In the June 2009 edition of this Newsletter (Baker & McKenzie's observations from the field: The impact of the Global Financial Crisis on hotel management), we identified a number of recent developments in hotel management agreements. It was our conclusion that together these had the potential to make hotel real estate less attractive as a property asset class. This was not good news for participants in our industry - especially the hotel operating companies which, in large part, have adopted an 'asset light' approach in recent years and would be most concerned by a lack of investment interest.
We have received significant feedback on that Newsletter from a broad range of industry participants - owners, operators and financiers. There has been almost universal agreement with the views expressed in that newsletter.
So where to from here?
At the upcoming Hotel Investment Conference Asia Pacific (Hong Kong 14 - 16 October 2009), the authors of this article will be hosting a Master Class entitled "The Management Agreement - Increasing Investor Appeal".
This interactive workshop will bring together a number of key industry stakeholders to debate some ideas and see if we can "build a better mousetrap". We have picked four topics to tackle in that Master Class and have set out some thoughts on those in this Newsletter. We have been advised that demand for the session is strong, which bodes well for some lively debate and positive outcomes. Of course, our discussion may highlight hot topics outside the four covered in this Newsletter which we can add to the list for future consideration.
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Non Disturbance
The issues
Non Disturbance Agreements (NDAs) are tri-partite agreements between the owner, operator and the owner's financier which require the financier to only act in a manner that is consistent with the Hotel Management Agreement (HMA). In the absence of a NDA, financiers are generally free to effectively ignore the terms of the HMA both in relation to operating and selling the hotel. From the deals we are seeing, in most jurisdictions, just about every major multi-national hotel operating company is making NDAs a standard requirement for every deal (whether operators are providing some form of financial contribution to the owner or not). Accordingly, the typical first draft HMA will contain an absolute obligation on the owner to ensure that a secured financier executes a NDA document identical to a pro-forma attached to the HMA.
This more rigid requirement for NDAs is a predictable reaction to the impact of the global financial crisis. Most, if not all, operating companies are now dealing directly with lenders on some of their hotel portfolios where owners have defaulted on their finance arrangements. The very situation NDAs are designed to deal with has come about because the operators want to have direct contractual relationships with lenders (which lawyers call privity of contract). Realpoint LLC, a credit rating agency that follows CMBS, has estimated that loans to the hotel sector in the United States totalling US$24.5 billion may be in danger of default, so operators will continue to perceive there to be some risk of owners becoming financially distressed.
We expect this trend towards mandatory NDAs will significantly increase the time and cost involved in getting a hotel management negotiation over the line both in the owner/operator negotiations and the owner/lender/operator discussions on the NDA. As the HMA is usually negotiated with the operator before the owner has finalised its funding, this approach will involve the owner entering into an absolute obligation to procure its secured financier to execute a NDA before it knows who its financier is going to be.
In the current financial climate with financiers imposing maximum limits on funding (e.g. US $50m per hotel), it may be necessary to arrange finance through a syndicate of banks with the necessary requirement to get agreement on all aspects of the NDA from every member of the syndicate.
This may result in the owner being unable to secure finance because no financier (or one or more proposed members of a financing syndicate) is prepared to accept the terms of the NDA. Also, we have seen the requirement to enter into the NDA resulting in more stringent loan terms (such as a lower loan to value ratio) as it may be perceived that the obligation to sell the hotel subject to the HMA would either reduce the number of potential purchasers or the price that would otherwise be achievable.
Of course, there are some banks who also insist on the operator entering into a NDA (which generally is aimed at giving the lender the right to cure any owner default under the HMA and contains more financier friendly terms than the pro forma NDA put forward by the operator).
The owner is often stuck in the middle trying to convince the financier and operator not to insist on a NDA.
Negotiating a NDA can be extremely involved as the operator and the financier can have diametrically opposed positions on a variety of issues (such as payment of back fees, tenure and the terms upon which the hotel can be sold and to whom). Advisory costs can quickly add up, and in addition to the cost of its own lawyers, the owner may be required to reimburse the financier and/or the operator for their respective legal costs.
Our preliminary suggestions
It is obvious that the best position from an owner's perspective is to have no NDA. Owners with strong bargaining positions will be seeking to adopt an operator selection process which gives maximum scope to achieve this result, normally with some form of "beauty parade". Operators who would prefer an exclusive dealing environment should give serious consideration to whether the requirement for a NDA is so important as to risk this valuable opportunity.
For us there is a fundamental distinction between a management agreement where the operator has no more than its fee stream at risk, and a situation where the operator has also contracted to provide financial inducements to the owner (such as refundable key money, loans and/or financial support for hotel income streams). In the former case, the operator is in substantially the same position as all other service providers and contractors. In the latter situation, the operator provides benefits to the owner which are more akin to the benefits provided by a financier or equity participant, and there are stronger arguments to justify the operator's requirement for enhanced security through a NDA.
