The bond market has never been more pessimistic on the chancesof KKR & Co. and TPG Capital being able to salvage the biggestleveraged buyout in history — the $43.2 billion purchase in 2007 ofthe electricity provider known then as TXU Corp.

Since the private equity firms bought the Dallas-based company,now known as Energy Future Holdings Corp., with $45 billion in debtfinancing, natural gas prices have tumbled 50 percent as a processfor extracting the fuel from shale called fracking rises inpopularity. That has cut electricity prices in half as well.

Less than a year after extending the maturities on more than$17.8 billion of debt, credit-default swaps traders are pricing ina 91 percent chance that the company will fail to meet itsobligations in the next three years. Its debt securities yieldabout 21 percent on average, up from 15 percent when therefinancing was announced in April.

“The clock has gotten much louder for TXU with this recentfalloff in natural gas,” said Jon Sablowsky, the head of trading atinvestment firm Brownstone Investment Group LLC in New York. Thecompany is overlevered and doesn't have “enough revenue to servicethat debt going forward, nor enough revenue to provide theconfidence to investors to help them refinance that debt,” he saidin a telephone interview.

KKR and TPG are losing a bet they made in 2007 that natural gasprices would continue to drive wholesale power prices higher, awager that soured when a recession sapped demand just as drillingexpanded in the gas-rich Marcellus shale in the eastern U.S.

Wholesale electricity prices plunged as gas prices dropped,hammering independent wholesale generators such as Energy Futurethat don't have the protections given to regulated utilities wherestates allow a certain level of profits.

The concern among credit traders has grown more urgent as theplunge in natural gas prices raises the potential cost of renewinghedges against price swings that expire in 2015.

Three-year credit-default swaps tied to Texas CompetitiveElectric Holdings, the company's unregulated merchant power unitknown as TCEH, have soared 45.7 percentage points during the pastseven months to 69.5 percent upfront yesterday, according to dataprovider CMA. That's 4.4 percentage points less than the cost forfive years of protection, compared with 24 percentage points onJune 15.

The price means the initial cost to protect against a default on$10 million of the company's debt through March 2015 has climbed to$6.95 million from $2.38 million in June.

Recovery Rate

The contracts are trading at levels that imply a 91 percentchance of default, based on market assumptions that bondholderswould recover 14.5 cents on the dollar in such a scenario,according to CMA, which is owned by CME Group Inc. and compilesprices quoted by dealers in the privately negotiated market.

Credit-default swaps pay the buyer face value if a borrowerfails to meet its obligations, less the value of the defaulteddebt.

Kristi Huller, a spokeswoman for KKR in New York, whoseco-chairmen are Henry Kravis and George Roberts, and OwenBlicksilver, a spokesman for Fort Worth, Texas-based TPG, declinedto comment.

Energy Future “generates stable cash flow through solidoperational performance in a growing market, has adequate liquidityand has re-worked its capital structure to reduce debt and extenddebt maturities,” Allan Koenig, a spokesman for the company, saidin an e-mailed statement. The power producer employs more than9,000 people, up 25 percent from 2007, he said.

Gas supply in the U.S. has grown since producers learned to usehydraulic fracturing and horizontal drilling to tap deposits lockedin dense shale rock formations.

The commodity, which traded as high as $13.58 in July 2008, willstay below 2011's average price of $4.026 for the next two years,or about $3.10 per million British thermal units for 2012 and $4for 2013, according to Robert W. Baird & Co., an investmentbank in Milwaukee. Natural gas for February delivery fell 12.6cents, or 5.1 percent, to $2.346 per million British thermal unitstoday on the New York Mercantile Exchange, the lowest settlementprice since March 2002.

That price is “brutal” for Energy Future because TCEH needs$6.15 to break even, and leaves “zero recovery” for bondholdersbeyond the first lien, said Andy DeVries, an analyst atCreditSights Inc. in New York.

Price Hedges

Hedges that contributed to one-time gains of $89 million lastquarter by locking in natural gas prices expire by 2015, accordingto the company's most recent quarterly filing with the U.S.Securities and Exchanges Commission. The hedges lock in natural gasat a weighted average price of about $7.36 for 2012, compared witha weighted average market price of $4.24.

“They're so well hedged in the near term, and they've got someroom under the maintenance covenants so weak gas prices shouldn'tbe a problem this year,” DeVries said. “It's when the hedges startto expire when push comes to shove.”

Energy Future reported a loss of $710 million on Oct. 28 for thethird quarter, as interest expenses and related costs rose by 50percent and sales fell 11 percent. The company and its wholly ownedpower-delivery unit Oncor Holdings had long- term debt of $40.18billion. U.S. Environmental Protection Agency rules intended toreduce cross-state air pollution will cost the company $1.5 billionthrough 2020, the company said in a lawsuit with the U.S. Court ofAppeals in September.

Lenders agreed in April to extend debt maturities on about $17.8billion of the company's debt and swapped some holdings atdiscounted prices for new securities.

“We view Energy Future Holdings Corp.'s multipledistressed exchanges and credit facility extensions as tantamountto default,” Standard & Poor's analysts Aneesh Prabhu andAndrew Giudici wrote in a Jan. 11 note.

Texas Competitive's $1.87 billion of 10.25 percent bonds dueNovember 2015 dropped 7 cents to 28 cents on the dollar this year,yielding 60.564 percent as of Jan. 17, according to Trace, the bondprice reporting system of the Financial Industry RegulatoryAuthority.

“Even if you're secured, you have to be scratching your head andwondering where the mechanism for repayment is coming from,” BonnieBaha, the head of the global developed credit group at DoubleLineCapital LP, which oversees $23 billion, said in a telephoneinterview from Los Angeles. “Given the competitive landscape, giventhe changes that have occurred in the natural gas industry thatweren't really foreseen at the time these deals were structured,I'd say your capital is better deployed elsewhere.”

Prospects 'Negative'

Energy Future's term loan maturing in October 2017 traded atabout 61.3 cents on the dollar yesterday, from 63.6 cents on Jan.9, according to Markit Group Ltd. The term debt due in October 2014was trading at 64.7 cents from 69 cents.

Energy Future unit Oncor Electric Delivery has $375.6 million of6.375 percent notes maturing in May and $524.7 million dueSeptember 2013, according to data compiled by Bloomberg. About $3.8billion of TCEH loans mature in October 2014, Bloomberg datashow.

“There are no near-term maturities and there's no maintenancecovenant that can be tripped in the near term, but there's a viewthat they're not going to be able to refinance their debt at TCEH,”Chris Chaice, an analyst at New York-based Covenant Review, said ina telephone interview. “Long-term prospects are very negative forTCEH. The time at which they can no longer support the capitalstructure is growing nearer.”

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