Let's not forget our US$45B TXU nightmare

They can’t all be like this, can they?

Canadians are sitting on 35 or so direct investments in some of the world’s highest-profile private equity buyouts. We’ve got direct ownership stakes in such firms as EMI, SunGard, Freescale, Dollar General, Alliance Boots, Avaya, CHC, Clear Channel, Energy Future Holdings (formerly TXU), Nielsen, Realogy, Skype…all thanks to our CPP Investment Board.

2005-2007 seems to have been when we picked up most of them, too, mirroring the “Golden Era of Private Equity” (see prior post “KKR Founder Henry Kravis on PE climate” May 29-07), that has turned out to be anything but.

With what we can glean from news reports, we’ve had some winners in Dollar General and Nielsen, for example. Realogy is in the residential real estate space, so one can surmise that’s a toughie. And I’ve already covered the sad outcomes of EMI, Freescale and SunGard in earlier posts.

But one can’t wrap this topic up without acknowledging our various stakes in the US$45 billion LBO of TXU, now called Energy Future Holdings. Back in 2007, this deal was certainly the top dog in the buyout world, as KKR, TPG and Goldman Sachs and the rest of the LBO syndicate put up US$8.5 billion; the balance came in the form of debt.

With the recession that followed and a drop in natural gas prices came some tough times. Last Fall, the LBO’s proponents had to push their junior lenders around in an effort to cut the debt burden on the business. According to an Oct. 2009 Bloomberg story, the deal is a “disaster”:

“This buyout is a disaster,” Dot Matthews, one of the analysts at New York-based CreditSights who wrote the report, said in a telephone interview. “They desperately need to cut the outstanding debt.”

The power company will issue as much as $4 billion of 9.75 percent secured notes maturing in 2019 in exchange for $6 billion of outstanding notes, Energy Future said in the regulatory filing.

Energy Future is asking debt holders with $750 million of 6.55 percent notes maturing in 2034 to swap holdings for 46.5 cents on the dollar of new secured notes if they tender by Oct. 19, according to the filing.

If bondholders reject the offer their securities may be subordinated by new debt, Matthews said.

“The once proud Texas Utilities has been reduced to threatening bondholders with a no-win proposition — tender and lose, don’t tender and maybe lose more,” according to the report written with analysts Adam Cohen and Scott Greenstein.

The TXU leveraged buyout was “done at the top of the market,” leaving the company with an untenable debt load, said Carl Blake, a Washington-based analyst at Gimme Credit LLC.

Energy Future has $44.5 billion of loans and bonds, including $22.4 billion coming due in 2014, according to data compiled by Bloomberg.

As a result of our stakes in KKR 2006, Goldman Sachs Partners IV and TPG V, plus our direct equity co-investment, we have four different plays on the TXU transaction. We doubled down, as they say, much like the EMI, Freescale or SunGard deals. That puts between C$150 – C$200 million exposed at the time (if we’d been in for barely more than 2% of the deal). If we had something like 3% of each PE fund, plus a C$75 million co-investment, we would have closer to C$300 million invested.

Added to the trauma of the junior lenders is the impact of the currency move on the CPPIB investment. Back in September 2007, the dollar was at 1.0546 to the USD. By October 7th, however, the dollar had rallied to 0.98 to the USD. Let’s assume that’s exactly when we funded, and we’ve only lost about 3% on the currency so far. It could have been far worse.

More importantly, if the junior lenders were asked to take a 53.5% haircut on their bonds, what does that mean for the equity holders? Usually, the equity has been flushed at that point, but in this case, the pain of the junior lenders can partially be blamed on weak terms and conditions in their deal as much as anything.

For 2010, adjusted EBITDA was up 8% to US$5.24 billion. With about US$35.375 billion of debt, an 8x EBITDA multiple seems more than fair from a valuation standpoint. That implies an equity value of US$6.545, a 23% drop since we made the initial investment.

Obviously, one could argue that it is rare for equity holders to do better than lenders, but for the sake of argument we can assume we are down at least 30% (or C$100 million) on a mark-to-market basis.

When added to the EMI, Freescale and SunGard losses, which appear to swamp the gains on Dollar General and Nielsen, it starts to add up. Individually, of course, these losses aren’t material to the overall performance of a $140 billion money manager. Which may explain why we have no disclosure of the carrying values of the PE portfolio, even in aggregate, as compared to our actual cost base (in home currency). Something that Washington, Oregon and UTIMCO do, for example.

It might be said that if these bad outcomes aren’t material to the overall performance of the fund, then fantastic outcomes wouldn’t have had any impact either. But I doubt very much anyone would ever make that argument if the Mega Buyout portfolio had doubled in value (currency aside) during the past six years.

In the meantime, we are just left to guess, despite being exposed to many of the largest Mega Buyout challenges in history.

MRM