Debt may ease private equity losses for Energy Future Holdings investors

Institutional investors that put money into Energy Future Holdings debt are finding those investments could help dull the pain of their substantial private equity losses in the failed energy company.

When Energy Future Holdings Corp., Dallas, filed for bankruptcy April 29 after almost a year of negotiations with debtholders, it was already clear that the private equity firms leading the deal — KKR, TPG and Goldman Sachs — would be the biggest losers. The firms and many of their investors already have written down their roughly $8 billion investment in the company.

Christopher J. Ailman, chief investment officer of the $183.3 billion California State Teachers' Retirement System, West Sacramento, said the pension fund has been writing down its private equity investment in Energy Future Holdings over the seven years that it has been an investor to less than 5% of its original value.

The pension fund has exposure to Energy Future Holdings primarily through its commitments to three private equity funds TPG Partners IV, TPG Partners V and KKR 2006 Fund. It also co-invested with TPG on the deal.

Still, Mr. Ailman acknowledged the pension fund's exposure to Energy Future Holdings through its distressed debt investments will be “an opportunity to make money.”

CalSTRS is an investor in Energy Future Holdings debt through investments in Oaktree Capital Group LLC and Apollo Global Management LLC distressed debt funds.

The size of CalSTRS' total investment in Energy Future Holdings could not be learned.

CalSTRS is not alone. Other institutional investors in the private equity funds that invested in Energy Future Holdings also invested in its distressed debt portfolios as a hedge against their private equity investments.

Jonathan Grabel, former CIO of the $1.2 billion retirement plan of the Montgomery County Board of Education, Rockville, Md., said the plan invested in distressed debt, in general, for just that reason. (Mr. Grabel became CIO of the $14.25 billion Public Employees Retirement Association of New Mexico, Santa Fe, in December. New Mexico does not have exposure to EFH through private equity, but does to its debt through investments in Oaktree funds.)

In an e-mailed response to questions, Marisa Grant, acting chief investment officer for the Montgomery County Board of Education, stated she could not confirm the original motivation for investing in distressed debt because the decision was made before she joined the pension fund's staff.

However, she added that several of the pension fund's distressed debt funds purchased Energy Future Holdings' debt “as prices came under pressure from the expectation that the company would file Chapter 11.”

Institutions with private equity and debt investments in Energy Future Holdings include the $289.1 billion California Public Employees' Retirement System, Sacramento; Oregon Investment Council, Tigard, which runs the $66.5 billion Oregon Public Employees Retirement Fund, Salem; the $94.6 billion Washington State Investment Board, Olympia; the $50.4 billion Pennsylvania Public School Employees' Retirement System, Harrisburg; and the $164.22 billion New York State Common Fund, Albany. Fund officials either declined to comment or could not comment by deadline.

Although the wrangling over the Energy Future Holdings and a proposed restructuring agreement has only just begun, observers expect the distressed debt investors could turn a tidy profit. Debt fund investors include Apollo Global Management, GSO Capital Partners, Centerbridge Partners LP, Mason Capital Management LLC, Fortress Investment Group LLC, Och-Ziff Capital Management Group LLC, Franklin Templeton Investments, Avenue Capital Group, P. Schoenfeld Asset Management LP, Third Avenue Management LLC and York Capital Management LLC, according to a recent bankruptcy court filing.

Many of the distressed debt firms started scooping up the debt just a year or so after the 2007 leveraged buyout of the firm that was then known as TXU Corp. The $45 billion LBO was done by a consortium led by KKR & Co. LP, TPG Capital and the private equity arms of Goldman Sachs & Co. Inc., Lehman Brothers Inc., Citigroup Inc. and Morgan Stanley. But the boom in shale-oil extraction in the U.S. and Canada caused natural gas prices to drop rather than rise — as the private equity buyers had expected — and Energy Future Holdings has struggled since 2008.

Many investors drawn to distressed debt saw it as a hedge against the leveraged buyouts made in the heyday before the 2008 market crash.

“In Maryland, we focused on direct lending as a risk mitigation way of investing in private equity,” said Mr. Grabel. Pension executives at the Montgomery County fund recognized opportunities in investing in the debt of broken LBOs, Mr. Grabel said.

The Energy Future Holdings bankruptcy has clearly hurt returns on the private equity side of the deal.

As of Feb 28, KKR 2006 Fund has an annualized net internal rate of return of -6.8% and a multiple of 0.8 times invested capital since inception, according to Paris-based private equity research firm Palico SAS. TPG Partners V has annualized net IRR of 1.1% and a multiple of 1 times invested capital as of the same date and also since inception, according to Palico. As of Dec 31, the most recent data available, GS Capital Partners had a net IRR of 5% and a multiple of 1.3 times invested capital, according to Palico.

The private equity funds' returns were far better a quarter earlier. As of Sept. 30, KKR 2006's return was 6.2% IRR and a multiple of 1.3 times invested capital, according to data from the website of CalPERS. TPG IV earned 16% IRR and 2.1 times invested capital and TPG V returned 0.1% IRR and 1 times invested capital as of Sept. 30, according to CalPERS data.

Meanwhile, some of the debt investors stand to earn hundreds of millions of dollars, people close to the transactions said.

Returns for some of the credit strategies bear that out. For example, Apollo Credit Opportunities Fund I LP earned 25% annualized IRR and 3 times invested capital, GSO Capital Solutions Fund LP returned 15.6% IRR and 1.3 times invested capital and Oaktree Opportunities Fund VIII-B earned 11% IRR and 1.1 times invested capital as of Sept. 30, according to CalPERS data.

Still, the investors' debt investments are not expected to make up for the losses in their private equity portfolios.

CalSTRS has a significant debt exposure to Energy Future Holdings, equal to one-third of its private equity exposure, said a person familiar with the situation.

“The distressed debt was accumulated by the distressed debt managers after there were problems at the company and debt started trading at a deep discount. It was an attractive investment opportunity,” the source said

Although the distressed debt will produce a significant return for CalSTRS, “overall the losses will be much larger than the gains on the distressed debt,” the person said.

Indeed, industry executives caution that distressed debt is not a perfect hedge in all situations for private equity.

While private equity invests money over a period of years, distressed debt managers invest the capital right away. It is hard to get the timing right, said Charles H. van Horne, managing director, Abbott Capital Management LLC, New York.

Moreover, distressed debt is more of a fixed-income strategy, Mr. van Horne said.

“The fact is distressed debt strategies tend to, over time, have lower multiples,” he said.

At the same time, investors have little control over whether their managers will buy debt of companies involved in a private equity deal.

“It is never a perfect hedge as you can't control the position or the size of the position, given the blind pool nature,” said Erik Hirsch, chief investment officer for alternative investment consulting and money management firm Hamilton Lane, Bala Cynwyd, Pa.

And distressed credit is no longer popular with investors because the deals are gone.

“Distressed credit opportunities are few in today's market, given the overall strength (of the debt markets) combined with low rates,” Mr. Hirsch said. “You aren't seeing (limited partners) adding it today. Those positions were assembled a few years ago.” n