TXU's 2007 LBO by KKR, TPG and Goldman and its subsequent bankruptcy filing on April 29th serve as an informative case study of the evolving nature private equity investments, commodity bets, various facets of the public utilities industry, and a complex, debt laden capital structure. S&P has a great recap of the events leading up to Energy Future Holding's filing; go here to read it. Also, check out this free webinar by Chapter 11 Cases to be held on 5/8 at 1pm ET.
What piqued my interest in this filing was the ring-fencing of Oncor, which obviated the subsidiary's need to file for Chapter 11 protection. Ring-fencing of a subsidiary is typically done by declaring a unit as a bankruptcy-remote entity (also known as Special Purpose Entity or Special Purpose Vehicle). Here's more:
"'Bankruptcy-remote entities' have been utilized for years in commercial transactions as a means to protect a defined group of assets from being administered as property of a bankruptcy estate in the event of a bankruptcy filing by an affiliated entity." Crowell Moring
Oncor, which is regulated transmission and distribution entity that is 80% owned by EFH, was ring-fenced at the entreaty of Texas Public Utility Commission (PUC).
"At the time of the merger of TXU Corp, EFH and Oncor made significant commitments to the Texas Public Utility Commission regarding the separateness of Oncor from EFH. These commitments, commonly referred to as Oncor's "ringfence" are included in Oncor's governing documents as well as an order of the Public Utility Commission of Texas which carries the weight of law." Oncor Website
It seems that the strategy worked: Oncor's collateral should not be used to pay EFH's debt. But that doesn't mean that the ownership of Oncor would be unaltered.
Post bankruptcy, some unsecured creditors including Avenue Capital, P. Schoenfeld Asset Management and GSO Capital could end up owning Energy Future Intermediate Holding Co (EFIH) and become the newly adopted parents of Oncor. A change of control like this would likely trigger a need for regulatory approval from Texas PUC to ensure that the modification would be in public interest. Moody's notes that this change of control may also come with a push for a rate concession during a public interest hearing. (Reuters)
A tax-free spin-off of EFIH, however, would not necessarily be a credit positive for Oncor.
"EFIH is expected to have about $5.4 billion of debtor in possession first-lien senior secured debt, and is likely to carry an additional $1.9 billion of second lien DIP debt backed by its unsecured creditors. In effect, this debt means there will be little deleveraging at EFIH during the restructuring process, and Oncor, as the only unit generating any revenue or cash flows, will ultimately be looked on to provide upstream dividends and tax payments to service the debt load. That said, the EFIH second lien DIP debt is structured as a mandatory convertible, so upon emergence, the unsecured debt will convert to equity, a credit positive." Electric Light and Power
While the spin-off sounds like an overall positive event for Oncor, one has to keep in mind the possible rate renegotiating that could take place as a result of the PUC hearing. Moreover, about 26% of Oncor revenues come from Texas Competitive Electric Holdings (TCEH), an indirect subsidiary of EFH and included in the Chapter 11 filing. (Oncor 10Q) So there is some revenue risk for Oncor to the extent that TCEH has trouble during the restructuring process. That said, post EFIH bankruptcy emergence and mandatory convert of the DIP to equity, Oncor's earnings and leverage profile look strong.
What does this mean for the Oncor bonds? They're okay for a high grade investment since they really lack the juicy yields we're used to, but they could be a good alternative to cash. The '32s and '33s are yielding over 125 bps in spread, but the dollar price is in the $130 range. I would rather be in the 5.25% '40s with spread of a little over 100.
One last thing: Don't try ring-fencing at home! (Okay, maybe you can, but get a lawyer first). Bankruptcy remote entities aren't necessarily bankruptcy proof. In 2000, Doctor's Hospital of Hyde Park, which had set up a "bankruptcy remote" vehicle called MMA to purchase the hospital's receivables, filed for Chapter 11. The Seventh Circuit disagreed with the nature of MMA's separateness, which called into question the Hospital's transfer of receivables to MMA.
"The bankruptcy judge made clear that a court should go beyond evaluation of the documented list of “separateness factors,” and examine whether the behaviors of the related entities are consistent with their purported “separateness.” The court further noted that when analyzing whether an asset transfer is a “true sale,” courts should carefully examine the true sale case law elements to see if they have been actually satisfied by the transaction." The Insolvency Blog