The Biggest Energy Private Equity Deal is on the Verge of Collapse and Why it’s a Big Deal
In our energy finance newsletter a few weeks back I wrote about some possible fallout after Energy Future Holdings (EFH), the massive private equity-owned Texas electric holding company and the result of one of the largest leveraged buy-outs ever, formally warned that it might need to seek bankruptcy protection.
Last week, EFH offered a restructuring plan to creditors in an effort to avoid bankruptcy. The restructuring offer will almost surely be rejected, but may lay the initial groundwork for some type of structured resolution outside (or even inside) of bankruptcy court.
A little more than five years ago EFH was created as the vehicle for the most expensive leveraged buy-out in history when a private equity group led by KKR, TPG and Goldman Sachs Capital Partners bought the Texas energy company at a price of $43.2 billion. The failure of EFH will be hugely important in terms of the direct impact on investors, lenders and the private equity market, but perhaps more important will be what this failure means for the broader energy landscape.
As it exists today, EFH is made up of three basic parts – Oncor, a distribution utility, Luminant, a wholesale power company and TXU, a retail power company. Both TXU and Luminant are owned by the EFH subsidiary, Texas Competitive, while Oncor, as a rate regulated distribution utility was separated and is 80% owned by EFH separately from the Texas Competitive entity through Energy Future Intermediate Holdings along with Texas Transmission Investments LLC, which owns 20%. That ownership separation, and a more comprehensive legal “ring-fence” around Oncor were critical to gaining regulatory approval from the Texas Public Service Commission, which wanted assurance that the debt used to buy the non-utility assets in the buy-out could not be applied against the utility, which would in turn require the utility’s rate-payers to support the debt through higher rates in the future.
The ownership structure (significantly simplified – I have never worked with EFH or on this series of transaction so this graphic is based only on my review of publically available information) looks like this:
The restructuring offer put forward this week would have creditors of Texas Competitive (which has roughly $32 billion in outstanding debt) forgive $25 Billion of that debt in exchange for new debt or cash of $5 Billion and an 85% stake in the EFH parent company, with the current ownership retaining 15% ownership. Assumed in the offer is substantial value for EFH’s interest in Oncor (the Texas Competitive assets are worth less than the current debt). This is an interesting assumption because while the penetration of distributed generation in Texas has been slow and hasn’t had as much of a disruptive effect on the demand for delivered electricity, it seems unlikely that Oncor’s value would not be viewed against the broader narrative that distribution utilities are in a very challenging market going forward in many markets.
Questions of the company’s survival began circulating not long after the purchase as doubts grew quickly over EFH’s ability to meet obligations on more than $38 billion in debt. The collapse in natural gas prices starting in 2008 significantly repressed wholesale power price in the Texas market because gas prices effectively set the marginal price of electricity in ERCOT (the power market in Texas in which EFH primarily operates). The result was that lower electricity prices, especially wholesale electricity where Luminant’s generating assets compete, undercut the ability to grow revenue as the buyers had projected. Adding to the debt burden Luminant commissioned 3 new coal-fired generating units in 2009 and 2010, adding billions to the overall debt burden, further increasing exposure to low natural gas prices.
A leveraged buy-out is typically based on the premise that there is unrealized value in an enterprise and that a new buyer, by heavily leveraging its purchase can, through increased revenue or reduced expenses, grow the relatively small equity component of ownership quickly and substantially. The risk to this approach is that a decline in revenue can be catastrophic as default on the debt used for the purchase can lead to dramatic or complete losses to the equity participants.
