The failure of Energy Future Holdings Corp., known as TXU Corp. when KKR & Co., TPG Capital and Goldman Sachs Capital Partners acquired it for $48 billion in 2007, and the stumbles of other huge deals of the past decade have reshaped how major buyout firms go about their trade.
The Dallas-based utility’s bankruptcy yesterday ended the biggest leveraged buyout on record and will wipe out most of the $8.3 billion of equity that investors led by three of the world’s largest private-equity firms sank into the company.
“Energy Future is emblematic of the peak of the buyout boom, when firms did very high-priced, over-leveraged deals that left little room for error,” said Steven Kaplan, professor at the University of Chicago Booth School of Business. “When you buy into a cyclical industry at the peak and you get the bet wrong, bad things happen.”
TXU marked the climax of an era when buyouts stretched into the tens of billions on dollars and Carlyle Group LP’s David Rubenstein predicted there would be a $100 billion LBO. After many of those deals faltered in the 2007-2009 global financial crisis, private-equity investors mostly shied away from companies valued at $20 billion and up, arguing that such buyouts are often overpriced, overburdened with debt and too big to exit easily.
Since the end of 2008, two private-equity buyouts priced above $20 billion have been announced, both in 2013. That compares with 15 in the five years through 2007, according to data compiled by Bloomberg. TPG told investors last year that its next fund will largely stay away from the biggest buyouts, according to a person who attended the firm’s annual meeting in October.
Three private-equity executives interviewed for this story said they didn’t expect a revival of super-sized buyouts any time soon. The executives asked not to be named because they didn’t want to be seen as criticizing competitors.
Large companies such as Energy Future tend to put themselves up for sale at times when debt markets are wide open and deal valuations are high, said two of the executives.
Those conditions in 2007 set the stage for a buyout that loaded Energy Future with $40 billion of debt, or 8.2 times the company’s adjusted earnings before interest, taxes, depreciation and amortization, a common yardstick for leverage. By contrast, debt averaged 5.3 times Ebitda for all U.S. buyouts in 2013, according to Standard & Poor’s Capital IQ. In the end, the debt combined with a collapse of natural gas prices, to which Energy Future’s revenues are pegged, toppled the company.
The biggest buyout funds have lagged behind smaller competitors in recent years, according to London-based research firm Preqin Ltd. Funds of $4.5 billion or more from the 2008 vintage posted median net internal rates of return of 7.8 percent through 2012, compared with 9.3 percent for pools of $501 million to $1.5 billion, the firm’s latest data show.
Of the megadeals announced before 2008, some have turned profits, such as those of hospital owner HCA Holdings Inc., energy pipeline operator Kinder Morgan Inc. and British retailer Alliance Boots GmbH. Others, including casino operator Caesars Entertainment Corp., broadcaster Clear Channel Communications Inc. and credit-card processor First Data Corp., have struggled with weak earnings and heavy debt.
“If you assembled all the mega-cap deals, you would have a poor-performing portfolio,” said Steven D. Smith, managing partner at Los Angeles-based private-equity firm Aurora Resurgence and a former global head of leveraged finance at UBS AG.
Kinder Morgan produced a gain of 180 percent for Carlyle and other backers. At Caesars, Apollo Global Management LLC’s investment has tumbled about 57 percent in value, based on the April 28 closing price.
“The core of what’s wrong with many of these mega-cap deals is that they got priced to perfection,” Smith said. “In this world nothing is ever perfect, and so there are surprises.”
Megadeals can be difficult for investors to cash out of, resulting in longer holding periods and less than stellar returns, said John Coyle, a partner at Permira Advisers LLP, a London-based private-equity firm with more than $30 billion in assets. Many of the targets are too big to sell to another corporation or private-equity group, making the only path to an exit a sale of stock in an initial public offering.
“If you elect to go the IPO route, public equity investors won’t forget that you paid a premium in the bull market of 2006 to 2007,” Coyle said. “They know your exit options are limited, and therefore, with exception for only the rarest of assets, they have the pricing power.”
