The private equity industry has seen its share of busts.
Buyout strategies are inherently risky, and sometimes even a firm’s best efforts can’t match up against unfavourable market environments or irreparably broken portfolio companies. A number JC Flowers II holdings come to mind, as does department store Mervyns and Hostess Brands. Unfortunately for its owners, the largest buyout in history may soon join those undistinguished ranks.
The record $48 billion buyout of Energy Future Holdings orchestrated by Kohlberg Kravis Roberts, TPG and others was a high-water mark for private equity’s so-called Golden Age. Energy Future Holdings’ fortunes have since taken a turn for the worse.
In October 2007, KKR, TPG and other members of the sponsor group committed $8.3 billion in equity to acquire Energy Future Holdings. By the end of 2012, KKR valued the company at only 5 cents on the dollar, down from 10 cents on the dollar the previous year.
The firms’ investment in the energy and power company came at a time when natural gas prices were on the rise. At the time of the acquisition, natural gas was selling at $5.78 per thousand cubic feet, according to the US Energy Information Administration. After spiking to more than $10 in the months following the EFH deal, the rise of alternative drilling techniques such as hydraulic fracturing drove up supply, which in turn led to a rapid decline in natural gas prices. As of November, natural gas was selling at $3.35 per thousand cubic feet.
As natural gas prices fell, so did the values of the Energy Future Holding’s nuclear and coal generation assets, according to a recent Energy Future Holdings filing with the US Securities and Exchange Commission. This has limited EFH's ability to hedge its wholesale electricity revenues at “sufficient price levels”. And if natural gas prices continue to fall, those declining revenues will make it difficult for the company to meet its weighty interest payments.
“Our substantial leverage, resulting in large part from debt incurred to finance the merger, and the covenants contained in our debt agreements require significant cash flows to be dedicated to interest and principal payments and could adversely affect our ability to raise additional capital to fund operations and limit our ability to react to changes in the economy, our industry (including environmental regulations) or our business,” according to EFH’s 2012 10-K US Securities and Exchange Commission filing.
Significant amounts of that debt will expire in the next few years – approximate principal amounts of $80 million in 2013, $3.9 billion in 2014 and $3.7 billion in 2015, according to the filing. And if EFH fails to repay its debts, Bloomberg has reported that the company’s creditors will probably force it into bankruptcy, which would wipe out TPG’s and KKR’s equity stake in the company.
Market analysts have not been optimistic about EFH’s immediate future. In January, Fitch lowered EFH’s credit rating from CCC, which indicates substantial credit risk, to Restricted Default, which indicates an “uncured payment default” on a bond, loan or other material financial obligation.
“They’re going to limp out of 2013 and run out in 2014 according our projection model,” Moody’s senior analyst Jim Hempstead told the Dallas Business Journal earlier this month.
As a public company, KKR’s filings and quarterly reports have provided a glimpse of Energy Future’s ongoing struggles. The firm marked the company at 40 cents on the dollar in its Q4 2009 filing, and EFH’s valuation has slipped or plateaued every quarter since.
The declining valuations mirror Energy Future Holdings' own quarterly reports, which indicate consolidated net annual losses of $2.8 billion, $1.9 billion and $3.3 billion in 2010, 2011 and 2012, respectively.
KKR's valuation of Energy Future Holdings
Given the portfolio company’s high profile – as well as the size of the investment – TPG and KKR LPs have kept a watchful eye on Energy Future Holding’s underperformance.
“It’s something we’ll be looking at. They have some other very nice investments in the fund too, and some promising investments, but that was a notable hit,” said Jay Fewel, a senior investment officer with the Oregon Investment Council. “KKR had warned us that this would likely occur, as did TPG.”
“I don’t think anyone’s thrown in the towel, but there’s certainly a lot of speculation going around.”
With that said, EFH’s performance hasn’t necessarily been a deterrent to KKR’s LPs, many of whom have re-upped with KKR’s North America Fund XI. Energy Future Holdings was acquired through the firm’s $17.64 billion 2006 fund, which also counts success stories like Alliance Boots, HCA and Dollar General as portfolio companies.
“They wouldn’t have recommended it to the board if there [was] that level of trepidation,” said a spokesperson for one longtime KKR LP that recently re-upped to the firm’s North American XI fund.
The performance of those portfolio companies has helped the 2006 fund overcome EFH to certain extent – the fund was generating a 7 percent net internal rate of return and a 1.5x investment multiple as of 31 December, according to KKR’s annual report.
The firm has still managed to fundraise at a healthy clip. Despite extending its fundraising period into the second half of 2012, KKR’s North America Fund XI had attracted “or hard circled” about $7.5 billion of capital as of early February, said Scott Nuttall, head of KKR’s global capital and asset management group, said during an earnings call.
“We said last quarter that we ultimately think the fund will be between $7 billion and $8 billion. Given the extended fundraising timeline and the line of sight we have today, we feel very comfortable about hitting the high end of that range,” Nuttall said.
TPG’s $15.3 billion Partners V Fund – which was also used in the Energy Future Holdings deal – hasn’t fared as well. That vehicle was generating a 0.86x multiple and negative 3.4 percent IRR as of 30 September, according to Oregon Public Employees Retirement Fund documents.
TPG, which declined to comment, is expected to come back to market to raise its next flagship fund later this year.