The erosion in earning potential, which was apparent not long after the transaction because of the collapse in natural gas prices undermined the expected revenue growth from the Luminant generating assets, made servicing the enormous debt burden created during the purchase over the long term unlikely. EFH and its owners were not blind to this risk, and used natural gas hedges to offset some of the down-side risk in power prices. These hedges have worked (reasonably well) to protect EFH’s ability to make regular payment on the debt and avoid default so far. However, hedges for commodities like natural gas are hard to get for more than a few years and the EFH hedges are now expiring in stages leaving the company more exposed to low gas and electricity prices. With this protection gone the gap between revenue and cash flow needed to make debt payments (including an upcoming balloon-type payment obligation during the second half of 2014) will simply be impossible to bridge. The result is that without a very sharp rise in natural gas prices or an agreement on the aspirational restructuring plan EFH will be in default before the end of next year, and likely forced into bankruptcy protection sooner than that.
Is this just another link in the narrative about how the fracking revolution, and the associated collapse in natural gas prices, is reshaping America’s energy landscape?
The answer is that but more. While the foundation for this story is the huge miss by the buyers on a bet about future natural gas prices, the whole story is complex and evolving, with fascinating historical context – the implications will be far reaching.
Both the causes and the effects of EFH’s troubles have or will provide important insight into the power industry:
· Wholesale power remains a tough business. A string of bankruptcies and restructurings defines the short history of the independent power business, and with EFH on the brink and Edison International’s Edison Mission Energy already under bankruptcy protection the challenging legacy of the wholesale power business will only grow. Providing some emphasis is this report from EIA that shows a down-turn for coal fired generation and an upturn for gas and renewables.
Less obvious in this chart is the lack of total growth in demand for new power since 2006. So not only is there a trend away from coal creating friction for EFH’s generation assets, but since the middle of the last decade there has been a flattening of over all electricity demand (refined Texas statistic are not as current or neatly summarized but other than a slight upturn over the past couple years look very similar to the US profile). Lack of overall demand growth, and for centralized generation this is a serious long-term trend, when combined with significant exposure to coal generation held by many independent and deregulated generating companies is creating a very challenging business environment.
· KKR, TPG and their investors are going to lose money, quite a bit of it. KKR has already written down the value of its direct stake (separate from managed funds) by 95%. Bondholders may take similar valuation hits; Warren Buffet called his investment in EFH bonds “a major unforced error” and has already written values down significantly. With the potential for some loss to even senior secured debt it seems likely that the cost of financing wholesale power is going up. If lenders accept the restructuring offer, there could be some small sliver of value preserved, but regardless of how that negotiation plays out expect the final analysis to look like a complete loss.
· Financing new coal generating capacity in the current climate in the U.S. looks like an extremely difficult prospect. In addition to the significant, overarching regulatory shift making coal-generated power more costly, the lingering uncertainty with respect to future regulation has created an extremely challenging landscape for new coal generation projects. As bad as things are in the market for developing coal-generating plants, the EFH story is going to make it even more difficult to find financing for new coal projects. EFH spent billions to build 3 new coal power plants in 2009 and 2010, and more than 2/3 of actual electric generation in 2012 was from coal. Regardless of the reality of the underlying economics, an EFH bankruptcy will compound a souring narrative on the value of coal generating plants in the U.S. market.
· Bankruptcy will test the Texas Public Utility Commission’s ability to protect ratepayers from the costs of the failed buy-out. Both the PUC and Oncor have expressed certainty that the “ring-fence” put in place to isolate Oncor from the financial risks of the deal is impenetrable, but an EFH financing arm has been leveraging Oncor intercompany dividends to pay down intercompany debt. The ring-fence will certainly be tested if EFH finds itself in Federal Bankruptcy Court. If there is even any serious consideration of breaching of that legal shield expect regulators across the country to make it even more difficult to use the a utility’s balance sheet as security for large acquisitions.
· Regardless of the outcome over the Oncor ring-fence challenge, look for regulators to press even harder to limit deals that might put a utility and its ratepayers at risk – and this resistance will compound the tension in the evolving reality for utilities of eroding electricity demand and increasing need for investment to replace and upgrade aging or vulnerable infrastructure.
Expect to hear a lot more about this story as EFH inches closer to bankruptcy – this may be the energy story that defines 2013.