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Does the record-breaking purchase of TXU signal a new strategy for private equity?
Economist Staff, The Economist
March 6, 2007
Another week, another record-breaking private-equity deal. But the $45 billion purchase of TXU, a Texan energy utility, is fascinating not just because of the high price agreed by a gang of private-equity firms led by Kohlberg Kravis Roberts (KKR) and Texas Pacific Group. The preparation of the deal was as much about politics as the number-crunching and financial alchemy that are private equity's stock in trade. In essence, the buyers are betting that the increasingly sensitive question of how to produce energy in an environmentally acceptable way is better handled by a privately owned firm than by one exposed to the public markets.
In recent months TXU has become the bogeyman of green activists, thanks to its plans to build 11 old-tech, "dirty coal" power plants in Texas — and possibly more in several other states. Such plants belch carbon dioxide into the atmosphere, contributing to global warming, and produce other noxious substances. Protesters demonstrated last month outside the capitol building in Austin. The mayor of Dallas has led a coalition of Texas cities opposed to the new coal plants. And the governor of Texas, Rick Perry, was roundly criticised for trying to speed through the construction of TXU's coal plants, before being blocked by a state judge.
The new private-equity owners of TXU say they will adopt a radically different approach. Capitalism's legendary "Barbarians at the Gate", made infamous by KKR's acquisition of RJR Nabisco in 1989, have become a bunch of tree-huggers. They will cut the number of new coal plants to three and abandon thoughts of similar plants elsewhere. They will invest heavily in new clean-energy technologies. And they promise to put environmental stewardship at the heart of TXU's culture, under the guidance of William Reilly, a former chairman of WWF, a green lobby group. That comes naturally, you understand, to a board member of WWF like David Bonderman, co-founder of Texas Pacific.
Environmental Defence, another lobby group, which had been suing TXU, greeted the new strategy as a "watershed moment in America's fight against global warming." Although campaigns against the three remaining plants will continue, many of TXU's critics have concurred. Such is the reward for a huge amount of behind-the-scenes work led by Mr Reilly, who is admired by green activists for his efforts to improve America's Clean Air act while serving in the administration of George Bush senior.
Texan politicians were also lobbied by Don Evans, a former commerce secretary, and James Baker, a former secretary of state, both of whom will serve on TXU's new board. Mr Baker will be chairman, which should take the heat off TXU's chief executive, John Wilder, who will remain in his post. All this is faintly humiliating for Mr Wilder, who must renounce a strategy he vigorously advocated (though he will be well paid for it). The new owners want him working for them, since he is an "excellent operations guy".
The Texas state legislature is threatening to block the deal, even though that is strictly beyond its power. Locals gripe that since the state deregulated its electricity market five years ago, rates have risen fast. The buyers have already promised a 10 percent rate cut for some customers, at a cost of $300m, but some lawmakers want more.
The new buyers argue that the political threats to energy firms are hard for a public company to handle. "The company before was focused on one constituency, public shareholders. That meant it had to concentrate on short-term growth," says Michael MacDougall, a partner at Texas Pacific. "This deal adds two more constituents, the consumers of the state of Texas and environmentalists. By balancing these three constituencies, we will get the best long-term result for the firm."
As well as the cancellations and the rate cut, TXU will increase spending on energy conservation. It will build a pilot "clean coal" plant on one of the cancelled dirty-coal sites. It will invest more in alternative energy — Texas is already America's leader in wind power — and, controversially, keep an open mind about more nuclear power.
In spite of all that, cynics question how virtuous the new owners really are. In recent years KKR and Texas Pacific each failed in separate bids for energy utilities. Their sudden greenery may have been devised to see off the sort of opposition that wrecked those deals. And cancelling the planned plants might benefit TXU, by leaving Texas short of power and so allowing the firm to raise prices. The private-equity buyers insist that the three plants being built, plus conservation, will give TXU and its stakeholders long enough to come up with a plan, but the state's population is expected to double by 2060 and Texans need plenty of electricity to run their air-conditioners in the blazing summer heat.
Whatever the motive, cutting back on new coal plants was a wise business decision. Doubters also note that the cost of building coal-fired plants has risen in recent years. Last year Duke Energy, another big utility with green pretensions, raised the projected cost of two coal-fired plants from $2 billion to $3 billion.
Lastly, new regulations could change the economics of coal by putting a price on carbon emissions. "It makes sense to assume we will have carbon regulation within three to five years," says Mr Reilly. On February 26th five western states agreed to set up a scheme to cap emissions; nine north-eastern states are already implementing one and Congress is contemplating a national cap. Even the Edison Electric Institute, an industry lobby, says it would not oppose mandatory limits on emissions under the right circumstances.
Wood Mackenzie, a research firm, forecasts that most of America, including Texas, will need more generating capacity in the next few years. But so long as the regulatory outlook remains highly uncertain, the safest option for many utilities, including TXU, may be to build fewer plants — a strategy that would at least bring the consolation of higher energy prices.
By betting that they can profit from social and political change, TXU's private-equity buyers seem to be following a road much travelled by their peers in venture capital, says Josh Lerner of Harvard Business School. This strategy has been "a long time coming," he says. But he notes that it is more dangerous than private equity's traditional approach. Playing politics may prove a risky business even for private-equity's masters of the universe.