25 August 2014
Lately, it seems like everyone wants to buy — or sell — an independent hotel management company. And this may be one of the best times to do so in a long while. Here are some thoughts on this timely subject by two of our hotel lawyers who have just completed a successful sale of an independent operator.
Why this may be the time to buy or sell a hotel management company
A hot trend and five key issues
Guy Maisnik and Joyce Men | Hotel Lawyers
One of the hottest trends right now is buying (or selling) independent hotel management companies. The demand is coming from all directions – existing management companies, investment funds and foreign buyers. Existing management companies are scrambling for market share, economies of scale and strategic markets. Investment funds are looking for the direct control over their hotel investments through a captive management company as well as attractive economic returns that a great independent operator can achieve with limited capital investment and risk compared to hotel investment. And foreign owners share many of these goals, and see the acquisition of a hotel management company as a solid way of entering into the hotel market in the United States.
From the potential seller’s standpoint, the timing may be optimal for a sale at this point in the cycle. A management company’ sale price is typically negotiated as a multiple of earnings. Traditionally, this multiple is four to six times earnings before interest and taxes, after making adjustments for expenses that would not continue to the buyer, and deducting from the price any interest-bearing debt that the buyer assumes. However, in this market, hotel management companies with a proven track record of performance, and a high quality (sustainable) earnings stream can command a price well in excess of six times earnings before interest and taxes with multiple suitors. The demand is there, but the process is complex.
And here are five key issues or questions you should consider before buying or selling a hotel management company.
1. How is Buying a Hotel Management Company Different? Regardless of whether you are buying or selling a hotel management company, there are a number of issues to consider. In many ways, buying and selling a hotel management company is not much different from buying and selling any other operating business. But it is uniquely shaped by the norms, customs and practices of the hotel industry, and its unique web of agreements, arrangements and operations. A number of these considerations create special issues discussed below that are absent from the purchase and sale of any other type of business. These include the common arrangements involved in hotel franchise agreements, hotel management contracts, ownership structure of hotel ownership entities, licenses and permits (including liquor license) that must be transferred or applied for, and assignments of other warranties, service contracts and agreements for use of amenities which may have been entered into by the independent management company on behalf of the owner.
2. Is the Buyer Financial or Strategic? A typical financial buyer will often want to use debt financing for 50% to 75% of the price, and will want sufficient cash flow to service that debt. Given the higher multiples for which hotel management companies are selling, the financial buyer will likely be more cautious in analyzing the company cash flow than the strategic buyer. The challenge with selling to a financial buyer is the lack of synergies, such as complimentary back-end systems, insurance, accounting and sales. However, a financial buyer may be more willing initially to ignore certain organizational weaknesses. Often, existing management is left in place with cost-cutting to improve value. A financial buyer typically purchases with a view to sell. A strategic buyer, on the other hand, presents different issues. Strategic buyers will often pay a premium for the business, particularly if competition is significant. The downside, though, is that strategic buyers will be more likely to scrutinize existing management at the company level (rather than at the hotel level), and will be less likely to keep senior officers and back-end services employees after closing. These positions are redundant with employees already in place with the buyer.
3. What is Actually Being Sold? Stock or assets of the hotel management company? In selling any business, one can either sell the assets or sell the stock in the target company. The liabilities and tax consequences are quite different for each. Sellers usually like to sell the stock of their company for a host of reasons. With a stock sale, Sellers will typically save taxes, and will be able to leave any existing liabilities with the company. On the other hand, buyers prefer to purchase assets for the opposite reasons — to get a higher tax basis and avoid unknown liabilities of the selling entity. Also, sellers have to be careful of IRC Code Section 751 (sale of hot assets) that can cause the price to be deemed attributable to the sale of ordinary versus capital assets. Either way, a careful analysis of the tax consequences and liabilities should be made before a decision is made to sell stock or assets, and how the purchase price is structured.
4. How Does Senior Management Drive Higher Values? Most hotel management companies will engage an investment banker to market the company. After performing their own due diligence, the investment banker will prepare an offering memorandum or “book” to describe the company and make a compelling story. Regardless of the investment banker’s talents, it is senior management that drives the company value. No one will have the passion to tell the company’s story better (including its future prospects and business plan) than the company’s leaders. The business plan can help sell the company at the higher value. And it can either indicate the value of retaining current management to implement the business plan, or demonstrate that the company can run well by a buyer independent of senior management.
5. What About Those Not Parties to the Transaction?
The Hotel Owner. One of the factors to consider when deciding whether to sell (or buy) the assets or stock of a hotel management company will depend in part on the assignability of the hotel management agreements. If the hotel management agreements are not assignable without owner consent, it may make take a significant amount of time and effort to secure each owner’s consent. Even if hotel owner consent is not required, the management contract may be terminable by the hotel owner upon such a major change in control. And, the Owner’s cooperation and approval may be required to facilitate the delivery of back-end enterprise systems, revenue management and the cost of operations, and to secure the stability of hotel employees. Hotel owners may have approval over operating budgets, CapEx budgets and marketing plans. This can be a lot of work, and the parties need to have a plan in place before approaching the hotel owner. Hotel owners will appreciate improved value – and the buyer and seller will need to sell the hotel owners on the benefits of the transaction to the owner. Hotel owners will not take well to a reduction in quality or an increase in management expenses. Sometimes, even a change in the form of reporting can be an issue. In other cases, hotel owners may extract a fee or other financial concessions, require protections or guarantees against perceived risks, or even modification of the hotel management agreement. Expect that there will be some hotel owner holdouts. If there are too many, naturally the deal will crater. The parties should anticipate them and address how this can impact the sale and the pricing.
