Coal was supposed to drive returns in the TXU deal. Image source: Tedder via Wikimedia.
When private equity giants KKR, TPG Group, and Goldman Sachs Capital Partners came together in 2007 to make a $44 billion bid for TXU Corp., they didn't foresee the calamity the deal would eventually become. In just seven years what amounted to the largest buyout in history -- in the relatively stable electric utility market -- would become the largest nonfinancial bankruptcy in U.S. history.
How did this happen? The answer lies in the risks private equity firms must take to generate outsized returns and the confidence that can lead even the smartest investors to make acquisitions at precisely the wrong moment in time.
Buying a dying industry with a lot of debt
At the peak of the private equity boom, buyout firms could raise billions in debt with the snap of a finger. In this case, the trio of KKR, TPG Group, and Goldman Sachs Capital Partners got $40 billion in debt financing to buy out what seemed to be a fairly stable company.
TXU was the largest coal power plant operator in Texas and served 3 million retail utility customers as well. The underlying bet during the buyout was that plunging natural gas prices that had hurt wholesale electricity profits would reverse course and that profits would increase at coal power plants owned by TXU.
At the time, the bet seemed logical and the buyout, while expensive, seemed relatively safe. On Oct. 10, 2007, the deal closed and TXU Corp. became known as Energy Future Holdings.
What could go wrong with such a buyout? After all, electricity consumption always rose and electricity prices always went higher, or at least they used to.
The things everyone knows
The buyout consortium's underlying theory at the time was that oil and natural gas prices were linked at the hip, something a lot of people thought at the time. If you look at how prices usually traded it was easy to see how one could think that. Long term, the two commodities always reverted to the mean. The outlier seemed to be rapidly falling natural gas prices in 2007, which it seemed obvious would climb to match oil before long.
WTI Crude Oil Spot Price data by YCharts.
What actually happened? Oil prices actually rose over the ensuing seven years -- except for a short decline during the recession -- and natural gas prices fell even further. The result was that electricity from natural gas power plants became even cheaper, making it difficult for Energy Future Holdings' coal plants to compete.
WTI Crude Oil Spot Price data by YCharts.
Sometimes the things that seem so obvious just don't happen the way you anticipated. No one saw the U.S. shale boom coming and that the resulting flood of natural gas would lead to its price divergence with oil, which once seemed impossible.
The downfall of Energy Future Holdings
As the price of natural gas fell, coal plants owned by Energy Future Holdings began to lose money, and the more than $40 billion in debt used to take the company private became a weight dragging the business down.
By April 2014 the company couldn't make its scheduled debt payments and was forced into bankruptcy. And that's where things got really strange. Energy Future Holdings had been split into two companies: Oncor, a regulated electric utility, and Texas Competitive Electric Holdings. The latter is the company that filed for bankruptcy, while the private equity owners still hope to extract some value from Oncor.
The convoluted structure has resulted in a prolonged bankruptcy, and Energy Future Holdings is not expected to file a legitimate restructuring plan before next summer.
The whole debacle comes with a few lessons for investors. First, using too much leverage because it can result in a company's demise, no matter how large it is. Second, don't get overconfident that the way the market worked in the past is how it will work in the future. Few would have predicted the drop in natural gas prices or the demise of coal, but those developments worked against Energy Future Holdings. Finally, don't trust private equity firms. They have pulled $560 million in advisory and monitoring fees out of the company since the buyout and created an operating structure that's built to squeeze everything they can from debt holders. Even Warren Buffett, who provided $2 billion in debt financing for the deal, called it a "big mistake." Now that's saying something about what a disaster this deal was from start to finish.
