Bill Cohan has a glowing account, in Businessweek, of how Blackstone made $12 billion or so on its acquisition of Hilton Hotels. On its face the outcome is indeed surprising: when the deal was originally announced, in July 2007, I wrote about the “crazy leverage” involved, and said that the banks and other lenders in the deal weren’t being remotely well compensated for the risk they were taking.
In a sense, I was right. The financial crisis sparked a huge restructuring of the lenders’ debts, on which they took haircuts of more than 50%. But somehow Blackstone retained control of the company — which means that instead of seeing Hilton handed over to its creditors, they ended up making billions of dollars when interest rates plunged and the stock market started hitting new highs.
As Cohan says, a lot of similar leveraged buyouts ended very badly. And yes, a lot of the credit for the success of this one can be attributed to the managerial prowess of Hilton CEO Christopher Nassetta. But there are broader lessons to be learned from what happened here, too.
The main lesson is that private equity is a bit like real estate: it’s a business which requires deep pockets. How is it that Blackstone managed to retain control of Hilton through its 2009–10 restructuring, when standard practice in such situations is for the equity to be pretty much wiped out? The answer is that Blackstone, even at the height of the financial crisis, had the wherewithal to find more than $800 million of new money, which it used not to invest in Hilton directly, but rather to buy back debt from bond investors at a deep discount. Blackstone was not only highly leveraged; it was also highly liquid. And the combination of the two was a winner.
In many ways that is the most impressive achievement here: there were very, very few private institutions at the time with that kind of cash. If Blackstone had not been willing and able to find the money to do this deal, there’s a very good chance that Hilton would have gone bust, and been taken over by its lenders. Instead, the lenders took a haircut, and Blackstone effectively managed to buy $1.8 billion in enterprise value (roughly speaking, the value of the equity in a company plus the face value of the debt) at a discount of 54%. Blackstone claimed that its own equity had fallen in value by much more than that — but because it was in Hilton for the long term, it had the patience to be able to wait until stock markets rebounded.
Which is the other important part of this deal: Blackstone got very lucky with respect to the stock market. It’s very hard to find any leveraged company which hasn’t soared in value between 2009 and today, and it’s worth remembering that Blackstone’s $12 billion gain on its Hilton stake is on paper only. Unless and until that stock is sold, it can go down in value just as easily as it can go up. In general, if you just bought the most leveraged companies you could find at the bottom of the stock market plunge in 2009, you would have made an absolute fortune in the past five years. Since Blackstone is in the business of running highly leveraged companies, you should expect anything it owned in 2009 to have done very well indeed.
Still, it’s worth recalling Matt Levine’s explanation of the big picture. In the years between Blackstone buying Hilton and Blackstone taking it public, the enterprise value of Hilton grew by about $7 billion. Some of that is good management; some of that is just the fact that stock-market multiples are higher now than they were back then. Hilton’s lenders, by contrast, lost about $1 billion on the deal, because they exited at the worst possible moment. Which means that Hilton’s owners, Blackstone, made substantially more than $7 billion. At the IPO they were up about $8.5 billion; today, they’re up about $12 billion.
Which says to me that buying junk bonds from Blackstone is something of a sucker’s game. As I said at the time, the lenders were taking equity-like risk, but only Blackstone was leaving itself open to equity-like returns:
Lenders, in this situation, are essentially taking equity-like risk... and aren’t being well compensated for it. $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.
Blackstone ended up investing $6.5 billion of its own (or rather, of its LPs’) money into Hilton, and is sitting on a $12 billion profit after 7 years. That’s an internal rate of return of about 16% per year, albeit a return which has yet to be realized.
While that’s an impressive achievement, and worth writing up in Businessweek, it’s worth putting it in perspective. Hilton, after all, was just one of Blackstone’s portfolio companies, and the really important number, as far as Blackstone’s investors are concerned, is how well their funds as a whole have performed, after fees. It’s great that one company saw healthy returns — but how did all the other companies do? How do Blackstone’s returns compare to those of the stock market as a whole, which is much more liquid and which doesn’t charge 2-and-20?
Cohan doesn’t say: indeed, he can’t say, because the funds in question haven’t been wound down yet. But, as this deal shows, you take a lot of risk when you invest with Blackstone. In order to get its impressive return, Blackstone needed not only to be able to come up with $816 million at the height of the financial crisis, but also needed a huge tailwind from the Federal Reserve. Those things can’t be counted on, in future. So while Blackstone surely handled its Hilton investment with great skill, I’d put at least half of its return down to dumb luck.
Indeed, it’s only because there was a financial crisis that Blackstone managed to double down on its investment in the first place, and that the Fed started pumping trillions of dollars into the American stock and bond markets. Absent the financial crisis, in other words, Blackstone’s overall return would have been much lower. Which is both a bit ironic, and also, maybe, a reason to believe that Blacksone won’t be replicating this result any time soon.
Felix Salmon is a senior editor at Fusion