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February 25, 2007

TXU Buyout – Private Equity Funds Paint Themselves Green

A New York Times story this morning is full of gushing praise from environmentalists for the promise by private equity funds Kohlberg Kravis Roberts & Company and the Texas Pacific Group for promising to scrap plans for eight coal-fired plants at Texas utility TXU Corporation which they are proposing to purchase in a leveraged buyout.  The Times quotes James Marston, whom they identify as running the Texas energy program for Environmental Defense, as calling the plan “a turning point in the fight against global warming.”  A wrong turn would be more like it.  Energy needs more investment, not less – particularly if environmental concerns are to be met.

Oversimplified, the leveraged buyouts which private equity firms do consist of having a target company take on lots of debt and use any other cash it might have to buy itself back from public shareholders.  The equity firms put some of their own money into the transaction which usually is just a tiny portion of the purchase price.  Typically, they then run the company in harvest mode making very little investment, paying interest on debt – some of which they hold themselves, and reaping a healthy cash flow after that.  Sometimes they resell depleted parts of a company for the same kind of residual value you buy a car for at the end of its lease. 

This is all legal.  Leveraged buyouts sometimes serve a useful economic purpose by giving current equity investors an exit (TXU stock was up sharply on the announcement) and freeing equity money to go elsewhere. Also sometimes the fiscal discipline necessary to pay back the debt is a good thing.

Details of this proposal are not available yet except for the unusual announcement about the plants that won’t be built.  However, this is clearly leveraged buyout heaven .  Not only do they get out of having to invest the money they’d rather harvest; without the planned new capacity, the price of the electricity TXU generates from its existing plants is bound to go up.  More cash flow.  Talk about green! 

Quite reasonably, there had been environmental opposition to the plans for these new C02 emitting plants although there was no responsible claim that the energy isn’t needed.  In fact many environmentalists realize that we need a more electric economy.  From a national security and economic point of view, of course, it is far preferable that we use domestic coal for energy than imported fuels. What TXU does has a huge effect on the price of electricity in its market which it dominates.  The to-be-canceled plants would have added 3.7% to the entire country’s coal-fired capacity.

It is also true that there is significant shareholder risk is building new coal-fired plants without knowing what measures the country will take to limit greenhouse gas emissions.  A carbon tax would certainly change the projected economics of those plants.  BTW, this is an argument for congress and the administration to act quickly so rational economic decisions can be made.

From the country’s point of view the decision to reduce planned investment in electricity generation is a very bad decision.  This is not an industry from which we want to have equity capital replaced by debt.  This is not an industry which we want to leave without adequate borrowing capacity for increases in capacity and environmentally-sound retooling of existing capacity.  This is not an industry we want draining its cash into the coffers of private equity firms.

Yes, it would make sense to build nuclear or solar plants instead of the planned coal plants.  Yes, it would have made sense to increase the investment so that, if coal is used, the CO2 is captured and sequestered (economically impossible unless there is a significant carbon tax or some other forcing action).  Yes, the buyout firms say they’ll look at all kinds of green stuff – but it won’t be the kind of green the environmentalists are thinking about.   It’s not in the nature of “private equity groups” to invest in increased production rather than harvest higher prices resulting from reduced capacity.

Unfortunately, well-meaning environmentalism has often been the unwitting ally of poor energy policy, artificial scarcity, and high energy company profits.  How come no new refineries have been built in the US in a long time?  Environmental opposition gives energy companies great cover for harvesting rather than investing in price-lowering capacity.  What about nuclear power plants?  Turns out that not dealing with the problem of waste has been a convenient excuse for both some environmentalists and energy companies to leave us much more dependant on fossil fuels from faraway places than we ought to be.

For economic, security, and environmental reasons, we need increased investment in new energy resources – we don’t want to encumber the old resources with new debt.

Full disclosure:  I negotiated a deal to sell a public company to a private equity firm.  With hindsight, I think it was the worst business mistake I ever made.

Even more disclosure:  I own a small amount of stock in coal firms.  I think we will need this resource.  I’d be happy to see it burdened by a carbon tax or tradable carbon credits.   

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MISSING THE FOREST FOR THE TREES The mainstream media, when focusing on business/Wall Street stories, is simply too fixated on the next biggest, record-breaking transaction by private equity firms. Both the print and broadcast business media seem to be... [Read More]


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