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Saïd Business School cases APRIL 5, 2014

Hilton Hotels: Real Estate Private Equity Ludovic Phalippou

Abstract On December 13, 2013, two days after its IPO, Hilton hotels traded above $22 a share. This meant that the 2007 take-private transaction of Blackstone had produced the largest gain ever in private equity at about $10 billion. In addition, Hilton had become the largest hotel group in the world by number of rooms up from 4th position 6 years previously, when Blackstone bought the company. How can such success occur with a cyclical business during the worst financial crisis since 1929-1933? Somebody definitely deserves a big box of chocolates; but who? The answer is surprising and offers a detailed insight into the life-cycle of real estate private equity transactions.

This note was prepared by Ludovic Phalippou and Dawoon Chung (MFE ’13) solely as the basis for class discussion. Ludovic Phalippou is Associate Professor of Finance at the Saïd Business School, fellow at Queen’s college and Oxford-Man institute, all at University of Oxford. We are grateful to Tim Jenkinson, Peter Morris for providing useful comments. © University of Oxford 2014 The University of Oxford makes no warranties or representations of any kind concerning the accuracy or suitability of the information contained herein for any purpose. All such information is provided “as is” and with specific disclaimer of any warranties of merchantability, fitness for purpose, title and/or non-infringement. The views expressed are those of the contributors and are not necessarily endorsed by the University of Oxford.

Hilton hotels: Real estate private equity

Ludovic Phalippou

1. Introduction “

“Blackstone has a paper profit of $8.5 billion in the McLean, Virginia-based hotel operator’s initial public offering today. That’s second only to the $10.1 billion of gains that Apollo Global Management LLC (APO) has had from its 2008 investment in chemicals producer LyondellBasell Industries NV (LYB) … Hilton would become No. 1 if the shares rise more than $2 above its IPO price.”1

On June 28, 2007, Hilton’s board convened a special telephonic meeting, together with the Company’s management and legal and financial advisors, to This represented a to the company’s stock price. During a lengthy discussion, the board members considered, among other things, risks to the Company’s ability to sustain the growth rates given the cyclicality of the lodging industry. Board members also looked at Blackstone’s experience. As it turns out, which had acquired over the four preceding years alone: Extended Stay America, Prime Hospitality, Boca Resorts, Wyndham, La Quinta Corporation, and the hotel REIT MeriStar Hospitality. These represented investments totaling $13.3 billion. The most important aspect of the offer, however, was the price. With 497,738 rooms, Hilton was the fourth largest global hotel group , a mere 4,351 rooms short of the number three position, Marriott, and 58,508 rooms short of the number one, InterContinental. Prior to Blackstone’s offer, Hilton was trading at a multiple of 12.2x .2 This was lower than most of its peers. This was probably due to the relatively high proportion of owned and leased business segment in Hilton’s earnings. 3 As the sum-of-the-parts analysis in shows, multiples are highest for the managed and franchised segment, followed by owned and leased and then timeshare segments.4 Also relevant to determining a fair price for the transaction was the premium paid in recent transactions. It is not uncommon to see a large premium when listed companies are taken over, especially when the deal is sponsored by a private equity firm.5 Prior to Blackstone’s offer, two publicly listed hotels were taken private by PE firms: Fairmont (January 2006) and Wyndham (June 2005), at premia of 28% and 19%, respectively. Another recent relevant transaction was TPG’s acquisition of Harrah’s Entertainment at a 36% premium. 1

http://www.bloomberg.com/news/2013-12-11/blackstone-s-hilton-joins-ranks-of-biggest-deal-paydays.html. The share price reached $22 – hence $2 above the $20 offer price – within days. 2 Among the top ten worldwide hotel groups by room numbers, those that were publicly traded in U.S. stock markets were selected for comparison. 3 In 2006, Choice owned only three out of 5,376 hotel properties, and Starwood’s managed and franchised hotel rooms represented 87.3% of total rooms, compared to 80.6% and 76.6% for Hilton and Marriott, respectively. 4 Management and franchise segment involves managing hotels, resorts and timeshare properties owned by third parties and licensing hotel brands to franchisees. Timeshare segment involves the sales, renting and management of timeshare properties as well as consumer financing services. 5 Premium is on average about 20%, and about twice as much when it is sponsored by a private equity firm. 2

