Update on TXU Corporation LBO

In 2007, a group of private equity firms and investment banks bought TXU Corporation for $45 billion in the largest leveraged buyout transaction.  The company changed its name to Energy Future Holdings Corporation but the fact remains that it is in trouble.  This is due to lower gas prices (the U.S. fracking expansion) and demand (from the recession and jobless recovery).  Two years ago, the debt associated to the deal was trading at a discount.  As of March 31, 2013, KKR has thrown in the towel and is valuing the bonds at 0.05 of cost.

On April 15, the company proposed to re-structure its $32 billion in debt.  Equity owners would be wiped out and the senior debt owners and the original private equity consortium would split the company 85%/15%.  Already, distressed debt managers Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC are buying debt which would be converted to equity stakes in case of re-structuring or bankruptcy proceedings.

A few institutional investors were unlucky enough to have negotiated terms to invest directly in the buyout.  Others were only invested in the private equity funds leading the deal.  Some of them are the biggest pensions such as California State Teachers' Retirement System, California Public Employees' Retirement System, Washington State Investment Board, Oregon Public Employees' Retirement Fund, New Jersey Division of Investment and Pennsylvania State Employees' Retirement System.  According to TorreyCove Capital Partners LLC of La Jolla, California, KKR 2006, the fund with the TXU deal, will still have a higher return than the S&P 500 in 2012.  KKR 2006 returned 7.09% versus 3.25% for the index.  The privileged co-investors included California State Teachers' Retirement System and Government of Singapore Investment Corporation.  There is no word if either managed to offload their direct investments through the secondary market.

In another twist, some fund managers think that Energy Future Holdings could extend its debt into the future. Since 2009, the company has re-financed $25.7 billion of its debt.

The source for this article can be accessed here.

Increased Risk Appetite Leading to More Block Trades

As the conditions in the equity markets have improved in 2013, the sell side has been engaging in riskier transactions.  In a Reuters article written by Anthony Hughes and Stephen Lacey, an increasing percentage of the Equity Capital Markets business has gone the route of the block trade.  This is a secondary or follow-on offering of a stock where the bank buys the shares and sells them to the buy side within the same or next day.  Another term for the trade is capital commitment.

The sources of stock in 2013 are private equity firms seeking exits from past leverage buyouts.  In the past, they would be early investors in or founders of a company seeking to diversify their investments.  Think Bill Gates and Microsoft.  Some large divestments in February of private equity deals include $1.8 billion for HCA (KKR and Bain Capital), $1.5 billion for LyondellBasel Industries (Apollo Group), $500 million for Sensata Technologies (Bain Capital), $321 million for Team Health Holdings (Blackstone) and $930 million for NXP Semiconductors (KKR).  Through February of 2013, follow-on offerings comprise of 40% of the entire capital markets business.  The share was 24.5% in 2012 and 18% in 2011.

Since the shares are owned by the bank, it is exposed to increased risk.  If the offering price was not above the buying price, the bank would suffer large losses.  Since the stock market has experienced rising returns, low volatility and investor optimism, there is an increased appetite for risk.  As one banker said in the article, "It is going to keep working until someone gets their face blown off."

TXU Corp: When A Buyout Does Not Work

In 2007, Kohlberg, Kravis, Roberts (KKR) and Texas Pacific Group (TPG) teamed up with Goldman Sachs Capital Partners to buy TXU Corporation.  The deal was valued between $45 to $48 billion with an $8 billion equity investment and the rest in debt.  The secured (backed by collateral) bonds are trading at 86 cents on the dollar and the unsecured bonds are trading at 55 cents.  Total debt is $36 billion.  KKR has marked its equity investment at $1.6 billion, an almost unthinkable 80% discount.  Last week, the credit default swaps tripled in price.  $22.5 billion of debt is due in 2014.  To pay back this large sum, the company, now called Energy Future Holdings Corporation can sell assets, have an IPO or ask current debtholders to trade their bonds for new bonds that have a later maturity date.  The catalyst for the fall in bond and rise in swaps prices was a claim by a hedge fund, Aurelius Capital Management, that the company technically defaulted on an intercompany loan i.e. loan between the parent and a subsidiary.

The company is not generating as much revenue and cash as was projected during the formation of the leveraged buyout because the price of gas is about $4 (per million British Thermal units.)  To pay off the loans, gas has to be between $7-$8.

There are two articles about TXU Corporation:  one at the Wall Street Journal and one at the New York Times.

Secondary Market for Private Equity

Private equity fund investors may want to sell their investments to raise cash, reduce their risk or re-balance their asset allocation.  These positions are similar to hedge fund investments.  They do not trade on a stock market daily and are hard to price.

At the 4th Annual Manager Search and Selection Conference at NYSSA in 2009, Nigel Dawn of UBS spoke about that year's state of affairs.  At the time, he was head of the Secondary Market Advisory team.  Historically, the spread between bid and ask prices was 8%.  In 2009, the spread was 20%.  Surprisingly enough, the growth was in private equity real estate funds.

