Second of three parts
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TXU Corp. could become the first national electricity company Americans have ever seen.
Private equity firms Kohlberg Kravis Roberts & Co. and TPG aren't saying how they plan to make money with their $45 billion bid for the public utility, but a consultant hired by The Dallas Morning News to analyze the deal speculates the buyers just might be planning to extend TXU from sea to shining sea.
That's the best guess for why the investors would put together the biggest leveraged buyout ever, taking on $24.6 billion in debt, to net a company that's already healthy and lean, according to the independent report by GF Energy LLC of Washington, D.C.
Trouble is, the U.S. doesn't have the regulatory framework to protect customers of a national utility, the report says. And the high level of debt involved in the deal could push up rates, leaving customers vulnerable.
Officials with the buyout companies declined to be interviewed on the record for this story. After reading the report last week, the buyout group said in an e-mail that it is "filled with generalizations and erroneous conclusions" but didn't elaborate.
Mike McCall, chief executive of TXU Wholesale, wrote in an e-mail last week to the lead author of the report, Roger W. Gale, that a change in ownership doesn't change the regulatory framework, and "a substantial body of enforceable rules, laws, procedures and protocols already exists" to regulate the power industry.
"This could be a recipe for trouble," said Tom "Smitty" Smith, head of the Texas office for consumer advocate Public Citizen.
Potential mergers
"In the end, much of the judgment about it comes down to whether one believes that big national companies owning large swathes of market share – like what we see in nearly every industry – is in the best interest of consumers. This transaction could ultimately result in its being turned into a national company – whether via organic growth or via acquisition of or by non-Texas companies."
Mr. Gale says the buyers' promise for greater separation between TXU's three businesses is the first step toward expanding them nationally and eventually spinning them off for a profit.
Already since the buyout was announced, TXU has changed the names of some units to reinforce the separation between them, and possibly set the stage for spinoffs. TXU Wholesale and TXU Power became Luminant. TXU Electric Delivery, the regulated power-line business, became Oncor.
"By separating the assets, the buyers get the ability to maximize the debt and equity and to position the new companies – Luminant, Oncor and TXU Energy – to be recapitalized, resold or rebundled," the report states.
TXU could expand nationally by buying other companies, such as power line operators, or entering another state cold by building new plants or offering retail service.
Retail electricity is one of the few businesses in the U.S. that hasn't been consolidated into a national platform, the report notes.
And expanding Luminant, the generation and wholesale business, might mirror NRG Energy, Texas' second-largest generation company, behind TXU.
New Jersey power plant operator NRG entered Texas in 2005 when it bought Texas Genco Holding LLC from a group of private equity companies, including KKR and TPG. Texas Genco was an old-fashioned private equity flip: The investors bought a lower-performing unit of a large company, shut down some unprofitable plants and sold it within two years at a profit.
TXU chief executive John Wilder had considered expanding TXU's reach to the Northeast, building coal-fired power plants possibly in Pennsylvania. But when the buyers showed up, those plans stalled.
He had also considered spinning off the power line business as a national transmission and delivery company.
Mr. Wilder said in an interview on Feb. 26, the day he announced the buyout deal, that he expects the investors to use TXU as a vehicle for growth in the utility industry.
"If they invested in TXU overall, then they would have this ongoing conduit to put investment capital to work on projects," he said.he said.
The U.S. utility industry is about as disjointed and regional as an industry gets. But states have begun to deregulate the retail and wholesale power segments, and a federal law preventing private, out-of-state, nonutility ownership has been repealed, making the industry ripe for mergers, some say.
The utility industry could be on the cusp of moving in the direction of the telephone or airline industries, which broke out of their regional molds after deregulation. Already a few power companies focus exclusively on operating generating plants and have expanded their reach across state borders.
Bringing in cash
"It is our view that it is more – rather than less – likely that the owners will transform the assets using them as a platform for future growth, recapitalizing them through initial public offerings, etc., and, perhaps, selling them. If so, this is not by definition a long-term transaction."
In the short term, the buyers will have to take other measures to make sure TXU is pumping out the cash needed to pay off the billions in debt required to finance the buyout. And they've only given a few clues about their plans.
They might innovate their way to revenue, the report states, or they may have to hike consumer prices.
The buyers have said they plan to sell a 20 percent stake in the power line business to another investor. Such a sale might generate enough money to "satisfy debtors and credit agencies, cash in on some returns for investors and invest in remaining assets," according to the GF Energy report.
That could put the new TXU owners in a position to innovate and invest in new retail products, perhaps products inspired by the $400 million the buyers will spend to help people cut their demand for power.
Or, the report says, the buyers may simply cut retail prices until 2008 to retain customers, then raise prices again and generate more cash flow.
Another possible money-making strategy is to simply sit on TXU until the stock prices of similar utilities rise, then sell, the report says.
The buyers' silence on this issue has worried some bond analysts.
"There is uncertainty concerning the strategic direction of the company as well as likely changes to the financial practices and corporate structure of TXU and subsidiaries," Fitch Ratings said in a research note.
The ratings agency has said it expects to downgrade TXU debt after the buyout. Some agencies already rate TXU at junk status.
When ratings agencies downgrade a company, lenders expect the company to pay higher interest rates to cover the higher risk. The buyers' cost of capital, therefore, could rise. And those costs could be passed on to consumers.
"We ... assume that the board is cognizant of the significantly increased risks of defaulting on its future debt obligations and the ramifications such an event could have on the assets and services provided by the company's businesses," Moody's Investors Service wrote in a research note.
Power plants
"If the buyers are able to build three new coal plants in the next five years, especially grandfathered units that don't require advanced CO{-2} controls, the value of those plants could be enormous to a potential buyer. Nuclear plants and IGCC [integrated gasification combined cycle], on the other hand, take longer to build, introduce significant technological and political risk, and are probably less likely to be built by the new owners than by a more traditional utility."
