Russ Winter notes that Blackstone’s acquisition of Hilton
hotels doesn’t make
a lot of sense from a cashflow perspective:
Typifying just how loonie these transactions have become, HLT has operating
income of about $1.2 billion, or a mere 4.1% of the take out price. Assuming
$25 billion in debt, that would place debt service at about $2 billion a year.
Blackstone plans no divestitures, so the math is straightforward, and the
presumption is as well, just borrow the balance. This is definitely the Terminator
roulette school of business economics.
In some ways, this is actually worse than the notorious "exploding ARMs"
which caused such damage in the subprime mortgage market. At least in that case
the borrower’s income was high enough to cover interest repayments for the first
two years. In this case, Blackstone could boost Hilton’s operating income by
50% overnight and it still wouldn’t have enough money to pay the interest
on its debts. (But hey! At least this means that Hilton won’t make any profits
– and no profits mean no taxes!)
Lenders, in this situation, are essentially taking equity-like risk. They’re
looking at Blackstone’s track record, which is stellar, and counting on Steve
Schwarzman being able to raise the value of the Hilton brand so much
that he can sell it off in five years’ time and repay the loans in full. This
is dangerously close to the "greater fool" theory of investing: my
loan might not make any sense on its own, but somewhere down the line someone
with an even bigger credit line will take me out. As far as I can make out,
no one has the slightest intention of actually paying down any of the principal.
The crazy thing is that the lenders aren’t even being well compensated for
all this risk. $2 billion of debt service on $25 billion of debt works out at
8%, which might be high by debt-market standards but is a pittance compared
to the returns that Blackstone’s limited partners are expecting. And the amount
of debt that Hilton is taking on – $25 billion – dwarfs Hilton’s
book value of about $3.9 billion. In other words, don’t expect much recovery
value in the event of a credit crunch, default, and liquidation.
Now Winter might be off on the exact specifics of Hilton’s future capital structure,
but the broader point remains. LBOs have long since passed the point where operating
income can cover interest payments – hence the increasing popularity,
over the past year or two, of payment-in-kind notes. (Never mind the interest,
I’ll just take more debt instead!)
And these kind of structures are more dangerous than CDOs and subprime mortgages,
because at least in those cases most of the debt being issued was A-rated or
higher. Even if the investors in the equity tranches of CDOs and mortgage-backed
securities are wiped out, most investors will continue to get the interest payments
they were promised.
In the case of junk bonds, however, it’s all junk. Which could be very bad
news for lenders. The only silver lining is that a lot of these junk bonds have
been rolled into CDOs, which can help bring their credit rating up a few notches.
I’d be much happier holding a triple-A tranche of a CDO loaded to the gills
with CCC-rated debt than I would be holding the junk debt itself. Of course,
I could still lose money, especially on a mark-to-market basis. But between
the CDO’s natural diversification, on the one hand, and the protection of lower-rated
tranches, on the other, I’d still be better off than unprotected bondholders.