Lights out: Largest leveraged buyout in history

Katie Bradshaw (MBA/MEM '15)

Katie Bradshaw (MBA/MEM ’15)

On April 29, 2014, Texas-based utility Energy Future Holdings Corp. filed for Chapter 11 bankruptcy, ending the largest leveraged buyout on record. Utility bankruptcies in general are rare, but even outside of the utility realm, a bankruptcy of more than $40 billion1 in an asset-based industry is unheard of. So naturally, many of us are left asking questions – what went wrong, and are other utilities at risk of going bankrupt?

What went wrong

In 2007, private equity firms KKR and Co., TPG Capital, and Goldman Sachs Capital Partners acquired TXU Corp. for $45 billion and formed Energy Future Holdings Corp. TXU Corp. was acquired as a leveraged buyout, where a large amount of debt is issued to fund the purchase of a company, in this case a record setting $40 billion. As is typical with private equity buyouts, the plan was to hold and improve the financial performance of the entity before reselling the company or cashing out by taking the company public. In 2007, a TXU Corp. buyout looked like a great investment. TXU Corp. was the fifth-largest energy concern in the U.S., serving approximately 2 million customers. Natural gas prices were at their peak, giving TXU Corp. sizable margins on their coal and nuclear power. And ultimately the deal was made possible by cheap and easily available debt combined with high deal valuations.2

The key assumption being made at the time of the buyout was that natural gas prices would remain high. Looking back, we know that was not the case. Energy Future Holdings only operates in Texas and relies primarily on coal and nuclear power. Investors were basically making a huge hedge against natural gas, particularly in the Texas market. Thanks to new technological advances and the expanded extraction of natural gas from the Eagle Ford Shale Play, natural gas prices dropped dramatically, reducing the reliance on coal and nuclear energy sources.

Looking back, most would agree that Energy Future Holdings’ reliance on natural gas prices remaining high (revenue risk) and their highly-levered capital structure (debt risk) ultimately led to their bankruptcy.

Utility revenue risks

Revenue risk is not unique to Energy Future Holdings and is an issue for other energy utilities, as well as water utilities. The Energy Future Holdings bankruptcy however, provides an excellent example of how important it is for utilities to understand their exposure to revenue risk and variability. Utilities must meet the challenge of dealing with the mismatch between having high fixed costs while depending largely on variable revenues. As a result of this mismatch, it is incredibly important for utilities to evaluate and minimize their revenue risk exposure.

There are several key factors that directly impacted the revenue risk exposure of Energy Future Holdings that could affect the revenue risk exposure for other types of utilities. These factors include:

Regulatory environment. In the deregulated Texas energy market, most customers can choose their electric provider, encouraging competition and allowing energy and fuel prices to adjust to market demand rather than prices being set by regulatory bodies. Before the buyout, TXU Corp.’s financial performance was great in the deregulated market when coal and nuclear were cheaper than natural gas. However, when natural gas prices dropped, coal and nuclear could not compete and Energy Future Holdings’ revenue declined.

In a regulated market, the impact of the lower natural gas prices would have been slower to affect pricing in the market and would have reduced revenue risk exposure for Energy Future Holdings. More broadly, regulatory issues affecting utilities may include initiatives related to water conservation, energy efficiency and water quality improvements. These initiatives may change customer behavior, reducing consumption and leading to revenue variability.

Technological advances. The development and application of hydraulic fracturing techniques lowered variable production costs of natural gas, thus enhancing its competitiveness with coal and nuclear. Development of current hydraulic fracturing practices first started in Texas in 1997 before really taking off in 2011.3

When the buyout of TXU Corp. was executed in 2007, hydrologic fracturing technology development was well on its way and should have been viewed as a potential threat to revenue growth in coal and nuclear. For other utilities, technological advances may be in the form of the development of energy or water efficiency technologies which drive down overall energy and water consumption and demand levels.

Geographic impacts. In the case of Energy Future Holdings, their location in Texas had a significant effect on their revenue risk exposure. Because Texas has large natural gas plays, the distance from the extraction site to the power generating facility is short, further driving down the already declining natural gas prices in the Texas market.

For other utilities, geographic impacts may be in the form of weather variability. Locations with large seasonal fluctuations and/or regular extreme weather events – such as droughts and floods – can change customer demand patterns, leading to significant revenue variability.

Lessons learned

Projecting revenue risk and minimizing revenue variability play a key role in utilities being able to achieve their financial and policy goals. Utilities of all sizes should consider modeling their revenue variability and evaluate ways that they can reduce their exposure to revenue risk either through pricing or other practices. Utilities that consistently struggle to project revenue and that fail to minimize revenue risk may have difficulty meeting their financial obligations. These utilities may end up in a perpetually distressed state, or worse, be forced to declare bankruptcy. Unfortunately, investors in Energy Future Holdings had to learn this lesson the hard way.

By Katie Bradshaw (MBA/MEM ’15)

Additional info, resources and tools:

Republished with permission from the UNC Environmental Finance Center blog.

[1] Creswell, Julie and Michael J. De La Merced. “Settling the Bets of the Private-Equity Megadeal’s Golden Age.” The New York Times. April 29, 2014. [2] Anderson, Jenny and Julie Creswell. “For Buyout Kingpins, the TXU Utility Deal Gets Tricky.” The New York Times. February 28, 2010. [3] Macmillan, Steven, Alexander Antonyuk, and Hannah Schwind. “Gas to Coal Competition in the U.S. Power Sector.” International Energy Agency, Insights Series 2013.