I just came across this article on The New Yorker website about the largest leveraged buyout in history – The purchase of TXU Corp in 2007. The price? 44 billion (with a ‘b’) dollars.
I remember when this deal happened, and I remember reading a number of articles at the time about the buyout. The narrative I remember was quite a bit different than the one in this New Yorker article. Here’s the quote in The New Yorker article that really jumped out at me:
Goldman Sachs, KKR & Co., TPG Capital, Lehman Brothers, and others paid more than eight billion dollars in cash, and incurred another thirty-six billion dollars in debt, to purchase TXU Corp., an electric-utility company that provided power to a quarter of Texas residents. They renamed the company Energy Future Holdings. Much like the home buyers who believed, in 2007, that house prices would continue to rise indefinitely, the private-equity firms assumed that the price of electricity, Energy Future’s main product, would keep increasing.
Here’s the truth. It didn’t much matter if the price of electricity kept increasing. Up, down, sideways, the price of electricity just wasn’t very important to those who invested in this deal. Sure, it would have been better if the price of electricity did continue to rise, but even if the price of electricity fell to zero, yes zero, the companies that put this deal together (Goldman Saches, KKR &Co, Lehman, etc) could still make money, and lots of it.
So how does one make money off of an investment in company that goes bankrupt?
The answer is “special dividends”.
What happens in leveraged buyouts is the companies that put together the deal want to turn a profit as soon as possible (which is understandable). They have a couple different paths to do this. But two of them are:
- Sell off parts of the business, and then take the cash and issue themselves a “special dividend”. Special dividends are just like dividends with stocks, they’re cash payments.
- Issue a bunch of debt on the company’s balance sheet (the company that was bought), and then take that cash and pay themselves a large special dividend. Nice work if you can get it.
So I’m sure Goldman Sachs, KKR, Lehman, etc, would have liked it if electricity prices held steady or increased, but this was not imperative to the deal being a success for them. The $8 billion in cash they put together in the deal could be recouped with asset sales and additional debt put on TXU Corp’s books, and then issued out to themselves as special dividends.
The business model was pretty simple back in ’06-07, just find someone who would lend you a bunch of money (super easy to do back then), and then buy a company. Start selling that company’s assets, and issue as much debt as you can on their books. Take these proceeds and pay yourself back in special dividends. This is a low-risk, high-reward strategy, and you’d be a fool to pass it up. But it’s not very good for the company that was bought.
On a side-note, Warren Buffett actually bought debt from this deal. He ended up losing $837 million dollars on this investment. I can’t believe he would have thought this was a good investment. TXU Corp was loaded with debt from this deal, $36 billion dollars to be precise (plus whatever else was added after the buyout completed). So Warren, I’m scratching my head here…