A Deal That Smells to High Heaven

The guy to complete the last big deal ordinarily gets to shout “King o’ the Mountain!” and, for a month or so afterward, there is much oohing and aahing on the business pages. That didn’t quite happen after Kohlberg Kravis Roberts and Texas Pacific announced their purchase of TXU, the large Texas electric-utility company.

At $49 billion, it was a record-breaker, although records of this kind are like records for the world’s tallest building: They often do not last very long. The previous record of $39 billion for the Equity Office Properties was set only a few weeks ago.

The curtain calls and chest-thumping on the TXU deal was foreshortened by the stock-market plunge. Attention was directed elsewhere, but we may have reason to come back to it if this baby comes a cropper. Even if it doesn’t, there is much about it that asks for a closer look and a few skeptical questions.

The first question is: Where did KKR and Texas Pacific get all the money? Successful as both entities have been in previous deal-making, buying this utility was a stretch. Left to their own preferences, you may assume that KKR and Texas Pacific would each have wanted to go solo, but the two investment funds obviously couldn’t come up with enough scratch to do it by themselves.

To swing the deal, which required $8 billion in up-front cash money, The New York Times reports, “Kohlberg Kravis and Texas Pacific are each putting up about $2 billion in cash. Goldman Sachs, Lehman Brothers, Morgan Stanley and Citigroup plan to invest $3 billion from their private equity firms.” That takes them to $7 billion—$1 billion shy of what they needed.

One more investor was required for that last billion. The last investor turns out to be J.P. Morgan Chase, Morgan Stanley and Citigroup. These same banks will be handling the $24 billion in loans that KKR and Texas Pacific need to finish paying for TXU. (The buyers are also taking on the $13 billion in debt that TXU already had, and that brings the total cost up to the $49 billion sale price.)

So here we have it: First the banks become part owners in the company being purchased, then they lend the purchasers the rest of the money needed to pay for the deal. This comes close to a form of self-dealing, and if it doesn’t smell to high heaven, there is no doubt some unpleasant scent seeping out of this thing.

Bankers are supposed to be gimlet-eyed persons who have no connection with those coming to borrow money. They are supposed to investigate the hell out of the entities applying for a loan; they are not supposed to be in business with them.

The way to deal with such quibbles is to give this kind of loan a respectable-sounding name: Hence the term “equity bridge.” The idea is that, after the banks have bought their billion dollars’ worth of stock in the company, KKR and Texas Pacific are obliged to find somebody or some equity or hedge fund that will take the stock off the banks’ hands. Be that as it may, the “equity bridge” buy-in looks like a “pay to play” operation, as one Wall Streeter put it.

Pay-to-play has been a recurrent source of scandal in public financing. Whether what’s going on here is, legally speaking, pay-to-play is best left to the lawyers, but it stands to reason that if TXU’s bond business is restricted to insider-trackers, somebody’s going to lose out. If it isn’t the banks, the bondholders, or KKR and Texas Pacific, then the most obvious candidate will be whoever pays the household-utility bills.

The banks are willing to buy into a company they plan to lend money to because these bond deals are so lucrative. Last year, KKR alone, according to The Times, paid various banks fees amounting to $837 million. The banks will convert the loans they’re going to make to KKR and Texas Pacific into bonds, many of which will be sold, while some others will probably be kept in their vaults.

You do not buy and sell electric companies as though they were a chain of pizza parlors or hospitals. People pay attention to what’s going on with electric companies, which may be why they are often called public utilities. To buy one, you must satisfy the stockholders, but there is a wider public that must be pacified: the consumers and, in the modern era, the environmental lobby.

The consumers in this instance are to be bought off with a 10 percent rate decrease. At least that’s what they’re being promised, although one does wonder what the homeowner is going to do about it if and when the decrease is followed by a jump in the monthly electric bill. Or, if the political situation that the company finds itself in is acrid enough that it cannot raise rates, then where does that put the bankers?

The equity bridge is by no means the only fancy wrinkle that the buyout people have come up with to finance their deals. For instance, they also use the “payment-in-kind (PIK) toggle note.” This is a form of debt that enables private equity firms to borrow more freely than they would otherwise be able to. The PIK toggle note permits the borrower to stop paying interest on its bonds: When the toggle is used, the unpaid interest piles up and must be paid when the bond matures—unless the whole thing is refinanced somewhere down the road. Give these people an envelope, a cup of coffee and a pencil, and you’d be amazed what tight straits they can squirm their way out of.

Whether the PIK toggle note is used, or the equity bridge, or some other gimmicks that haven’t yet surfaced in the business press, the underlying lesson is that credit is very easy to get if you’re on the inside. You would almost think that the bankers were pushing the money out the door, the way they are willing to relax terms and embrace lower standards.

Does this easy money, this “don’t worry about a thing, we’ve got you covered” approach, remind you of something? Could it be the residential-housing market? The bankers there have been making 100 percent, no-down-payment loans to people without asking to see their financials—PIK-toggle-type mortgages, loans to people with low credit scores or none.

All that remains now is to see who can and cannot pay their bills.