Blackstone's $26 Billion Hilton

Deal: The Best Leveraged

Buyout Ever
The most profitable private equity deal in history was badly
timed but brilliantly executed
by William D Cohan
September 12, 2014, 1:33 AM GMT+2
Photograph by Thomas A. Kelly/Corbis

In the early spring of 2009, with the recession deepening, Christopher Nassetta
stood alone in an empty house in Arlington, Va., surrounded by moving boxes
and trying not to despair. What he hoped would be the crowning achievement of
his career—executing, as chief executive officer, the turnaround of Hilton
Worldwide Holdings, the legendary hotel company founded by Paris Hilton’s
great-grandfather—had turned nightmarish. He’d just returned to the East Coast
after closing Hilton’s Beverly Hills headquarters, and that was the least of his
troubles.

Eighteen months earlier, in the

fall of 2007, Blackstone Group
had bought Hilton in a $26
billion leveraged buyout at the
height of the real estate bubble.
Jonathan Gray, Blackstone’s
global head of real estate and the
architect of the Hilton deal,
invested $5.6 billion of
Blackstone’s money and had big
plans for revitalizing the chain,
the epitome of cosmopolitan
glamour in the Mad Men era.
Central to Gray’s plans had been
hiring Nassetta away from Host
Hotels & Resorts, where he was
CEO.

Behind this week’s covers

At Hilton, the two got off to a
Photograph by David Brandon Geeting for Bloomberg decent enough start, but then, as
Businessweek; Prop Stylist: Priscilla Jeong the financial crisis hit and the
 economy tanked, it appeared
that Blackstone and its partners had paid too much, used too much debt, and
couldn’t have picked a worse moment to close the deal. Some of its partners—
among them, Bear Stearns and Lehman Brothers—would soon cease to exist.
After Lehman’s collapse, tourism went into a severe slump, Hilton slumped, too,
and it appeared that all of Nassetta’s bright ideas for restoring the chain’s luster
would never get implemented. Adding insult to injury, rival Starwood Hotels &
Resorts Worldwide sued Hilton in federal court, alleging that Hilton employees
had stolen the plans for its successful W Hotel franchises in what it called “the
clearest imaginable case of corporate espionage, theft of trade secrets, unfair
competition, and computer fraud.” The Department of Justice began
investigating Starwood’s charges.

“Revenue’s running down 20 percent,” Gray recalls. “Cash flow is down around
30 percent. We get a huge suit. The DOJ opens up an investigation. It was
definitely a low moment in the deal.” Blackstone was in serious danger of losing
the bulk of its $5.6 billion. “I promise you this is the absolute bottom,” Nassetta
recalls Gray telling him that summer, bucking himself up, too. “How can it get
any worse than this?”

Four years later, when Blackstone took the company public in December 2013, its
timing proved impeccable. And this July, when Hilton’s stock closed at $24.80,
Gray and Nassetta had officially transformed Hilton into the most lucrative
private equity deal ever, with a paper profit of $12 billion.

One key to this good fortune is

obvious: the historically low
interest rates maintained by the
Federal Reserve. But plenty of
other deals benefited from low
lending rates, too, and fell apart.
In fact, of the nine hospitality
and lodging LBOs completed in
the same time frame as
 Blackstone’s Hilton acquisition,
only Hilton and La Quinta Inns &
Suites (another Blackstone deal)
weren’t forced into bankruptcy
or a debt restructuring.

The full story of the richest LBO

in history is actually a story of
private equity working as
advertised. By persuading its
Click to enlarge. Photograph by David Brandon Geeting for lenders to exercise forbearance,
Bloomberg Businessweek
restructuring its debt before it
had to, and practicing smart
management, as opposed to indiscriminate cost cuts and pink slips, Blackstone
made Hilton perform better than most thought possible.

“There weren’t many people in the room with me who still believed,” Gray says
of 2009. “But the good news is we were able to say, ‘Look, we’ve got plenty of
cash’—I don’t think we ever went below a billion dollars in cash on our balance
sheet—and, ‘We really believe in this business.’ ” Still, he confides, he had to
filter out the negativity while he waited for things to improve. “It’s no fun
reading that you’re not very smart.”

