Over the last few months, we have witnessed a significant uptick in activity in relation to management agreement negotiations both in Australia and elsewhere.
New developments have attracted significant activity. Almost invariably, a number of potential operators are approached and invited to submit proposals for each opportunity.
Interestingly, we have also been asked to advise owners in relation to a significant number of situations where the existing management agreement is reaching its end and the owner has opted to put the management opportunity out to tender rather than roll over the management agreement with the incumbent operator.
As a consequence, we have been given a rare opportunity in the current market to witness first hand a wide variety of the types of contract strategies which are currently in vogue (and those which are not) particularly where the opportunity is to manage a "trophy" hotel or resort.
Operator selection landscape
The period since the onset of the GFC has been challenging for the hotel industry and particularly in the five star space.
When a management agreement is coming to the end of its term, or a new development arises, many owners are opting to put the management opportunity out to tender rather than going with either the incumbent or a single proposed operator. The owner usually engages a skilled and experienced commercial negotiator as well as ourselves to guide him or her through the operator selection process.
What follows is a snapshot of the more compelling aspects of contemporary contract negotiations.
Current management agreement negotiations - the focus
We are seeing an increasing trend for owners and operators to settle a potential contract negotiation impasse by the use of one or more trade-offs.
A classic example is where the owner wants the ability to be able to sell the hotel with vacant possession during the term of the management agreement, but the operator is resisting this right. If this impasse is not overcome, then there is a risk that the parties will be unable to strike a deal. In such circumstances, the owner and its advisers should consider the commercial terms as currently negotiated to determine whether there are any provisions which impose obligations on the operator that can be traded off in return for the benefit that the owner is seeking.
A relatively common trade-off is the removal of some form of operator non compete provision.
In the absence of a trade-off, the management agreement would provide that if the hotel is sold, then the management agreement must be novated to the buyer of the hotel. The agreement would also provide that during the term, the operator is restricted in some fashion from operating a competing hotel within a specified radius of the subject hotel.
The trade-off comes about where the parties agree that, at some point in the term, an automatic provision clicks in or the owner is granted the right to elect to sell the hotel with vacant possession (generally subject to the payment of an agreed termination payment). In return, the operator's non-compete restriction is removed or relaxed in some fashion.
Such trade-offs provide benefit to both the owner and the operator.
Other examples of trade-offs are:
the granting of an operator right of first refusal to acquire the hotel in return for the relaxing of terms, which the operator imposes on the type of person that can acquire the hotel;
the relaxing or removing of a performance based termination provision in return for the introduction of a without cause termination provision;
the owner agreeing to give the operator a first right of refusal to acquire the hotel in return for the operator agreeing to relax the requirements of any non disturbance arrangements such that if the owner's financier comes into possession of the hotel any restrictions on who can acquire the hotel cease to apply; and
the concept of a "manchise" where the relationship between the owner and the operator starts out as a conventional management agreement with the owner having an election to transform the relationship to one akin to a franchise subject to the payment of a specified fee or the provision of some other benefit to the operator.
It will be evident that the scope for trade-offs is only limited by the intellectual dexterity of the parties and their advisers. Importantly, a willingness to explore such trade-offs can be a critical ingredient in making a deal stack up.
2. Fee arrangements
We are witnessing a progressive shift to a fee configuration which is placing downward pressure on base fees (i.e. usually calculated by reference to hotel revenue) with a corresponding upward movement on incentive fees (i.e. usually calculated by reference to hotel profitability).
The reason for this is obvious as it seeks to align the financial fortunes of the owner and the operator.
Furthermore, there is increasing consideration being given to sophisticated tiered incentive fee models, which seek to reward the operator more generously the greater actual hotel profit exceeds budget.
There are negotiations which have explored fee arrangements that take into consideration the potential sale of the hotel. This is a development which is potentially beneficial to both parties but, to date, is usually dismissed as too difficult to reach agreement on.
Operator fee arrangement models are constantly being augmented. Common developments are occurring in relation to branded residences, which are aligned to the hotel in some fashion; in relation to use of the hotel by members of a timeshare scheme which is also operated by the operator of one of its affiliates; and the constant tweaking of financial outcomes relating to purchasing rebates and associated benefits.
3. Operator financial contributions
It will come as no surprise that if an owner wants an operator to make some financial contribution, then this needs to be raised by the owner at the outset of negotiations.
Since the onset of the GFC, operators have increasingly resisted any obligations which impose a requirement to provide any form of financial contribution.
Notwithstanding this tendency, if a management opportunity is highly prized, operators will consider a variety of financial contributions if it assists in securing the opportunity.
Even in such circumstances, the operator will be at pains to structure the contribution to be in the form of a loan rather than a payment. Thus, income guarantee provisions (which allow the operator to claw back guarantee payments if profitability subsequently exceeds pre-agreed thresholds) are favoured by operators to payments in the nature of key money or equity contributions or provisions which provide for non payment or forfeiture of management fees if pre-agreed profitability thresholds have not been met.
4. Operator refusal rights
There was a time when it was virtually a standard requirement of many operators for the management agreement to contain a provision to the effect that on sale of the hotel the operator was afforded some advantage or priority to purchase the hotel. These provisions fell out of vogue for some time, but it is now becoming increasingly common for operators to require such a provision.
