Splitting a Casino Company in Two Made It Worth More
By putting the buildings in a tax shelter and borrowing against them separately, the buyers loaded the casino company with far more debt than a normal buyout allowed.
The Wall Street Skinny · Private Equity Knows Something Private Credit Doesn't | This $30B LBO Holds the SecretWhen Apollo and TPG, two buyout firms, bought the casino operator Harrah's for $30 billion in 2008, they did not really buy one company. They bought a parent company that sat on top of two separate businesses, and that split let them borrow far more than a normal buyout would allow.
Under the parent sat an operating company, which managed the casinos, and a property company, which owned the buildings themselves. The structure had appeared earlier in hotel deals, but it was still unusual for a buyout, and it was designed to stretch debt beyond traditional limits.
The reason was taxes. The property company was set up as a real estate investment trust, or REIT, whose rental income from leasing the casinos back to the operating company could avoid corporate income tax and be paid out as generous dividends. Kept together, the buildings and the casino operations would have been taxed as one company. Apart, the pieces were worth more than the whole.
There was a borrowing advantage, too. A loan against a building is usually cheaper and easier to get than a loan against a business, much like a home mortgage is cheaper than a loan to a clothing brand. Lenders also prefer to sit as close as possible to steady cash flows like rent, because they get paid first if things go wrong, an advantage known as structural subordination.
Timing helped. In the commercial real estate lending frenzy of 2006 and 2007, the property company borrowed $6.5 billion of the deal's $24 billion in debt as commercial mortgage-backed securities. Like a residential mortgage, where a bank makes a $700,000 loan on a $1 million house and then packages it with other loans to sell to investors, these casino mortgages were pooled and sold.
The payoff was extra borrowing power. On roughly $3 billion in annual operating cash flow, about $17.5 billion in ordinary buyout debt already amounted to about six years worth of cash flow. The property loans added about two more years worth of cash flow in debt, which was unheard of in a typical buyout. Together the borrowings let the deal carry about eight times its yearly cash flow instead of six. At the time, Harrah's, later renamed Caesars, was one of the 10 largest buyouts ever done.
Questions people ask
What exactly is a REIT and why does it avoid corporate tax?
A real estate investment trust is a company that owns income producing property and passes most of that income to shareholders as dividends. Under U.S. tax law, it can deduct those dividends, so it generally pays little or no corporate tax if it distributes at least 90 percent of taxable income. Shareholders then pay tax on the dividends they receive.
What is a commercial mortgage-backed security?
It is a bond backed by a pool of loans on offices, hotels, malls, or in this case casinos. Banks make the loans, bundle them together, and sell slices of the pool to investors who collect the interest and principal. The system lets banks lend again, but investors take the loss if borrowers stop paying.
What does it mean to say a deal is levered six or eight times?
It compares total debt to EBITDA, roughly a company's annual operating cash flow before interest, taxes, and noncash charges. Six times means it would take about six years of that cash flow to repay the debt in full. Higher leverage magnifies returns when business is good, but leaves less room to pay interest when business slips.