If, for whatever reason, a NDA is required, consideration needs to be given to finding an equitable balance between the owner's and operator's interests. The following are examples of the approaches we have seen:
• The obligation on the owner to obtain a NDA from secured financier(s) is downgraded from an absolute obligation to a "reasonable efforts" obligation. This can be bolstered by provisions requiring the owner to use reasonable efforts to select a financier who is amenable to the concept of a NDA in the form proposed by the operator (provided that this does not have an adverse impact on the terms of the finance to be provided) and the owner must use reasonable efforts to allow the operator to engage with the proposed financier in an effort to convince the financier of the merits of the NDA. It would also be helpful for an obligation to be imposed on the operator to give reasonable consideration to arguments advanced by the financier as to why any provisions of the operator's pro-forma NDA should be amended or deleted.
• The obligation to obtain a NDA is only imposed if the proposed financier is not the holder of a banking licence issued by a government authority or is not an "institutional" lender. The rationale here is that a recognised bank lender would be expected to impose prudential requirements regarding the borrowing to weed out weaker projects or covenants, which minimises the prospect that the owner will default. This may be coupled by additional requirements in relation to specified loan covenants (e.g. the amount of the loan cannot exceed X% of the value of the hotel at the time that the loan is taken out).
• If the owner is not able to secure finance from a single financier on a commercially reasonable basis, and is required to obtain funding from a syndicate of two or more financiers, then this brings about a "softening" of the obligation to procure a NDA.
Merger and acquisition activity by operating companies: consolidation and brand sales
The issues
The major operators are focussing more than ever on enhancing their brands (there are no hotel brands in Interbrand's 2009 ranking of "Best Global Brands"), and leveraging maximum value from those brands. The Hilton Worldwide/Starwood dispute over alleged theft of confidential material clearly illustrates the depth of resourcing that goes into developing concepts and brands, and how valuable that material is.
At the operating level, getting the right brand on the right hotel is a critical issue for hotel owners and operators alike. This is usually determined by the nature of the relevant hotel and the market it operates in, both in terms of prospective guests and competing hotels.
Having secured the flag they want, hotel owners look to protect their asset, and many current HMAs contain provisions which restrict an operator from managing a competing hotel within a specified area surrounding the relevant hotel. The restriction may be absolute or apply to a specified brand or brands. It may remain in place for the duration of the HMA or expire at some earlier time.
From a commercial perspective, we have doubts about whether such a restriction is warranted or indeed in the best interests of the owner. Operators constantly tell us that, even if they were minded to do so (which we are assured they are not), it is not possible to engineer reservation systems to take business from one hotel and redirect it to another. They also point out that there are significant synergies and benefits from having a number of similarly/identically branded hotels in close proximity to each other.
Despite our reservations, the overwhelming majority of owners we speak to think that such provisions are necessary and must form part of the commercial arrangement with the proposed operator.
We expect that merger and acquisition activity amongst hotel operating companies will increase, and this may include takeovers of whole groups or individual brand sales. If we are right, this means that the operating companies will focus on non-competes at a strategic level, and that owners of existing hotels will be looking at their HMAs to assess their protection.
So what happens if the operator that has agreed to the restraint either acquires a competing operating company, or is acquired by a competing operating company where that competing operating company operates a hotel within the non-compete area?
Usually, HMAs provide that if such a transaction occurs the owner cannot take any action as a consequence of the transaction. Some HMAs are more sophisticated and provide that the operating company is prevented from rebranding the competing hotel to the brand used in relation to the hotel under consideration. So if an operator is using brand X for the relevant hotel and subsequently acquires a hotel operating company which operates a hotel in the non-compete area under brand Y, and brand Y and brand X are direct competitors, then the prohibition is only breached if a decision is made to rebrand the hotel from brand Y to brand X. For a particular destination, this may or may not be the best outcome for driving visitation, occupancy and profitability when the benefits of clustering are considered.
We can understand why operating companies seek to exclude this scenario from a standard non-compete area restriction as it would limit their options on any relevant M&A deal.
Our preliminary suggestions
The starting point in this discussion is to determine whether there is any truth to the view that a non-compete area is necessary to protect the business of the relevant hotel. As the practical ability to prioritise or redirect business from one hotel to another is an IT/operational question, we will leave it to industry participants with operational expertise to provide comment. One view from the owner side is that if the owner can get the operator to agree to a restraint, that right is valuable and could be traded with the operator at a later stage in return for some benefit to the owner.
However, if we presume that there is a justification for including a non-compete area, what suggestions can be put forward to address the issues that the conflicting positions of the owner and the operator throw up?