While he’s familiar to some investment bankers because of Blackstone’s history

of savvy real estate deals, especially the purchase of Equity Office Properties
Trust, Gray, 44, is little known outside Wall Street. A billionaire (his Blackstone
shares are valued at about $1.3 billion), he’s a Phi Beta Kappa graduate of the
University of Pennsylvania and determinedly low-key—“annoyingly calm,” his
wife, Mindy, says. He prefers philanthropy to a Hamptons manse, spending time
with Mindy and their four daughters over parties and auctions. He does own a
five-bedroom apartment on Park Avenue but drives a Toyota minivan and wears
a plastic Timex watch.
Considered a likely successor to Blackstone President Hamilton James, Gray is
certainly less flamboyant than either James or his boss, Stephen Schwarzman,
whose fortune is estimated at $10.8 billion and whose lavish parties inspire
urban myths. Schwarzman and Pete Peterson, a former Nixon administration
Commerce secretary, founded Blackstone in 1985 following a power struggle for
control of Lehman Brothers. They must be glad they lost that one: Blackstone
now manages about $280 billion in so-called alternative assets for wealthy
individuals, college endowments, pension and sovereign wealth funds, and
corporations. The firm mainly invests in private equity deals, hedge funds, and
other esoteric, and often risky, opportunities.

One reason Blackstone has been so successful is its ability to attract and rely on
young talent. Gray joined the firm in 1992 right out of the Wharton School and
quickly began learning from his mentors, John Schreiber, Thomas Saylak, and
John Kukral.

During the summer of 2006, Gray says, there was an enormous amount of capital
that was finding its way into commercial real estate. “And in response to that,
we’re trying to figure out how can we find an edge. We have this simple motto
where we want to try to buy hard assets at a discount to replacement cost.” In
other words, he was looking for an opportunity to buy all of a company’s stock
for less than it would cost to build, say, all the hotels it owns. Gray got excited, he
says, when he realized that real estate assets were “cheaper on the screen than
they were on the street.” He could make money on that perceived difference in
value.
The lobby in the Hilton Hotel in San Angelo when it was
decorated to resemble a corral for an event circa 1930s Cattle Raisers Museum, Fort Worth, Texas

Gray first approached Stephen Bollenbach, Hilton’s CEO, in August 2006.

Bollenbach was open-minded about a buyout, but the two men couldn’t agree on
a price. In the meantime, Gray’s focus shifted to buying Equity Office from real
estate mogul Sam Zell. At $39 billion, the Equity Office deal was not only huge,
but also highly complex. It began with a battle for control of the company
against another bidder. Then, no sooner had Blackstone bought the company, it
began reselling many of Equity Office’s properties to several developers. Thanks
in large part to Gray, Blackstone made a fortune, although just how large it’s not
saying.

Gray called Bollenbach again the following May and told him Blackstone was
willing to consider a deal closer to Bollenbach’s asking price of $48 per share. On
July 3, 2007, the two sides agreed on $47.50 a share in cash, valuing Hilton at
some $26 billion. Blackstone financed the purchase with about $5.6 billion in
equity from two of its funds and a few co-investors, plus around $20.5 billion
from a group of 26 big banks, hedge funds, and real estate debt investors. Gray
says the price Blackstone paid was high, as was the company’s debt load. But
Gray managed to get the banks to lend him most of the purchase price at low
rates, with easy payment schedules and less restrictive terms than usual. Often,
if a company has operating losses for consecutive quarters, lenders will demand
immediate repayments. The loans Gray negotiated had none of these so-called
covenants—and that proved prescient.
Gray’s next big move was to replace Bollenbach with Nassetta, whom he’d known
since the early 1990s. They’d met in the aftermath of the savings and loan crisis
when the federal government established the Resolution Trust Corp. to sell bad
mortgages and other squirrelly securities it inherited from failed savings banks.
A few years later, when Nassetta was CEO of Host, Blackstone sold the company
some hotels from its portfolio. From Nassetta’s perspective, the decision to take
on Hilton was complicated by Hilton’s main headquarters being in Los Angeles
while he and his family (the Nassettas have six daughters) lived in the
Washington (D.C.) area. Still, he agreed to have lunch with Gray at Occidental
Grill & Seafood in Washington to discuss the job. “I definitely walked away from
that lunch thinking that this is a once-in-a-lifetime opportunity with a once-in-
a-lifetime partner,” Nassetta says.