The following year, David Tom, CFA, of the VCFA Group had a presentation about the secondary private equity market.  He deals with three types of investments:  limited partner interests in small and middle market buyout, venture capital, mezzanine and other private equity funds;  secondary direct private investments; and portfolios of private assets.  Secondary funds had $50 billion in assets under management with larger funds (anything over $500 million) holding 80% of the assets.  The secondary market is steadily growing.  In 2009, it was 4% of the total US private equity AUM and 3% of global AUM.  This is up from 1.5% and 1% in 2000 and 0.2% and 0.2% in 1990.  Historically, there has been a excess of secondary investment being sold on the market and not enough buyers.  The gap is much larger during crises such as the credit crisis of 2008 and the dot com meltdown in 2001.

Again, thanks to NYSSA for holding two great events.

Using Distressed Debt to Take a Company Private

An investment firm may turn a public firm into a private firm by buying its distressed debt.  The target firm may be going through bankruptcy proceedings, close to defaulting or already defaulted on its debt.  There are four main methods of buying a company.  A leveraged buyout (LBO) may not have worked.  As part of the LBO, the banks providing financing issued debt to the buyside.  In this case, new investors will buy the loans of the failed deal at distressed prices.  During the bankruptcy process, the debt investors will receive all the equity of the target firm.  A second way is to buy the company's equity and initiate a turnaround of the company.  The last two methods involve Chapter 11 bankruptcy.  Before filing for Chapter 11, a reorganization plan where the debt holders convert their bonds to equity and become majority equity holders.  The public equity owners are wiped out completely.  The last method requires a major debt holder, primarily the company's competitor, to propose a reorganization plan.  This allows the competitor to obtain non-public material information about the target company and initiate a takeover.

Basic Mechanics of a Leveraged Buyout

Let's detail how a leveraged buyout transaction is completed.  We will not discuss how investment ideas are found or performance of private equity fund managers or risk management.  The simplest way to describe a leverage buyout is through an analogy.  A common transaction that everyone is familiar with is a traditional home mortgage.  For example, the home buyer will want to purchase $1 million house.  $200,000 will be paid as a down payment and $800,000 will be financed by the bank.  The lending institution will approve or deny the loan based on the buyer's credit score, salary history, payment history, current debts and assets.  To a certain extent, the information may determine the interest rate of the loan.  The buyer's annual salary will be used to pay back the debt.  The house will be used as collateral for the loan.

For the leveraged buyout, the down payment is the investor's equity in the deal and a consortium of lenders will finance the loan.  In turn, the lenders will package the loan to banks or investors as a leveraged loan or bonds - high yield (junk) or mezzanine debt.  The banks that financed the LBO will earn fees for either transaction.  Both of these vehicles will be considered more risky/have a higher change of defaulting because the company will be saddled with a large amount of debt.  Interest rates will be higher to compensate investors for the increased risk.  The company will use its future earnings to re-pay the loan.  In the example above, this is equivalent to the home buyer's salary.  As in a mortgage, the company's assets will be used as collateral for the leveraged loan.  Leverage gives the buyer the possibility of increased returns or losses.

This is a bare bones, simplistic version of the deal.

Introduction to Leveraged Buyouts

As venture capital invests in emerging companies, leveraged buyouts invest in established, underperforming companies.  The most common scenario is a private equity fund, the merchant bank division of an investment bank or the target company's management buying a publicly traded company.  The company is taken off the markets and becomes private.  Since the initial investment (cash or equity) is usually low, its assets and cash flow are used to finance the transaction.  Financing is a combination of equity and debt with 40% to 60% being senior debt, 20% - 30% being mezzanine debt and 20% - 40% being equity.

The private equity fund has a general partner that makes the investments and several limited partners that are the investors.  The investments are usually reviewed in the first five years of the partnership.  The partnership normally lasts ten years.  As the fund exits its investment companies, the investors receive their profits.

So, how does a private equity firm turn a company that is an unattractive investment to one that everyone wants to buy?  They can improve operating efficiency, create an entrepreneurial mindset, streamline companies, build up companies and turnaround companies.  Improving operations means that there is closer oversight of the company and improved management.  The approach for creating an entrepreneurial mindset is to allow management to improve the company or carve out a subsidiary to follow its own agenda.  Streamlining and building up companies are strategies that are the opposite of each other.  The streamlining strategy means to concentrate on a firm's core businesses while the building up involves combining several companies.  The hope is that the whole is greater than the sum of the parts.  Turnarounds take underperforming companies into outperforming companies.  In each of the strategies, the private equity fund will have members on the board of directors of the target company.  They will help the board in running the company more efficiently.  Taking the firm private allows the company to concentrate on its business rather than focusing on making quarterly projected earnings per share demanded of a public company.

In venture capital, the investor cashes in on the company through an initial public offering or a sale to another company.  For leveraged buyouts, the same exit strategies are used.  Additionally, the company can have another leverage buyout, a straight refinancing or sell it to another private equity firm.  In both the second buyout and straight refinancing, the company adds more debt in order to reward company management or the equity holders a dividend.