Rolling the dice

As the gaming industry expands, private equity has been increasingly tempted to bet on gambling's global boom. But like the act of gambling itself, casinos remain a risky proposition. By Dave Keating

In the days and weeks after Hurricane Katrina ravaged the US gulf coast, the region was full of speculation. As one-time residents and business owners scoured the wreckage, the same thought was on everyone's mind: What will it take to fix this? It seemed as if everyone had an answer, but one of the loudest and most popular suggestions took some by surprise. A consensus soon emerged. The gulf coast would need a massive revival of its casinos in order to rebuild.

Surprisingly, the local casinos may be the businesses that need the least amount of help. The gaming operations in the gulf, legalized in the early 1990s, were some of the first businesses to recover from the hurricane. In Mississippi's battered coastal region, three of the major casinos were back up and running by December, attracting thousands of visitors who have helped the area's gambling industry post surprisingly strong numbers. In January, three casinos, all in Biloxi, pulled in nearly $64 million, according to the Mississippi Gaming Commission. The total in Biloxi the previous January was $90 million—when the city had nine casinos in business.

They may be surrounded by destruction, but inside, Biloxi's casinos are hopping.

Mississippi officials have therefore pinned their hopes on the casino industry as the key to rebuilding the coast. In October, they even passed a law allowing casinos to come on land, provided they remain within 800 feet of the shore (they had previously been relegated to barges floating on the water). Casinos also got some assistance from Senator Trent Lott, who helped them win federal tax relief to rebuild.

Such an action, particularly by a Republican senator, would have been inconceivable 25 years ago. But the fact that the gulf coast is now lined with packed casinos is a testament to just how much public attitudes toward gambling have changed.

“The shame of gambling has disappeared from the American conscience,” says Father Richard McGowan, a professor at Boston College who specializes in public policy surrounding gambling, tobacco and alcohol. McGowan says over the past 20 years, gambling interests have embarked on a campaign to rebrand themselves as the “gaming industry” in order to move gambling into the entertainment sector. “As kids, we all go out and play games,” he says. “So what the industry has been trying to say is this is a good form of entertainment.”

The strategy has paid off. A recent survey by the American Gaming Association showed that 84 percent of the American population has no problem with gambling whatsoever. And recent trends are bringing more people to gambling than ever before. Since the beginning of the decade, poker has soared in popularity, driven by television coverage of major tournaments. Poker's newfound status, combined with the rising popularity of online gambling sites, has brought gaming to the masses.

“Now, the question in most states is not whether or not we're going to have gambling, it's how much gambling are we going to have,” McGowan says.

Father McGowan isn't the only one to notice the trend. The business community has taken notice as well, and investors of all stripes have begun to eye a sector which had traditionally been considered too risky for the faint-of-heart. With massive deregulation underway worldwide, investment in gaming is going mainstream. Since the legalization of gaming on Native American reservations in 1988, US gambling revenues have risen from $8 billion to more than $60 billion today. Today, 39 US states have legalized some form of casino gambling as a way to stimulate their economies and create jobs. Since 1988, the pro-gaming momentum has had a domino effect across the country, with each state fearful that if they don't legalize some forms of gambling, a neighboring state will.

And the US is not the only country easing restrictions. The United Kingdom, long regarded as one of the most strictly regulated gaming environments in Europe, just passed the Gambling Act of 2005. The legislation will usher in the most significant changes in British casino gaming in nearly 30 years, relaxing several existing regulations as well as allowing 17 new casinos to open: eight small, eight large and one “super casino.” Continental Europe has also seen efforts to deregulate. In France, for example, a new law, which takes effect in May, allows casinos to mix traditional tables with slot machines and consumers to put money, rather than tokens, directly into the slots. Analysts expect other European states to pass similar measures.

But how will private equity firms cash in on the trend?

For starters, they could look to Colony Capital, which has been the most active private equity real estate firm in the industry. By taking advantage of consolidation, which has forced new product onto the market via divestitures, Colony has established a major foothold in the sector. In September 2004, when Harrah's Entertainment bought Caesars Entertainment, Colony acquired four casino hotels from the combined entity for $1.2 billion. That same year, the firm also completed a $280 million purchase of the Las Vegas Hilton, added a new tower to Resorts Atlantic City hotel and agreed to infuse $127 million into the deal that merged Accor's casino business with that of Groupe Lucien Barrière. As one of the few private equity firms licensed in US gaming, Colony has been in a unique position to scoop up gaming interests from large conglomerates who don't want to sell to their competitors. The firm has been investing in the sector since 1997 when it bought Harveys Casino Resorts, the owner of hotels and casinos in Colorado and Iowa, for $420 million.

“When Colony bought Harveys in 1997, we saw an industry with only big, strategic players and no one to sell to except each other,” Colony chief executive officer Tom Barrack told sister publication Private Equity International last year. “We thought we could act as a liaison to all these larger companies. Now, the consolidation in the industry has been great fuel for our acquisition program.”

