Hard Rock bets on a three-way deal

NEVADA -- Companies don't typically buy a Nevada casino until first obtaining a state gaming license necessary to own and operate the property.

An increasingly complex and competitive landscape is changing that by driving investors to consummate deals more quickly.

The most recent example is the three-way deal that paved the way for Morgans Hotel Group - a newcomer to Nevada and casinos - to purchase the Hard Rock Hotel without having first obtained a gaming license.

Joining Morgans in the purchase is DLJ Merchant Banking Partners, the private equity arm of investment banking giant Credit Suisse that is funding two-thirds of the equity used to purchase the Hard Rock for $770 million from Peter Morton. Individuals with Morgans and DLJ will be licensed as members of an investment partnership that has applied for ownership of the rock 'n' roll-themed property.

Regulators allowed the Hard Rock to change hands this month by first approving a third party to operate the casino while Morgans and DLJ officials complete the yearlong process of obtaining a gaming license.

Golden Gaming, which owns the PT's Pub chain, a few small casinos and thousands of slot machines in Nevada convenience stores, gas stations and bars, accepted that challenge.

The arrangement is somewhat unusual, even in a state that has previously approved third-party casino managers.

Rather than hiring and paying its own casino staff, Golden will be renting Hard Rock's 500 or so employees from Morgans to run the casino. Golden also won't be putting its own money at risk by funding the casino's bankroll or becoming an equity partner in the Hard Rock.

Golden's chief duty will be making sure the casino is run in compliance with state law. For its trouble, the company will receive a management fee of $3.3 million a year. In turn, Golden will pay Morgans a base rent of $20.7 million a year. The deal-clincher is a special incentive for Golden: The company will receive 25 percent of any profit from casino operations.

The remaining 75 percent will collect in an escrow account that will be given to Morgans and DLJ after the companies are licensed. Because Nevada regulations prevent casino managers from sharing revenue with unlicensed companies, Morgans and DLJ won't get their hands on that money until they are licensed.

"Our first thought was that this was a somewhat unusual and complicated situation," said Blake Sartini, Golden Gaming's chief executive.

That's one of the reasons Sartini, one of the founders of the Station Casinos chain, turned down a management deal at the Hard Rock before Morgans was identified as the buyer.

"We didn't want to go in as a blind date," he said.

Morgans' involvement changed his mind.

"I entered into this arrangement because I like the Morgans model," he said. "This is a one-of-a-kind opportunity. The Hard Rock is one of the most iconic properties in Vegas."

Golden's annual rent is believed to be less than market rate for a casino of the Hard Rock's size and reputation. But the incentives, including the bonus and a potential partnership in the Hard Rock, are significant.

Golden is betting that the property will earn more than ever under Morgans leadership.

DLJ will be putting up an initial $150 million for upgrades at the Hard Rock, which may include expanding the property, as well as a separate $600 million loan for future projects.

Morgans will receive a 4 percent management fee from DLJ as well as performance-based bonuses to operate the noncasino areas of the Hard Rock. As an added insurance policy, both parties are subject to loan guarantees that the Hard Rock upgrades will be completed and perform to expectations.

The setup may not have passed muster decades ago because of concerns that unlicensed entities and convoluted third-party arrangements could open the door to shady business operators, legal experts say.

"In the old days operators would have waited until they were licensed to buy the property," Hard Rock gaming attorney Jeff Silver said. "But now everyone's in a hurry and financial markets are moving quickly."

But Gaming Control Board member Mark Clayton said the arrangement with yet-to-be-licensed landlords, as well as bonuses and revenue-sharing, isn't unique. In recent years the Reno Hilton and several downtown casinos changed hands with third-party casino managers at the helm.

Wall Street dollars effectively pushed out mob ownership of casinos, removing fears about disreputable front companies. These days, "unknown" partners are likely to be blue-chip investment bankers and public companies managing billions of dollars. Regulators are now more familiar with these entities, particularly private funds that finance business deals and are now seeking a more active role in operating casinos and other businesses.

Morgans is a respected company known for developing exclusive hotels, such as the Delano in Miami's South Beach, in the world's cultural centers. The small company, analysts say, probably wouldn't have been able to afford the purchase without help from DLJ Merchant Banking, led by a banker who financed the Strip's first megaresorts and is familiar with the gaming licensing process.

"This is a unique marriage," said Neal Pomroy, managing director of DLJ Merchant Banking. "We have a shared view of what that property can be. Morgans is one of the leaders in managing boutique properties and harnessing their value. And you can't find many private equity sponsors with (gaming) experience."

Morgans was under a time crunch to buy the Hard Rock, sold in a private auction that attracted other bidders. The New York hotelier was eager to own its first casino in Las Vegas.

"We didn't feel there were many properties with the potential that the Hard Rock has," Pomroy said.

Some on Wall Street have unfairly characterized the deal as risky because of its unique characteristics, Pomroy said.

"I wouldn't make that leap," he said. "We think this is a very good investment that will (become less risky) as improvements are made."

Golden's reputation, rather than its money, is at stake. Running a successful casino will burnish its image but could harm the company should the venture fail. The company also is on the hook should the casino violate any gaming rules.

"Obviously there's a risk when you have a company that owns the property and a separate company that runs an integral part of the operation," Sartini said. "We felt it was a risk worth taking."