Private Equity: A Bid Too Far?

Why Wall Street has doubts about the offer from Apollo and Texas Pacific for Harrah's

It's like a big game of poker, and the prize at the center of the table is the world's largest casino company. On Oct. 2, Harrah's Entertainment Inc. (HET ) revealed that it was the subject of an unsolicited takeover offer of $81 a share, 22% higher than the previous closing price. The all-cash offer from buyout firms Apollo Management and Texas Pacific Group would value Harrah's at a staggering $26 billion, including the $11 billion of debt already on the company's books.

The size of the deal -- potentially the fourth-largest leveraged buyout in history -- surprised even longtime casino industry watchers used to profligate spending. "It's an awfully attractive offer," says Marvin Roffman, a onetime casino analyst who's now president of Roffman Miller Associates Inc., an investment advisory firm based in Philadelphia. Both of the companies declined to comment. But the likely lure is Harrah's roughly $2.4 billion a year in earnings before interest, taxes, depreciation, and amortization, as well as a wide range of properties that could be sold to reduce debt.

But the deal may prove a hard sell. A few days after the takeover offer was made, the stock of the Las Vegas-based casino giant closed at $75 a share, a sharp rise from the $66 it was trading at before the offer but well below the $81 buyout price. That suggests that Wall Street doesn't expect the deal to fly. The regulatory hurdles faced by casino deals may partly explain the skepticism. But it likely also stems from the sense that firms are overreaching in attempting a buyout on this scale of such a highly regulated, debt-laden company.

If Harrah's accepts the takeover offer, it will extend private equity's record-shattering run this year. Seven of the 10 largest buyouts of all time were announced in 2006, including hospital chain HCA Inc. (HCA ) for $32.1 billion and energy pipeline company Kinder Morgan Inc. (KMI ) for $27.5 billion. The size and scope of the buyouts are raising concerns about a potential wave of credit defaults down the line. With so much money chasing deals, private-equity firms are pricing for perfection, even as they venture into unfamiliar areas. By then loading on debt, they leave little wiggle room should any problems emerge. And if companies can't generate enough cash to meet mounting interest payments, bankruptcy may loom.

Harrah's seems to be joining the Street in adopting a cautious stance. The committee of nonmanagement board members still evaluating the proposal "has not determined that a transaction is in the best interests of Harrah's and its stockholders," the company said in a statement.

A key catalyst for the buyout boom is one jaw-dropping statistic: As of early October, 436 new funds had raised a record $300 billion worldwide in 2006, according to industry tracker Private Equity Intelligence. "Deal sponsors are hunting elephants," says Chris Donnelly, who tracks leveraged loans for rating agency Standard & Poor's Leveraged Commentary & Data unit, which, like BusinessWeek, is part of The McGraw-Hill Companies (MHP ).

That helps explain why private-equity players are moving beyond their normal stomping grounds into areas where they may confront complex new issues. Consider the regulatory hurdles in the proposed buyout of Harrah's: Since it does business in 13 states, the deal would have to be approved by 13 casino commissions, a process that could take years. Such reviews typically require proof that the proposed deal will result in a financially sound company that will contribute to the communities where it operates. In Nevada, the casino commission won't consider a merger proposal until shareholders approve the deal. In addition, principals at the two firms would have to undergo background checks before they can receive casino licenses. An investigation into reports that options on Harrah's shares surged before the buyout announcement could delay regulatory approvals even longer.

Then there are the worries that firms are overpaying. Martin Fridson, CEO of high-yield bond market strategist FridsonVision, points out that many private-equity firms are no longer buying "fixer-uppers" that can be radically restructured for huge gains. "There's not much room for improvement [in operations] and owners are getting top dollar," he says. "What will be achieved?"