Hilton hotels: Real estate private equity

Ludovic Phalippou

2. Hilton Hotels Hilton Hotels Corporation is a hospitality company engaged in the ownership, management and development of hotels, resorts and timeshare properties and the franchising of lodging properties. Conrad Hilton bought his first hotel, The Mobley, in Texas in 1919. The Company he created was led by members of the Hilton family up until 1996 when Stephen F. , former chief financial officer at Walt Disney Co., succeeded Barron Hilton as the chief executive of the Company.6 Joining the merger and acquisition wave of the late 1990s, Mr. Bollenbach expanded the Company through a series of transactions. Most notably, , spun off the firm's gaming arm (Park Place Entertainment), and acquired Promus for $4 billion. As a result of this series of transactions, Hilton added over 1,300 hotels under various hotel brands including Doubletree, Embassy Suites Hotels, and Hampton Inn. The Company grew its room stock by more than 350,000 rooms between 1995 and 2007. This was the highest among the top ten hotel groups.

Hilton’s growth in rooms was accompanied by a substantial growth in revenue and earnings 7 before interest tax depreciation and amortization (Ebitda) – as shown in From 1995 to 2006, , respectively. The annualized growth in Ebitda of was the highest among its peers. This growth was mainly financed by debt, and following the December 2005 acquisition of Hilton International for $5.7 billion, 8 Moody’s cut Hilton’s debt ratings to “junk.” The downgrade of Hilton’s senior notes to Ba2 from Baa3 affected about $3.7 billion of debt. These high annualized growth numbers should not, however, obscure the volatility of the business. Following the September 11 attacks, . Starwood fell by 46.5%, while Marriott and Choice fell by 34.1% and 33.2%, respectively. The S&P 500 index, which included Hilton, Starwood, and Marriott, declined by 13.1% ( ). Consistent with the stock-market reaction, Hilton’s The Ebitda of nd Starwood suffered even larger declines, with Ebitda falling by % in 2001. Both stock prices and Ebitda figures recovered relatively quickly. From the trough of 2003 to 2006, the Ebidta of Hilton and Marriott both doubled and their stock prices trebled.

6

Note that Appendix A provides a glossary of terms used in this case-study and Appendix B describes the different competitors of Hilton hotels. 7 From the top ten hotel groups in Exhibit 1, those that were traded in the U.S. stock markets since 2000 were selected for comparison. 8 In 1964, Hilton was split in two, with the London-listed Hilton Group focusing on growth outside the U.S. The 1964 breakup agreement had banned Hilton Hotels from operating outside of the North America. 3

Hilton hotels: Real estate private equity

Ludovic Phalippou

3. Blackstone Group Founded by Stephen A. Schwarzman and Peter G. Peterson in 1985, Blackstone is a global asset management and advisory firm. Blackstone began as a mergers and acquisitions boutique with a modest balance sheet of $400,000. Since then it has grown to . Blackstone’s AUM of $70 billion in 2006 was more than double that of KKR, which was founded almost ten years earlier in 1976 Interestingly, while 9

Although the firm started as an advisory firm, its asset management business, including the management of corporate private equity funds, real estate funds, and mezzanine funds, has become the most important activity in terms of revenue contribution. The comprising ( ). In particular, billion as of March 1, 2007, representing an annual growth of

.10

Since Blackstone began its private equity and real estate business in 1987, it raised five private equity funds and eight real estate funds with total capital commitments of $34 billion and $24 billion, respectively ( ). Funds have been regularly spaced over time, with typically three years between each fund. Exceptions are between the first and second funds and between the third and fourth funds. The second and fourth buyout funds should have been raised around 1990 and 2000 respectively (instead of 1994 and 2003), but 1990-1991 and 2000-2001 were lean years for buyout funds. Note also the two real estate funds raised in a row (2006 and 2007) testimony of both the massive flow of capital is search of real estate investment vehicles over these years and Blackstone’s high returns in its real estate funds ( . , both funds having been recently raised. was the largest real estate fund ever raised, with capital commitments of on, and had the e in Hilton. . Given that (

), it was As shown in the size of Blackstone real estate business was only comparable to that of Morgan Stanley Real Estate Investing and Lone Star Funds. 9

http://online.wsj.com/news/articles/SB118252107097944849. From the public offering, Schwarzman received $684 million in cash, and his Blackstone stake was worth $8.83 billion after the first day, which made him ranked by Forbes as the 53rd-richest person in America in 2008. 10 Blackstone company filing (2007) 4