In late March, Colony announced that it had joined a number of other private equity and real estate firms—including Goldman Sachs' Whitehall Funds, Providence Equity Partners and The Related Companies—to acquire Kerzner International for $3.6 billion. The company operates the Mohegan Sun casino in Connecticut and the biggest casino in the Caribbean, located at the Atlantis Resort in Paradise Island on the Bahamas. The company is planning to expand in the Bahamas and is among 11 groups looking to win one of the two gaming licenses the country of Singapore is planning to issue.

Other private equity gaming investment has been on a smaller scale. Last August, Oaktree Capital Management purchased a 33 percent stake in Rampart Casinos, which owns the Cannery and Rampart Casinos in Las Vegas. Given the difficulty in obtaining a US gaming license—Tom Barrack has compared the licensing process to the Bataan Death March—the move may have had a strategic objective.

Brian Ward, a partner based in the Philadelphia office of Ernst & Young whose practice focuses on the gaming industry, says there are ways to obtain a gaming license without making a complete buyout.

“Historically, the challenge for anyone entering the casino industry in the US has been the requirement to obtain a gaming license in the state you want to buy in,” he says. “But what companies have done is buy something small in Nevada, like a small casino or a small vendor to casinos, to get a license. Once you've done that, getting a more significant investment, or a more significant license, is less of a challenge.”

Although the number of private equity firms investing in the US gaming sector remains small, there has been a flurry of activity in Europe. Last year, Colony invested 15 percent in the creation of a major European casino operator called Groupe Lucien Barrière. In August, the private equity firms Candover and Cinven sold equal equity stakes in UK bingo and gaming company Gala Group to UK buyout house Permira, making the three private equity firms equal owners of the franchise. And in November, the European buyout firm Bridgepoint acquired France's third-largest casino operator, Moliflor Loisirs. The company has over 1700 slot machines in 20 casinos located in mid-size towns throughout France.

Valerie Textier, a partner at Bridgepoint in Paris who led the deal, says the firm has big plans to expand the operation.

“There are 190 casinos in France, but a lot of them are still small groups of five or 10 casinos or independents,” she says. “There is a lot of consolidation that can take place, and Moliflor has a good track record of acquisition.”

Textier says the ideal exit for Bridgepoint would be to make some acquisitions and then sell Moliflors to a US player. She said that the government has issued permits for the approval of casinos in 24 French towns and Moliflor wants to fill the void, especially in the center of the country, which does not have very many casinos.

Perhaps the most frequent refrain from private equity firms investing in European casinos is the need to build “US-style casinos” on the continent. In France, for instance, most properties have very few slot machines compared to those in the US. Textier says that needs to change. Nikos Stephanopolis, a partner with BC Partners, which recently bought a majority stake in Greek casino operator Hyatt Regency, echoes this sentiment. He said BC made the purchase because the casinos which Hyatt Regency owns are unlike most of the others in Greece.

“Their casinos are very Las Vegas, US-type casinos,” he says. “They cater to a mass market, they're not dependent on the high roller, and that makes it a more stable business.”

The traditional image of the European casino is that of the lavish palace catering to tuxedo-clad James Bonds betting vast sums of money without a care in the world—the stereotype has an element of truth to it. A jacket and tie are required at most European casinos and the concept of endless rows of one-armedbandits like in Las Vegas just doesn't exist. But this is slowly changing. Even in Monaco, where high-class high-rollers have a long history, the principality's newest hotel, the Bay Resort, has broken with local tradition: it only has slot machines.

But it's not just in the proliferation of slot machines that US casinos differ from their European counterparts. In many European countries, such as Greece, there is only one casino license allowed per city, so the concept of an enclave of casinos like in Las Vegas or Atlantic City is currently unfeasible.

The gaming sector, both in the US and abroad, represents a unique opportunity for private equity real estate investors because it combines elements of an operating company with a real estate business. Tom Barrack has called gaming, “the lodging business with great cash flow.” Investments in the gaming sector often come as companions to hotels or hotel chains, which allows the owner to avoid the lumpy, volatile cash flows often associated with the hotel industry. And though hotel rooms in Las Vegas and Atlantic City used to be given away practically for free, today the expansion of non-gambling entertainment, especially in Las Vegas, has meant the rooms are being sold at market rates.

Hotels aren't the only potential real estate investment that can be coupled with the gaming sector. Retailers are increasingly being lured to casinos, as gamblers are more likely than everyday consumers to make large purchases. When people win big, they're likely to consider it someone else's money, and are more likely to spend it. When they lose, they might be consoled if they take something home.

Many casino resorts have been attracting retailers in droves. In Las Vegas, Atlantic City and newer gambling hubs around the country, numerous casino-oriented retail projects are underway. And more are planned.

“In Nevada, the highest contribution to the margin of the casino is the slot machine,” says Ernst & Young's Ward. “The second-highest is now the room inventory. So now you're seeing a broad cross-section of people that have interests in the gaming industry that go across the lines of hotels, casino operation, entertainment, shopping and restaurants.”

New York City-based Gordon Group Holdings, creator of Las Vegas' The Forum Shops at Caesars, has been particularly active in this field. Gordon owns all the retail and restaurants at Mohegan Sun in Connecticut and has projects planned in Atlantic City.

