“Compared to our capital structure, that’s not a big change.”
– Michael Cohen, deputy general counsel, Caesars Entertainment (CZR)
The above quote comes from Caesars’ hearing in front of the Nevada Gaming Control Board on Wednesday, as the company successfully attempted to have its spinoff of a new company, Caesars Acquisition Company, approved by the board. (That quote, and other Cohen quotes subsequent, courtesy of Howard Stutz in the Las Vegas Review-Journal.) Caesars will distribute 125.4 million rights to shares in Caesars Acquisition (CAC) to existing CZR shareholders, who will have the right to buy shares in CAC for $9.43 in share. News of the spin-off sent CZR shares 13 percent higher on Wednesday; the stock closed Friday at $16 per share, near all-time highs reached in late March around $18.
CAC will own Las Vegas’ Planet Hollywood resort, rights to a minority ownership in the still-unfinished Horseshoe Baltimore, and Caesars Interactive, which owns the social gaming (now number one in market share) and online gambling businesses of Caesars, along with the World Series of Poker. They will also receive a $1.1 billion note from a Caesars subsidiary. Caesars Entertainment will still own a majority of CAC, through non-voting rights. Meanwhile, voting control of the new company will be controlled by Hamlet Holdings, consisting of affiliates of TPG Capital and Apollo Capital Management (APO), the two firms who led Caesars’ move private back in 2008.
If that all sounds somewhat confusing, rest assured: it is. The S-1 filing to register the spinoff – which will be publicly traded under the symbol CGP – is dense, complicated, and convoluted. At its core, the move is an attempt to shield certain Caesars assets – notably Caesars Interactive – from the company’s $21 billion debt load. If Caesars’ corporate entity goes bankrupt, the theory goes, shareholders can now retain ownership of the fast-growing social gaming and high-potential online gambling operations, even if the company’s land-based properties (now excluding Planet Hollywood and Baltimore) wind up being returned to Caesars bondholders in the event of a restructuring.
It’s easy to see why this move should create excitement on the part of equity investors, who now (presumably) see a lower risk of their entire investment being wiped out in the case of a Caesars bankruptcy. But Wednesday’s 13 percent gains made little sense, for a number of reasons. The first reason is that CZR stock already made a giant move based on the spin-off. In late April, the stock gained 27 percent in a day and 33 percent for the week after it announced the creation of Caesars Growth Partners; CAC is simply a vehicle designed to invest in CGP. In short, Caesars gained $200 million in market value this week based on the confirmation of a decision that had already been made – and announced.
Beyond the short-term moves, a reading of the S-1 registration statement filed with the SEC shows serious long-term questions about the success of the spin-off, and the potential value of CAC shares. To begin with, as Caesars’ Michael Cohen himself admitted in front of the Nevada Gaming Control Board, the spin-off does little to improve the financial position of Caesars’ corporate parent. Only $500 million in debt is being laid off on CAC, leaving some $20.6 billion remaining on Caesars’ balance sheet. “Nothing really changes,” Cohen told the board. “It’s just a new corporate structure.” Caesars is also giving up modest revenue streams in the future, such as 50 percent of the management fees from Planet Hollywood and the Baltimore project, along with its share of earnings from the Horseshoe Baltimore and profits from the social gaming arm.
But most notable is the multiple conditions and restrictions placed on CAC stock that are set up clearly to benefit Caesars shareholders. In the near term, this has a roughly zero net effect; Caesars shareholders are the only ones who can become CAC shareholders, as the only to purchase CAC shares in its initial offering will be through the exercise of rights at $9.43 per share. Once the spin-off is completed, CAC shares will be publicly traded, however. Investors could hold their CAC shares, and dump their CZR shares; or vice versa. Once that occurs, the spin-off is clearly set up to benefit CZR shareholders over CAC shareholders, whose enthusiasm for the interactive division may blind them to the many disadvantageous aspects of the spin-off.
