Barbarians, the aftermath: Part 2, the melody
[Continued from yesterday’s Part 1.]
[Previous posts on the proposed takeover here (newest), here, here, here, here, here, here, here, and here (oldest).]
In the opening part of this post, we saw how Equity Office, languishing in the financial doldrums and unappreciated by the public markets, found a way to primp itself up and attract the street’s notice:
No momentum, no wind
One might have thought that Blackstone’s offer would win the day unopposed, but then, perhaps encouraged by a nod and a wink from Equity,
Is your REIT a goer, eh?
Vornado made an appearance, and for a time looked likely to win the prize. But then events, as they often do, started to move of their own accord.
Another county heard from! Though not mentioned up until now, there was another financial party with interests to be satisfied: holders of Equity Office’s bonds. As detailed in another article from the Journal’s thorough and insightful subscriber-only coverage:
The deal came with significant gamesmanship between existing bondholders and the company.
On Dec. 26, before Vornado appeared on the scene, EOP and Blackstone announced plans to buy back all of EOP’s $8.4 billion in bonds as part of the Blackstone buyout.
Just as lenders are jokingly described as people who will sell you umbrellas only if it isn’t raining, they have a similarly through-the-looking-glass orientation toward repayment — when you want to repay them, they don’t want you to do so. Specifically, borrowers want to repay when interest rates have fallen, and when that happens debt that carries an above-market interest rate can sell for a premium. Here, Blackstone probably had a more straightforward but equally compelling set of reasons: it wanted clear title so that it could put its own new first mortgage financing, or sell assets, without the complications of lenders’ liens.
The offer covered short-term bonds due within the next 10 years and longer-term bonds due as late as 2031. But debt investors rallied against it, rejecting the terms as too little for the long-term bondholders.
“How dare you try to pay me back?”
“It was an impressive effort, especially the way bondholders seemingly looked out for each other,” says Sid Bakst, a bond manager at Robeco Weiss, Peck & Greer who wasn’t involved in the EOP affair.
What’s a lender to do when someone wants to pay him back? What leverage could the lender have?
In that case, bondholders had some leverage against the company. They were protected by provisions in the debt, known as covenants, that limited the amount of new debt EOP could take on in a buyout. Without the consent of existing bondholders, in other words, Blackstone might not have been able to finance the deal.
In other words, the bondholders were protected not only by the debt covenants, but also (we can infer) by prepayment lockouts. (Otherwise the buyers could put on the new debt by paying off the old debt.) The buyers need to place new debt, and couldn’t do so without clearing the old debt, and for that they needed bondholder approval.
What’s the definition of a trader? As one of my clients said to me, entirely seriously, “for the right price, every position is always for sale at every time.”
AIG Global Investment Group, which held both long-term and short-term bonds, banded other investors against the offer. By Jan. 11, EOP and Blackstone agreed to boost the offer to long-term bondholders by about 20%, paying nearly $950 million for the $725 million in outstanding bonds.
The principle here is ‘yield maintenance’: make a cash payment that equals the rough present value of the premium element in these above-market bonds. These bondholders got a 31% premium ($950/$725); other bondholders got less.
For the remaining $7.6 billion in debt, EOP and Blackstone agreed to pay about $8 billion.
A 5% premium. Why a better premium one that for the others? Presumably the nature of the collateral secured by the debt covenants — some properties hocked to cover some debt, other properties hocked to cover other bonds. Some bondholders got no premium whatsoever:
No bond premium for me … not any?
In the end, the buyout firm paid $23 billion and assumed $16 billion in debt to win Equity Office.
It was all in who had what covenants covering what assets.
How it finished, and how it signals market transformation. As I posted yesterday, the biggest surprise is that in a global market awash in capital, private equity’s faster OODA loop enabled it to outmaneuver and just plain outbid public capital, even smart aggressive public capital.
Blackstone “executed with surgical precision,” says Tom Barrack, founder of Los Angeles-based Colony Capital, a large private-equity real-estate firm with close links to Equity Office, Blackstone and Vornado.
Barrack likes clean strikes
Again from the subscription-required Journal:
Market observers say Blackstone’s win is a vivid illustration of how private-equity firms now have a leg up in the battle for control of companies and assets such as commercial real estate in the
I’m not ready to vote yet
It may also signal that the REITs have reached their financial apogee:
Equity Office and Vornado are both publicly traded real-estate investment trusts, or REITs, which invest in real-estate assets and aren’t subject to corporate income tax as long as they pay out at least 90% of profits as dividends.
A creature of the tax code, REITs are like sharks; they have to keep swimming to keep breathing. But that mandate to pay out income also means that REITs have difficulty maintaining internal organic growth. Equity Residential and AIMCO got big, 8-10 years ago, because their stock traded at a higher P/E multiple than other REITs’, based largely on the marketplace’s perception that Equity and AIMCO were able to improve ’same-store earnings’ (Wall Street’s charming misnomer for increasing NOI). When that perception of operating advantage dissipated, neither REIT could grow because they could not accumulate capital for purchases.
