Don't mess with Texas

NEW YORK (Fortune) -- So Kohlberg, Kravis, Roberts and the Texas Pacific group, along with four investment banks, inked a deal to pony up $32 billion in cash and assume $13 billion in debt to acquire TXU, Texas's second-largest power company. So the buyers cleared it with big-time pollution watchdogs like the Environmental Defense Fund and the National Resource Defense Council by agreeing to double TXU's use of wind energy and cancel plans for eight coal power plants.

Big deal. That's been the easy part of the most expensive private equity investment in history. Now some of the buyout industry's most elite players are facing angry mayors, ticked-off state lawmakers and even a few overheated grandmothers - the myriad stakeholders in Texas's brewing energy mess. So far, local politics have been a Texas-sized headache for the buyers - if things continue as they're going now, it could derail the deal.

Unlike discussions with the national environmental groups, consultation with Texas stakeholders didn't begin until just a couple days before the deal was inked on Feb. 26. "They had done four months of due diligence," says State Senator Troy Fraser, "but no member of the legislature, leadership or public utility commission had been contacted."

Most Texas officials, ranging from the governor to city mayors, found out about the deal on Friday, Feb. 24, just two days before it was announced. "It was nothing substantive," says Terry Hadley of the Public Utility Commission of Texas. "It seems to have amounted to a last-minute courtesy call."

Now KKR, TPG and a small army of lawyers and lobbyists are reaching out to officials and groups across Texas. "We communicated as much as was appropriate and possible with senior officials prior to the announcement," says Jeff Heller, an Austin-based spokesperson for KKR and TPG. "Now, we're meeting daily with them to listen. We look forward to continuing this effort."

But the TXU deal comes amid a tumultuous time for Texas's energy market. Over the last four years, Texas has totally deregulated its electricity market, with wholesale - the building of plants and selling their energy - going fully deregulated this past January. Since that process has started, prices have more than doubled in some areas, cities have seen retail electricity markets concentrated, and some - like Governor Rick Perry - say shortages could cause rolling blackouts as soon as next year if more power plants aren't built.

"Energy is the biggest topic in Texas right now," says Senator Fraser. "Over 350 lobbyists have been hired. It's a very hot issue, involving billions of dollars."

The environment also became a huge issue when TXU (Charts) proposed building eleven new coal-fired plants. "The move by TXU was so overreaching that people rose up like a tsunami all over the state," says Dallas Mayor Laura Miller. "And I think that there is a potential for that perfect storm of people to rise again on some of the same issues."

The early outlines of KKR and TPG's plans for TXU are raising issues on both economic and environmental fronts.

Texas's elected lawmakers are particularly concerned about prices. KKR partner Fred Goltz was asked to testify in front of the House Committee on Regulated Industries last Tuesday. He said TXU's new owners planned to cut rates by 10 percent for 1.3 million customers in lieu of $50 in rebates.

But members of the House committee wanted the rebates retained, and thought the rate cut should be at least 20 percent, and ideally 30 percent. And while they do not have any legal authority over rates, "There are some things the legislature can do that are not favorable toward the consummation of your agreement," Rep. Phil King told Goltz.

Indeed, on that very same day, the House considered - and the state Senate committee overseeing energy deregulation passed - three energy bills. KKR and TPG personnel were initially present at the Senate committee hearing, held later on Tuesday, but left the session because they did not want to be called to testify, according to observers.

One bill would break up any energy market where one player had more than 25 percent of the customers - for TXU, that would be in the Dallas area (where it has 56.3 percent, according to Senator Fraser's office) and north Texas (43.5 percent). Another would break up any vertically integrated energy company - like TXU, whose three subsidiaries build plants and sell their power, build power lines, and market electricity to consumers. The third would give the Public Utility Commission of Texas the power to review - and block - any transaction involving a regulated entity.

KKR and TPG lawyers and representatives have previously said that there is nothing in Texas law, post-deregulation, that would require the deal to be OK'd by a regulator. That didn't matter to the Senate: "My investigation found that there had never been a utility sold without a regulator's approval," says Senator Fraser. "We hurriedly put together legislation that would close any loophole."

Next page: Don't mess with Texas (cont.)

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