KKR & Co.'s Energy Future Holdings Corp., struggling toavoid default, is enjoying a $450 million windfall at the expenseof bondholders.

Energy Future, formerly called TXU Corp. and taken private byKKR, TPG Capital and Goldman Sachs Capital Partners five years agoin the largest leveraged buyout, exchanged $1.15 billion of newnotes last week for old ones with a face value of $1.6 billion. Themove came after the old securities tumbled when the firm said in anOct. 30 regulatory filing that it may be liable for $23 billion oftaxable income if it cuts ties to units that default.

The disclosure “allowed them to get a better” deal on theexchange, Andy DeVries, an analyst at independent bond researchfirm CreditSights Inc., said in a telephone interview. The filingprobably was intended to rattle bondholders and cut the value ofthe outstanding debt before the swap, he said.

The assertion that Energy Future timed its tax disclosure toknock down bond prices to buy them back on more favorable terms “ispatently false,” Allan Koenig, a spokesman for Energy FutureHoldings, said in a telephone interview.

“The Oct. 30 tax disclosure is wholly unrelated to the debtexchange” and the swap “gives financial flexibility in the shortand long term,” he said. “We have been and always will be incompliance with U.S. Securities and Exchange Commission laws.”

The Dallas-based company has posted seven consecutive quarterlylosses and will face a “material restructuring” in the next 12months, according to Moody's Investors Service. Its long-termborrowings soared to $37.4 billion as of Sept. 30 from $10.6billion before the LBO. Meantime, natural gas prices have fallenabout 74 percent from their 2008 peak. The price of electricity inthe Texas market is linked to natural gas costs.

When Energy Future was taken private for $43.2 billion, it wasprofiting from low power-generation fuel costs and rising naturalgas prices. The company, under former Chairman and Chief ExecutiveOfficer C. John Wilder, earned $2.6 billion in 2006 afterrebounding from a failed international expansion that left it onthe verge of bankruptcy four years earlier.

Sagging Fortunes

With its fortunes again sagging, Energy Future has been tryingto extend maturities through debt exchanges, borrowed to pay offintercompany loans and made efforts to shield profitable assetsfrom potential creditor claims in the event of a restructuring.Fitch Ratings said it's likely the company may remove provisions inits bond indentures that would further protect those assets.

Andrea Raphael, a spokeswoman at Goldman Sachs, didn't returntelephone and e-mail messages seeking comment on Energy Future'sfinances. Kristi Huller, a KKR spokeswoman, declined to comment.Owen Blicksilver, a spokesman for TPG with Owen Blicksilver PublicRelations Inc., declined to comment.

Energy Future disclosed in October, along with a $407 millionthird-quarter loss, that it had a $19 billion excess loss accountand $4 billion deferred intercompany gain that are reflected in thetax basis of the stock it holds of Energy Future CompetitiveHoldings and may be triggered as taxable income if those shares aresold.

The announcement caused its bonds to plummet, with the marketvalue of the old debt involved in the swap falling to $991 millionfrom $1.1 billion, according to CreditSights. Its 5.55 percentnotes due 2014, which traded at 83 cents on the dollar before thequarterly filing, fell as low as 50 cents in November beforerebounding to 88 three hours after the exchange deal was madepublic, according to Trace, the bond-price reporting system of theFinancial Industry Regulatory Authority.

The bonds increased to 88.5 cents to yield 12.4 percent on Dec.7, Trace data show.

“We think there is a better chance the disclosure was meant todrive down the price of EFH bonds so management can commence anexchange offer,” DeVries wrote in a Nov. 4 report.

The new bonds allow Energy Future to pay interest with extradebt instead of cash. That may improve the company's near-termfinances as it works to shield an 80 percent stake in itsprofitable Oncor Electric Delivery Co., which is regulated anddistributes power to homes and businesses, from a potentialrestructuring of other units that generate and sell power incompetitive markets.

Exchange Premium

Energy Future issued the new bonds through its Energy FutureIntermediate Holding Co. and EFIH Finance units, which sit betweenthe parent and Oncor in the firm's capital structure.