To begin with, CAC shareholders will not control the voting rights of the company; affiliates of TPG and Apollo will, assuming they exercise their full allotment of exercise rights for the spin-off. (The S-1 appears to contradict itself on this matter; multiple times, it mentions that these affiliates have promised to exercise at least $500 million worth of rights; but in two other places, it appears that TPG and Apollo have already promised to exercise their full allotment, which would require over $800 million in capital. An e-mail to Caesars investor relations regarding this apparent discrepancy had not been returned as of press time.) The lack of voting power for individual shareholders is also true of Caesars, and subjects shareholders to the whims of the two massive fund companies, whose goal is not necessarily to boost the company for the sake of all its shareholders, but to find a way to get out of their disastrous 2008 buyout as cheaply as possible. Indeed, the complicated nature of the spin-off – not to mention Caesars’ already obtuse corporate structure – is intended to favor shareholders over debt holders. This is fine for CZR and CAC shareholders in the near term; but there is a risk that at some point Apollo and TPG will start looking out for themselves over other equity holders.
And because CAC’s structure is so clearly beneficial to Caesars, it seems likely that TPG and Apollo are hoping that CAC’s share price will be boosted by investors who see the company as a play on real-money gambling, allowing current investors – including TPG and Apollo – to cash out at inflated prices. But CAC investors need to be careful, as Caesars Entertainment shareholders will, no pun intended, hold all the cards.
To begin with, any opportunity that CAC attempts to use its $1 billion-plus in cash on must first be brought to Caesars Entertainment; only if Caesars Entertainment rejects the opportunity (likely because it lacks the cash to go forward) can CAC make an investment. That right of first refusal, obviously, doesn’t go both ways, meaning that, particularly if Caesars corporate were to somehow rebound going forward, CAC would wind up with only the projects that Caesars itself didn’t even want.
Adding insult to injury, Caesars shareholders will retain a “call right” on CAC, beginning three years after the spin-off occurs. The price will be, according to the filing, based on the “fair market value” of CAC shares based on an independent appraisal. Most notably, Caesars can buy back the acquisition vehicle with shares of its own stock, meaning that shareholders who buy only CAC (and not CZR) shares to get away from the company’s stagnant land-based operations can, against their will, be forced to take back Caesars shares. Meanwhile, if shares are trading on optimism about US (or European; Caesars’ WSOP brand does have modest overseas exposure) real-money gambling, at any moment their value can tumble back to whatever “fair market value” the appraiser decides. Those investors who question the independence or competence of that appraisal seem likely to have little recourse, since, again, the company’s voting rights will be controlled by its largest shareholders.
So, if CAC shares rise, within three years Caesars will most likely buy the company back, forcing CAC shareholders to again hold equity in CZR, and perhaps at a discount to the then-trading price. If they don’t, CAC shareholders will have seen substantial losses. As such, buying CAC alone as a long-term investment (ie, past 2016) would appear to be a “heads you win, tails I lose” type of purchase. Beyond that, beginning five years after the sale, CAC’s board (again, controlled by TPG and Apollo) will have the right to liquidate the company and sell off all its assets. After eight and a half years, the board must liquidate the company, barring an agreement between Caesars corporate and the spin-off. Again, this may come at an inopportune time; but investors will likely have little, if any, recourse to seeing the company sold or otherwise dismantled.
The complex nature of the transaction belies the immediate analysis of the deal: that Caesars was “spinning off” its interactive assets. While the deal is technically a spin-off, Caesars is keeping voting control of the new company with its majority owners, and making sure that it doesn’t miss out on any potential success in either social gaming or real-money gambling. As Jeffrey Goldfarb wrote for the New York Times’ Dealbook when the spinoff was first announced in April, “the complex transaction mostly seems designed to buy still more time for the ailing $31 billion leveraged buyout.” Goldfarb went on to add that the “convoluted experiment” was an attempt to “blind [the] market with science.” “For all its intricacies, the plan hardly makes Caesars any more the master of its fate,” he concluded.