Fridson and others also worry about private-equity firms piling too much debt onto companies. Credit defaults remain very low now, but many debt experts predict a big wave of defaults in a year or two. Credit quality has sharply deteriorated in the last couple of years, with more debt coming out at lower ratings. That has Fridson predicting that default rates will head back to peak levels seen in earlier bust cycles. Jay M. Goffman, a top bankruptcy lawyer with Skadden Arps Slate Meagher & Flom, is also predicting a bust in coming years as a result of all the added risk. "It's coming, I can feel it in my bones," he says. "Everyone believes that their deals will work with lots of leverage, but history and economic cycles do repeat themselves."

In Harrah's case, new owners would eventually have to tackle problems that bedeviled its seasoned management. For many years, the company tried to be the Holiday Inn of the casino business, blanketing the country with nice but not too extravagant casino properties. The company's target market has been mid-market gamblers -- the retiree who drives to Joliet for the night, rather than the high-roller arriving in Vegas by private jet.

UPSCALE MISSTEPS

Harrah's now owns 37 casinos that fall under 12 different brands, including Bally's, Caesars, and Horseshoe. But it has never built the kind of giant casinos that wow Wall Street and attract gamblers from around the world. One attempt, the Harrah's in New Orleans, backfired when the company agreed to limit restaurant and entertainment venues in a deal with local businesses, and to pay $100 million in taxes to the state. The casino couldn't meet its financial obligations and declared bankruptcy before Harrah's got full ownership in 2002.

Harrah's began taking steps to better integrate its portfolio when it hired Harvard Business School professor Gary P. Loveman as chief operating officer in 1998. Two years later, Harrah's launched its highly regarded Total Rewards loyalty program, which used database mining to target different classes of gamblers, mailing offers for free rooms, meals, and other discounts to gamblers based on their level of play.

Loveman, who acquired the upscale Caesars brand last year in a $9.3 billion merger, had promised to extend Harrah's reach by adding new higher-end properties and freshening up older ones. That's crucial: If casinos don't funnel large chunks of cash into sprucing up hotels, restaurants, gaming parlors, and other amenities, they risk seeing customers abandon them for the glitzier atmosphere next door.

So far, Harrah's attempts to launch snazzy new offerings have stumbled. A megaproject expected to be announced in Las Vegas this summer was delayed, and new projects in Spain, the Bahamas, and Slovenia failed to generate the same excitement as the fast-growing Asian markets, which Harrah's has been unable to crack. That was reflected in Harrah's stock price prior to the offer: It was down 6% for the year, while Las Vegas Sands, Wynn Resorts (WYNN ), and MGM Mirage (MGM ) were up 72%, 26%, and 5%, respectively.

Finding the cash to turn Harrah's into a more exciting operator could be tricky, since buyout deals usually employ gobs of leverage. According to S&P's Donnelly, the average ratio of a company's debt to earnings before interest, taxes, depreciation, and amortization in large leveraged buyouts has risen from just over four times in 2002 to 5.8 times by 2006's third quarter. More worrisome, the ability of companies to cover interest payments on the debt taken on in these deals is plummeting. In 2004, the ratio of EBITDA to interest charges was 3.4; it was barely above 2 in 2006's third quarter.

Apollo and Texas Pacific aren't sharing details of their financing, but a hefty debt load is a given. Peggy Holloway, the analyst at Moody's Investors Services covering gaming and hotels, figures that if the investors put 20% in as equity -- roughly $5 billion at the purchase price -- Harrah's would end up with debt about eight times its estimated 2006 cash flow of $2.4 billion. If the deal was financed at an interest rate of 8% or so, cash flow would cover just one and a half times its interest payments. With so little margin for error, Holloway questions whether Harrah's could spend enough to stay competitive.

All of which means that the bid for Harrah's, like a lot of deals, is aggressively priced. The economy has to chug along nicely, business strategies must pan out, asset sales have to fetch expected prices, and no unforeseen problems like weakening consumer spending can get in the way. Perhaps that's why Harrah's management and board isn't folding just yet.

By Christopher Palmeri and Jane Sasseen

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