Every microgeneration is molded by its own financial bubble. Right now, for instance, there's a vigorous debate about a tech bubble in which WhatsApp, a service that I am definitively too old to use, is worth $19 billion. But for me, the bubble closest to my heart will always be the one that peaked in 2007, a year that was so frothy that I was able to get a job in investment banking.1 And so I have a hipsterish attachment to TXU, the Texas electric utility LBO that was, and remains, the largest leveraged buyout ever, and that stands as one of the symbols of that bubble.
Also I have a hipsterish attachment to the name "TXU," though the company is now called Energy Future Holdings.
Anyway TXU/EFH/whatever filed for bankruptcy today, rudely ending its era right in the middle of the current, techier era. It was ... it was not a good deal, you'd have to say. Its private equity sponsors have lost, in round numbers, all of their money.2 And it's filing for bankruptcy with something north of $40 billion of debt, relentlessly unfavorable natural gas prices, and a rather unfriendly environment for electric generators in Texas. But, still. It was the buyout of my era and I'll shed a tear for it.
What else can we say about it? Well, for starters, today Apple did a $12 billion bond deal to avoid taxes, and Pfizer is working on a $98.7 billion merger to avoid taxes, and both of those things have come in for some criticism. But Energy Future actively chose not to avoid taxes. It could have avoided taxes. Energy Future is structured like so:
Most of the debt is on the purple side of the chart, at Texas Competitive Electric Holdings.3 The prepackaged bankruptcy plan is not public yet, but from the company's announcement it's clear that the plan is to hive off TCEH to those lenders and keep the regulated business within the Energy Future corporate structure. One way to do that would be to sell TCEH's assets to those lenders, with the lenders paying for the assets with their debt. Those assets have a very low basis (are very depreciated), but selling them to the lenders would lead to a basis step-up, letting the lenders take a lot of future tax deductions (by depreciating the assets again, more or less). This would have saved the lenders something like $5 to $8 billion.
There's no free lunch in the tax code, so TCEH's future tax savings would come at the expense of saddling Energy Future with a huge tax liability right now. Except! Energy Future has no money. So the IRS would get paid at some number of pennies on the dollar, and Energy Future would pay off its senior creditors at the expense of the IRS. This would make the IRS mad.
Energy Future decided not to make the IRS mad:
TCEH and its subsidiaries would separate from EFH without triggering any material tax liability, and TCEH’s first lien lenders would receive all of the equity in the reorganized TCEH and the cash proceeds from the issuance of new debt at the reorganized TCEH in exchange for eliminating approximately $23 billion of TCEH’s funded debt.
The plan seems to be for a tax-free spinoff of TCEH, in which TCEH's new owners (and old lenders) would not get any basis step-up or tax savings, but in which the IRS would not be stuck coming after the very bankrupt Energy Future for its money.4
This seems like sort of a weird choice? Like, the IRS wasn't in the room, why not take their money and give it to some of the people in the room? You can sort of understand why -- a tax claim might hold up the case, and "the nature of the proposed transaction, in which private-equity funds would benefit from a deal that creates a massive and perhaps unpayable debt to the IRS, makes the case particularly sensitive" -- but, for an industry known for its tax aggressiveness, this seems a little tame.
And it's already made some other people mad. Here you can read some complaints from a group of second-lien creditors at TCEH,5 and they make sort of an interesting case. The claim is that Energy Future's managers are colluding with the big TCEH secured lenders -- Apollo, Oaktree and Centerbridge -- to drive down the value of TCEH. The goal, in this theory, is "to allow the Senior Lenders and management to print cheap reorganized equity and wipe out billions in legitimate creditor claims": If the bankruptcy court finds that TCEH is worth less than the amount of the secured claims, then the secured lenders can just take it, giving the junior lenders nothing.
The tax-free spinoff, which reduces the value of TCEH, is supposedly part of that plan:
[T]he Sponsors and the Debtors’ management have shifted gears and appear to have refused to meaningfully consider any restructuring that would expose EFH (the Sponsors’ investment vehicle) to tax liabilities that might result from a separation of the merchant power and transmission business, despite the unambiguous economic interests of subsidiary creditor groups. This refusal appears designed to avoid the reputational repercussions to the Sponsors from having massive tax liabilities go unfunded at EFH. Instead of addressing fiduciary responsibility of TCEH’s management to TCEH’s creditors, the Debtors now appear, with the approval of Senior Lenders, intent on saddling TCEH with future tax liabilities – via a “tax free spinoff” of the unregulated business that would be to the direct detriment of the Second Liens and other junior creditors largely excluded from restructuring discussions to date. With expected recoveries in excess of their claims, the Senior Lenders appear all too willing to accept such future tax liability in exchange for a quick trip through Chapter 11 that would extinguish junior interests.
