The plan to combine the real estate investment trusts is driven by the usual pressures of scale, but whether it comes to fruition or not will depend on how board members view the future of the two companies.
Editor’s note: This is the first part of a two-part analysis of the proposed Pebblebrook-LaSalle merger. Part two examines the two companies’ shared history and what it could mean for a combined entity.
Pebblebrook Hotel Trust’s proposal to merge with LaSalle Hotel Properties is likely to be top of mind over the next several weeks and months. Although one might conclude this unfolding drama is about the intertwined history of these two large owners, I see this as strategic.
Pebblebrook’s motivation likely reflects ongoing pressures that it, LaSalle and virtually all hotel REITs face to become larger. However, whether a merger happens will come down to how LaSalle’s board views the future.
The fiduciary duty of a board is to maximize the long-term value of the company for the benefit of all shareholders. This is no easy task, as it boils down to assessing the present value of various scenarios about the future, each requiring numerous assumptions. Management and outside advisors give input and present analyses, but each has inherent and often hard-to-detect biases. Director independence and a willingness to ask tough questions and challenge assumptions are essential in coming to the right conclusion.
Both companies’ boards have to see more value from a transaction than from remaining independent. As Pebblebrook’s CEO Jon Bortz noted in his letters to LaSalle’s CEO Mike Barnello and LHO’s chairman Stuart Scott, there are strategic benefits to combining, particularly given the similar asset style, operators and locations of the two portfolios.
One recent example of how this process plays out can be found in RLJ’s proxy material related to its merger with FelCor last summer.
Subsequent to its agreement to acquire FelCor, RLJ received a non-binding, all-cash offer from a private equity firm, reported by The Wall Street Journal to be Blackstone. RLJ’s board turned down the offer of $24 per share, above where its stock was trading, and in fact above where it has traded since this offer was disclosed in July 2017 (though it got close to that level briefly).
Many investors might have preferred RLJ accept a cash buyout for $24 per share, rather than take the execution risk that the combination with FelCor would result in a higher value at some point in the future. But RLJ’s board, after receiving the opinion of its advisors and looking at lots of information not available to the public (including its investors), came to the conclusion that the long-term present value of a combined RLJ-FelCor was greater than $24 per share.
Larger companies, if operated well and appreciated by investors, often have unique advantages over smaller companies. For much of LaSalle’s life as a public company, particularly under the leadership of Jon Bortz, it had a cost of capital advantage over most of its peers; for most of Pebblebrook’s existence, it has as well.
During times when Pebblebrook was undervalued, relative to the value of its assets in the private market, it turned lemons into lemonade by selling assets that were not being fairly valued as part of the company, which made the remaining portfolio relatively more valuable. Combining the two might give the combined company an even greater capital cost advantage.
The offer outlined in Pebblebrook’s letter to LaSalle would give LHO holders about $30 worth of Pebblebrook stock. While that might not be seen as quite as valuable as $30 in cash, Pebblebrook’s offer is likely quite attractive to investors given its management team and track record, as well as the similarity of the portfolios, ample operating and overhead efficiencies and the scale of the combined company.
Evidence of that attractiveness can be seen in the market response to the release of the letters to LaSalle: Pebblebrook’s stock went up substantially, an unusual response to an all-stock proposal. In most cases, arbitrage investors respond quickly to proposed takeovers, buying the target (recipient of stock) and selling short the acquirer (issuer of stock), locking in a gain from any difference in value relative to the deal proposal, but subject to the risk of the deal closing. This trade generally depresses the acquirer’s stock price. Pebblebrook’s first-day gain suggests that investors saw a lot of value creation potential from the combination and comparatively low execution risk.
LaSalle’s board has to make the same determination: Is $30 worth of Pebblebrook stock (or whatever consideration that might be offered in the future) worth more than the present value of LHO as a standalone company? Both alternatives have substantial execution risks. While LHO shareholders might prefer an all-cash offer or mix of cash and stock, and while they would certainly prefer a higher offer from Pebblebrook, I suspect most would prefer that LaSalle take Pebblebrook’s best offer.
Institutional investors are a thoughtful group. They analyze companies and potential transactions quite closely and do a good job of assessing the trade-off between growth potential and execution risk. But the election of directors essentially delegates the responsibility to make the decision about transactions to the board, with approval by the shareholders.
To make their voices heard before that decision is made, investors speak to management and occasionally provide public communication to the board, as one shareholder has done recently. HG Vora, a holder of 7.1% of LaSalle’s stock, sent a letter to the LaSalle board and filed it with the SEC on 2 April. (HG Vora is a large real estate-focused hedge fund with ample experience investing in hotel REITs.)
The letter stated HG Vora’s view that the strategic benefits of combining with Pebblebrook are “compelling” and recommended that the board commence negotiations with Pebblebrook while also determining if other buyers might offer more. LaSalle’s management is likely to communicate a summary of other investor feedback to the board as well.
I believe that the most likely outcome to this situation is a merger between these two REITs, but it is far from a sure thing. The logic and potential value creation the combination would bring is likely to be sufficient to overcome the substantial obstacles to a deal. Given the benefits of scale for public hotel companies, brands and REITs, I expect consolidation to be a recurring theme in the years ahead.
After a 30-year career as a stock research analyst, David Loeb created Dirigo Consulting LLC, which advises on capital markets, strategy and communications issues. Clients have included REITS, brands, and private equity investors. He can be reached at email@example.com.
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