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You are here: Home  January 2009  Financial News Negotiating better 3rd-party agreements

Negotiating better 3rd-party agreements

By Jim Hilton

In the past few years, Canadians have seen numerous instances of hotel owner-operators selling their brand of hotel to third party investors while retaining management of the hotel property. This activity reflects what is happening in several other countries around the world.

What is driving this shift? On the buy side, until recently, there have been large pools of capital (pension funds, hedge funds, private equity) seeking limited investment opportunities. On the sell side, owner-operators have been striving to improve their return on equity and to receive positive recognition by the stock markets. They have done so by focusing on the steady income stream available from long-term management contracts and by redeploying their capital previously tied up in the ownership of hotel properties.

To a hotel guest, these changes in ownership should be virtually invisible. The manager’s role is to operate the hotel efficiently for the benefit of the owner. A knowledgeable operator is essential to ensure that the hotel asset achieves its full income-earning potential. The key to the new relationship between the former owner/manager and the new owner is a properly drafted and sensibly negotiated hotel management agreement that contains a fair balance of duties, approvals, incentives and remedies creating an alignment of interests for the manager and the new owner.

Hotel management agreement

The key considerations in settling the form of hotel management agreement are as follows:

Fees: What is to be the basis for the manager’s fees? To protect the owner, it would be preferable that fees be based upon profits, not just revenues, as a revenue-based fee structure may not sufficiently encourage the control of management expenses.

Term: Generally speaking, the owner will usually prefer a shorter term, including several renewal options. This affords the owner greater flexibility in terminating the manager without having to prove cause or to pay liquidated damages. On the other hand, the manager will generally seek to have a longer term contract in order to recoup its start-up costs and to achieve a steady fee base to drive its return on equity, as described above.

Performance Tests: A “comparable set” of other hotels should be used as the measure in any performance test. The owner should be entitled to terminate the agreement if performance levels are not achieved during prescribed time periods. The manager may request a right to “make good” on profit shortfalls to avoid termination.

Radius: In order to eliminate conflicts of interest, the manager should not be entitled to operate another hotel (or at least another hotel under the same brand) within a specified radius from the owner’s hotel.

Approvals: The owner will wish to have approval rights over the manager’s annual plan, including the capital expenditures budget, repair and maintenance budget, marketing plan, staffing levels and salaries, and insurance coverage.

Property Improvement Plans: The manager will be eager to ensure that the owner reinvests sufficient capital in the upkeep of the property so as not to diminish the reputation of the brand owned by the operator.

Financing: Hotel lenders generally look favourably upon hotels that are branded and managed by a reputable operator. There will be several points of discussion between the lender and the manager, including:

o    restrictions on material amendments to the hotel management agreement without the lender’s approval

o    agreement by the manager to continue to perform under the hotel management agreement if the lender enforces its security and takes control of the hotel

o    the lender will wish to have approvals over the furnishings, fixtures and equipment  budget and the capital budget

o    the manager will seek priority for the payment of hotel management fees over debt service payments on the loan

o    agreement of the manager to a buy-out of the hotel management agreement if, following enforcement by the lender, the lender has sold the hotel to a buyer who does not wish to assume the hotel management agreement.

Transfers: The owner and the manager often have conflicting aims with respect to transfers of the hotel property. The owner may seek the ability to freely transfer the management agreement as part of any sale of the hotel. On the other hand, a management agreement that cannot be terminated upon sale will likely inhibit the liquidity of the hotel. For its part, the manager will usually wish to retain its management role following a transfer so as to continue to enjoy the benefits of its long-term contract and stable income stream. However, the manager may wish to have an option to terminate the agreement if the new owner is a competitor of the manager or if the manager is not satisfied with the new owner’s reputation. The manager may also be concerned about the possible negative impact of a new owner’s status and reputation on the manager’s gaming licences or liquor licences.

One solution, from the owner’s perspective, is to include a buy-out (liquidated damages) clause in the hotel management agreement. The quantum of the buy-out is often determined as a specified percentage of the anticipated fees that the manager would have earned over the balance of the term, based on the fees earned during the most recent 12- or 24-month period.

Dispute Resolution: Some dispute resolution method, such as mediation or arbitration, is essential in order to avoid resort to the courts.

Jim Hilton, partner, Blake, Cassels & Graydon LLP is one of Canada’s leading commercial real estate counsel with over 30 years experience and has extensive expertise in advising domestic and international investors, lenders and developers on the acquisition, development, financing and disposition of office, retail, hotel and industrial properties. Blake, Cassels & Graydon LLP is one of Canada’s leading business law firms.

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