New Paradigm of Government Distress

This article originally appeared in Business Insider

July 7, 2011

A Slow-Moving Disaster

The state of Illinois is broke, and if it were a company it would at this moment be in the midst of a chapter 11 bankruptcy process.  A recent Bloomberg Businessweek article highlights just how bad things are in the Land of Lincoln:

  • The state is $4 billion behind on bills to 8,000 businesses, charities and state agencies.  Of that number, 114 are owed over $1 million.
  • This mountain of overdue bills exceeds the entire annual budget of the state of Delaware and is more than 10 percent of Illinois’ general budget for the upcoming year.
  • Banks are refusing to lend against these receivables, a sure sign that a state default is no longer a fringe idea.
  • Tax increases raised $7 billion for the state, which was insufficient to cover a $13 billion deficit.  The partisan fight over more borrowing continues.

State budget cuts are getting progressively deeper, and municipalities, faced with an end to federal stimulus money, the financial struggles of states, and declining property tax assessments, are being pressed to find new and ingenious methods to keep expenses down.

Painful Changes Needed

Sadly, cost reduction is not an area of expertise in most governments.  In the turnaround and restructuring community a shakeout is viewed as inevitable.  At the most basic level a restructuring of state and municipal debt as well as pension and healthcare obligations is essential.  Shared services and joint purchasing proposals will need to be moved from the drawing board to implementation.  We can expect vicious fighting between bondholders, government employees (current and former), voters and the unlucky politicians caught in the middle.

The policy implications of an age of local government financial distress must be considered as well.  California’s Proposition 13 was enacted in opposition to rising property taxes at a time (1978) when only half of the Baby Boomer generation was in the midst of their childbearing years.  We are a very different society with different demographic and social trends now, and more property tax fights might be expected, with long-term impacts on the resources placed at the disposal of local governments.

Meredith Whitney Was Right

When Meredith Whitney mad her bearish call predicting a wave of municipal defaults, scorn was heaped upon her.  In a follow up research report looking at the state finances, Whitney reiterated her bearish call, pointing out that the health of state finances is even more precarious than is generally acknowledged.  While many fixed income investors have argued technical points of her analysis, I believe that by taking a step back it is clear that Whitney is making the directionally correct call and those opposing her analyses are propounding a type of exceptionalism that has traditionally led to significant losses for investors.

True believers are difficult people.  Often the very traits that allow them to be ahead of the curve on issues make them poor proponents of those issues to the broader public.  This is exactly the problem with Whitney.  She is media savvy and, since her Citigroup call, seems to be hooked on making big predictions.  As another Business Insider piece pointed out, she could learn a great deal from economist Nouriel Roubini, whose firm also has a bearish view on the U.S. municipal bond market, but has been politic enough to couch their prediction in the soothing tones of economist-speak.

A New Paradigm

We are living in an exciting time, during which the role of state and local governments will be reshaped, with luck for the better.  The old paradigm had something for everyone: nearly risk-free returns for creditors, job security for government employees, pension and healthcare benefits that were both very generous (for employees) and underfunded (for taxpayers).  It was an imperfect system but it worked for a long time.  That time is now at an end.  Stakeholders can fight all they want (and they will), but change has come, and we expect that this change will be contentious but ultimately for the best.

The Demise of a Bad Deal

This post originally appeared in Business Insider

Victory has a thousand fathers, but defeat is an orphan.

– John F. Kennedy

Things seemed so simple in 2007. Energy company TXU looked like a sure-thing. Demand for energy was climbing. The company’s robust profitability suggested an ability to service a substantial debt burden. Throw in some operational efficiencies and TXU had the appearance of a golden opportunity for some of the biggest PE firms in the U.S. to ride increasing energy demands to riches.

It has not worked out quite that way. Following its purchase in 2007 in a $48 billion buyout, the company, now renamed Energy Future Holdings had its profitability crushed by the unset of large scale fracking and the accompanying collapse in natural gas prices. Arguably good management and savvy financial engineering are the only reasons that the day of reckoning has been put off as long as it has. Natural gas hedges minimized the pain in the early years after the buyout. And on the balance sheet side there have been several distressed exchanges and refinancings in specific tranches of the company’s $43.6 billion debt structure. But there is only so much that good management and creative financial engineering can do when faced with an investment thesis that has been proven false, and market expectations are that a bankruptcy filing is imminent.

Losses happen in investing, but it is interesting to see in this case the maneuverings of savvy investors on all sides.
• PE firms KKR and TPG Capital contributed $3.5 billion in equity to the original deal
• Goldman Sachs Capital Partners contributed $1.5 billion in equity
• $3.3 billion of equity was contributed by clients of KKR, TPG and Goldman, as well as Lehman Brothers, Citigroup and Morgan Stanley
• Investor Apollo Management Group, Oaktree Capital Group and Centerbridge Partners have taken considerable stakes in various tranches of the company’s debt, positioning themselves for an eventual ownership stake following a restructuring

Recent news suggests that that $8.3 billion equity commitment may, post-restructuring, shrink to an ownership stake of less than 3 percent. The pain is not limited to the equity in this deal, though. Moody’s recently reported that due to the sheer size and complexity of Energy Future Holdings’ restructuring, it would likely result in lowered recoveries across the capital structure.

With $270 million in interest payments due November 1, one of the largest non-financial bankruptcies in U.S. history is likely about to be filed. A successful chapter 11 reorganization will allow a way forward for the over-indebted company, but will be a black eye for investors floored by the punch they did not see coming.

About the Author

David Johnson (@TurnaroundDavid) is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services. He can be reached at 312-505-7238 or at