Comment & Analysis

The $8.9bn buyout of Penn National Gaming by Fortress Investment Group and Centerbridge Partners has become the latest casualty of a slowing economy and turmoil in the credit markets.

However, unusually in the current contentious deal environment, the termination of the buyout agreement has been relatively smooth.

The banks - rather than the private equity buyers - will pay Penn National (NASDAQ: PENN - news) a $225m termination fee. They would rather pay that than finance a deal that was forged in far more optimistic times and would involve heavy losses on billions of dollars of debt.

At the same time, the two private equity firms and the two lead banks - Deutsche Bank (Frankfurt: DB9999 - news) and Wachovia - will invest $1.25bn in Penn National mandatory redeemable preferred equity, which will return nothing until the shares are above $67 - the price at which the original buyout was struck. On Thursday, Penn National shares rose 2.48 per cent to $29.31.

Penn National will use the proceeds to pay back debt, buy shares and expand its business.

Penn National said that to attempt to strike a deal at a lower price "was not a viable option". The company, which operates 19 gaming and racing facilities and makes much of its revenues from slot machines, also said it concluded that "the likelihood of successfully navigating remaining approvals, credit facility conditions for funding was highly uncertain".

The collapse of the Penn National deal came a day after Harrah's Entertainment announced it would take advantage of its ability to suspend cash payments on a portion of its debt, highlighting the stress the gaming industry is beginning to feel. In past economic contractions, the gaming industry has been relatively immune.

US Airways is slashing the number of flights to Las Vegas, while other carriers with frequent flights to the gambling capital of the US have disappeared. "Harrah's leveraged buyout piled on debt just as operating results started to weaken," noted Kim Noland, an analyst with independent bond research boutique GimmeCredit in a recent report.

"Harrah's first quarter results were disappointing and it may be some time before results improve, given the 'new' type of recession in which gaming companies don't exhibit the same resiliency they did in earlier downturns."

Still, relative to rivals in the industry, Harrah's is in good shape. For example, it uses a fleet of planes to fly high-spenders to its casinos. It also has excess cash on its balance sheet and $2bn in undrawn bank lines. But, like many other private equity owned firms, it has made a decision that when credit is tight, it is far better off issuing more debt than paying precious cash interest payments. The decision affects $1.4bn of bonds.

"This was never an investment based on cutting costs," says one person close to the deal. "This was always about growing the company. Harrah's needs capital to invest so it can grow and this is the cheapest capital."

Apollo Management, which along with TPG bought Harrah's for almost $28bn at the end of 2006, has exercised its right to issue more debt rather than pay cash interest on several of its companies. It has told investors in the debt of other of its deals that they can also expect to receive more debt as soon as their portfolio companies have the right to cease paying cash.

Additional reporting by Roger Blitz