For years it was the fallout of the financial crisis, rather than a reconsideration of deal-making practices on the part of private-equity firms, that put a halt to the biggest deals. Debt financing for LBOs all but evaporated in 2008, when speculative-grade corporate loan issuance in the U.S. fell to $157 billion from a then-record $535 billion in 2007, according to S&P’s Capital IQ. It wasn’t until November 2011 that a corporate buyout once again topped $7 billion in size.
Large company deal valuations fell from the boom-era median of 12.7 times Ebitda to 8.6 for the nine largest corporate buyouts completed from 2009 to 2012, according to data compiled by Bloomberg. The proportion of equity to debt jumped to almost one-to-one in deals such as TPG’s and Canada Pension Plan Investment Board’s $5.2 billion purchase in 2010 of health-care data provider IMS Health Inc. and 2012’s $7.15 billion buyout of oil and gas driller EP Energy by Apollo Global and others.
Revived markets have eased the credit drought, as speculative-grade loan issuance rebounded to $605 billion last year, when banks pulled together debt packages for $24 billion-plus LBOs of computer maker Dell Inc. and foods group H.J. Heinz Co. Yields on junk bonds, which are used to finance acquisitions, have dropped to 6 percent from more than 16 percent five years, according to Bank of America Merrill Lynch Index data.
Debt markets have rallied so strongly that $15 billion to $20 billion loan and bond packages for LBOs are possible, said one of the private-equity executives.
Even as lenders have opened their purses, buyout firms continue to apply the brakes to jumbo deals. The executives interviewed for this story, whose firms backed megadeals in the heyday, said some limited partners have urged them to steer clear because of their checkered results.
Limited partners, the pension systems and other financial institutions that supply the money buyout firms invest, have curbed commitments to buyout funds raised since 2009, shrinking sponsors’ capital. Buyout fundraising fell to a post-crisis low of $77.5 billion in 2011 from $229.6 billion in 2008, according to Preqin. Last year, $169 billion was gathered.
Clients have also pressed firms to avoid banding together with two or more competitors to raise the billions of dollars of equity that the biggest buyouts demand. It was only by pooling money, as KKR, TPG and Goldman Sachs did in the Energy Future deal, that firms were able to pull off the largest LBOs.
The consortium-backed deals left limited partners that had money with several of the firms with added risk in a single deal. Last year’s $24.9 billion Dell buyout skirted that issue because company founder Michael Dell provided most of the equity, with a single buyout firm, Silver Lake Management LLC, furnishing the rest.
“Limited partners don’t enjoy paying multiple managers fees to be invested in the same underlying companies,” said Jay Rose, a partner at StepStone Group LP, a San Diego, California-based pension-fund adviser.
TPG, which is preparing to raise a new buyout fund this year, told limited partners at its annual meeting last year that it will avoid megadeals unless an opportunity is exceptional, according to an investor who attended. The firm plans to go back to investing in upper middle-market deals with smaller equity contributions, this client said. The firm also said that group deals largely are a relic of the past, according to the person.
The focus on smaller deals also reflects a tougher fundraising environment since the financial crisis. Like many of its peers, TPG expects to raise a smaller fund than the prior vehicle, which gathered $19.8 billion in commitments in 2008. Fund VI, which was 85 percent invested at the end of September, is on a path to run out of capital by mid-to-late 2014, based on the current investment pace, said another investor who attended the annual meeting. TPG this year sought as much as $2 billion from its largest investors to bridge the gap until it starts marketing its main fund.
Despite the obstacles, megadeals have come back before.
KKR’s $31.3 billion takeover of RJR Nabisco in 1989, by far the largest buyout of its era, barely escaped bankruptcy in 1990 and dealt KKR a loss of about $816 million on its $3.6 billion equity investment, according to a confidential KKR marketing document obtained by Bloomberg News. Not long after that transaction closed, the economy slumped, debt markets fell into disarray and it wasn’t until 2006, when KKR and others bought HCA, that a deal of similar size was struck.
“Even though most firms say they won’t pursue mega-buyouts, in the private-equity industry memories can be short and some just can’t help themselves,” said David Fann, president and CEO of TorreyCove Capital Partners LLC, a San Diego-based pension-fund adviser.