While Gray says Bollenbach was a “brilliant strategist,” he found Hilton sleepy.
“The company I wouldn’t say was the hardest-driving business,” he says. Based
in Beverly Hills, Hilton’s executive offices closed at noon on Fridays. Nassetta,
too, found Hilton’s corporate structure—with five business units strewn across
the country—to be counterproductive. It was “disjointed and complacent,” says
Nassetta as diplomatically as he can. Adds William Stein, a Blackstone real estate
partner, “We went to all five of the offices that were corporate offices, and at
every single one of those offices they would tell you, ‘We got it right. This is how
the company should work. The other four places are completely wrong.’ And
each one gave you the same story. We’re thinking, ‘No one’s talking to each other
here. It’s unbelievable.’ ” Nassetta put an end to this Balkanization. “We’ve
completely transformed the culture to one that is integrated, aligned, and
performance-oriented,” he says. Bollenbach could not be reached for comment.

The Gray-Nassetta business plan also called for Hilton to expand its
international presence, which had shriveled from the company’s pioneering
days when Conrad Hilton opened gorgeous hotels in places such as Istanbul,
Bogota, and Tokyo. “It was as if Hilton didn’t have a passport to leave the United
States anymore,” Gray says. Nassetta brought back the founder’s motto: “To fill
the earth with the light and warmth of hospitality.”
Blackstone’s Hilton acquisition closed on Oct. 24, 2007. A few months earlier,
two Bear Stearns hedge funds had collapsed and were liquidated. In August,
French bank BNP Paribas <https://www.bloomberg.com/quote/BNP:FP> froze
three mutual funds because it could no longer properly value the mortgage-
backed securities in which the funds had invested. Signs of stress were
everywhere, Gray says, but “we didn’t know the world was about to go through a
global financial crisis. … We plowed ahead.”

In March 2008, Bear Stearns collapsed and was sold to JPMorgan Chase. As part
of its deal for Bear Stearns, JPMorgan insisted that the Federal Reserve Bank of
New York take $29 billion of Bear Stearns’s assets off its books. One of the assets
that JPMorgan didn’t want was Bear’s $4 billion chunk of the Hilton loan. Bear
and the others involved in financing the Hilton deal still owned the loan because
the disruption in the capital markets had prevented it from being turned into a
security and sold to investors. Gray tried not to take personally that Jamie
Dimon, JPMorgan Chase’s CEO, wanted to ditch the Hilton loan. “You don’t like
to see your debt tagged that they didn’t want it,” he says, “but frankly, with all
the leveraged deals, people weren’t discriminating. People were just saying,
‘Look, the markets have fallen, the economy’s slow.’ Nobody wanted to buy
anything at that point.”

In 2009, Hilton’s revenue declined 15 percent. That fall, Gray wrote a tough-love
letter to Blackstone’s investors informing them that the value of the firm’s equity
in Hilton had fallen by 70 percent, or roughly $3.9 billion. Matthew Clark, a
longtime Blackstone investor and the state investment officer at the South
Dakota Investment Council, which manages $12 billion, was concerned. “We
knew that highly leveraged companies were very vulnerable when things are
down that far, and so I was worried that if things got worse, eventually these
things could go to zero,” he explains. “I was worried that all of our stocks could
go to zero.”