In our view, if an owner is minded to provide the operator with some form of a refusal right then this should be a benefit which attracts some form of consideration - either in the form of a cash payment or some concession in relation to some other aspect of the management agreement.
Importantly, the refusal right should not be so comprehensive as to have a real negative impact on the potential saleability of the hotel to third parties should the operator decline to exercise such rights.
We have been asked to advise on poorly drafted refusal right provisions which have introduced an unhealthy level of uncertainty and potentially significant owner cost in relation to the hotel sale process.
5. Performance based termination
These provisions continue to constitute a heated battleground between owners and operators particularly in circumstances where the owner or its consultants have had previous experience of the shortcomings of most (if not all) of the standard performance clause formulations currently in use.
Whilst we spend considerable time in negotiations seeking to tighten up commonly used performance based termination clauses, there is a lot of support for the view that if a without cause termination provision can be obtained, but only at the cost of the removal of a performance based clause, then this course should be considered (even if the termination fee that would be payable if the clause is activated would be substantial).
6. Without cause termination
As with operator financial contributions, a request by an owner for without cause termination rights is usually met with strong resistance from most (if not all) major operators.
This is a very significant issue for most operators as they do not wish to face the possibility of being removed from a hotel before the expiration of the term of a management agreement. This is the case even if the termination fee is an approximation of the management fee stream over the balance of the term of the management agreement.
From an owner's perspective, this is also a major issue particularly taking into consideration the shortcomings noted above in relation to performance based termination provisions.
Whilst without cause termination at any time is still comparatively rare, increasingly operators are prepared to consider termination on sale whether it be from the outset of the management agreement or, more commonly, after a period of years has elapsed.
If the operator expresses a willingness to agree to a without cause termination provision in any form, it usually comes as part of a package consisting of significant trade off benefits to the operator.
This can be one of the most important rights that an owner can have. In order to maximise the likelihood that it will be obtained, consideration should be given to making it one of the first topics of discussion with a potential operator and ideally as part of a highly competitive operator selection process.
In circumstances where the operator agrees to a termination without cause provision, which can be exercised on sale, there is also a desire on the operator's part to include in the termination fee payment calculation a percentage of the hotel sale proceeds. However, these discussions are generally challenging as it remains difficult to measure the true value of the operator's contribution.
There was a concern following the onset of the GFC that negotiation of non-disturbance provisions in management agreements, and the consequent negotiation of non-disturbance agreements with secured financiers, would become a very ugly aspect of negotiations.
The good news is that this has not eventuated. In fact, in our experience, such negotiations have been conducted relatively smoothly. The concern that the operator and the financier would adopt diametrically opposed positions has not eventuated. In fact, if anything negotiations in this respect over recent times have been reasonable and measured.
That said, the inherent conflicting positions of the operator and the financier with respect to the whole topic of non-disturbance always needs to be front of mind and dealt with proactively.
8. Owner assignment rights
Those provisions that impose restrictions on an owner's unfettered right to sell the hotel remain vexed, and hold the prospect of becoming an increasingly significant impediment to satisfactory contract negotiations.
There is usually a list of qualifications as to who can acquire the hotel. For practical purposes, the most onerous of these requirements prohibits the owner from selling the hotel to a competitor of the operator or an entity that controls or holds a significant financial interest in such a competitor. Usually, a prohibition regarding sale to a competitor is not a significant practical issue, but the prohibition regarding sale to an entity that has a financial interest in a competitor can create issues and, in a number of negotiations we are aware of, has held the potential to be or has actually been a deal breaker issue.
This is an issue that needs to be addressed at the earliest opportunity, which is sometimes difficult because it generally does not surface at the time that the commercial terms of the deal are being negotiated. In our experience, the issue can generally be negotiated through the use of trade-offs. It is particularly important that the language of the relevant clause be considered carefully to ensure that it is not unduly broad or vague.
As a general observation, standard operator template documentation is tending to be more operator friendly, complex and lengthy. This is becoming an increasingly significant issue in relation to operator selection.
There is some evidence that start-up management companies are giving serious consideration to adopting simplified documentation in an effort to enhance market competitiveness.
Traditionally, there has been far greater interest in franchising from owners than operators.
We are witnessing a significant increase in operator enthusiasm to embrace franchising (particularly in Australia) as opposed to the traditional management arrangement model. It is too early to tell whether this enthusiasm for franchising will extend to other parts of Asia.
Franchises can provide significant benefits to both owners and operators particularly in mature hotel markets, where the opportunity for operators to grow through management agreements has become increasingly difficult.
Summary and conclusion
In summary, our key observations relating to the current hotel management negotiation landscape are as follows.
There is evidence that owners are imposing pressure on operators to provide greater deal flexibility and are increasingly using competitive tenders as a means to achieve this. As a consequence, the bargaining pendulum would appear to be shifting in the owner's favour.
Trade-off provisions are becoming increasingly common as a means to deal with the conflicting objectives of owners and operators.
In Australia franchising, at least as a discussion topic, is becoming more common place. This suggests that franchising may become more widespread and common throughout Asia.
We have covered a lot of territory in this newsletter. In prior newsletters, we have discussed a number of the topics covered in this newsletter in greater detail. Please contact us if you would like us to send any relevant back editions of the newsletter.