How Starwood Became a Player

If Hilton Hotels Corp.’s takeover bid for ITT Corp. ends up being trumped by Barry Sternlicht and his Starwood Lodging Trust, Hilton could lay much of the blame on the U.S. Tax Code.

Sternlicht, 36, built Starwood Lodging from the ruins of a bankrupt hotel investment firm rooted in the San Fernando Valley using an arcane tax loophole to renew Wall Street’s interest in the company.

Starwood’s stock, in turn, has skyrocketed over the last three years, enabling the chief executive to use the high-flying shares as currency to gobble up a string of more than 100 hotel properties. Last month, Starwood agreed to buy the luxury Westin hotel chain in a $1.8-billion deal.

Now Sternlicht is making his most daring move yet: trying to acquire ITT--the parent of the Sheraton hotel chain, and a company many times bigger than Starwood--in a deal that would create the world’s largest hotel company. Starwood reached agreement Monday to pay $9.8 billion in stock and cash for ITT and to assume about $3.5 billion of ITT debt. The purchase price is three times higher than Starwood’s own stock market value.

On Tuesday, Hilton Chief Executive Stephen Bollenbach, who has doggedly pursued ITT for nine months, said he would not try to top Starwood’s offer, which is 17% higher than Hilton’s bid.

Even those familiar with Starwood’s ambitious growth plans were surprised by the company’s bold bid for ITT.

“Starwood became a world-class hotel company much faster than anybody thought it would,” said John Arabia, senior lodging analyst at Green Street Advisors in Newport Beach.

How did Sternlicht and Starwood, obscure names outside of the hotel industry, become powerful enough to even consider swallowing ITT?

Starwood has benefited from two market trends: a strong rebound in the hotel business generally, and a renewed surge of investor interest in real estate investment trusts, or REITs. Credit, too, Sternlicht’s ability to staff Starwood Lodging with capable hotel managers.

Those factors have helped swell the value of Starwood’s stock, which has nearly quintupled during the last three years. The stock has jumped 61% this year alone, to a close Tuesday of $59.19 a share in New York Stock Exchange composite trading.

But perhaps one of Starwood’s most important assets is its peculiar structure.

Starwood Lodging, which moved its headquarters to Phoenix from Los Angeles last year, is actually two companies whose stocks are “paired,” or trade as one issue. One is Starwood Lodging Trust, a REIT that owns the hotel properties. The other is Starwood Lodging Corp., which manages the hotels’ operations.

Starwood is among only a handful of U.S. companies that have such a setup, because the tax advantages inherent in the structure prompted Congress to abolish the setup in 1983. Starwood and the others were allowed to keep it, however.

But it wasn’t until a decade later that people such as Sternlicht realized that the unique structure could be valuable not only for sheltering earnings, but also as a way to persuade investors to pour more cash into his operation, which in turn helped him make more acquisitions.

Here’s how it works. The REIT, which owns the properties, avoids corporate taxation by passing along at least 95% of its profits to its stockholders. But a REIT typically cannot operate the business on its land; it’s supposed to passively collect rents or mortgage payments from its holdings and hire another company to run the business there.

Enter the other half of the “paired-share” firm. That entity runs the business (in this case the hotel) and can itself substantially cut its taxes by passing along most of its profit to its paired REIT in the form of rents or mortgage payments.

The result: Both companies avoid most federal taxes, and the REIT keeps more of a property’s cash flow because it doesn’t have to hire an outsider to run the enterprise on its land.

Sternlicht, who wasn’t available to be interviewed Tuesday, created Starwood in 1994 after taking over management of a firm named Hotel Investors Trust, an operation that was in bankruptcy at the time. He changed the name to Starwood, after a Colorado mountain resort, in early 1995 and began amassing a string of lodging properties at bargain prices.

Sternlicht, who also manages a separate investment fund, has impressed real estate and hotel executives by his ability to tap into his extensive network of wealthy investors and Wall Street firms to finance his deals.

“He’s a Wall Street player and knows his way around the street,” said Donald W. Wise, a hotel specialist at the brokerage firm CB Commercial. “He was able to lay his hands on [different] kinds of financing when for everyone else the chance [of tapping the same sources] was slim or none.”

Some industry analysts say that Starwood’s unique corporate structure and tax benefits give it an unfair advantage over its corporate rivals.

“Clearly, Hilton is the superior operator,” said hotel industry analyst Andrew Zarnett at the securities firm Ladenburg Thalmann. But “there is a significant competitive advantage that these paired REITs have that allow them to play the game with three or four more outs than [other] companies. That’s not equitable.”

But the example set by Sternlicht hasn’t gone unnoticed, and the few other paired-share enterprises have become hot properties. One is Santa Anita Cos., the Arcadia-based horse-racing operation, which has agreed to a takeover by Meditrust, a hospital REIT.

Another horse-racing operator, Hollywood Park Inc., was among the paired-share firms grandfathered by Congress. However, Hollywood Park voluntarily relinquished the structure a few years later. Now, though, Hollywood Park is trying to get the setup back because it’s become so valuable in the marketplace.

* HILTON BACKS OFF: Hilton Hotels’ chief executive said he won’t top Starwood’s bid for ITT. D2