Private Equity Firms Propose Leveraged Buyout of TXUPeriodic or frequent readers of this blog will notice that I have interests in utilities (Electric and Gas) and also investing. These two interests collided today with the announcement that a private equity consortium led by
Texas Pacific Group and
KKR were "close" to a deal to acquire
TXU which is a giant utility based in Texas for $32 billion, or about $70 / share, a $10 / share premium over the current share price of about $60 / share.
TXU also has about $12 billion in debt outstanding, and it is likely that many of these debt holders will see the value of their holdings hurt since the private equity firms are planning to issue
colossal amounts of debt to make this purchase (see here for a
recent blog on bondholders getting hurt on buyouts).
KKR is the famous firm in "Barbarians at the Gate" which was a major business book and even a made-for-TV movie. Texas Pacific Group is a giant buyout fund and one of the largest employers in the USA. These buyout firms are getting larger and larger and the market is willing to lend them more and more money at favorable rates, which allows them to do bigger deals in turn. Generally no one expected them to make a run at a company as big as TXU, and one with as many regulatory entanglements as this.
Background on TXUTXU was formerly known as Texas Utilities. Texas Utilities has roots in Dallas and serves the Dallas area in terms of distribution along with natural gas. The company has a strong generation division and since the state of Texas "
de-regulated" (in parenthesis because it was a botched effort like the rest of the US) the generation unit has been going gangbusters.
TXU had a near-death experience with diversification, purchasing overseas assets and getting into power marketing a bit like Enron (Enron was a Houston based company, after all). The stock bottomed out at around $10 but management cleaned house, spun off bad investments, and moved the stock price all the way up to $60, where it sits today prior to this buyout offer.
TXU Tries To Build for the FutureTXU had ambitious plans for the future. In other blog posts I have railed about how the US energy industry has stopped investing in new generation and that NIMBY activists are strangling improvements in energy while growth in energy use continues unabated. In Texas, however, things looked promising because of their pro-business climate and friendly attitude towards new construction.
One sidebar about Texas - there are different "reliability districts" for the USA and Texas essentially walled themselves off from the rest of the US with a district called ERCOT. Texas chose to do this, which ensures that if neighboring states take actions that could hurt Texas, they will be insulated from these changes. On the other hand, if other states have cheaper power than Texas, this power can't be brought into the state. This "wall" helped Texas avoid some of the spillover of the Enron debacle; in the West, for example, California's energy collapse had horrendous effects on neighboring states because they drove up the price of power in adjacent states as capacity poured into California to meet their crisis (to the extent that it could because of poor transmission investment).
However, even in Texas it can be hard to get things done.
TXU was planning on building 11 large coal-fired plants in the state, which would have used plentiful US based energy (we have lots of coal here) rather than sending our $$ to unstable
regimes overseas. While coal is attacked for pollution, the only other choices for large scale energy production are nuclear (which has been shut down in the US by the NIMBY crowd) and natural gas, which is frankly
un-economical at current prices. I salute the management of TXU for actually trying to build a better future for Texas rather than just waiting for the crisis of non-investment to brew as energy demand increased across the state. Here is a site that TXU set up called "
the Reliable Texas Power Project" to sell their plan.
TXU Faces Investor ResistanceIn order to build these new power plants, TXU was going to spend a lot of money. Major base load power plants are expensive in the best of times, but frequent detours demanded by capricious regulators make the situation even worse.
There are generally two types of expenditures - capital investment, which are purchases for long lived assets like power plants, and expenses, which are the short term costs needed to run the business for salaries, fuel, maintenance, etc... Capital investment is usually funded with debt or equity and then it becomes expense as it is depreciated over its useful life, which can be 30+ years for a major investment like a power plant (indeed, most of the generation in the US is from facilities originally built in the 60's and 70's since very little "base load" generation has been built since, although many of them have been heavily modernized).
A general rule of thumb for utilities is that capital expenditures should be around 100% of earnings. If capital expenditures are > 100% of earnings, investors start to get scared that too much debt is being piled on. At far less than 100%, investors worry that the company is not investing in the future. This ratio is for utilities, which are heavily capital intensive.
If you go to the
TXU web site and look at their
Q3 earnings presentation, they were planning on investing in capital expenditures at a rate of 135% of earnings for several years in order to build the generating plants cited in their reliability project above (go to page 6 of the presentation to see this slide).
An Unholy Alliance - Private Equity and NIMBY GroupsWhile
TXU management is willing to take on the interest groups and try to plan for Texas' future, the buyout groups have completely different interests. THEY WANT TO MAKE MONEY. Bizarrely, by not investing in the future, they can make a lot of money.
Let's think about this. Texas is a "closed" state, because of the
ERCOT design as I alluded to above.
TXU already owns a lot of generation in the state, and unless they build new plants, it is highly unlikely that anyone else is going to come in here and build more plants.
Thus rather than invest in new capacity, the private equity groups can just run the existing plants and keep the cash. As demand goes up and generation gets scarcer, they will just make more and more money off their existing investment. Think of it as if you had an apartment building and no one let you build any new buildings, but every year more and more people came into your city, which would allow you to drive up rates. In a functioning economy, entrepreneurs would come in and build more buildings, putting the market back into equilibrium, but in this example no one can build new buildings and you are essentially in the catbird seat charging premium rates.
The private equity guys are fine with investing nothing in the business, loading it up with cheap debt, and watching the energy crisis unfold, because they will make piles and piles of money. God knows if
TXU can't even get new plants built, anyone else would have a horrendous time getting it done. And if the private equity guys are smart they can bond with the
NIMBY's to stop anyone else from getting anything done, too, so new competition never materializes.
I was in the utility industry for a long time and know lots of people still there. In general, while they make mistakes, they genuinely try to look out for the future of the residents of their states and feel they are part of the public interest.
TXU was really sticking its neck out with this plan because the old-line people cared about the future of their state and knew that an electricity crisis was looming.
The money managers, on the other hand, know how to make money. Lots of times you can make the most money by NOT investing in businesses and harvesting the cash. This strategy is especially useful when debt is cheap (like it is with today's interest rates) and people are willing to lend it to you without investing much in the way of equity.
ConclusionTexas was one of the few states trying to plan for a future and to invest in new generation capacity. With this deal, the industry is essentially rudderless, waiting for doom as demand keeps rising while capacity shrinks. NIMBY crowds can point to getting rid of old light bulbs, solar, and wind power, but that is a drop in the bucket compared to base load generation.
This is a seminal day for the industry. If this deal goes through expect many more similar deals since
TXU was one of the biggest players in the business. And expect the power companies to be run by financial people to maximize their return, which can often come from disinvestment and harvesting assets, to the detriment of future conditions.