Private Equity: Hot for Hotels

Blackstone's $26 billion bid for Hilton shows public markets may be undervaluing lodging stocks. Could Starwood or IHG be next?

Hotels are attracting big interest from private investors, who seem to value lodging stocks much higher than public markets.

That's the conclusion many are drawing from a proposal to take the giant Hilton Hotels Corporation (HLT) private in a $26 billion deal. The private equity Blackstone Group (BX) announced late on Tuesday that it will pay $47.50 per share to buy Hilton, a 40% premium over Monday's closing price.

The "big gap" between private and public markets "is not sustainable," Robert LaFleur, an analyst with Susquehanna Financial Group, wrote in a report on Thursday. Either hotel stocks rise, or private equity will buy up the whole hotel space, he says.

By midday on Thursday, stocks in the hotel, resort and cruise sector were up 8.8%, according to Standard & Poor's.

There is a perception among some public investors that hotel stocks are near or past their peak after a few years of strong growth, LaFleur said in an interview. In the U.S., new hotel construction is only now beginning to meet demand built up after new hotel construction slowed in the years after the 2001 terrorist attacks.

However, while public investors are wary, private equity firms are flocking to hotels. Private firms usually use large amounts of debt to finance their buyouts. So, they often prefer real estate investments, like hotel companies, in which property provides good collateral for loans and a steady stream of cash to pay off the debt. Public investors rarely tolerate as much debt in a public corporation.

Private equity also is attracted by the fact that hotels are undervalued compared to other real estate, LaFleur says.

Though the value of hotels has risen, LaFleur wrote recently, hotels are seen "as a risk-adjusted 'bargain' relative to other asset classes like office buildings, malls and apartments." Prices of other commercial property has soared to stratospheric levels.

Blackstone raised eyebrows when it agreed to buy Equity Office Properties Trust for $36 billion late last year. Compared to Equity Office, "Hilton looks pretty cheap to them probably," LaFleur says.

Blackstone had a special interest in Hilton because Blackstone already owns more than 100,000 hotel rooms in the U.S. and Europe, including the La Quinta Inns and Suites brand and LXR Luxury Resorts and Hotels. Blackstone seems to expect synergies from combining its own hotel holdings with the 2,800 hotels and 480,000 rooms operated by Hilton under the Hilton, Doubletree, Embassy Suites, Hampton Inn and other brand names.

Hilton only recently reunited the company that was split decades ago between a U.S. and foreign branch. The merged Hilton is expanding aggressively overseas and taking advantage of a short supply of hotel rooms in many major cities.

"This transaction is about building the premier global hospitality business," Jonathan Gray, a senior managing director at Blackstone, said in a statement. "We are committed to investing in the company and working with Hilton's outstanding owners and franchisees to continue to grow and enhance the business."

Wachovia (WB) analyst Jeffrey Donnelly expects Blackstone to accelerate the growth of Hilton's holdings. Hilton already plans to add more than 250 hotels and 35,000 rooms to its system this year, S&P notes. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies [MHP].)

"This announcement should re-spark investors' beliefs that additional private equity buyouts are eminent," says CIBC analyst David Katz in a Wednesday report. He expects interest in Starwood Hotels & Resorts Worldwide (HOT) and Intercontinental Hotels Group (IHG), but probably not Marriott (MAR), which Katz says is less likely to be taken private.

Analyst see little chance that another counter-offer will be made for Hilton. That reflects the high premium on the stock, the synergies Blackstone expects and also the sheer size of the $26-billion deal. "The transaction size is beyond the reach of many real estate opportunity funds," Donnelly wrote.