No major operating company would agree to a restriction in an HMA stopping it undertaking a merger or acquisition and they are likely to be equally robust on any proposed HMA term that would hinder, or negatively impact the value of any such deal. In our view, a more realistic position is to give the owner the option to terminate the HMA if an M&A deal was completed which adversely affected the business of the relevant hotel.
These are our preliminary thoughts.
• The owner could have the absolute right to terminate the HMA as a consequence of a breach of the non-compete provision (but with no right to damages - the assumption being that terminating the HMA is a sufficient remedy).
• The owner has a right to terminate if it can convince an independent dispute resolution party (e.g. an expert) that the operation of the hotel under brand Y/X within the non-compete area has an adverse impact on the operator's ability to profitably operate the owner's hotel under brand X.
• The owner does not have the ability to terminate but is entitled to claim for damages. Here the operator would have the option to pre-emptively terminate the HMA (and in those circumstances the owner would not have the ability to make a claim).
• The owner has the option to substantially reduce the term of the HMA (to say two years after the date that the operator takes control of the management of the competing hotel).
• Where a termination on sale provision is not otherwise available, such a right would come into operation from the date that the operator takes control of the competing hotel, possibly coupled with the payment of a termination fee to the operator.
• The owner has the option to convert the HMA to a franchise.
Restrictions on sale - termination on sale and acceptable purchasers
The issues
To promote hotel investment and ownership, it must be a common goal for owners and operators to make hotel real estate a relatively liquid asset. Owners who have successfully negotiated a termination on sale right into their HMA are able to sell their hotel with vacant possession in a relatively unfettered sale process where the hotel can be sold to the party that is prepared to pay the highest price.
As hotel real estate sales peaked in 2006 and 2007, that right (which is usually conditional on a termination payment being made to the operator) helped agents and owners drive some successful bidding processes, and deliver strong sale prices. However, operators are now far more reluctant to agree to a termination on sale right. A survey we conducted with Jones Lang LaSalle Hotels in late 2008 of 72 recently signed HMAs in the Asia Pacific region showed that termination on sale rights were included in 43% of the sampled HMAs, though that was down from levels revealed by similar surveys in 2001 and 2005.
If an owner is not able to negotiate a termination on sale right (meaning that the hotel can only be sold subject to the existing hotel management agreement), then its lawyer should highlight that the typical HMA contains a number of restrictions on sale that the owner should seek to improve. Those restrictions will cover sale of the hotel real estate (including by granting a lease) as well as a sale of the ownership interests in the owning entity (whether those are partnership interests, shares or units in a trust). This is one of the more complicated matters HMAs cover, but in our experience, most of the standard provisions on hotel sales and change of control of the owner in template HMAs are the result of years of tinkering and are far from clear.
Given the length of the usual HMA, and the core obligation of the owner under the HMA to maintain the hotel and provide working capital for the hotel business, it is not unreasonable for operators to want to put some restrictions on possible purchasers. However, clearly any provision which excludes a prospective buyer, and the competitive tension they can create, from the sale process is a concern for the owner.
Accordingly, any such restraints should not operate to hinder or frustrate a sale to a genuinely acceptable buyer, or to negatively impact the price the hotel might otherwise achieve.
Our preliminary suggestions
The key issue we think on hotel sale restrictions is the definition of a qualifying or acceptable new owner.
Providing they are tightly defined, the usual restrictions on persons of ill repute, or persons with whom a US company cannot deal under US law, are understood and accepted. More stringent requirements are made where the operator holds a gaming licence, and owners should consider how far-reaching those provisions are.
A more difficult concept in both drafting and practice is establishing whether a prospective new owner, to pick on some typical drafting, "has the financial capacity to perform the obligations of the Owner under this Agreement". This can be very subjective, and where value is being paid for the hotel, it is difficult to think of a benchmark beyond simply having the financial capacity to complete the hotel purchase. This restriction draws surprisingly little debate, and is in many cases deleted.
If a hotel is to be sold subject to the operator's continuing management, generally the owner is prevented from selling the hotel to a 'competitor' of the hotel operator. Following a decade of consolidation of ownership and institutional investment in hotel assets, this restriction on sale to a "competitor" is something we have focussed on.
It is now difficult to determine whether a particular company or person is a competitor. Many hotel investors now hold equity in hotel operators as well as owning hotel real estate assets. This includes, for example, Blackstone (which owns Hilton Hotels), Colony Capital (which owns Fairmont Raffles), and Kingdom Holdings (which has a significant interest in Four Seasons).
We have worked on a more prescriptive definition to capture a genuine competitor of an international operating company: an "international hotel operator". As a starting point for debate, that definition is:
International Hotel Operator means a person directly and principally engaged in the business of managing or operating, or engaging franchisees to manage or operate, branded hotels or other short term accommodation for third party hotel owners:
(a) [in at least two of the following regions: North America, Europe, Middle East, Asia]; and
(b) under one or more internationally recognised lodging brands,
but excluding (i) [a person principally engaged in the business of owning hotel real estate
assets], and (ii) [a person that controls less than [50]% of any such operator].