It’s at this moment that Gray and his Blackstone partner Kenneth Caplan made
the opportunistic decision—Caplan prefers “proactive”—to negotiate a debt
restructuring with Hilton’s creditors. Normally, a company would do this only if
it had defaulted or tripped a clause in its loan that resulted in penalties or
steeper rates. In this case, no interest payments had been missed. The only
catalyst for the negotiation, Caplan says, was Blackstone’s desire to buy some
“insurance” with the creditors. Getting a reprieve from its creditors—by
stretching out the debt repayment schedule and converting a portion of the debt
to equity, meaning it wouldn’t have to be paid back at all—could buy Gray and
Nassetta the precious time they needed.

It was no easy task. For the plan to work, all 26 creditors, among them Deutsche
Bank, Morgan Stanley, Goldman Sachs, and Bank of America, plus hedge funds,
debt funds, and the Federal Reserve Bank of New York, had to agree to the deal.
“If it wasn’t an attractive proposal for everybody, it wouldn’t have gotten done,”
Caplan says. “The lenders didn’t give us a discount just because they were nice
guys or whatever. They were doing it in their own self-interest.” If they sold a
small amount of their debt at a discounted level in exchange for greater value
later, he says, “that was a positive for them. It was literally thousands of phone
calls over a 9- or 10-month period. I’d say my wife knew the names of many of
our lenders by the end of it.”

The toughest negotiator turned out to be the New York Fed, which ironically was
being advised by BlackRock, the huge asset manager run by Larry Fink that was
once part of Blackstone. The Fed, the hotel chain’s largest single creditor, was
reluctant to be seen as taking a discount on a portion of its Hilton debt lest it be
interpreted as giving a financial bonanza to Blackstone. “The banks were more
like, ‘Let’s get this out of Dodge,’ ”—as in, take the money and run, says one
participant in the negotiations—“but the Fed was tough.” The Fed also wanted a
fee as part of the restructuring, since the other creditors were promised fees for
future work on Hilton. In the end, the Fed sold a $320 million face amount of its
Hilton debt back to the hotel chain at a loss of $180 million, though it did get an
(undisclosed) multimillion-dollar payment.

By April 2010, Gray and Caplan had corralled the lenders into a new agreement.
To pull it off, Blackstone also invested $819 million of new equity into Hilton,
which the company used to buy back $1.8 billion of its secured debt at a discount
of 54 percent from the original borrowed amount.

Jacques Brand, CEO of Deutsche Bank’s North American business and a key
banker to Hilton and Blackstone, says the combination of the additional equity
investment and the reputations of Gray, Nassetta, and Schwarzman made the
restructuring possible. “To write a $5 billion check and then to write another [for]
nearly $1 billion clearly demonstrated to the market that Blackstone was
absolutely committed to this investment, and that both it and Hilton were trying
to transform the business,” Brand says, kissing up to his client.

“Obviously it was a perilous time,” Gray says. “The people at the banks and the
Fed—and the world at large—thought we were pretty insane.”
Critical as the debt restructuring was, Gray credits Nassetta, 51, with the rescue
of Hilton. And he did it by recommitting to Hilton overseas, expanding its
available rooms, and going upmarket. At the time of the acquisition, the hotel
chain had 116,000 rooms under construction, 19 percent of them in international
properties. Today, it has 210,000 new rooms on the way, 60 percent of which are
abroad. Hilton now has more than 700,000 hotel rooms total—good for No. 1 in
the world.

“That didn’t happen overnight,” Nassetta says. “It happened by grinding it out.
We were making progress each year. While we were doing the restructuring,
while the world was upside down, we redoubled efforts. … While we cut
significant costs out of the business, we reinvested huge amounts into its
growth.” He’s proud of the expansion. “It’s like taking a trans-Atlantic flight on a
747 from Kennedy to Heathrow and having three engines under repair but you’ve
got to keep the plane flying,” he says.