The same thing happened to Equity Office; with its share price flat, its buying buyer was becalmed, and it could not shake the markets out of their slumber.
None of our share prices are going anywhere
So it put itself into play — and along came Blackstone.
How financial transformation will drive asset transformation. But it’s not just the capital markets that have been transformed. What once was the Equity Office empire will not be broken up into component pieces:
Blackstone is expected to move quickly to sell off many of the office buildings in Equity Office’s portfolio. By doing so, it will generate cash it can then use to pay down some of the debt it is taking on, lowering the risk that market conditions could change and leave it exposed.
Now listen, I don’t want my edifice wrecked
This disaggregation is in effect a repudiation of the original Equity Office value proposition of diversifying markets within an asset class.
The original REITs, thirty years ago, bought anything and everything.
You never know what you’re gonna get
Over the decades, the markets decided they wanted REITs who were more than aggregators, they were operators. So asset-specific REITs emerged. But even within that asset class, people expected diversification to be a benefit. Instead it proved a detriment, as Equity’s weak-market properties held back the valuation of its strong-market properties. In fact, disaggregation figured in both bids:
Even if it acquires EOP [Article dated January 20 — Ed.], Vornado intends to add only three more cities — Boston, San Francisco, and Los Angeles — all coastal markets that meet the company’s strategy of owning in cities that benefit from international trade and where it’s difficult to build, which limits competition, according to a company statement. Its two private-equity partners in the deal — Starwood Capital and Walton Street Capital — would divvy up EOP’s hundreds of other buildings and are expected to sell off at least some of them.
Does the Blackstone takeover signal that even the specific-asset-class REITs will in turn be forced to subdivide themselves into regional or market-differentiated varieties?
“I think the last real-estate cycle demonstrated that you don’t necessarily benefit from having a national footprint unless your properties are located in very strong markets,” said Keven Lindemann, director of the real-estate group at SNL Financial, a research group based in
No, no, SNL Financial, not Saturday Night Live!
Blackstone clearly had breakup in mind. As the Journal noted:
Anxious to reduce the risk of the transaction, given the fancy price tag, Blackstone wasted no time in selling off its newly acquired assets. It plans to sell a clutch of
The importance of a post-acquisition plan. In general, buyers acquire property with a plan of renovations or repositioning, as well as a financial plan. Here, its quest to break up Equity Office into more valuable component parts, Blackstone had an unlikely ally — Equity Office itself encouraged Blackstone to explore selling properties:
After Vornado entered the race in mid-January, Equity Office — also known as EOP — gave Blackstone permission to hold concrete talks with potential buyers about specific asset sales.
People think that selling properties is a zero-sum game, but in some ways the seller’s advisor is most effective if it also serves as a volunteer facilitator or consultant to the buyer. In my real life, our company Recap Advisors advised the owner of portfolio consisting of (x) a large (by our standards!) portfolio of affordable properties in
So we hoped
As our offering description said:
The Owner intends to sell the entire portfolio on the best price consistent with a reliable and timely execution. Specifically, the Owner has the following goals:
· Maximize value. The properties are owned by two investment pools (the “Funds”) and the Owner has a fiduciary duty to maximize proceeds for those Funds.
· Sell all the properties. They may be sold to one single buyer or multiple buyers.
· Sell [the property management company]. The company itself is profitable, stable, and effective. It adds value to the properties.
· Complete the transaction by [date certain]. A long drawn-out disposition, with properties being sold in clusters or tranches subject to contingencies or unpredictable timing, may impair [the owner’s] management capability or create inefficiencies of declining scale.
Eventually the owner located a buyer who was willing to acquire the whole portfolio, but in its offer identified six properties that (for sound reasons from its perspective) it wanted not to keep. The owner gave the buyer permission to seek an on-sell buyer for those six, provided that the buyer had to close on the acquisition, and provided further that the owner received a portion of the ‘flip profit’ (if any) from that resale.
Despite various ups and downs, including the necessity for securing HUD and RHS approval, in actual fact the selected buyer did eventually close on all 35 properties (link in .pdf) and on-sold 6 of them to another buyer.
Out of the HUD business!
Just as in our small case, the cooperation of the seller with the buyer’s post-acquisition strategy proved valuable to all concerned:
Still, Blackstone may have some tricks up its sleeve. Hours after clinching the deal, it lined up the sale of $7 billion of individual properties. And it could probably shop others to
Even though those two entities were originally part of Vornado’s team, after the game is over, all bets are off. Now what?
Now what?
[Continued tomorrow in Part 3.]
