Will giant TXU LBO become a distressed debt deal?

Energy Future Holdings Corp., the company formerly known as TXU Corp., is morphing from the largest LBO ever to what could be an enormous distressed debt buying opportunity.

Money managers are mixed on Energy Future Holdings as a current investment. Some can't wait for the Dallas-based energy company to fall into bankruptcy, hoping to buy distressed debt on the cheap. Others won't touch the bonds because they don't believe natural gas prices will increase.

Industry executives have been buzzing about an impending Energy Future Holdings bankruptcy since the company proposed a restructuring plan on April 15.

Although an Energy Future Holdings spokesman said there are no current plans to file for bankruptcy, a recent Securities and Exchange Commission filing outlines a possible restructuring that could occur outside of bankruptcy court.

That proposal would erase the $32 billion in debt that remains from the 2007 leveraged buyout. Under the plan, the first lien holders or senior creditors would get a combination of equity and a slice of a $5 billion cash pool or new long-term debt. The first lien holders would own 85% of the company and the original private equity buyers would retain 15%, said Jason Hahn, a senior high-yield analyst in the Des Moines office of Principal Global Investors. He was discussing information contained in the SEC filing. This would be a better outcome for the original private equity buyers, who might end up with zero should the company file for bankruptcy, he said.

Some hedge fund, private equity and fixed-income managers — including Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC — already are scooping up the debt. Industry insiders suspect they are hoping to parlay the debt into an ownership stake after a restructuring. The result of that kind of buying spree means even more exposure to Energy Future Holdings for investors.

GSO, the credit business of The Blackstone Group LP, has a small passive position in Energy Future, Blackstone spokesman Peter Rose said in an e-mail.

This was not the projected outcome in 2007 when a consortium led by Kohlberg Kravis Roberts & Co., TPG and the private equity arms of Goldman Sachs & Co., Lehman Brothers Inc., Citigroup Inc. and Morgan Stanley bought TXU for about $45 billion. None of the firms in the investment group would comment for this story.

Buyers paid a 15% premium, believing that demand for power would either be stable or would grow, and that prices would be stable, said Greg Schooley, a New York-based partner in the private equity practice of A.T. Kearney, a global management consulting firm. Instead, the recession and the explosion in production of natural gas in the U.S. caused the price of natural gas to plummet, he said.

The giant deal left some of the largest investors with Texas-size exposures. Not only do investors have commitments to one or more of the private equity funds involved in the original deal, but also a number of them are co-investors, having invested in the deal separately. Some of those co-investors are the $163.7 billion California State Teachers' Retirement System, and Singapore's more than $100 billion Government Investment Corp.

CalSTRS, the $258.3 billion California Public Employees' Retirement System, the $66.8 billion Washington State Investment Board, the $61.1 billion Oregon Public Employees Retirement Fund, the $72.5 billion New Jersey Division of Investment and the $25.5 billion Pennsylvania State Employees' Retirement System are also invested in TPG Partners V and KKR 2006 — the funds that bought TXU.

CalPERS holds TXU bonds with a market share of $6.93 million through external managers, Joe DeAnda, CalPERS spokesman, said in an e-mailed response to questions. He said, however, that CalPERS executives would not answer questions on the impact of an Energy Future Holdings bankruptcy on the pension fund's private equity portfolio.

Likewise, CalSTRS does not reveal and so declined to comment on co-investments, spokesman Ricardo Duran wrote in an e-mailed in response to questions. “We support our partners in working toward a successful restructuring in events such as these,” Mr. Duran wrote.

But in documents filed with the SEC, KKR has marked down its investment in Energy Future Holdings to close to zero. KKR has valued Energy Future Holdings at 0.05 of cost as of March 31.

Some institutional investors already sold their interests in the funds that hold Energy Future Holdings.

New Jersey Division of Investment, Trenton, sold off half its interests in two TPG Partners funds including TPG Partners V as part of a $575 million secondary market sale of interests in private equity funds. New Jersey spokesman William Quinn declined to comment. According to the pension fund's most recent investment report, however, New Jersey's $187.5 million commitment to TPG V had a market value of $107.7 million, not including $93.8 million in distributions, as of Sept. 30.

Mr. DeAnda declined to say whether CalPERS sold its interests in the two funds and to discuss the pension fund's exposure to Energy Future Holdings.

David Bonderman, co-founder at San Francisco-based TPG Capital; KKR spokeswoman Kristi Huller; Morgan Stanley spokesman Matt Burkhard; and Goldman Sachs spokeswoman Andrea Raphael, all declined to comment.

Even if Energy Future Holdings does go bankrupt, the KKR 2006 fund should still earn 300 to 400 basis points above the S&P 500 — 7.09% for the fund as of Dec. 31, 2012, vs. 3.25% for the index — according to an analysis by alternative investment consulting firm TorreyCove Capital Partners LLC, La Jolla, Calif.

“Private equity funds should be viewed in the context of its investment portfolio, not one specific investment,” said David Fann, TorreyCove's president and CEO.

Indeed, according to the KKR's first-quarter earnings report, the KKR 2006 fund had net unrealized gains of $1.1 billion.

Oregon PERF's $1.4 billion commitment to KKR 2006 has earned a net internal rate of return of 8% as of Sept. 30, according to Oregon PERF's latest private equity report. Oregon's $300 million commitment to TPG V has earned -3.4% for the same time period.

Distressed debt and private credit managers say Energy Futures Holdings is one of the only potential supersize debt transactions they see for the near future.

Should Energy Future Holdings go bankrupt, it would involve a number of credit managers, said Keith Williams, managing director, senior portfolio manager at Crestline Investors Inc. He made his comments on an April 17 panel at The Pension Bridge annual conference in San Francisco. Crestline is a hedge funds-of-funds manager in Fort Worth, Texas, with about $7.2 billion under management.

Still, distressed debt of Energy Future Holdings could be so pervasive that large credit managers would have trouble avoiding the credit, said Daniel Hennessy, senior consultant at San Francisco-based investment consulting firm Alan Biller and Associates, speaking on the same panel.

The company might not default on its debt, but Mr. Hennessy said he expects EFH would go through some sort of reorganization, either within or outside of U.S. Bankruptcy Court, by the end of 2014. It could happen this year because there is so much debt at stake — some $32 billion, he said.

Other managers are not so sure. Some think the company will continue to extend its debt “until everyone forgets about it,” said one private equity firm executive who declined to be identified. Since 2009, the company has extended the maturities of approximately $25.7 billion of debt to 2017-2021, according to a recent SEC filing. n