The restructuring agenda seems all too clear and all too common. The Trustee believes that management and the Senior Lenders hope to be able to extinguish junior obligations and reward themselves with newly-minted, underpriced equity, predicated on an intentionally depressed valuation measured at a historic industry trough
Ehh I don't know about this, but there's a circle-of-life element to the motion that I sort of like. Broadly speaking, the point of an LBO is for patient, smart, financially savvy private investors to buy a company when valuations are depressed, and then wait for a recovery. That is what happened to TXU in 2007: Natural gas prices were low, and the private equity buyers thought they'd go higher and make them lots of money.6 Naturally, some shareholders objected that private equity was trying to steal their company at a depressed valuation -- that the deal was "unfair, inadequate and substantially below the fair or inherent value of the company," and that the directors who approved it were conflicted.
But in fact, prices went lower, and the sponsors lost a lot of money. And in hindsight, their bid looked way too rich, not too cheap: They paid 8.5x EBITDA to buy TXU in 2007, a bit above market valuations, and they they never looked on that much EBITDA again.
Now, once again, TXU -- sorry, sorry, Energy Future -- is being sold to savvy investors, and once again excluded junior claimants are complaining that the company is being undervalued and the deal is conflicted. Once again, the savvy investors seem to be betting on gas prices going up.7 Once again, they seem to be paying about 8.5x EBITDA.8 Eventually, somebody is going to make this deal work; if KKR, TPG and Goldman couldn't do it in 2007, maybe Apollo, Oaktree and Centerbridge will do it in 2014. The TXU era may be over, but the Energy Future cycle will begin again.
I started on July 2, 2007. My timing was impeccable. By the end of the month, Bear Stearns was liquidating mortgage hedge funds.
2 I mean, they collected some fees and stuff, it's not all bad. But they look likely "to recoup just 1 percent of the original investment" of some $8.3 billion of equity in the bankruptcy.
3 See page 12 of this EFCH 10-Q for a sense of it: $19.5 billion of TCEH term loan facilities, and billions more of notes.
4 I mean, instead it'll come after the also bankrupt TCEH for its money, but just in the regular way: If TCEH has profits, the IRS will tax them. As opposed to a multibillion-dollar one-time gain in a bankrupt entity.
6 See the merger proxy: "the future natural gas prices embedded in the implied value of TXU Corp.’s generation assets based on the $69.25 Per Share Merger Consideration were higher than the future prices TXU Corp. management believed were likely, taking into account the inherently unpredictable factors that impact long-term natural gas prices." Here is a good explanation of why an electric generator makes or loses money based on natural gas prices.
7 I can't entirely vouch for it, but this, from the second lien motion, is sort of interesting:
The investment decisions of two of the Senior Lenders reported to be directly involved in negotiations with management and the Sponsor Group appear to signal that these parties expect natural gas prices to rise in the future. First, Oaktree Capital Management (“Oaktree”), a major holder of TCEH first lien securities, has accumulated an 8.2% equity stake in Dynegy Corporation (“Dynegy”), currently worth approximately $185 million as of February 20, 2014. Dynegy is a member of the Debtors’ peer group with cash flows similarly tied to natural gas prices. Second, Apollo Global Management (“Apollo”), also a significant holder of TCEH first lien claims, recently sold a controlling ownership interest in LyondellBasell, a petrochemical company, whose cash flows move inversely with natural gas prices, thus signaling Apollo’s opinion that gas prices are poised to rise.
8 I guess? TCEH has about $1.66 billion of projected 2015 EBITDA (see page 3 here), and by my math will have about $14 billion in debt ($32 billion or so of existing debt, minus $23 billion cancelled in the bankruptcy, plus $4.475 billion of debtor-in-possession financing, is $13.5 billion or so of debt in the new TCEH, or about 8.2x EBITDA).
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