Monday, September 22, 2014

Blackstone’s Hilton Deal: The Best LBO Ever?

A recent Business Week article proclaimed Hilton the best LBO ever. This was based on the size, $12B, of Blackstone’s unrealized gain. Some details are as follows:

1)     Investment Size: Blackstone’s initial fall 2007 equity investment was $5.6B. This represented Blackstone’s largest single equity investment. It contributed another $820MLN as part of a 2010 restructuring. Blackstone had written off 70% of its investment in 2009 reflecting poor performance as the financial crisis impacted hotel occupancy.

2)     Deal: the deal was concluded at the height of the pre crisis LBO boom. It was overpriced, double digit purchase price multiple, and over leveraged with just 20% equity and a double digit funded debt multiple. The $20B in debt, was primarily Covenant-Lite loans.

3)     Restructuring: lack of financial covenants allowed Blackstone to control the restructuring process. In 2010, they contributed additional equity, got lenders to reduce billons in debt (AKA forgive) and extend loan maturities.

4)     Winter 2013 IPO: a partial $2.4B IPO was completed which gave Blackstone’s Hilton equity interest an implied gain of $10B. The stock price has improved. The implied gain now stands at $12B the largest single transaction gain for a LBO which represents a 2X multiple of investment (MOI).

I question whether this is the best LBO ever-particularly from the limited partners’ (LPs) viewpoint.  Consider the following:

1)     Unrealized Paper Profit: Blackstone and its LPs still have received no cash. They are feeling better than in 2009 with a gain instead of an unrealized 70% loss for sure. The PE model is based on the precept that there is no exit until cash is returned. Some will argue that it is smart to hold on to the stock because it is appreciating. Remember, that Blackstone gets 20% of any stock appreciation. It would be better for LPs to get the cash and buy Hilton on their own to keep 100% of any gains.

2)     Not Risk Adjusted: This investment is volatile and represents a huge concentrated bet of LP capital. Wonder if LPs are happy with the returns given the IRRs-especially what they could have received on an alternative high risk assets. Consider an equally leveraged $26B equity portfolio in 2007 would have also yielded a $12B gain.

3)     So-So IRRs: IRRs are mediocre even based on the implied values. The December, 2013 implied IRR was in the mid teens, while the current IRR is in the low teens. I am sure these are below what was initially projected when the investment was proposed.

4)     Over Betting: You can always manufacture high dollar returns by investing large amounts. This does not mean, however, you have created value. As the Kelly Criterion shows, beyond a certain point, taking more exposure becomes suboptimal due to a higher risk of ruin in bad states-i.e. you crap out of the game too early.

I am not taking anything away from them - I am glad things worked out. Sometimes, it is better to be lucky than smart. The Business Week story mistakenly assumes the current positive outcome flows from the original decision. The Hilton gains, however,  come from a lender value transfer who accepted a large discount on their loans and leverage - not from the investment target selection.  The deal does show, however, how PE, Wall Street and apparently some journalists think. Despite what you learn in business school, they do not care about risk or the time value of money. The key metric for them is MOI. Additionally, it demonstrates the value of covenant - lite loans for borrowers, which comes at the expense of lenders.


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