TXU Kicks Up Some Dust

Behind the Deal

The six-buyer private equity group is led by Kohlberg Kravis Roberts & Co (KKR) and Texas Pacific. You might be familiar with those names, as they have made several forays into the electric business—some successful and others not. KKR and Texas Pacific are no strangers to the Texas electric market. They, along with other investors, sold off their $3.65 billion cash investment in Texas Genco (11,000 megawatts of generation) to NRG Energy in 2005 for $4 billion in cash and $1.8 billion in common and preferred stock and the assumption of $2.5 billion in debt. KKR is also an investor in utility transmission, known as ITC Holdings, having purchased (along with other investors) DTE Energy's transmission assets for $610 million in cash. KKR has also proven it is capable of finishing deals of the TXU size since it was part of the second largest buyout ever—a $33 billion deal in 2006 for Hospital Corp. of America.

But not all of KKR and Texas Pacific attempts at acquisitions in the utility business have gone smoothly. KKR was part of The Saguaro Utility Group's failed acquisition attempt of Arizona based UniSource. Regulators rejected that deal because they were not convinced that customers would benefit. They were furthermore concerned that the new directors lacked utility experience and that the owners would "milk the business" and then sell it five years later. Similarly, an attempt by Texas Pacific to acquire Portland General Electric was rejected.

Despite these failures, there are examples of successful private buyouts of publicly traded electric utilities. Take Warren Buffet, whose investment arms acquired MidAmerican and, most recently, PacifiCorp. In Texas, TNP Enterprises (formerly Texas New Mexico Power) was acquired in 2000 by a private investor group led by William Catacosinos, the former chief executive of the Long Island Lighting Company. Interestingly, TNP was the first so-called leverage buyout of an electric utility that began the recent trend towards private investment in the industry. TNP was subsequently sold in 2005 to PNM Resources.

KKR and Texas Pacific have apparently learned from their missteps of the past. The investment group has put together an offer with many appealing features including:

• $69.25 per share offer, representing a 25 percent premium over TXU's stock value just prior to the announcement. TXU believes this to be an exceptional offer because they say recent premiums have averaged less than 16 percent. TXU also points out that the sale price is equivalent to selling forward long-term power at the equivalent of over $60 a megawatt hour (6 cents per kilowatt hour) into perpetuity.
• Giving TXU the right to shop for a better deal through April 16, 2007. TXU would owe $375 million in a breakup fee if it finds a better deal.
• Paying a $1 billion breakup fee to TXU if the transaction does not close because of the failure to obtain financing.
• Reducing TXU's plan to build 11 new coal plants to just three plants.
• Offering to "un-mothball" over 1,600 megawatts of capacity to ensure reliability for customers
• Investing $400 million over the next five years in demand side management initiatives.
• Increasing TXU's share of renewable energy by increasing its purchase of wind power by 2.5 times, to over 1500 megawatts making TXU the largest purchaser of wind in the United States.
• Reducing retail power prices by 10 percent for residential customers in TXU's traditional service area who haven't already selected one of TXU Energy's other lower-priced offers. This reduction will result in savings of over $250 per year for the average affected household.
• Offering a retail price protection program through September 2008
• Opening new TXU Energy offices in Houston, Corpus Christi and Abilene and ramping up a statewide campaign to win new customers across all of Texas.
• Reaffirming TXU's commitment to reduce SOx, NOx, and mercury emission by 20 percent relative to 2005 and reduce CO2 emissions back to 1990 emissions level by 2020.
• Assigning no additional debt to TXU's energy delivery (transmission and distribution) business.
• Installing new company advisors including former U.S. Secretary of State, Jim Baker, former EPA Administrator Bill Reilly, and several prominent Texans, including former U.S. Secretary of Commerce Don Evans, Chairman of the University of Texas Border Regions, James Huffine and former Texas State Representatives and U.S. ambassador to Sweden, Lyndon Olson.

Reaction to the Deal

Despite the positive features of the offer, there has been some opposition. Within days of the announcement seven lawsuits were filed by various shareholders, including the International Brotherhood of Electrical Workers (IBEW) Local 98 Pension Fund and J&B Charitable Remainder Trust. These lawsuits essentially allege that directors of TXU Corp. breached fiduciary duties owed TXU Corp. shareholders by approving the merger agreement. These charges don't seem likely to stick since TXU has until April 16 to look for a better offer. In a separate lawsuit, however, the Security and Exchange Commission (SEC) charged that unknown investors pocketed more than $5.3 million in illegal profits from insider trading before the announcement. The SEC said the insider trading was done through foreign brokerage firms to conceal the investors' identities.

The deal also caught the eyes of lawmakers from Washington to Austin. Senator John Kerry, who chairs the Senate Commerce Committee Technology and Innovation subcommittee, plans to open a hearing on the issue, stating, "We need to learn more about this specific deal and the technologies available—from clean coal to energy efficiency and renewables—so that we can avoid relying on outdated technology to meet our energy needs," Senator Kerry plans to introduce legislation that would prevent new coal-fired power plants from being built in Texas if they don't include technology that would capture carbon dioxide.

At a more local level, several state legislators are mulling over legislation that would give the state's utility regulators more say in a deal of this type. When Texas deregulated its retail electricity market, the state's utility commission authority to oversee mergers was limited and mainly restricted to the transmission and distribution portion of the utility business. TXU did not win many favors with its aggressive push for coal power plants and many legislators are unhappy over the large profits pouring in from the deregulated generation and retail electricity business. In addition to the profit issue, other concerns have been raised about burdening the businesses with too much debt and the proposed splitting of TXU into three units (generation, retail, and wires), which critics charge the consortium will seek to quickly break up the company and sell it off.

But KKR and Texas Pacific have been to this rodeo before, so in this case, they are taking a very conciliatory attitude. They have already offered to not change the debt structure of the "wires" utility and KKR testified at a Texas House of Representative committee that it was "willing to listen" to demands for further rate cuts. They have also stated that "In the current regulatory system, we are prepared to commit to our holding of TXU for more than five years,"

The Texas electric utility business has certainly seen dramatic change under deregulation. The historical industry stalwarts—CSW/AEP, TNP, and Reliant Energy (former Houston Lighting and Power) have sold off large chunks of their generation fleets, and, in the case of CSW/AEP their entire retail business. TXU, for its part, has kept its fingers in all parts of the business—generation, transmission, and distribution but is now proposing the largest private equity buyout ever. Yes, there will be some two-stepping required to get the deal across the finish line, but these buyers have the resources and appear willing to negotiate satisfactory terms to make the deal happen.