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Updated from 10:55 a.m. EDT

Private equity and gaming?

The combination has several industry watchers scratching their heads following


( HET) announcement Monday that it received a buyout bid from two big private equity funds.

The country's largest casino operator said it is reviewing an $81-a-share offer from Apollo Management and Texas Pacific Group. Such a deal, which could be valued near $25 billion including debt, would rank among the highest leveraged buyouts of all time.

The move, however, is an unconventional one for private equity firms.

For one, Harrah's doesn't offer private equity investors underperforming assets, so it's hard to comprehend how these funds will pay a steep multiple for the company's cash flow


wring out higher returns.

Harrah's has "done an excellent job of operating its assets to peak efficiency," says Matthew Jacob, an analyst with Majestic Research. "So it may be difficult for a new management team to improve results at those properties."

Neither Apollo Management nor Texas Pacific have any experience operating casinos. That means the firms are likely planning to bring in operators or keep some of Harrah's management, especially the company's CEO, Gary Loveman.

Although private equity has dabbled in the gaming space before, a deal of this magnitude is unprecedented in the sector.

Colony Capital recently has picked up casino properties, including the Atlantic City Hilton and several others from Harrah's, which unloaded them after its purchase of Caesars in 2005.

"What's attractive about the space is the free cash flow, and maybe

the bidders are taking a long-term perspective," says Smedes Rose, an analyst with Calyon Securities. "Maybe they see opportunity to extract value out of the company."

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By Rose's estimate, if Harrah's accepts the $81 deal and the private equity players used 75% leverage to buy the company, the bidders would get a 9.6% free cash flow yield based on Harrah's estimated 2008 earnings before interest, taxes, depreciation and amortization. If the bidders upped their price to $85, the yield would drop to 9%.

Those initial yields work for the private equity funds, as long as they believe they can boost the yields in later years. But how they plan to boost the yields remains a question.

Surprise Move?

Some people are speculating that the bid was induced by Harrah's, which didn't say whether the offer was solicited or unsolicited.

"I wonder who's driving this transaction," says Joe Weinert, a casino consultant with Spectrum Gaming Group. "I'm not so sure that this is being driven by the outside. It's possible that Harrah's, frustrated with what it sees as penalties on its stock price, is seeking to take the company private."

Joe Fath, an analyst with T. Rowe Price, which owns shares of Harrah's, says his sense is that management is not keen on doing the deal. However, he says the company is between a rock and a hard place, since the immediate buyout could be just what investors are looking for.

"Larger shareholders have been pushing them to do less development and buy more shares," Fath says.

Although he admits it could be a possibility that Harrah's management approached the bidders about a deal, Fath says a conversation he had on Tuesday with Steve Bollenbach, the CEO of


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and a Harrah's director, left him with the impression that the buyout bid came out of left field.

"He was not going to give me anything, but I got the sense they (Harrah's board) were surprised by this," Fath says.

On the other hand, he noted that Harrah's was supposed to hold an investor day in September about its development plans, but that has been pushed out. Even as of last week, the conference was delayed until January, suggesting Harrah's might have been approached before then, Fath says.

Big Spending

Most expect the Harrah's offer -- if it is accepted by management -- would take anywhere from six months to a year to be finalized. The new owners will have to endure the grueling task of getting regulatory approval from the various states to transfer Harrah's casino licenses.

There's also another looming issue: Running a casino is a capital-intensive business. That's another trait that private equity players typically don't look for in acquisition targets.

This large level of capital expenditures, along with the large volatility in earnings due to the swings that come from high-end gamblers, is a reason why

Starwood Hotels


exited the casino business in 1999, just two years after entering.

In 1997, Starwood was still a real estate investment trust and used the tax benefits of that structure to buy ITT Corp., which owned numerous hotels and the Caesars' casino properties, for $10 billion. It later sold the gaming assets to Park Place Entertainment, which eventually became Caesars Entertainment and was swallowed by Harrah's last year.

As Weinert, the casino consultant, points out, when Starwood purchased ITT there was buzz that a lot of gaming companies would explore the REIT structure.

Crescent Real Estate Equities

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, a REIT, planned to merge with

Station Casinos

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but ended up canceling the deal.

Now, private equity is creating a similar buzz for casinos, but the industry doesn't have much of a track record in gaming. Colony Capital hasn't been too vocal about whether it is on target to achieve double-digit returns at its casinos.

Some industry experts speculate that Apollo and Texas Pacific might eventually sell some of Harrah's underlying assets, while keeping management contracts in place.

This would be similar to the transformation that Starwood and

Intercontinental Hotels Group

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are undergoing in the lodging sector.

At this point, it's all speculation.