Hilton hotels: Real estate private equity

Ludovic Phalippou

4. Landscape of the Institutional Real Estate Market in 2006 Real estate attracted record amounts of capital in the 2000s. As shown in , U.S. commercial real estate transactions totaled Increasing appetite for commercial property investment drove up transaction values of real estate, which is measured by capitalization rate. . shows the by 2006. Throughout this period of “cap rate compression”, the appropriate level of cap rates was widely discussed and debated.11 There were wide concerns that real estate was experiencing yet . Cheerleaders pointed out that over the last decade real estate performance had been higher than that of listed equity, and with a much lower volatility. Cassandras replied that

Real estate investment is broadly classified as either public or private. Public real estate, referred to as Real Estate Investment Trusts (REITs), uses the pooled capital of numerous investors to purchase, manage and develop income-generating properties. REITs are required to distribute at least . Private real estate investment funds, such as real estate private equity funds, have a specified exit timeline, typically six to eight years. As shown in , real estate private equity is about twice as large as real estate public equity in the US. As a source of capital, however, both are dwarfed by debt providers. Real estate transactions are highly levered. On aggregate, in the US, . As shows, private n i . Fundraising was at its , following the 2001 recession, down to $14.2 billion from $21.8 billion in 2001. Of particular interest, hotel transaction volumes were relatively flat from 1998 to 2003, hovering below the $20 billion a year mark. Starting in 2004, hotel deals grew exponentially and reached $80 billion in 2006 ( ). Along with developers and private investors, private real estate funds were a major investor in the hotel industry. f

.12

This real estate boom was probably ignited by the very low interest rate policy of the U.S. Federal Reserve and other central banks after September 2001. From 2002 to 2004 the LIBOR rate, which is the interest rate at which banks lend to one another, hovered belo per year. As r ).

11

“Cap Rates and Real Estate Value Cycles: A Historical Perspective with a Look to the Future” Babson Capital Research Note, June 2009 12 REIT Guide (2nd Editoin), Deloitte 5

Hilton hotels: Real estate private equity

Ludovic Phalippou

5. Capital Structure

The large amount of debt and the retiring of cash, however, leads to higher vulnerability to downturns. A . In the case of Hilton, e funded the transaction with Such a high leverage was typical, albeit of the high side, of buyout transactions conducted in 20052007. Another important metric to gauge leverage is the ple. In Hilton’s case, it was his was about s the a year ). To compare, the largest PE transaction ever – Texas power company TXU Corp., which was taken private by KKR and TPG a few months earlier (February 2007) – had a similar leverage (81.5%) but a more typical debt to Ebitda multiple of 6.6x. shows the capital structure of the Reader’s Digest LBO in November 2006. Again the Hence,

The main characteristic of the 2005-2007 credit boom was that debt tended to be ‘ i.e. w s. This was the case for Hilton’s debt. Traditionally, lenders would attach a number of covenants to any debt package and particularly so when the company takes on board a large amount of debt. Many were alarmed by this development. The Economist thought it was concerning and short-sighted. The Financial Times endorsed the view of Anthony Bolton, who warned on his retirement from Fidelity Investments in May 2007 that cov-lite is "the tinder paper for a serious reversal in the market." 13 ” for Hilton using management projections, assuming exit after 6 years and the same exit and entry multiples umed to be a (based on analyst projections), and t Interest expense projections are based on a e optimistic management projections. This is The credit limit, however, needs to be carefully n Hilton’s case, a cash reserve had been deposited with the lenders which could, upon the Company’s request, be used for debt service, capital expenditures and general corporate purposes. Although at the time the Daily Telegraph reported that there were “worries over a global credit crunch as investors start to baulk at the increasingly risky debt investment vehicles being hit by rising interest rates”, if it all goes as planned, Blackstone would more than quadruple its investment from 13

Others argued that the move to cov-lite was a welcome simplification of loan documentation, fully justified as the banks would hedge their risk by transferring exposure to the loan in the CDO market. It was also pointed out at the time that cov-lite loans operated in a very similar way to bonds, but at lower values. 6

