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Replies to #9 on Vistra Corp (VST)

Enterprising Investor

04/29/14 10:44 PM

#10 RE: Enterprising Investor #9

For Energy Future Holdings, a colossal collapse but limited pain for buyout’s architects (4/28/14)

When Energy Future Holdings files for bankruptcy, the two private equity firms that engineered the $45 billion buyout of the former TXU Corp. are expected to see their stake reduced to virtually nothing.

But what might be devastating for other financial firms has done little damage to KKR & Co.’s and TPG’s positions as the private equity titans of Wall Street.

According to experts and private equity insiders, the two firms managed to minimize the hit to their balance sheets and reputations through a strategy to shrink their exposure and that of their investors if the 2007 buyout went south.

The firms put only a fraction of their own money into the deal. They collected hundreds of millions in fees along the way. And their investors made money even when losses at EFH started piling up.

“It gives them a black eye. But it’s in the context of one bad investment, and they have many other good investments,” said Don Shelly, a professor at SMU’s Cox School of Business. “They’re going to take a hit, but they were smart enough to syndicate it out and not take too big a piece themselves.”

To buy EFH, Texas’ largest power company, KKR, TPG and Goldman Sachs Capital Partners, which came later to the deal, had to come up with $8 billion in equity to complement close to $25 billion in loans and bond offerings they pulled together.

Spreading the risk

According to filings with the U.S. Securities and Exchange Commission at the time of the merger, the firms pulled together up to $3.7 billion of that equity from sources including Morgan Stanley, Citibank and their own existing clients.

The rest would have come from the three firms, primarily from the private equity funds they sell to investors, which spread money across a variety of deals.

Exactly how much came out of the firms’ own pockets is not made clear in securities filings. But KKR, which as a publicly traded company must disclose its financials, reported that the firm’s own exposure to the deal amounted to just $200 million. The firm, which recorded $7.9 billion in profits in 2013, has since written that investment down to $10 million.

But KKR, TPG and Goldman Sachs have collected more than $300 million in management fees and debt restructuring payments from Energy Future since the buyout, according to SEC filings. And the firms also shared with the now-closed investment firm Lehman Brothers a $300 million transaction fee at the time of the merger.

Such fees are standard in leveraged buyouts, intended to cover all the costs associated with the deal and the firms’ own overhead. But they probably have also served to reduce the losses suffered by KKR on its $200 million investment and by TPG and Goldman Sachs on the unknown sums they invested in the deal.

“It’s hard for me to figure out who the loser is here other than the big [creditors groups] who put the money behind the deal,” said Geoffrey Gay, an attorney with the Texas Coalition for Affordable Power, which acts as a watchdog on the power sector.

“I’m not sure the people who put the deal together are going to lose all that much. … Are they losing their shirt? I don’t think so.”

A spokesman for the three private equity firms declined to comment for this article.

Investors insulated

But the firms show little sign of damage from their failed bet on Texas’ largest power utility.

KKR, which revolutionized the private equity world with the takeover of RJR Nabisco in the 1980s, has watched its stock price more than double since it went public in 2010.

TPG, the global firm headquartered in Fort Worth, raised more than $35 billion from investors over a five-year period ending in 2013, more than any other private equity firm, according to the magazine Private Equity International. And analysts say the firm could double the estimated $2.4 billion it and its partner paid for the clothing retailer J. Crew in 2011.

Their reputation was in many ways protected by the fact that their investors, who would have put up much of the $8 billion in equity, still managed to turn a profit on the deal.

The equity came primarily from two separate funds, named KKR 2006 Fund and TPG Partners V. Even with the Energy Future losses, those funds were diversified enough to keep them in the black.

According to the Oregon Public Employees Retirement Fund, which invested in both funds and makes public its investment performance, the KKR fund has on average produced a 7.7 percent annual return on the retirement fund’s $1.3 billion investment.

The TPG fund on average produced a 1.2 percent rate of return for the pension fund’s $300 million investment.

But any investment fund that operated through the 2008 financial crisis would have performed below industry standards. Of the 30 private equity funds in which the Oregon pension fund invested in 2006, the average rate of return was less than 5 percent.

Warren Buffett’s lament

The majority of the losses in the Energy Future buyout have come among the financial houses that either loaned EFH money or purchased its bonds. Debt on the company’s unregulated business has been trading for between 72 cents and 3 cents on the dollar, according to a report in March by the research firm Credit Sights.

Last month, financial guru Warren Buffett told Berkshire Hathaway investors that his close to $2 billion bet on Energy Future bonds had lost the company $873 million.

“Most of you have never heard of Energy Future Holdings,” Buffett wrote in his annual shareholders letter. “Consider yourselves lucky; I certainly wish I hadn’t.”

For now, the private equity industry’s top firms appear to be backing off the big-dollar deals like those that defined the years in the run-up to the financial collapse.

At a meeting with the Oregon pension fund earlier this year, TPG co-founder James Coulter said the firm had shifted strategy to focus on smaller deals.

“We have returned to what private equity does well after a period of time in which the industry did a lot of large deals with kind of mixed results,” he said.

How long that strategy will remain in place is unclear. But Shelly, the SMU professor, said he did not expect it to last long.

“These things are cyclical,” he said. “They’re saying that now, but it will come back. When you’re a big player, you have to have big deals to move the dial. How many $2 billion deals are you really going to do?”