As noted above, no less than Caesars’ deputy general counsel admitted the same thing. In noting that Caesars was shedding just half a billion in debt, he told the Nevada board that “Caesars has a lot of debt. We think it’s manageable, but others disagree.” In fact, many others disagree; among them appear to be the government of South Korea, which denied a Caesars license in the country due to concerns about its solvency, as sources told both Reuters and the Wall Street Journal. In the S-1 filing, Caesars appeared to be making a similar argument. In its “Reasons for the Rights Offering” section, Caesars wrote that “Growth Partners’ [Growth Partners is the vehicle being purchased, in part, by CAC] flexible capital structure provides it with the ability to bid on and develop new projects in new and expanding markets quickly without the constraints of a more complex capital structure.” In other words, Caesars is basically saying that CAC and CGP will have cash to expand, whether to acquire new interactive businesses or develop new casino projects, cash that Caesars simply does not have. Indeed, as I wrote last November, Caesars only owns minority stakes in its newest properties in Baltimore, Cleveland and Cincinnati, further evidence that the company simply does not have the financial resources to develop any of those projects with substantial help from joint venture partners.
The problem with the “spin-off” is that it hardly changes Caesars’ capital structure. The inclusion of Planet Hollywood does push off some near-term debt (the property has a loan that comes due in the spring of 2015), but overall little has changed. And yet the closely tied nature of the two companies following this transaction may remove many of the supposed beneficial effects. For instance, if CAC – rather than Caesars corporate – were now to attempt to be licensed in Korea, would the Korean government no longer be worried about Caesars’ potential insolvency? Or would the fact that creditors could potentially wind up owning Caesars’ business, its operations, and its trademarks – all of critical importance to CAC – mean that the same risks that apply to Caesars would apply to the spin-off? It seems unlikely that, given CAC’s close ties with Caesars, and, more importantly, the fact that CAC could likely be owned by Caesars in three years, the spin-off will do much to assuage regulatory agencies or governments considering applications for new projects.
Furthermore, the nature of the spin-off may impact the logic that propelled rumors of the transaction well before it occurred: that the debt-free interactive assets could be returned to shareholders, removing the bankruptcy risk from what appear to be the company’s most-desired assets. In the “Risk Factors” section of the filing, Caesars notes that should the parent default and head into bankruptcy, a bankruptcy judge could conclude that the spin-off was either fraudulent or a disguised financing, and make CAC assets available to Caesars creditors. CAC shareholders would no longer be considered owners of the interactive assets; simply creditors standing in line with the holders of Caesars’ $21 billion in debt.
It’s not clear how substantial that risk is; to be fair, “Risk Factors,” like most legal documents are written to include nearly every type of contingency. (Terrorism, military action, and other catastrophes are always mentioned; as rare or unprecedented as such an action would be, executives are far more comfortable avoiding potential liability should something occur that was not presented as a possible risk.) But in the case of Station Casinos, that company did settle with creditors upset about its own 2007 leveraged buyout; according to the Las Vegas Sun, bondholders agreed to put up a small amount of additional cash for an ownership stake in several Station properties.
In the case of a default by Caesars’ corporate arm, creditors would no doubt sue for ownership of the CAC assets, arguing that the company knew – or should have known – it was headed for insolvency and was simply trying to transfer assets away from bondholders’ reach. Whether or not such an argument would be successful is far from clear; but the “go-away-now-come-back” nature of the spin-off would seem to lend credence to those types of arguments. At the very least, Caesars bondholders might settle for a piece of CAC – diluting shareholders, even those with no exposure to CZR stock.
All told, the two sharp jumps in CZR shares based on the spin-off – creating, in total, over a half a billion dollars in shareholder value – remain largely irrational. Little has changed at Caesars corporate, and it’s far from clear that the goal of protecting Caesars’ interactive assets has even been reached. Meanwhile, CAC shareholders will be at the mercy of Caesars and its corporate owners, and Caesars’ interest payments continue to dwarf its pre-tax profits. Does that sound like a $2 billion company to you? Because, right now, it is.