David Stockman: How The Fed Helped Bushwhack TXU
David Stockman, Budget Director under President Reagan and then a partner at private-equity firm Blackstone Group, has graciously permitted me to post excerpts from his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA. This is the second installment from Chapter 25, “DEALS GONE WILD: Rise of the Debt Zombies.” In this chapter, he vivisects the LBO craze before the financial crisis. This installment is the second part of the insane and largest ever buyout, Texas mega-utility TXU Corporation, as it was called then; it’s now in bankruptcy. The first part of the TXU debacle is here. And then there is Goldman….
As it happened, the Fed’s rock-bottom interest rates were contagious and fueled a boom in debt-financed gas drilling that soon caused supplies to soar and natural gas prices to plummet. In this manner, the power plant “fuels arb” was flattened and with it the company’s financial results. The Fed thus unintentionally bushwhacked the largest LBO in history. So doing, it demonstrated just how badly the nation’s central bank had mangled the free market.
When Bernanke slashed interest rates to nearly zero, it triggered a Wall Street scramble for “yield” products to peddle to desperate investors—at the very time that the natural gas patch was swarming with drillers willing to issue just such high yielding securities. The natural gas price bubble had encouraged a drilling boom based on horizontal wells and chemical flooding of gas reservoirs. This “fracking” process can liberate prodigious amounts of natural gas that otherwise would remain trapped in low-porosity shale reservoirs, but it also slurps capital in vast amounts: fracked wells generate bountiful gas output during their first few months of production but then peter out rapidly. Thus, the whole secret of the so-called fracking revolution was to drill, drill, and keep drilling.
The tens of billions of fresh cash required for the shale-fracking play was not a problem for the fast-money dealers of Wall Street, who had just the answer: namely, high-yielding natural gas investments called VPPs (volume production payments). These were another form of opaque off-balance sheet debt. In this case investors provided up-front funding for gas wells in return for a fat yield and a collateral claim on the gas.
Accordingly, a flood of Wall Street money found its way to red-hot shale gas drillers like XTO, which was soon swallowed whole by ExxonMobil, and to the kingpin of the shale-fracking play, Chesapeake Energy. Its balance sheet grew explosively between 2003 and 2011, with proven reserves rising from 2 trillion cubic feet to 20 trillion and total assets climbing from $4 billion to $40 billion.
It was virtually limitless Wall Street drilling money that accounted for this pell-mell expansion. During this same eight-year period, Chesapeake’s outstanding level of “high yield” borrowings—bonds, preferreds, and VPPs—soared from $2 billion to $21 billion. In this respect, Chesapeake was only the most visible practitioner of what was an industry-wide stampede to “borrow and drill.”
This debt-driven explosion of reserves, production, and injected storage eventually left giant drillers like Chesapeake gasping for solvency; massive new gas supplies caused prices to steadily weaken and then crash. By the spring of 2012, natural gas was trading at a price so devastatingly low ($2.50 per Mcf ) that even the monster of the gas patch, ExxonMobil, cried uncle. “We are losing our shirts” complained its CEO, Rex Tillerson.
With little prospect that natural gas will revive anytime soon, TXU’s revenues and operating income will remain in the sub-basement. The $36 billion of LBO debt raised at the top of the Greenspan bubble is therefore almost certain to default owing, ironically, to the aftershocks of the even larger debt bubble which fueled the fracking binge.
The larger point is that artificially cheap debt causes profound distortions, dislocations, and malinvestments as it wends its way through the real economy. In this case underpriced debt fostered a giant, uneconomic LBO and also massive overinvestment in natural gas fracking. When the collision of the two finally brings about the thundering collapse of the largest LBO in history, there should be no doubt that it was fostered by the foolish money printers in the Eccles Building and the LBO funds who took the bait.
Why Debt Zombies Remain: Goldman And TPG’s Thirty-Week Raid ON Alltel
The massive debt created by the giant LBOs of 2006–2008 has stuck to the ribs of the US economy ever since. This is true even in the $28 billion Alltel buyout, where the private equity sponsors of the deal, Goldman Sachs and TPG, were able to harvest a $1.3 billion profit without breaking a sweat during their thirty-week stint as at-risk owners. But the $24 billion of debt used to fund the LBO didn’t go away when the sponsors collected their quickie winnings. It was just shuffled along to the buyer, Verizon, where it was added to its existing debt of $42 billion.
The Alltel LBO thus functioned as a financial laundry. The company’s debt was raised from $2 billion to $24 billion and an equal amount of cash was paid out to its public shareholders and speculators. Then, after only a few months in the garb of an LBO, its heavily mortgaged assets were passed on to a new corporate owner.
The Alltel LBO was thus recorded as a roaring success because its sponsors made a 50 percent annualized return. Yet that was possible only because the next owner—a lumbering quasi-public utility that has been destroying shareholder value for a decade—kissed the buyout shops with a modest premium on their small equity investment, and then carried the whole mountain of LBO debt forward on its own balance sheet.
This preposterous debt shuffle could not have occurred on the free market because Verizon’s purchase price at 19X operating income was ludicrous. This was especially so since the Alltel wireless business was overwhelmingly a “contiguous” rather than an “in-market” acquisition, meaning that there were virtually no cost savings.
The real synergy, in fact, was purely financial. Verizon’s after-tax cost of debt was only 3.7 percent, meaning that its debt financing cost on the $28 billion purchase price was just $1.0 billion annually. Since Alltel’s $1.5 billion of operating income substantially exceeded this figure, the acquisition computed out to be “accretive.”
Plain and simple, the deal was driven by state policy—the tax deductibility of debt capital and the radical financial repression policies of the Fed. Undoubtedly, the monetary politburo had visions that its ultralow interest rate régime would spur investment in plant and equipment or IT system upgrades. In fact, it was supplying high octane fuel for financial engineering—a signal to corporate executives to grow their asset base the easy way—that is, on the floor of the New York Stock Exchange.
The proud new owner of Alltel’s $24 billion of LBO debt, however, was actually a poster boy for failed financial engineering. For more than a decade Verizon’s serial M&A had caused the scope of its operations to continuously swell, even as its earnings had gone steadily south, falling from $2.70 per share in 2004 to less than $0.90 in recent years. Despite the capital intensive nature of telecom, Verizon had skimped on CapEx, causing the inflation-adjusted value of its plant and equipment to shrink by about 25 percent over 2002–2011. Yet the decade-long M&A spree of executives obsessed by merger mania and pumping their stock price caused its nominal asset base to grow by $60 billion, or 35 percent.
So the smoking gun wasn’t hard to find: nearly 90 percent of that asset gain was due to a doubling of its goodwill—that is, M&A deal premiums. Indeed, Verizon’s goodwill now totals more than $100 billion and represents nearly 45 percent of its asset base.
Such massive goodwill, alas, is a telltale sign of a debt-ridden deal machine of the type fostered by the Fed’s bubble finance. The startling fact, therefore, is that the nation’s largest telecom services vendor has a tangible net worth of negative $17 billion. Its deal-making executives have been destroying value for more than a decade, aided and abetted by central bank money printers.
Wolf here: Stay tuned for the next LBO installment (the prior one is here). For my review of David Stockman’s bestseller, see… “Money Printers And Wall Street Coddlers.” You can find his book at your favorite bookstore or at Amazon…. THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.1 views