Texas-Size Woe for KKR, TPG

Texas-Size Woe for KKR, TPG

Weight of Leverage Saddles Buyout of Former TXU, Ripples to High-Yield Funds

By MATT WIRZ And GREGORY ZUCKERMAN

A humiliating endgame for the largest leveraged buyout in history may come sooner than investors had anticipated.

A hedge fund's allegations of a default by the Texas power producer formerly known as TXU Corp. roiled credit markets last week and intensified scrutiny by investors of the $45 billion deal. Even owners Kohlberg Kravis Roberts & Co. and TPG acknowledge the deal has become an albatross. KKR already has written down the $8 billion equity investment by 80%.

The company's unsecured bonds tumbled 13% to about 55 cents on the dollar last week, while the price of one-year credit-default protection tripled on TXU, now called Energy Future Holdings Corp. That reflects increasing market fears that the company could default on its debts, dashing the private-equity firms' hopes to hang on until a recovery in natural-gas prices.

The bond losses have implications for almost every high-yield bond fund in the country, as TXU's unsecured bonds make up about 1% of the overall market and are the ninth-largest out of more than 1,000 credits in the Merrill Lynch high-yield bond index. The bonds stand to be wiped out in a potential restructuring and retain value largely because of the interest that holders expect to collect before debts are reworked.

The chief financial officer of Texas's largest power company said it isn't insolvent and isn't considering a restructuring, but said leverage is onerous.

"We continue to fight the fight, [but] ultimately, the long-term answer for the capital structure is to inject equity" in the form of an initial public offering or other equity sale as natural-gas prices eventually recover, said Paul Keglevic, the finance chief.

The same leverage that could prove so lucrative for KKR with hospital operator HCA Holdings Inc. has been disastrous for TXU because of the company's exposure to cyclical commodity prices.

Four years ago, KKR and TPG led the purchase of TXU, paying 25% above its trading price. Natural-gas prices subsequently plunged, as did the rates the company could charge electricity customers.

Before the buyout, that wouldn't have been a problem. TXU had only $11 billion of debt. Now, it has $36 billion, $22.5 billion of which matures by 2014. The biggest leveraged buyout of all time has boiled down to an expensive bet on the price of a commodity.

Natural gas has fallen 43% since TXU's buyout, and settled at $3.927 a million British thermal units on Monday. Analysts don't predict a meaningful rebound in prices for at least two years. But TXU needs natural gas between $7 and $8 a million British thermal units just to generate enough earnings to cover its secured loans, which start maturing in October 2013. With so much new natural gas on the market, largely collected from shale-gas deposits across the U.S., most analysts expect prices to stagnate. And if prices stay below $7.50, refinancing will be nearly impossible, said Chris Taylor, an energy strategist at FBR Capital Markets.

Until recently, the price of TXU bonds and credit-default swaps reflected expectations that the day of reckoning wouldn't come until late 2013.

But a challenge by Aurelius Capital Management LP accuses the company's key unit of defaulting on terms of its $20 billion loan, forcing investors to re-examine whether the day of reckoning might come sooner.

TXU remains current on all debt payments, and Aurelius's default allegation rests on an interpretation of intercompany loans between the company and a subsidiary.

The fund alleges that loans to the parent company from operating unit Texas Competitive Electric Holdings Co. wasn't conducted on an arm's-length basis, violating terms of syndicated loans Aurelius owns. Mr. Keglevic dismissed the claims as meritless.

.Regardless of whether Aurelius wins the legal argument, the fund has turned the spotlight on TXU's finances.

Trading activity in TXU credit-default swaps hit a three-month high in the week before the hedge fund sent a letter detailing its claims to Citibank, the arranger of its loans. The company immediately repudiated the allegations, but swaps pricing soared after the disclosure, hitting $1.8 million to protect $10 million of debt for one year, up from $430,000.

Aurelius bought more than $100 million of the TXU subsidiary's loans in the weeks before it sent the letter, according to a person familiar with the matter, but it remains unclear whether the fund bought credit-default swaps as well.

If Citibank sides with the company on the issue, Aurelius could try to force a technical default but would need support from a majority of loan holders, a high hurdle given their number.

Even if KKR and TPG fend off Aurelius, others likely will follow, said Jim Hempstead, an analyst at Moody's Investors Service who has been raising questions about TXU's viability for years. If lenders believe a restructuring is inevitable, they have good reason to trigger a restructuring before the company raises more debt or runs down its cash balance, he said. The secured loans, which would benefit from a quicker restructuring, rose to 82 cents on the dollar from 84 cents last week, before the Aurelius move.

Anyone looking for a precedent to a TXU restructuring should study how secured bondholders forced Calpine Corp. to file for bankruptcy protection in 2005, said Mr. Hempstead. Like TXU, the Texas power producer carried a big debt load, $17 billion, that crippled the public company in 2004 when natural-gas prices collapsed.

Calpine struggled for years to dig out from under the debt load with the same type of bond exchanges and extensions TXU is executing. But after the bondholders won a legal campaign contending Calpine had violated debt covenants, it finally filed for Chapter 11 protection.

The twist: Natural gas rallied throughout the restructuring, and even junior creditors recovered 75 cents on the dollar after a two-year restructuring.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com