Gray, right, brought in Nassetta as Hilton’s turnaround CEO Photograph by Christopher Leaman for
Bloomberg Businessweek
Under Nassetta’s leadership, Hilton’s market share, profit margins, and the
amount of outside capital it attracted from developers that wanted Hilton to
manage their hotels increased. Like Marriott, Hilton runs hotels it doesn’t own,
and for Nassetta, this was an important way to improve Hilton’s balance sheet.
Hilton’s time share business also grew, attracting investor money that displaced
as much as 80 percent of Hilton’s own capital in the program. And Nassetta
quadrupled Hilton’s spending on its luxury brands. In 2009 he started Home2
Suites by Hilton, which now has close to 170 hotels open or in development.

Nassetta still had to contend with the Starwood lawsuit, however. In it, the rival
hotel group held that two executives Hilton had hired away from Starwood had
stolen more than 100,000 electronic and paper documents containing
“Starwood’s most competitively sensitive information.” While preparing for a
separate arbitration, also involving the poaching of employees from Starwood,
Hilton executives discovered the purloined documents, packaged them into
eight boxes, and sent them back, unannounced, to Starwood’s offices in White
Plains, N.Y. According to Starwood’s complaint, Hilton’s general counsel had
attached a note to the boxes asserting that the documents were “neither
sensitive nor confidential” and that he was returning them “nonetheless in an
abundance of caution.” In December 2010, Hilton settled the litigation with
Starwood by agreeing to pay its rival $75 million in cash. Hilton also agreed not
to develop for two years any hotel with the hip, modern feel of Starwood’s W
hotels, the subject of the documents taken from Starwood. Following the
settlement, the DOJ lost interest.

By the late summer of 2013, Hilton had started to hum. Companywide revenue
for 2012 was $9.3 billion, up from $8.7 billion in 2011. The ratio of debt to
earnings had declined. Things were going so well that Blackstone began to think
about what had once been unimaginable: cashing in. Soon after a complete debt
refinancing in October 2013, Blackstone, Hilton, and their bankers began
working on Hilton’s IPO prospectus. Led by Brand and Deutsche Bank, the IPO
trumpeted the revitalized Hilton. Investors found the story irresistible. “It’s a
unique story,” says Tyler Henritze, a Blackstone senior managing director. “Most
people underestimated … the degree to which the business had grown during the
downturn. People were blown away.”

One of the clichés of Wall Street is a collection of exuberant executives gathering

above the floor of the New York Stock Exchange to ring the bell on IPO day. As
trading has become electronic, the exchange itself has become nothing more
than an elaborate television set for this rite of passage. Corny or not, Nassetta,
Gray, and their respective teams at Hilton and Blackstone embraced this ritual
on Dec. 11, 2013. Nassetta calls it the finest moment of his career.

“When we rang the bell, Jon and I turned to each other, and I’ll never forget it,”
he says. “Very few words were spoken, big smiles, a big hug.” What didn’t need
saying: “We’d never lost faith in the company, never lost faith in one another.”
They gave each of the floor brokers managing the stock’s trading a terry cloth
bathrobe—just like the ones guests aren’t supposed to steal from their hotel
room. Hilton’s stock closed at $21.50 at the end of the first day of trading, giving
the company an equity value of around $20 billion and Blackstone a gain of
almost $9 billion. That made it second on the list of all-time profitable deals to
the $10.1 billion that Apollo Global Management earned on its investment in
LyondellBasell Industries, a large chemical company. Later, as Hilton’s stock
rose, it took over the No. 1 spot.

Although deal junkies rarely praise a rival, David Solomon, the co-head of
investment banking at Goldman Sachs, says Hilton’s success has been good for
Wall Street—good for everybody, that is, who gets big fees for pushing paper
around.

“Yes, success has many fathers, and it’s easy to see in hindsight, but a lot of
people didn’t get it right,” he says. “The two people who deserve an enormous
amount of credit for this deal are Jonathan Gray and Chris Nassetta. They got it
right, and that’s what they’re paid to do. But they are also terrific people, and I’m
thrilled for their success.” Of course, he’s also got to feel pretty good about the
$443 million Goldman invested in Hilton’s equity that’s now worth about
$1.3 billion.
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