The Real Lesson From the EFH Bankruptcy
Eileen Appelbaum and Rosemary Batt
Texas energy company Energy Future Holdings Corp (EFH) filed for bankruptcy last month only seven years after it was purchased by a consortium of private equity firms in the largest leveraged buy-out in history. Few would have predicted EFH's ultimate demise in 2007 when Kohlberg Kravis Roberts, TPG Capital, and Goldman Sachs' private equity arm made history with a $48.1 billion buy-out that won the backing of environmentalists, local and state legislators, community groups, and unions. Private equity, it seemed, would save EFH from the foolish strategies of its then-CEO, C. John Wilder, who planned to build 11 new coal-fueled power plants, to outsource workers' jobs, and who refused to lower electricity prices that he had raised after hurricanes. So what went wrong?
The truth is that the cards were stacked against EFH in the first place because the private equity owners loaded the company with almost $40 billion in debt.
EFH's bankruptcy reveals the inherent risks of the private equity model--even when firms seem to do everything right. The excessive debt used by private equity firms in a leveraged buyout puts the company at great risk of default and bankruptcy, no matter how welcome the takeover or how well private equity works with the company's other stakeholders.
The private equity consortium did many things right; they knew they had to build a political constituency to support the takeover. And they did. They consulted with a broad swath of local groups and negotiated in good faith with the union that represented many of the company's workers. The firms met with environmentalists, local and state legislators, community groups, and even businesses to win their blessing. They hired former U.S. Senator Richard Gephardt to facilitate negotiations with the union that represents much of the company's workforce. In 2007, the private equity consortium negotiated a union contract that called for no staff reductions, a neutrality clause, and a commitment to terminate outsourcing and to bargain in good faith with the union. The AFL-CIO marketed the EFH buyout as an exemplary model of how unions and private equity can work together. And since 2007, there have been no layoffs. In fact, employment has grown.
Yet now, EFH finds itself in bankruptcy. The lesson from the EFH debacle is that even when private equity firms seem to do everything right and treat other stakeholders fairly, the private equity business model is fundamentally a high-risk strategy built on excessive debt. As we demonstrate in our forthcoming book "Private Equity At Work: When Wall Street Manages Main Street," published by the Russell Sage Foundation, when things go well, private equity partners do exceedingly well, multiplying their returns. But when things turn sour, other people pay.
That's because private equity has very little skin in the game. The private equity investment funds only paid 18 percent of the total $48 billion price in the EFH mega-deal -- with the partners themselves putting in a small fraction of that percentage. EFH was with saddled with 82 percent debt. The partners bet on the price of natural gas rising, but they were wrong. When gas prices ultimately tanked, EFH's high debt burden constrained the company's ability to adjust to the new reality. But, private equity partners did not pay the price for their own risky gamble. By 2012 they had taken home at least $528 million in fees even as the investors -- creditors, pension funds, and other limited partners -- lost big.
As for the workers and union -- who knows? Their fate depends on how the bankruptcy is structured, whether facilities are closed, and whether the company retains its commitment to workers' pensions. But the stark reality, made clear by the EFH bankruptcy, is that the private equity business model allows these moneyed firms to reap massive profits, as they gamble with the livelihoods of other stakeholders, even when deals go wrong.
Interestingly, it is the regulated part of EFH -- Oncor -- that is doing well. It is not part of the bankruptcy because it was 'ring-fenced' by state regulators. Because Oncor is subject to state regulation, limits were placed on the debt it could take on. While EFH as a whole has $36.5 billion in assets and $49.7 billion in debt, Oncor has about $7 billion in assets and $7 billion in debt. As a result of the financial health of Oncor, Electricity will continue to flow to its 10 million customers.
EFH holds a lesson for public policy limit the size of debt that private equity partners can load on the companies they acquire. Limiting the tax deductibility of interest on debt financing, so that taxpayers are not subsidizing the wealth accumulation of private equity partners, is a policy whose time has come.
Eileen Appelbaum is Senior Economist at the Center for Economic and Policy Research. Rosemary Batt is the Alice Cook Professor Women and Work at Cornell University. They are the co-authors of the forthcoming book "Private Equity At Work: When Wall Street Manages Main Street," published by the Russell Sage Foundation.