As an alternative to the second limb (and acknowledging the difficulty of defining an "internationally recognised brand"), one could look to capture the scale of genuine international hotel operators by having a number of rooms threshold ("with not less than 400,000 guest rooms under management").
A further alternative could be to use brand ownership as the identifier of a competitor: branded hotel operators own, or one of their controlled entities owns, the intellectual property rights to the relevant brand or brands.
Performance-based termination provisions
The issues
Whilst there is always some debate on any given HMA deal whether a performance test should be included, they are often requested by owners, and sometimes insisted upon by lenders. Like many other provisions in HMAs, performance tests cannot be viewed in isolation: they are rarely included where the operator is making some type of financial contribution or for new markets, and are not as strongly sought after where without cause termination rights (with payment of a termination fee) are included in the HMA. However (perhaps because operator contributions and without cause termination are so rarely given), the survey we conducted with Jones Lang LaSalle Hotels showed that performance tests were included in 75% of the sampled HMAs.
As we have previously commented in these
Newsletters, owners will find it very difficult to successfully enforce existing performance tests. In our view, owners should carefully consider whether to trade away other key commercial terms in order to have a performance test included in the management agreement.
There are a number of challenges inherent in the accepted performance tests, including the difficulty in obtaining data for comparable hotels (on RevPAR tests), the requirement that a hotel fails the test in X consecutive years (on tests linked to performance against budget), the application of force majeure carve-outs.
Operators would argue that the existing tests operate well by excluding the impact of external events the operator cannot influence (i.e. GFC, swine flu, poor CapEX investment), and that terminations of large branded operators under these clauses are rare because they ordinarily meet their performance hurdles.
Our preliminary suggestions
In our view, the key difficulty is settling upon what constitutes unacceptable operator performance. Against what benchmark should operators be judged? Some alternatives are:
• Market
• Occupancy
• ADR
• RevPAR
• GOP (either with an absolute number, or as a specified minimum percentage of Gross Revenue)
• Genuine accounting profit (including all owner costs)
• The performance of any hotels the operator owns and manages in the vicinity of the relevant hotel (if any)?
It is often accepted that an operator does not take market risk - only where the operator is performing at a level comparable to its peers, should it be regarded as underperforming. The RevPAR tests achieve that market comparison.
Perhaps operators should take market risk, especially in markets they understand well. Rather than a test against budget (which is difficult because budgets can be aggressive, aspirational, realistic or pessimistic), perhaps a test tied to agreed GOP thresholds or genuine accounting profit could be an improvement. Obviously setting those numbers in advance, especially for a long HMA, is difficult, but in our view, performance tests should apply to provide owners with a remedy where performance is at or approaching disaster, not just slightly down on what an alternative operator might be able to generate.
If a hotel project is subject to a financing structure that the operator has accepted as being sustainable, and the hotel fails to make an accounting profit, the project is clearly in very real trouble. In those circumstances, providing there are appropriate protections around CapEx (particularly for existing hotels) and tax or accounting measures which can manipulate profitability, perhaps the right thing to do is for the owner and the operator to part company.
We do think that any test period should not be too short: against the background of a long term HMA relationship, careful consideration should be given to what is an appropriate test period.
This is really a development of one of the existing models. An alternative that has some appeal to us is dispensing with the performance test, and instead focussing on the without cause termination right (with a termination payment to the operator) as a better way to give owners the flexibility and exit rights they want in circumstances where the hotel is not performing.
This has the benefits of simplicity, certainty, and flexibility to deal with poor performance (as the termination fee operators take is a multiple of recent management fees which will be adversely impacted if the hotel has performed poorly).
Clearly there will be some negotiation in setting the quantum or multiple of any termination payment, and operators would want any termination payment to reflect the ongoing revenue stream and other benefits the operator would sacrifice on termination.
We hope this Newsletter and our preliminary thoughts will give those attending the Master Class the opportunity to prepare for, and engage in, a lively debate.
We will publish a further Newsletter sharing and commenting on the discussions at the Hong Kong Master Class.
For further advice regarding this article, please contact Graeme Dickson graeme.dickson@bakernet.com or Robert Williams robert.williams@bakernet.com.
About Baker & McKenzie
Founded in 1949, Baker & McKenzie provides sophisticated advice and legal services to many of the world's most dynamic and successful organizations through more than 3,900 locally qualified lawyers and more than 5,800 professional staff in 67 offices and 39 countries. Baker & McKenzie is known for having a deep understanding of the language and culture of business, an uncompromising commitment to excellence, and world-class fluency in the way we think, work and behave. (
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