Dynegy LBO: A Couple Of Problems

(Bloomberg Gadfly) -- Dynegy is no stranger to leveraged buyouts -- attempted ones, anyway.

The merchant power generator spent late 2010 entertaining not one, but two proposed buyouts by Blackstone and Carl Icahn, respectively. Both ultimately fizzled.

Now the idea of someone potentially taking Dynegy private has resurfaced, most recently as a valuation exercise in a report published this week by Morgan Stanley.

In theory, it could work. Then again, LBO models can spit out exquisite returns provided you plug in rosy-enough assumptions about profits and, especially, how much you can sell the business for down the road. Hovering over any such deal in this sector is the memory of what happened with Energy Future Holdings (formerly TXU), bought for $48.4 billion in 2007 in a deal lead by KKR -- and which is now emerging from bankruptcy.

In Dynegy's case, several things could tick private equity's boxes. First, the stock has collapsed over the past year or so.

Dynegy LBO: A Couple Of Problems

As a result, Dynegy looks cheap relative to both its listed rivals and power plants being bought and sold privately. The equity check for a Dynegy acquisition would also be pretty small. Morgan Stanley's model assumes a theoretical acquisition price of $25 a share -- a premium of almost 100 percent -- costing less than $3.3 billion overall.

What's more, provided expansion plans are kept in check, Dynegy throws off cash. Consensus estimates for the years 2016 through 2018 compiled by Bloomberg add up to $1.3 billion, equivalent to almost the entirety of Dynegy's current market cap.

The biggest obstacle: debt.

Dynegy's pro forma net debt is estimated by CreditSights to be $9.8 billion, or about 6.5 times forecast 2016 Ebitda. Layering on a 60 percent debt-financed bid at $25 a share would take that to more than 7.8 times -- assuming some bank would finance it.

Even if they did, every dollar of free cash flow would be needed to pay off debt, leaving little room to absorb unforeseen problems. With no scope for dividends along the way, the buyer's eventual exit price would be even more crucial than usual. Using Morgan Stanley's model, assuming a sale after 7 years, here's how our theoretical private equity buyer's returns stack up at different Ebitda multiples:

Dynegy LBO: A Couple Of Problems

A multiple of 7 or 8 times isn't that demanding. What isn't clear is how demanding it might seem by the mid-2020s.

As I wrote here, apart from the vagaries of the natural gas market, merchant generators face structural challenges as renewable-energy sources have suppressed wholesale power prices in important markets such as Texas and California.

Against this, once the Engie deal closes, Dynegy will be more heavily weighted to the so-called PJM market, which covers a large swath of territory on the eastern seaboard and across to parts of the Midwest. However, this market faces challenges of its own:

PJM has a daunting 35,000 megawatts of potential new capacity in development, representing a 20% boost to an already oversupplied grid. With essentially no load growth and few near-term plant retirements, the supply would pressure the capacity price at the nation's largest unregulated power grid, driving many generators into the red. The price fell 40% in the 2016 auction as gas generation inundated the market. (Kit Konolige, Bloomberg Intelligence)

Closures of older plants should help. But as the recent bailout awarded to several nuclear plants in upstate New York demonstrate, any LBO buyer would have to factor regulatory wildcards into their risk premium (Dynegy is one of several plaintiffs suing to reverse the state's plan).

None of this rules out someone buying Dynegy, but paying less than $25 would certainly help mitigate their risk. Acquire Dynegy at only a 30 percent premium to today's price, and those IRRs start to look pretty good at an exit multiple of just 6 times Ebitda, using Morgan Stanley's model. Whether the company would recommend a deal at a price where the stock traded just 3 months ago is another matter.

Should Dynegy's stock remain weak or fall further, the greater the chance that some deal emerges. The M&A market for U.S. generation assets has been strong:

Dynegy LBO: A Couple Of Problems

This mismatch between the private and public markets' enthusiasm, as well as an accommodating bond market, point to an LBO floor in sector stock prices. Ironically, the emergence of Energy Future Holdings from Chapter 11 should mark the entrance of another potential buyer into the asset market.

A strategic buyer, or a private equity firm with existing power assets, could at least reap some savings to bolster cash flow. And in Dynegy's case, after the Engie deal closes, its biggest shareholder with 15 percent will be Energy Capital Partners, a savvy private equity firm specializing in the sector.

It is worth remembering, though, that ECP acquired its stake in Dynegy effectively for nothing. That was also a feature of Blackstone's earlier attempt at a full buyout, due to a proposed side-deal with NRG Energy. Similarly, Riverstone's recent $5 billion LBO of Talen Energy was facilitated in large part by the private equity's firm's existing 35 percent stake and the target's own cash balance.

That doesn't rule out other types of suitors showing up. It does suggest, though, that even if Dynegy looks cheap, the smart money would still drive a hard bargain.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Adjusted for the Engie deal and the recently agreed restructuring of subsidiary Illinois Power Holdings

  2. Math dictates that exiting more quickly might also boost your IRRs, of course, although that would also provide less time for paying down Dynegy's debt.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.