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February 27, 2007

TXU Deal - $24 Billion That WON’T Be SPENT on Energy OR the Environment

The numbers now available for the proposed leveraged buyout of Texas utility TXU by Kohlberg Kravis Roberts & Company and the Texas Pacific Group show that $24 billion dollars of new debt will be created as part of the deal. This is in addition to the $12+B (WSJ) or $13B (NY Times) TXU already carries on its books.

What neither The Times or The Wall Street Journal are explaining is that this new debt, which will be an obligation of the recapitalized utility, not the leveraged buyout firms, is borrowing capacity which will now NOT be available to build new power plants or make existing power plants more environmentally friendly.

The purpose of the $24B in new borrowing is to raise the lion’s share of the funds needed to buy the stock now held by equity investors.  There are 459.24 shares outstanding and the leveraged buyout firms are offering $69.25/share for the stock so roughly $32B is needed to buy this back (and pay banking and legal fees for the transaction). According to the NY Times article, the remaining $8B will come from the LBO firms’ equity and directly from some of the LBO firms’ investors ($1B).

The stock is currently paying a dividend of 3.09% after a recent run up in price. The debt will pay considerably higher interest. The current equity holders get out at a premium to recent prices so they are not really losers unless they wanted to let this bet ride.  They’ll have their money back to reinvest.  Reflecting this, the stock was up over 13% just yesterday.

But things look very different over in the bond market. The company’s existing debt traded down reflecting the huge new burden of debt to be added. From a different article in The WSJ:

“Standard & Poor's warned that TXU Corp's corporate credit rating of triple-B-minus, the lowest rung in the investment-grade ladder, could be downgraded into junk territory. Fitch Ratings went a step further and downgraded its issuer default rating on TXU to double-B-plus, or junk, from triple-B-minus.”

From a public policy point of view, what is important is the company now will have very little if any capacity to add debt either to build new plants or make old ones cleaner. Obviously prior to this deal, it could have borrowed up to $26B for these purposes if not more.  However, again according to The WSJ, Texas Regulators don’t have the legal authority to block this deal.

Environmentalists can rest assured that the company won’t build the new coal-fired plants it had planned; it’ll have to keep that promise because it won’t have the borrowing capacity left for new construction. We can all rest assured that they won’t be adding significant green capacity for the same reason; $26B of equity is gone from the energy industry. Texans (and actually all of us) can be assured of ultimately paying more for energy in the future (despite a short-term cosmetic rate decrease the company is promising to a minority of its customers for a year) since a lot of capital that could have build new capacity won’t.

Michael Parekh blogs that the mainstream business press has missed the real impact of the story because they’re fixated on the size of the merger: “It is to the business press what the sad passing of Anna Nicole Smith has been for the mainstream broadcast and print news organizations.” He’s right; there’s a huge story here about our energy future that is just simply being ignored.

There’s also an ongoing story about how leveraged buyouts work which is worth telling.  They are not always bad; in mature industries they may even be appropriate. But the “leveraged” part means that debt gets substituted for equity and investment in new or improved capacity by the target company goes down.

Previous post on this: TXU Buyout – Private Equity Funds Paint Themselves Green

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