The announcement sounded routine: Warren Buffett’s Berkshire Hathaway offered last week to purchase a Texas utility, Oncor, for $9 billion. Berkshire would also assume Oncor’s debt, so the deal has a value of about $18 billion.*
But the interesting story is not this announcement. The interesting story is what has occurred over the past 10 years, leading up to this. This is where the real investment lessons are.
In 2007, three of the biggest and seemingly smartest financial firms purchased Oncor’s predecessor firm, TXU, for $45 billion.
Goldman Sachs’ private equity arm, along with KKR and TPG (huge private equity firms) bought TXU in October 2007. TXU, the energy firm, relied on coal-fired plants to produce its electric power. The investment firms based this huge transaction on their prediction that natural gas prices would rise. The investment firms predicted that as natural gas prices rose, TXU would have a competitive advantage over other power companies.
At the time of the 2007 purchase by these top private equity firms, this $45 billion deal was the largest leveraged buyout (LBO) on record. The 3 firms invested $8 billion of their own money and they borrowed the remainder from others, by issuing bonds. It was reported that in 2007, after the leveraged buyout, the renamed Energy Future Holdings had more than $40 billion in debt.
Enter Warren Buffett….in late 2007. Berkshire Hathaway purchased $2.1 billion of these Energy Future Holdings bonds that were needed to finance the TXU leveraged buyout. The bonds were called “high-yielding,” which means they were risky and below investment grade. Buffett must have agreed with the investment thesis that natural gas prices would increase.
Some of Wall Street’s best and brightest were very wrong. In 2007, natural gas prices were around $7-8 per BTU (British Thermal Unit). After a brief spike upward in 2007-08, the price of natural gas has plummeted ever since. Natural gas has traded in a range of $2-$5 per BTU from 2008 to today.
Due to the significant decrease in natural gas prices, Energy Future Holdings struggled financially and was unable to handle its huge debt burden. By April 2013, KKR, TPG and Goldman Sachs had written down the value of their $8 billion investment to zero (a 100% loss).
In 2013, Berkshire sold its $2.1 billion of bonds at a loss of $873 million (a 41.6% loss). In one of his annual shareholder letters before 2013, Buffett wrote that he had “totally miscalculated the gain/loss probabilities when I purchased the bonds.”*
Energy Future filed for bankruptcy protection in 2014. It was the biggest bankruptcy of a private equity-backed company since the 2007-2009 financial crisis.
In 2007, Energy Future was valued at $45 billion.
Berkshire is offering approximately $18 billion for Energy Future’s remaining operating unit, Oncor. It is unclear whether Berkshire’s offer will be successful, as it requires regulatory and creditor approvals and another entity may submit a competing offer.
So what is the learning? What are the lessons from this experience?
- Making a prediction about the direction of something like the price of natural gas (or oil, gold or an individual stock) can be very costly, if you are wrong.
- This is why we do not rely on making predictions as the basis of our investment strategy.
- Not making predictions may seem counter-intuitive, especially if you are new to our firm, but we focus on things which we control. As we cannot accurately and consistently predict the future, we do not attempt to base our investment recommendations on predictions.
- We do not recommend purchasing high-yielding “junk” bonds.
- Berkshire Hathaway is a huge conglomerate and can afford to lose huge sums of money. They are fine and survived, despite the huge bond losses from these junk bonds. o Berkshire Hathaway is a huge conglomerate and can afford to lose huge sums of money. They are fine and survived, despite the huge bond losses from these junk bonds.
- We purchase investment-grade corporate bonds in certain industries on behalf of our clients, as we feel the risk/benefit is worthwhile, versus only government bonds or CDs, for most clients.
- We would not have purchased these types of junk bonds, as the risk-reward is inadequate. The higher interest rates may seem appealing, but the underlying risk of the company’s ability to repay the bond is the primary objective.
- Our primary concern when purchasing bonds on behalf of our clients is that there should be a very good expectation of getting the bond principal repaid. Risk will always exist, but junk bonds have a much higher rate of default, so buying them is not worth the risk.
A few weeks ago, I wrote a blog post about a book titled The American Spirit by historian David McCullough. He emphasized over and over throughout his brilliant collection of speeches the importance of reading, understanding history and learning the lessons from history. He said you never know where your reading and research will take you and what you will learn.
When I read last week that Buffett and Berkshire was offering to purchase this utility, I had no idea that Buffett had previously lost almost a billion dollars related to the same entity. I did further research and learned about the background of this company. This further reinforced the strength and rational of many of our investment principles.
I hope that my extensive reading about all kinds of topics is of great benefit to our clients, in all kinds of ways.
*Source: WSJ, “Warren Buffett’s Oncor Play Shows Berkshire’s Energy Ambitions,” July 7, 2017
Other sources available upon request.