Hilton Hotels staged an initial public offering yesterday, years after the group was taken private by Blackstone in a giant 2007 leverage buyout. The deal ended up deploying almost all the tools in the private equity toolkit. There were genuine improvements in management, including cost-cutting and a shift to a more lightweight franchising model. But there was also plenty of pure financial engineering. In some ways most important of all, there was patience. Hotel occupancy plunged across the board during the recession, and public-traded hotel firms' stocks tanked. Blackstone just held on to its hotels and profited from the inevitable recovery that public markets failed to have faith in.
But was it a good deal? David Gelles says yes:
[Steven] Kaplan of the University of Chicago said that compared to an investment in the public markets, Blackstone’s investment in Hilton has been good but not great. Since the start of 2007, the Standard & Poor’s 500 stock index is up 25 percent. Blackstone more than doubled its money.
“This is a good deal if you’re measuring it relative to the public market,” Mr. Kaplan said. “But it’s not a home run.” Other alternative investments and asset classes have performed better over the last six years.
But here's where you have to remember the importance of leverage. When Blackstone bought a $26 billion hotel group in 2007, they only put $5.5 billion in cash into it. The other $20.5 billion was debt. When you finance an investment with debt and the investment pays off, the leverage multiplies your gains.
Suppose you'd bought $26 billion worth of stock back in 2007 with $5.5 billion down and a $20.5 billion loan. Well if the $26 billion investment appreciated by 25 percent, it'd be worth $32.5 billion today. Pay back your $20.5 billion loan, and you're left with $12 billion—more than doubling your initial investment. Of course it's a bit more complicated than that. Just like Blackstone with Hilton you have to account for interest on your loan on the downside and dividends (or Hilton revenue) on the upside. Blackstone's deal worked in part because when the market was at a low point they were able to persuade lenders to write down some of the value of the debt—in effect a cheap refinancing. But the bottom line remains that in crucial respects it's the leverage that's doing all the work in making this leveraged buyout payoff. The skill was not in the selection of the enterprise (a random basket of stocks would have done just as well) to buy, but in the acquisition and renegotiation of the loans.