The Lender. The hotel owner’s lender will be quite interested in who is managing its hotel collateral. In most loan documents, the lender will have approval rights over who is managing the hotel. Many lenders have direct subordination agreements with the hotel manager, and those agreements need to be understood to determine the rights of the parties in the transaction. There may also be cash management banks, deposit account control agreements and CMBS lender requirements that also have to be worked through. While not insurmountable, the parties should be prepared to dig into the loan documents of each hotel and determine what needs to be accomplished. Sometimes a task as simple as obtaining those documents can become a challenge, particularly if the hotel owner is not cooperative or well organized. However, the more the buyer can take on the heavy lifting of obtaining the lender consents, the smoother the transaction will be. Key advice? Best to have analyzed all applicable loan documents up front, so this process does not become a drag on the transaction.
The Franchisor. If the hotel is branded under a franchise arrangement (as most independently operated hotels are), the brand franchisor will likely also need to approve the new buyer. This is certainly the case with the traditional brands, such as Marriott, Hilton, IHG, Starwood, Hyatt, Wyndham and the like. In many cases, the new buyer will need to be on a list of pre-approved hotel managers. If the buyer is not on the franchisor’s approved list, the process of getting such approval can become much more difficult and could delay the transaction.
The Employees. Confidentiality is important in the sale of any company as the loss of employees can impact the company and the sale. At the letter of intent stage, it should be fairly simple to keep matters confidential (it is also easy to slip up, so it’s a good idea to plan for leaks). However, it is unrealistic to believe that the potential sale can be kept from employees for long — whether at the property level or at the company corporate headquarters. As the transaction proceeds, more employees will become involved and word will get out. Once that happens, the seller will need to provide certain assurances to employees about the process that will likely provide virtually all of them with a good future and opportunity. The toughest time for the seller will be the 4 to 12 weeks of the buyer’s due diligence until the buyer becomes finally obligated to complete purchase. Deals can fall apart, and the seller needs to be prepared to address employee issues at critical stages of the transaction.
Licenses and permits. Depending upon the laws if each state where a hotel is located, and the contractual arrangements between the hotel manager and the hotel owner, a number of operating permits and licenses will need to be transferred to the buyer. Key will be the liquor licenses used by a hotel for its bar, restaurant and rooms, and transferring liquor licenses is a process in and of itself and needs to be treated as such. The transferring of liquor licenses or the right to serve alcohol will require state approval. Often, a separate agreement and escrow has to be arranged. Some states will permit a temporary transfer of the liquor licenses, so that the buyer can operate off the seller’s liquor licenses. This will also typically involve the negotiation of an interim license agreement between the buyer and seller. It may also require the hotel owner’s and its lender’s cooperation in the process. In some states, the liquor licenses can be encumbered, and separate lender approval for the transfer will need to be obtained. Parties should focus on the liquor license early in the transaction process to avoid potentially delaying the closing.
Run with a Plan to Sell. Management companies with a goal to sell in the future should keep in mind that running the company as if it will be marketed and sold one day in the near future will improve the likelihood of a sale and increase the value of the company. Regardless of whether a seller intends to sell or not, the management company should be run as if it will be sold, but selling owners should be doing everything they can to prepare the business for an eventual sale. This means getting all operations in order in a manner consistent with the highest professional standards, such as clear, complete and consistent (and preferably audited) financial statements, budgets, books and records, contracts and other corporate governance documents. Selling owners must be prepared to provide assurances and evidence to the buyer of the solidity of the revenue stream, whether such assurances come in the form of escrowed holdbacks or earnouts. Audited financials, which for a growing company might seem like an unnecessary expense, could improve the management company’s sale prospects. The more complete, accurate and cleaner the records, the higher the value and quicker the close.
Expect Complex Issues to Arise. The sale of hotel management companies tend to be more “dynamic” than the sale of other businesses. Independent hotel management companies manage the hotel assets of third party owners, whereby the hotels can be encumbered by third party loans, and operated under the auspices of third party franchise and engagement in heavily licensed activities. As a result, all of these stakeholders will have approval rights at some level in the process, and these stakeholders have to have confidence in the transaction. In addition, with employees at both the company headquarters, many of whom will ultimately be terminated, and at the hotel asset level, most of whom will not be terminated, the selling owners have to navigate a number of hotel employment concerns critical to the successful operation of the hotel assets.
Sellers and buyers of hotel management companies would do themselves a valuable benefit engaging knowledgeable tax and hotel experts with experience with addressing and resolving the key issues and challenges in buying and selling hotel management companies. Having the right expertise at hand will increase company value and make the transaction a smoother process with fewer consequences to all parties involved.
Guy Maisnik is the Vice Chair of JMBM’s Global Hospitality Group®, a senior member of JMBM’s Chinese Investment Group™ and a partner in JMBM’s Real Estate Department. With three decades of complex commercial real estate and finance experience, he advises clients on hotel transactions including buying and selling hotels, senior and mezzanine financing, joint ventures, equity and debt participations, workout and debt restructure, management agreements, design and construction. Contact him at MGM@jmbm.com or 310.201.3588.
This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We’ve done more than $68 billion of hotel transactions and have developed innovative solutions to unlock value from hotels. Who’s your hotel lawyer?