Blackstone-Hilton Buyout Raises The Bar - And Eyebrows

By Ryan Barnes | July 03, 2007 AAA

Just off of its IPO less than two weeks ago, the Blackstone Group (NYSE: BX) is wasting no time in putting its dollars and clout to headline-grabbing use. Late Tuesday Blackstone announced its intention to purchase Hilton Hotels Corp. (NYSE: HLT) in a $26 billion privatization deal that would make it one of the 10 priciest leveraged buyouts (LBOs) in history.

The offer calls for the purchase of all outstanding shares of Hilton for $47.50 apiece, a whopping 32% premium to the closing price on Tuesday in a shortened holiday trading session. Hilton's board agreed to terms late Tuesday, and is so far singing the praises of Blackstone as a premier hotel manager/owner.

If the deal passes, Blackstone will own roughly half a million hotel rooms in over 75 countries. It will become one of the largest real estate holders in the world - thanks to the recent $36 billion purchase of Equity Office Properties, and already-owned hotel assets like La Quinta Inns and LXR Luxury Resorts.

The official specs of how the roughly $19 billion in cash will be gathered up is not yet known, but it will likely be a combination of existing funds, equity and debt.

Blackstone can draw on both real estate and equity funds raised from investors to make the purchase, of which there are still billions remaining in the coffers.

Some Questions Beg to be Asked
There ought to be a lot of raised eyebrows when looking at the trading activity in Hilton on Tuesday, as the announcement was made well after the close, yet the stock rose over 6% in the short session on nearly twice the normal volume. Options activity was also well above normal levels, adamantly suggesting that someone got wind of the deal before official news broke. Not that any of us should be shocked at this, but these kinds of leaks tend to bring unwanted attention from the SEC and other regulators. (For more on how the SEC does its job, see Policing The Securities Market: An Overview Of The SEC.)

Also hanging over the heads of all private equity firms is the threat of a major tax change that could change the profitability of all these mega-deals we've been seeing. Currently Blackstone gets to operate as a public company while only paying a 15% tax rate, rather than the standard 30% rate most companies pay. This could change following the passing of a bill recently introduced to Congress that would kill the 15% party, slow down the pace of buyouts, and even keep other private equity firms from trying to float shares (via an IPO) themselves.

Supply/Demand Balance Still Favorable
Simply put, there aren't a lot of new hotels being built these days, which means that hotel operators have been able to steadily raise their rates. Hilton estimated it could double net income levels by 2009 due to this pricing power. HLT stock has already climbed all the way up from the single digits in late 2001 to current levels above $35.

As a whole, the hotel industry has been rebounding nicely since a near-collapse in travel following the U.S. recession and terror attacks of the 2001-2002 period. But lodging has long been considered an extremely cyclical business, and it remains to be seen if the supply/demand balance will hold up during the next downturn in the business cycle. Blackstone certainly seems confident that the cash flows will remain solid, but I am cautious as to whether we'll see a rush of subsequent deals in the sector.

Parting Thoughts
Hilton should trade near the $44 to $45 level in the coming days, which would leave a little room for arbitrage for a patient investor (the deal is set to close in the fourth quarter). The likelihood of a higher offer coming in (and being accepted) appears to be remote, as well as seeing a premium this high for any subsequent buyouts in the sector because most of the independent hotel operators will rise on speculation when markets open on Thursday.

We've already seen some sizable deals this year, including a $3.4 billion buyout offer in February for the Four Seasons Hotels group. There are still some large independent players out there, such as Starwood Hotels & Resorts (NYSE: HOT) and Marriot (NYSE: MAR), but a potential buyer with the experience, capital and related assets of a Blackstone would be hard to come by. Blackstone has also stated it intends to invest a lot of capital into Hilton after the purchase, which makes this deal far from the hands-off, quantitative approach taken by most private equity financiers.

The outlook for hotels seems favorable for the near-term, but over time the supply of hotel rooms will increase. It needs to be balanced out by increased travel from international tourists and U.S. baby boomers. With such a high premium being paid (which values HLT shares at roughly 40-times '07 earnings), investors may trust Blackstone's due diligence in this deal, but BX stock could come under pressure in the coming weeks as investors digest the scope and ramifications of this deal and the pending tax legislation.

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