A big question for bond holders and consumers is whether investors view power plants as a short-term cash cow or a long-term value proposition.
The buyers promised to build only three of the 11 coal-fired power plants TXU had originally proposed. Some analysts say that's a strategy to boost profit right away.
"The ability to maintain the robust cash flow position was largely a function, in our opinion, of the continuation of favorable [wholesale] market conditions, and we now believe the cancellation of many of the new coal projects will ensure, to some degree, that TXU's base load fleet remains well positioned over the longer-term,"Moody's said in the research note.
In other words: Limit electricity supply, and prices will rise.
The buyers have said they will consider building a coal gasification plant, which uses cleaner technology, and more nuclear reactors, but there's no commitment to spend money on generation beyond the three higher-pollution coal plants.
The report questions whether there's any incentive for the buyers to make such long-term plans, since they've only committed to owning the company for five years. It can take a few years just to gain the licenses, permits, engineering assessments and construction plans required to break ground on a nuclear or clean-coal plant.
Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College, says that's the wrong way to think about a private equity deal.
"They're accused of not taking a long-term focus, they're asset strippers, flippers, all these pejorative terms," he said.
"They have to do an exit, probably into a public market or to a buyer that's a public company. So they've got to have built something that has substantial value," he said.
If the value of TXU is based on how much profit the company is expected to generate in the future, then building more power plants is a money-making strategy, Mr. Blaydon said. The plans alone to build such plants could be valuable to a buyer, he said.
Game plan
"Private equity players are much less consumer-focused than TXU is today. They are driven by achieving a single goal: Maximizing the value of the asset as quickly and dramatically as possible."
In the past, private equity investors have snapped up distressed or flabby companies, trimmed costs and resold for a hefty profit. Those days are over as a surge of investors hunt for deals. Now, the game is to actually improve the company before selling it, experts say.
Those past deals left private equity firms facing a lot of scrutiny. Critics worry that the investors, shrouded in secrecy, are out to strip companies of their assets and sell off everything bit by bit for a giant profit.
The investors don't face as much regulatory oversight as a public company. And regular people don't get to invest within the high-profit deals. Rather than market their funds to the masses, private equity companies tend to focus on big institutional investors or wealthy people.
The whole idea for private equity investors is to buy a company and boost the cash flow – or at least expectations of future cash flow – so that the value of the company increases. These aren't investors that hold on to companies to enjoy slow, steady profit. Private equity buyers make their money by selling the companies for a big return.
There are three ways to boost the value of a company to maximize that return, according to Mr. Blaydon at Dartmouth.
"Buy it cheap and sell it at a better price,"he said. That's characteristic of the deals in the 1980s, when giant, inefficient conglomerates didn't always understand the value of some of their businesses. Private investors often bought undervalued businesses and remarketed them for a hefty return.
A more complicated way of making money is through fancy financing.
Buy a company that doesn't have much debt and load it up with more. This can actually lower costs, said Mr. Blaydon, who has worked as a private equity partner.
The interest the company must pay on bonds might be lower than the dividends it was paying on stocks. Also, interest payments are tax-deductible, Mr. Blaydon said. Dividend payments aren't.
These days, with so many buyout companies competing for deals, private equity companies have a third way of making money.
"The way everyone has to do it now is to actually improve the company, improve the cash flows,"Mr. Blaydon said, by cutting costs or boosting revenue.
"It's some variation of all of that that they're going to be looking at when they look at TXU,"he said.
Lack of regulation
"These 'barbarians at the grid' are driven by fundamentally different incentives than TXU and other utilities that have grown out of a slow-moving, low-risk, customer service driven culture and monopolistic structure."
Should TXU be purchased by a private company and expand operations to other states, it could challenge regulators' authority to monitor the company's full activities across business units, and threaten their access to all of TXU's financial data, the GF Energy report shows.
TXU became an especially attractive target for KKR and TPG when Congress gave utilities the right to sell to private, out-of-state investors. Yet, the government hasn't created a regulatory framework that would offer the same protections to consumers in multiple states, the report says.
Top brass at the buyout companies and Mr. Wilder, the chief executive of TXU, had been kicking around the idea of a deal for years. The investors mostly thought about acquiring one of TXU's businesses, not buying the whole company, Mr. Wilder said in the Feb. 26 interview.
That was the day the buyout group made their offer of $69.25 a share, higher than TXU stock had ever traded.
"I think just the depth of the capital markets and the amount of liquidity they could access, I think it opened up their eyes that they could potentially be a corporate investor in TXU, and then use TXU as their vehicle to invest capital in the energy infrastructure in the future,"Mr. Wilder said in the interview.
The investors won the right to buy the whole company in 2005, when Congress repealed the Public Utility Holding Company Act. The act had blocked out-of-state, private, nonutility investors from buying power companies.
But there's no regulatory structure meant to protect all consumers equally if an out-of-state company exercises its right to buy a utility and expand it to many states, according to the report by GF Energy.
The buyout must gain permission from the Federal Energy Regulatory Commission, which is "broadly disposed to approve almost any merger," the report states, and has done so before state regulators could act.
The proposed TXU deal must go before the Public Utility Commission of Texas for a review of the buyout's impact on the regulated power-line business unit, Oncor. The PUC still sets rates for that.
The commission has a more limited, fuzzy role in overseeing the deregulated wholesale and retail markets.
"Ownership of utilities by a holding company or by private entities raises concerns over transparency," the report states. "While most utilities are required by state law to file reports detailing operations and some level of finance, the existence of multiple layers of regulated, unregulated, and holding companies – especially those straddling multiple states – makes this more difficult."
See chart of KKR's previous acquisitions
