Crazy Leverage in the Hilton Deal

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.