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by Douglas Wignall & Alex Mavridis

When searching for an operator to manage their hotels, owners frequently seek operators who are willing to offer some form of support to assist with the financial requirements of a project.  Support can come as a direct financial contribution, or indirectly in the expectation that this will encourage other investors and facilitate finance.  Some of the options available and their advantages and disadvantages are discussed below.

Owner’s Priority

Typically an operator will take a Base Fee (calculated as a percentage of revenue) and an Incentive Fee (calculated as a percentage of profit). Payment of the Incentive Fee can be subordinated to an owner’s priority to cover  fixed charges such as rates and taxes, or a set distribution.   Provision is usually made for the operator to be repaid the subordinated Incentive Fee in future years when there is sufficient profit available.  Such an arrangement can be in place for a set term or extend over the length of the contract.

Advantages

• Indicates operator commitment to forecast or expected returns
• It is a simple formula and relatively easy and quick to negotiate
• Provides a more stabilised return for the owner which can assist with meeting necessary financial requirements in the leaner years of operations

Disadvantages

• There is no guarantee that owner will receive the full amount of the owner’s priority as returns are still dependent on sufficient profits
• Claw back provisions can be in place which means any subordinated incentive fees have to be repaid
• It is not usually possible to negotiate subordinating the operator’s Base Fee

 

Key Money

Key money is a contribution by the operator towards the capital cost of the project. Typically key money does not become payable until the opening date of the hotel.

Advantages

• Indicates operator commitment
• It is also a simple formula and relatively easy and quick to negotiate
• Subject to certain qualifications (see below), key money is a contribution to capital cost, not a loan and therefore not re-payable

Disadvantages

• Does not, in itself, give the operator any incentive to achieve better results
• Typically operators look for a longer term contract to offset the cost of the Key Money
• Contributions are usually fairly moderate compared to the cost of the project but can be as high as £2,000,000 on major projects
• Operators can look to claim concessional taxation advantage on these contributions at the expense of the owner
• Contributions are usually repayable in the event of early termination of the HMA
• As funds are typically not forthcoming until the date of opening of the hotel, care needs to be taken if it is planned to be used to fund construction or pre-opening expenses

 

Equity Participation

Equity participation is not common although there are a few operators who are willing to invest in projects. Equity is either sliver equity (a small piece of the equity pool) or a co-investment. Sliver equity can be sought when projects have a small financial shortfall and are used for top-up purposes whilst co-investment decisions by operators are driven for prime global locations, roll out of new brands or other strategic investment decisions.

Advantages

• Shows a commitment on the part of the operator
• Operator has an interest in maximising profit and the return on investment

Disadvantages

• As the operator will be wearing two hats, conflicts of interest arise over matter such as operator performance, capital expenditure requirements, budget approvals and timing of adoption of brand standards
• Operators management agreement is usually tied to their equity stake so virtually impossible to remove them as operator
• The operator will have to be excluded from voting on operational matters in the shareholders’ agreement
• If the shareholding is split 50:50 there will always be the danger of deadlock and the owner will have to ensure that the shareholders agreement entitles the owner to a casting vote
• Equity participation will involve an additional tier in the structure – a shareholders’ agreement – which  inevitably increases the negotiation time and legal expense

 

Guarantees

There are some operators willing to give guarantees. The figure is typically related to a known debt repayment figure or a specific financial return to owner.

Advantages

• Indicates commitment on the part of operator
• Operator is incentivised to achieve results in excess of the amount guaranteed

Disadvantages

• Operator is likely to insist on higher management fees (NB could be offset if the operator guarantee allows owner to negotiate better terms with lenders/investors)
• Very rarely given
• The precise terms of any guarantee will involve considerable negotiation. Operator will want the guarantee to be limited in amount, time and circumstances, with the opportunity of clawing back amounts paid under the guarantee in future years

 

Conclusion
Whether it be a franchise or management agreement, operators look at their arrangements and assess the net returns to them over the life of the contract.  It is possible to obtain limited financial support from an operator but this is typically only available for “priority” projects for the operator and usually comes at a cost.  Owners need to assess and prioritise their needs in the arrangement prior to commencing negotiations with operators. Understanding what is important to both your side and the other party will help drive a faster and cleaner process enabling both sides to get closer to achieving their required deliverables.

Douglas Wignall – with his legal background – and Alex Mavridis – with an asset management focus – have between them negotiated and advised on numerous franchise and management agreements in five continents on behalf of owners and operators.   They are part of the team of Hotel Solutions Partnership that advise, assist and work with owners and operators to provide value added services to the hospitality industry.