David Stockman, Budget Director under President Reagan and then a partner at private-equity firm Blackstone Group, has graciously permitted me to post excerpts from his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA. This is the first installment from Chapter 25, “DEALS GONE WILD: Rise of the Debt Zombies” – the titles alone are reason to read the book! In this chapter, he vivisects the LBO craze before the financial crisis, particularly the largest buyout ever, Texas mega-utility TXU Corporation, as it was called then, now in bankruptcy.
The wildest speculators in Leo Melamed’s pork-belly rings at the Chicago Merc could never have dreamed up a commodity trade as fantastical as that underlying the $47 billion LBO of TXU Corporation. It was basically a bet on a truly aberrational price gap between cheap coal and expensive natural gas—a “fuels arb”—that couldn’t possibly last. So the largest LBO in history was the ultimate folly of bubble finance.
Electric power utilities are normally stable generators of cash flow, plodding along a tepid path of growth. But TXU’s financial results in the year before its February 2007 buyout deal had been mercurial, making its initially benign leverage ratios an illusion. Thus, TXU had posted about $11 billion of revenue and $4.5 billion of operating income prior to the buyout, but by fiscal 2011 the company’s sales were down by 35 percent, to $7 billion, and operating income was just $960 million. Its bottom line had plummeted by nearly 80 percent from the pre-LBO level.
Accordingly, the company’s leverage ratio has become a horror show. Its fiscal 2011 debt stood at $36 billion and thereby amounted to nearly thirty-eight times its reported operating income. In LBO land that ratio is beyond the pale—it’s a veritable financial freak.
How the largest LBO in history ended up this far off the deep end is a crucial question because it goes right to the heart of the great deformation of finance. The TXU deal is the financial “Vietnam” of the Greenspan bubble era, not some dismissible aberration from the main events. It was sponsored by the “best and brightest” in the private equity world including KKR, the founding fathers of LBOs, and David Bonderman’s TPG, which was also a successful LBO pioneer of legendary rank.
Since the equity portion of the financing at $8 billion was only 17 percent of the total capitalization, TXU’s existing $12 billion of conventional utility debt had to be tripled, to $38 billion, in order to close the deal. Accordingly, Wall Street had a money orgy coming and going. Fees on the new deal exceeded $1 billion, and at the LBO closing there was an epic $32 billion payday for selling shareholders, including the hedge funds which had front-run the deal.
At the time, the reckless wager embodied in the TXU buyout was rationalized as nothing special. The purchase price at 8.5 times EBITDA was purportedly in line with the 7.9X average for publicly traded utilities. Yet when the onion was peeled back by a year or two it became clear that the buyout was being set up at a lunatic multiple: an astonishing 18X the company’s EBITDA in 2004.
This jarring difference reflected the fact that TXU’s income was temporarily and drastically inflated by a utility deregulation bubble floating on top of a natural gas bubble. Under the Texas deregulation scheme, wholesale electric power prices were set by the marginal cost of supply, which was natural gas fired power plants. But TXU generated most of its power from lignite coal and uranium, so when natural gas prices soared its own fuel costs remained at rock bottom. The company’s revenue margin over the cost of fuel, therefore, also soared, rising from 38 percent in 2004 to nearly 60 percent in 2006. The gain was pure profit.
If deregulation meant a permanent increase in TXU’s profit margins, of course, the heady February 2007 LBO valuation of its current cash flow might have made sense. The underlying reality, however, was that the price of wholesale electric power in Texas at the moment had been inflated by a humongous natural gas price bubble which flared-up in the wake of Hurricane Katrina’s August 2005 disruption of offshore gas production.
Natural gas prices had soared to the unheard of range of $10 and $15 per thousand cubic feet (Mcf), compared to a band of $2–$5 per Mcf that had prevailed for years. So TXU’s fulsome cash flow was running on the afterburners, as it were, of one of the greatest commodity bubbles of recent times.
At the same time that TXU was booking revenues of 13.7 cents per Kwh based on natural gas prices, the fuels cost at its base-load nuke plants was 0.4 cents per kWh and just 1.2 cents in its lignite coal plants. Thus, at the coincident peaks of the Greenspan credit bubble and the natural gas price bubble in February 2007, TXU was selling electric power at 12X and 36X the cost of its lignite- and uranium-based power, respectively.
These markups were off-the-charts crazy. Even after absorption of modest fixed operating costs (labor and maintenance) at its power plants and corporate overhead, the profits were staggering. It was only a matter of time, therefore, until the natural gas bubble ruptured and TXU’s power margins came crashing back to earth. By David Stockman, author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.