Icahn's no good, very bad Dynegy deal

December 16, 2010: 12:20 PM ET

Longtime corporate raider Carl Icahn beat out Blackstone's bid for Dynegy, but it's not clear how he can make a return on his investment.

By Cyrus Sanati, contributor

Carl Icahn

Why is this man smiling?

Carl Icahn may be biting off a bit more than he can chew with his latest deal.

The billionaire activist investor jumped head first into the volatile energy industry yesterday, agreeing to buy wounded Houston-based power giant Dynegy for $660 million, plus the assumption of $4.8 billion in debt. At that price, Icahn has two options: he can be very patient, waiting for asset prices to rebound, or very aggressive, declaring war on the company's bondholders, to recoup his investment. Neither one is promising.

Dynegy (DYN) had been on the block for nearly two years. Its bankers at Goldman Sachs (GS) and Greenhill (GNH) pitched the company to anyone who would listen, but failed to seal a deal as investors were concerned about the company's crushing debt load. Then in August, private equity giant Blackstone Group (BX) came along and offered $4.50 a share for the company, or $550 million.

Dynegy was in bad shape at that point. It had been burning cash for a while as weak natural gas prices helped to drag down power prices. Blackstone looked at Dynegy as a long-term play with an investment time horizon of at least five years to around 10 years, a person with knowledge of the firm's thinking told Fortune. It had already sealed a deal to sell some of the company's best power plants in California and Maine to rival NRG (NRG) for $1.36 billion. Blackstone was planning to use that cash to keep the company afloat until power prices rebounded for a sustained period of time. It would then either take the company public or sell it off in pieces.

But Icahn and Seneca Capital, a hedge fund, fought to block the deal on grounds that it undervalued the company. Blackstone later upped its offer to $5 a share, but shareholders rejected the deal last month, threatening to put the company into bankruptcy.

Enter Icahn. The Wall Street maven has offered a 10% premium to Blackstone's best offer at $5.50 a share. If the offer passes a shareholder vote, Icahn could take control of the company by the first quarter of next year.

Bad options

It is still unclear what Icahn's intentions are for the company if he is successful in grabbing control. Icahn made the offer using just public information and was not privy to confidential company data, according to a person close to the deal. Blackstone, on the other hand, was privy to that data, so Icahn could be in for some surprises down the road.

One option would be for Icahn to wait for power prices to rebound so he could sell off the company's assets at a higher price than the premium he paid for them. But it is unclear when this rebound in power prices would occur given the now chronically weak natural gas market. There is an overabundance of natural gas on the market due to an explosion in shale drilling, so it may take years for that market to rebound. In any case, Icahn rarely holds his investments for more than two years, so it's unlikely that he will be waiting around for power prices to rebound in five years or so.

There are few buyers out there willing to pay top dollar for power plants at this moment. Any attempt to break up the company and sell it now would yield "far less than $5 a share," according to a person with intimate knowledge of the company's assets. Even selling those choice power plants to NRG will be harder. David Crane, the chief executive of NRG, has said publicly that if he had to bid again that he would pay less than he was willing to pay Blackstone. Plus, any sale to NRG would require Icahn to pay Blackstone the equivalent of 2% of the deal on top of a potentially lower purchase price, according to a break clause in the original deal.

If all else fails, Icahn could effectively declare war on the bondholders in an attempt to get them to take a haircut. In this scenario Icahn would likely threaten to sell off assets, pocket the cash and push the company into bankruptcy. This would undoubtedly raise fraudulent conveyance issues, in which the bondholders would sue Icahn to get that cash back, arguing that it was unjustly taken from them. The imbroglio could take months or even years to settle and cost millions in legal fees. Bondholders may be more willing to take a hit to avoid a total mess in bankruptcy court.

Either way, it's still unclear if Icahn will even be successful in getting his hands on the company. Seneca Capital may push for more money and agitate other shareholders to block the bid. UBS said in a research note yesterday that Mr. Icahn's offer could be a "stepping stone to a 'better' bid." Nevertheless, is hard to see a white knight riding to Dynegy's rescue given that it has been on the block for the past two years. Icahn's office did not respond to repeated requests for comment.

The winner in all of this may end up being Blackstone given all the fees it stands to collect risk free. It already collected a $10 million cost reimbursement after Dynegy's shareholders rejected the deal. It could soon receive a $16.8 million breakup fee if the company is sold. And if Dynegy sells some power plants to NRG, Blackstone stands to reap up to an additional $30 million. So while Blackstone is in the deal-making business and not in the fee collecting business, a $55 million payday is still an impressive one.

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