Hilton hotels: Real estate private equity

Ludovic Phalippou

6. The day of reckoning Blackstone executives probably knew that the Ebitda projections, if anything, were a bit on the optimistic side. If they came true, Blackstone wo by far the largest capital gain ever in the PE/RE space. This meant that there were margins for error. But maybe this time it needed more than a margin for error. June 2007 turned out to be the very peak of the leveraged buyout and real estate market. The headlines radically changed. On 25 March 2008, the Financial Times ran an article explaining that since this Hilton deal: “not a single private equity deal has been hatched above $4bn, and only $49bn of leveraged buyouts larger than $1bn have come forth (…)significant bankruptcies in private equity portfolios are a certainty, as is the next round of bad press that will accompany them. (…) Not only are new deals scarce, a number of agreed deals that had not yet closed have hit the rocks, spawning recriminations and litigation.(…) In recent weeks, both Moody's and Standard & Poor's have issued reports identifying an increasing number of debtors at risk of default. Not surprisingly, many of those companies are private equity-backed. S&P's list includes more than 50 worrisome private equity portfolio companies.” It looked as though the private equity world was doomed right after the Hilton transaction closed. Diane Vazza, a managing director at ratings agency Standard and Poors, commented on the situation in PE by saying, "the day of reckoning has arrived". This was certainly not the type of market timing skills that Blackstone would like to boast to future investors.

Hilton was certainly not the only one in trouble. Other hotel groups, although not as highly leveraged, would still suffer the dive in Ebitda generated by this On 6 March 2009, the Starwood and Marriott stock prices were down ectively 14 (from July 2007 - the time of the Hilton deal). Choice fell 39%, and the S&P 500 fell by 55%

One good aspect of being private may be that you do not see your stock price hitting zero! But the harsh reality bites nonetheless In 2009, Hilton’s E of what had been projected at the time of the deal for 2009. How could debt be serviced, covenants met and Hilton avoid being seized by debt-holders then? To begin with, remember that Hilton’s debt was e. In addition, the in 2009. This rather unexpected combination of events led to a miracle: net earnings ended up being the same in 2009 as the (rosy) projections. 14

As of December 31, 2007, Starwood, Marriot, and Choice had net debt to enterprise value ratio of 29%, 17%, and 10%, respectively. 7

Hilton hotels: Real estate private equity

Ludovic Phalippou

7. Doubling up The waves of quantitative easing might have helped preserve net earnings for Hilton, but it does not mean that the equity stake is preserved. PE-owned companies such as Hilton may not see its daily stock price but the value of the debt can be a good indicator. The sharp decline in hotel stock prices raised the likelihood that Hilton’s equity was worthless and Blackstone actually wrote down the value of its equity stake in Hilton by 70% in 2009. But Blackstone saw what could be called an investment opportunity (or a doubling strategy): buying back the debt and then cashing in both the increase in equity and in debt value in case of a recovery? Buying distressed debt was a specialty of the house. The head of Blackstone’s corporate advisory and restructuring practice, Mr Studzinski, was reported to be “having the time of his life. He and his stable of 134 advisers have been riding high on the opportunities being created by companies in trouble.”15 In The restructuring included the repurchas Funding for the repurchase of the secured e. Recall from

at Blackstone raised a As not many deals were being executed, This looked like yet another reason to . Finally, $2.1 billion of junior mezzanine debt was converted into preferred equity. Singapore's sovereign wealth fund, GIC Private Ltd, an active investor in franchised hotel properties across the U.S., was one of the lenders that participated in the debt restructuring. 16 A year and a half later, things still looked gloomy. Moody’s released a ‘splashy’ report arguing that the large leveraged buy-outs of 2006-2008 underperformed the wider market in terms of ratings, default rates and revenue growth despite the recent wave of debt restructuring. High-yield bonds for Clear Channel and Harrah’s Entertainment, now renamed Caesars, both of which had already restructured, were trading at 70 cents on the dollar. The senior bank debt of the largest LBO ever, TXU, was trading at 60 cents on the dollar. The hotel industry, if anything was more affected for its heavy reliance on corporate travel, wages and discretionary consumer spending. A record number of lodging companies filed for bankruptcy protection in 2009 (e.g. Extended Stay America, which Lightstone acquired from Blackstone two months prior to Hilton’s transaction for $8 billion, financed by $4.1 billion of securitized first mortg...