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End Run Around Equity

With financial institutions looking to move distressed loans off their books, it can be faster to acquire a company by buying its bank debt – as Penn National Gaming recently did.
Vincent Ryan, CFO.com | US
November 1, 2010

Corporate raider Carl Icahn is currently trying to drag out the takeover of MGM by Spyglass Entertainment by buying up the movie studio's senior secured loans. Although his ultimate goal is to thwart the takeover entirely, purchasing a company's debt can actually be a way of obtaining assets cheaply and completing a deal fast.

Just ask Penn National Gaming, a casino operator that acquired control of the M Resort Spa Casino via this method in October. Wyomissing, Pennsylvania-based Penn National bought the upscale M Resort for a fraction of the debt the ailing company owed. The deal took a matter of weeks, compared with the three to six months it would have taken to buy the equity. In the process, Penn National won a heated auction from another bidder. (Penn National dropped a bid earlier this year for the Fontainebleau Las Vegas, which was ultimately acquired by Icahn.)

Buying debt as a means to a "backdoor" acquisition may be an idea whose time has come. Targets are definitely available. Many companies are still overleveraged, and banks are tired of stringing them along. Banks are also in a better financial position to realize losses, so they are willing to sell the debt at a discount to avoid having to take over a borrower, place it in bankruptcy, and wind up with an equity holding. At the same time, corporate loans are trading higher in the secondary market, so banks may feel they can get a fairer price than they could a year ago.

"Lenders are opportunistic and willing to consider alternative structures," says Evan Greebel, a partner at law firm Katten Muchin Rosenman who advised one of the bank sellers of the M Resort debt. "An intelligent buyer may look to acquire the debt as a mechanism to control the company."

M Resort had $860 million of debt outstanding and was in default on its loans when the controlling lender, Bank of Scotland, decided to put it up for sale. When a group of eight bidders was winnowed to two, Greebel's colleague Ken Noble came in with a proposal for Penn National to buy the debt. "That was very appealing to the bank, because an equity deal would have required antitrust clearance and approval from gaming regulators before the transaction could close," Greebel says.

A reason the structure was preferred on both sides is that it simplified the deal — an equity purchase would have involved many representations and warranties and various steps to the closing, Noble says. "After we wrapped up the debt structure, [the deal] took four or five days," says Greebel.

As the buyer, Penn National spent $230.5 million for a property that cost $1 billion to build. With 390 rooms and more than 92,000 square feet of gambling space, the M Resort opened in March 2009 in the teeth of the recession. An analyst at Barclays Capital says once synergies are achieved, the acquisition could produce a mid-teens-to-20% EBITDA return for Penn National.

While Penn National is the economic owner of the business, it only becomes the equity owner of record once it acquires the equity from the developers and is licensed by the Nevada Gaming Commission. Penn National executives say the approval could come by the first quarter of 2011. The negotiations with the owners, who developed the property, could result in a debt-for-equity exchange, analysts say. If Penn National wants to cleanse the property of any open claims or liabilities, it also has the option of using the bankruptcy courts.

How does an acquirer value such a transaction? The baseline for valuing a target's debt is the underlying value of the collateral, and that baseline is adjusted for two main factors, says Noble. One is market dynamics: if there is an auction, what is it worth to do a preemptive deal and short-circuit the process? It may be necessary for the buyer to pay a higher price to cause the seller to terminate an ongoing auction. The second factor is execution risk: turning debt into equity ownership can be complicated or not, depending on the loan agreements, says Noble. "Here Penn National had a solid understanding of the private company that controls the equity and was comfortable that the execution risk, once they acquired the debt, was knowable and not significant," he says.

While the M Resort transaction occurred in gaming, Greebel says the technique is translatable to other industries: "It would suit any situation in which the lender has a significant amount of one company's debt and is no longer interested in working with the borrower anymore."




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