways and other assets critical to the everyday lives of citizens, drawn by steady, long-term returns. The Carlyle Group, for example, in 2006 launched a $1.1 billion fund to invest in public and private infrastructure assets, and KKR is reportedly trying to raise as much as $2 billion for its own fund.

Will local authorities, environmental groups and myriad other parties invariably interested in sensitive infrastructure assets be as willing to give the firms the benefit of the doubt if Energy Future goes under?

Fortunately for private equity, the desperate need among cash-strapped states for private investment might outweigh the failure of one deal, said Colin Blaydon director of the Center for Private Equity at the Tuck School of Business at Dartmouth College.

“If the regulators can be assured that the capital structure will not precipitate a crisis that affects the operations of the utilities, they are going to continue to look favorably on these deals because the capital needs of these utilities are enormous and the private equity industry is possibly the best source for them to be able to obtain the capital they need,” Blaydon said.

(This story first appeared in Buyouts magazine, a peHUB sister publication. For a free trial subscription to Buyouts, click here. -Ed.)