If you are reading this column by the pool at the Delano South Beach in Miami Beach or while hanging out at the bar at St. Martins Lane Hotel in London or the Royalton in Manhattan, you may not be aware that behind the scenes of your comfortable surroundings, all is not well.
Morgans Hotel Group, the owner and manager of these three boutique hotels and others like the Mondrian in SoHo, is being crushed by a deal it cut with Ronald W. Burkle’s investment firm, the Yucaipa Companies.
It all started back in October 2009. Morgans, founded by Ian Schrager and Steve Rubell of Studio 54 fame, was struggling under the weight of the financial crisis. Revenue was declining precipitously as consumers panicked and shunned luxury.
Worried about liquidity and searching for expansion, Morgans hit upon a deal with Yucaipa. The investment firm would make a $72 million infusion in what is known as a private investment in public equity, or PIPE.
Such deals are complicated and are usually done with distressed or struggling companies. An investment firm will take a large ownership position, rescuing the company. But the price for this rescue is high. A PIPE is usually done on quite advantageous terms and includes complicated options, preferred returns and redemption features all intended to give more value to the investor.
The reason for this trade-off is that typically the company has no choice. One study of PIPEs found that without the investment, the majority of target companies would be out of cash within a year.
Unfortunately, this comes at the expense of other shareholders. This same study, of over 2,500 such deals, found that after the investment, existing shareholders receive average returns of negative 22 percent, compared with average gains of 27 percent for the PIPE investor.
It is no surprise that a knowledgeable investor like Mr. Burkle, known for buying and selling supermarket chains, negotiated great terms for his PIPE. In exchange for $72 million, Yucaipa received preferred securities and warrants to acquire as many as 12.5 million shares of Morgans Hotel. The preferred even has a “death spiral†feature: It starts at a dividend rate of 8 percent, but this rises to 10 percent in 2014 and 20 percent in 2016 if the preferred is not repaid.
The kicker is that Yucaipa also received the right to nominate one director and extensive control rights over Morgans. This includes veto rights over a sale of the company, acquisitions worth more than $100 million and any sale of nearly all of the company’s assets.
It is unclear if Morgans’ management appreciated the consequences of handing this degree of control over the company to Mr. Burkle’s Yucaipa. On an investor conference call in 2009, the president of the company at that time said that Mr. Burkle’s investment was “shareholder friendly†and provided the company with a “great deal of flexibility to weather the remainder of the downturn.†Shareholders may not have done so either, as they also approved part of the transaction.
Looking back at the deal, a company representative said on Tuesday: “Morgans Hotel Group was deeply indebted and needed an equity lifeline in 2009 and the Yucaipa deal was a good solution to provide necessary equity capital. The terms of the transaction were generally consistent with the credit market environment at that time. That deal was validated by stockholders, 87 percent of which voted in favor of allowing the transaction to proceed.â€
Nearly four years later, Mr. Burkle has continued to take control. Yucaipa owns 27.9 percent of Morgans, and with the company’s consent he also bought $88 million of its debt, which comes due in October 2014. Yucaipa’s first appointment to the board, Michael J. Gross, now runs Morgans.
But Morgans has a problem. It has mortgage debt of $180 million due in 2015 and $172 million in debt due in 2014, about half of which is held by Mr. Burkle’s Yucaipa. Remember that the interest payments on the preferred rise to 20 percent in 2016.
Morgans, meanwhile, has changed its business strategy, so that it is selling hotels and focusing on managing luxury hotels under its brand. It has been a fitful transition, and the company has lost more than $200 million in the past three years.
In normal times this might create financing problems for Morgans. But we currently live in a near-zero interest rate environment, and luxury hotels are an increasingly hot commodity. If you have been to the Delano lately you can see that is the case as the 1 percent luxuriates en masse by the pool. So even though its performance is less than stellar, Morgans should be able to refinance its debt.
The problem is that Morgans’ friendly deal with Mr. Burkle is looking not so welcoming to other investors.
According to people close to Morgans, the company has been told by its bankers that if it cannot eliminate the favorable terms and various forms of financing with Yucaipa, it will not be able to raise significantly new amounts of capital.
So Morgans has announced another complicated deal that it calls a deleveraging transaction. The hotel company has agreed to give Yucaipa the Delano South Beach and Morgans nightclub and food and beverage management business in exchange for cancellation of the warrants, preferred shares and debt.
As part of this transaction, Morgans announced a $100 million rights issuance amounting to more than 50 percent of its current equity, an extraordinary number of shares to issue. Yucaipa also agreed to backstop the rights offering, having the potential to raise its share ownership by a significant percentage if other shareholders did not participate.
OTK Associates, an investment vehicle run by the Olshan and Taubman real estate families that owns 13.9 percent of Morgans, has started a campaign to stop the transaction with Mr. Burkle’s Yucaipa.
The investment group has sued in a Delaware court, claiming that the deleveraging transaction was unduly favorable to Yucaipa. At a hearing in April on the matter, Vice Chancellor J. Travis Laster halted completion of the transaction and appeared to find evidence to support OTK’s allegations. The judge stated that “there is evidence in the record to call into question things†the directors did, implying that they may have been too close with Mr. Burkle and Yucaipa.
Now OTK, which voted for the 2009 transaction, is running a slate of seven directors to try to unseat the Morgans board at its June 14 annual meeting. The investment group’s claim is that in today’s environment the Burkle deal is too expensive, and the hotel company instead should be able to find a deal, something evidenced by Morgans’ recently receiving a proposal to acquire the entire company.
This is a mess, and it has created a huge upheaval at the company with tens of millions being spent on lawyers and bankers.
I sympathize with the position Morgans is in. It is very difficult to find a better deal than the one with Yucaipa, given the rights that Mr. Burkle’s fund already has. An analyst at MKM Partners echoed this in a note, rating the company neutral but stating that the deleveraging transaction “has the power to be transformative.†Still, it also appears that Morgans may not have fought as hard in the past as it probably should have.
It is clear there is a lesson here for other companies.
In 2009, Morgans needed money but was not completely out of options. Still, it took a PIPE deal with hard terms. That deal is coming back to haunt the company.
You can’t blame Yucaipa for acting in its self-interest, but you can blame Morgans’ management then for failing to appreciate the consequences of the PIPE investment at the time. It locked them into the arms of Yucaipa in a way that is exceedingly difficult to escape.
It’s a reminder for every corporate board the next time it contemplates an investment like this, and a sobering thought for those executives and beautiful people sitting today by that Delano pool â€" your investment choices years ago can linger, pushing you to even worse decisions.