“People who come to gaming markets want to be entertained, and there are other forms of entertainment besides gaming,” says Scott Gordon, the company's president. “They cross the board from food and beverage and retail shopping to spa facilities and golf courses. We're really a part of a growing market here that historically hasn't been as multidimensional as it should.”

The reception Gordon is getting for this concept today is a far cry from the reaction investors had to Gordon's father in the late 80s. When Sheldon Gordon, now Gordon Group's chairman, first tried to woo retailers to the Forum Shops he had to practically beg. Back then, retailers didn't think people would shop where they gamble. Now, there seems to be no limit to what people will do where they gamble.

With the gaming industry and areas surrounding it growing by leaps and bounds, the new attention from private equity and real estate firms is perhaps warranted. But many analysts warn that, despite recent growth, this is a rough-and-tumble industry, one not only tightly regulated, but also dependent on government approval. Its success depends on striking a balance between public acceptance and favorable tax regimes.

“The industry needs public approval,” notes Father McGowan. “It doesn't exist until the government tells you it exists. You can't open a casino wherever you want, you have to get permission.”

Right now there's so much money to be made, it seems as if you can't lose running a casino. This is in large part due to the shift in public attitudes about gambling. But two things could quickly change this. The first would be if gambling addiction started to emerge as a serious problem, either in brick and mortar casinos or online. Another risk is the effect a huge scandal, where a casino or online gaming site was shown to be cheating its customers, could have on the regulatory environment.

Another big area of concern for investors is the shifting tax laws levied by some regulators. “Many investors say that when they invest a significant amount of money, they only like to invest where they can anticipate a stable tax environment,” says Ward. Some in the industry say gaming taxes have been anything but. Often, a state legislature will first legalize some form of gambling and start with a reasonable tax rate. Companies apply for and receive licenses, and pour millions of dollars into developing casinos. Once they're up and running, some state legislatures have been known to institute a huge tax hike in certain cases forcing the casinos to close down. In Colorado, for instance, limited-stakes casinos were opened in three small mountain towns in October 1991. By July 1992, the number of casinos in the towns grew to 68. The legislature subsequently raised the taxes on the casinos, and by the end of the year 21 had been forced to close.

Faced with budget shortfalls, legislators are much quicker to increase taxes on something like gambling than on the individual voter. A significant economic downturn, such as the one faced after September 11, 2001, could cause states to increase taxes on gaming to exorbitant amounts. In 2002, more state legislators increased taxes on legal gaming than at any other time in US history. Taxes on Indiana riverboat casinos were raised from 20 percent to 35 percent, while the Illinois legislature increased the top tax rate on casinos to 50 percent from 35 percent.

Still, at present there is undoubtedly a great deal of money to be made in the gaming sector. And private equity real estate firms may be uniquely positioned to take advantage.

The question is: do they have the stomach for it?

International investors are eyeing Macau.

When administration of Macau, a small territory consisting of three islands on China's Southeast coast, was transferred from Portugal to the People's Republic of China in 1999, the handover was historic. Macau was not only the last remaining European colony in Asia, it was also the oldest European colony in China, first settled by the Portugese in 1557.

Located next to Hong Kong, the special administrative region (SAR) of China has long been overshadowed by its larger and more famous neighbor. But Macau is carving out a niche for itself in the lucrative area of gambling, which has been central to the SAR's economy for over 100 years. Though gambling is illegal in mainland China, it was legalized in the colony in 1847. Today, the gaming industry generates over 40 percent of Macau's GDP and gambling taxes form 64 percent of Macau's government income. The three small islands that make up the city have at least 14 casinos, plus numerous tracks for dog and horse racing. Many forms of gambling are legal in Macau but the most popular game by far is baccarat. VIP high-roller baccarat generated more than 70 percent of total gaming revenue in 2004.

With the gaming industry representing such an important part of Macau's economy, it is tightly controlled by the government. In 1962, the government granted the Sociedad de Turismo e Diversoes de Macau the monopoly rights to all forms of gambling. The license expired in 2001, and the next year the government disbanded the gambling monopoly and granted four new licenses to other casino operators, including American companies Las Vegas Sands and Wynn Resorts.

However things aren't all rosy for Macau. The gambling industry can also be a source of instability in the Macau economy, as it is heavily dependant on the prosperity of other Asian economies, especially that of Hong Kong. Most native Macanese say they don't visit the casinos, and most of the gaming is done by big-spending visitors from Hong Kong, who can take a ferry to Macau 24 hours a day to satisfy their gambling urges.

Given all the activity taking place in the colony, the locals may have to get used to crowds. Most gaming analysts predict that Macau will replace Las Vegas in the near future as the gaming capital of the world. And a consortium of casino operators and hospitality companies, including The Sands, Four Seasons and Intercontinental, have unveiled plans to develop a $12 billion Las Vegas-style Strip in the colony.

“It took 75 years for Las Vegas to emerge as an international destination,” said Sheldon Anderson, chief executive of The Sands, in March. “Our intention is to establish that feat in less than three years.”