The securities, which are due in 2018 and pay 12.25 percentinterest with extra debt, were exchanged at a 16 percent premium tothe market value of existing debt held at the parent level,according to CreditSights.

Had it conducted the swap six weeks ago, before the market valueof the securities plunged to as low as $700 million in the daysfollowing the tax disclosure, Energy Future would have had to spend$1.27 billion to give creditors the same premium.

The new bonds were exchanged for $234 million of 5.55 percentdebt due November 2014; $510 million of 6.5 percent notes due in2024; about $453 million of its 6.55 percent securities due in2034; $94 million of 10.875 percent debentures due 2017; and $313million of 11.25 percent bonds due 2017.

Energy Future expanded on the tax liability in a Nov. 6 filingknown as a “8-K” in response to investors' questions.

“The excess loss account and deferred intercompany gaindescribed in the Energy Future Holdings form 10-Q were created inconnection with financing transactions and internal restructuringsthat involved Texas Competitive Electric Holdings and its assetsbut not Energy Future Intermediate Holding or Oncor Holdings,”Energy Future said in the filing.

The debt exchange is part of a move to improve the finances atthe portion of the firm linked to Oncor while distancing thoseassets from units such as Texas Competitive Electric Holdings Co.,where Moody's said a default is “highly likely” to occur in thenext 12 months.

After cutting legal and financial ties, “you can then look atEnergy Future Holdings and Energy Future Intermediate Holdingpretty much as a standalone entity,” Shalini Mahajan, an analyst atFitch, who doesn't expect the tax implications to be triggered,said in a telephone interview. “We don't think Oncor gets pulledin, in any kind of bankruptcy proceedings.”

Buying Time

Energy Future also benefits from the ability to pay interest onthe new bonds with additional debt, giving the company more time toimprove its balance sheet, Mahajan said. The so-calledpayment-in-kind feature may save $360 million in interest costsover three years, helping boost liquidity to a level adequate until2016, she wrote in a Dec. 5 report.

Moody's changed its rating outlook on the electricity providerto “developing” from “negative” after the exchange, saying in aDec. 5 report that “the probability of a default occurringsimultaneously across the Energy Future Holdings family, excludingOncor, is diverging.”

The parent company is rated Caa3 by Moody's and CCC at Fitch,levels that denote bonds with high default risk. S&P changedEnergy Future's rating to SD from CCC on Dec. 6, characterizing theexchange offer as a “selective default.”

Losses have been tempered by Energy Future's stake in Oncor,whose rate of return on investment is set by regulators. The unitreported net income of $321 million for the first nine months of2012 and paid a $100 million dividend to Energy Future, the size ofwhich is regulated, up from $64 million in 2011. The parent said inits Oct. 30 filing that it expected to receive a distribution ofabout $47 million from Oncor that day.

“Lenders accepting the exchange might be looking to the value,if any, of being closer to the asset that provides essentially allcash flow” that Energy Future uses to meet obligations, TerryPratt, an analyst at S&P in New York, said in a Dec. 6report.

Natural gas futures cost $3.55 per million British thermal unitslast week, down from $6.88 on Oct. 11, 2007, the day KKR and TPGtook Energy Future private. Prices have plunged from a peak of$13.58 in July 2008 as the worst financial crisis since the GreatDepression sapped demand and as expanded drilling in the gas-richMarcellus shale in the eastern U.S. created a supply glut.

“Natural gas prices are never going to get where they need themto get to be able to make that capital structure work,” PeterThornton, an analyst at high-yield researcher KDP InvestmentAdvisors Inc., said in a telephone interview.

A decision by Energy Future to put Energy Future CompetitiveHoldings and its Texas Competitive Electric Holdings unit intobankruptcy protection would raise the question of whether thoseunits' creditors, “if they're going to get zero or are otherwiseseverely impaired, will they have a claim on that Oncor equityvalue, because of the tax liability or the intercompany loan orsome other link to the parent?,” Thornton said.

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.