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.

Inflation and Oil Prices

I was alerted to a posting at www.hedgeworld.com by Irene Aldridge, portfolio manager at ABLE Alpha Trading, about the relationship between oil prices and inflation.  One of the major factors affecting inflation is the amount of money supply in the US.  The Federal Reserve Bank has added almost $500 billion in the past year as part of Quantitative Easing 2.  Based on historical patterns, the Fed would take money out of the system due to the recent rise of oil prices due to the unrest in the Middle East.

Manager Selection Process for Private Equity

For investors, the manager selection process begins with their investment strategy.  Using this as the baseline, they identify which fund managers match their strategy.  The managers may be ranked in various categories based on their performance and experience.  Any team not falling in one of the following would not be invested in:

• Star - top quartile returns for at least 3 funds for at least 2 business cycles
• Established - top quartile returns for most of its funds (at least 3 funds) for at least 2 business cycle
• Emerging - new fund manager team with limited history in working together
• Re-emerging - turnaround situation;  previously star or established team that is being re-structured, had bad returns or had operational issues

The investors should use their network to find good investments and quality managers.  Star teams are referred to new investors by their current universe of investors.  New investors should establish a relationship with star managers before they start raising funds for their next follow-on funds.

In the prior post, we read a study on how private equity fund manager performance persists from one fund to another.  Therefore, successful managers are oversubscribed when opening a new fund.  They will first allow the investors of the original fund first crack at investing in the follow-on fund.  Because of this, the fund will generally be closed before new investors are invited.  Fund managers tend to retain known investors as fund raising can be time consuming and expensive.  New investors that could be invited to the fund would be those with industry experience or can help in exiting positions.

Once a manager is found and is receptive to having the new investor in a fund, the next step for the investor is to conduct due diligence on the manager.  The first step is screening.  This means eliminating funds that do not have the right investment strategy or performance/quality requirements.  About 1/3 to 1/2 of funds are pass this stage.  Then the investor interviews the manager to get a detailed understanding of the organizational structure, people, office dynamics, experience and track record.  Based on the information gathered, fund managers are evaluated to choose the best investment.  Funds are graded based on a relative ranking and much of the decision making is subjective.  More detailed due diligence is done for funds that get through the evaluation process.  The investors look at any legal issues, any issues from the initial due diligence phase and check references from co-investors, competitors, officers from past investments and past investors.

The investors decide whether or not to invest in a particular fund.  It does not mean that the investors will not look at the team again for another fund.  On the other hand, the manager has to accept the new investor into the fund.  The manager may reject the new investor if there is too much money invested already or if the investor has a history of defaulting on investments or causing problems for the manager.

Private Equity Return Factors

Six researchers from Germany wrote a research paper about the different factors that affect private equity fund returns.  The researchers were Philipp Aigner, Stefan Albrecht, Georg Beyschlag, Tim Friederich, Markus Kalepky and Rudi Zagst.  They analyzed 358 funds and found the following results:

• Fund manager performance persists from fund to fund.  For managers ranked in the top 25%, 41.7% returned to the top 25% in their follow-on fund.  For managers ranked in the second 25%, 50% moved up to the top 25% in their follow-on fund.
• Diversifying the region and sector of the fund does not affect returns
• Diversifying the financing stages of the investments positively affects returns i.e. the more diversified the fund is, the better the returns
• General partner/manager experience has a positive affect on returns
• Performance of publicly traded markets has a positive effect on returns i.e. higher returns in the public markets mean higher returns for the private equity fund.  But good performance of the markets during the vintage year affect the fund returns negatively.  The vintage year is when the fund is opened and receives investment capital.
• Interest rates have a negative effect on returns i.e. higher interest rates mean lower returns
• Gross domestic product growth has a positive effect on returns.  If the growth is during the vintage year of the fund, then it has a negative effect on returns.

An Interview with David Einhorn of Greenlight Capital

I was alerted to this great transcript of an interview by the Financial Crisis Inquiry Commission in November 2010.  The interviewee is David Einhorn of Greenlight Capital.  David is a famous hedge fund manager for his public short positions on the Ambac, MBIA and Lehman.  But let's be clear.  His strategy is not only shorting.  His fund has a net long position in the market.

Some topics discussed were:

• Ratings agencies
• Credit bubble
• Risk management using Value at Risk
• Mark to market accounting
• Short selling

Municipal Bond Prediction by Nouriel Roubini's Firm

Roubini Global Economics has published a research report about the municipal bond market.  It predicts that defaults will total $100 billion over the next five years.  Actual losses to investors will be $35 billion because of the high rate of recoveries for these bonds.  This prediction is in line with Bill Gross of Pacific Investment Management Company and much more optimistic than the $2.9 trillion worth of defaults foretold by Meredith Whitney, the eponymous analyst of Meredith Whitney Advisory Group.  The report was written by David Nowakowski and Prajakta Bhide.

Nouriel Roubini, also known as Dr. Doom, is famous for forecasting the credit crisis and is the chairman of Roubini Global Economics.

Sample of Sellside Global Strategy Research Report

During large scale events such as the ongoing situation that started in Tunisia and has moved on the rest of the Middle East and North Africa, sell side institutions may publish a combined research report from multiple departments.  This is the case with the Strategy Snapshot from Credit Suisse.  Here the fixed income division writes about commodities, foreign exchange, mortgages and emerging markets.  The main themes are:

• If oil prices reach $150/barrel or gas prices reach $4.50/gallon, then they will negatively affect any economic recovery
• Italy will be most affected by Libya's turmoil but should be able to obtain energy from other sources
• Any Algerian trouble will affect Spain and Italy
• Major concerns of the US markets are Government Sponsored Enterprises reform, debt ceiling for the federal government and 2012 US budget
• Recommended emerging markets currencies to invest in are the Mexican peso, South Korean won, Chinese renminbi, Indonesian rupiah, Israeli shekel, Polish zloty, South African rand and Turkish lira.