M &A activity in the hotel sector is on the rise. The consolidation continues with this week's news that Prince Hotels, a subsidiary of Japan’s Seibu Holdings, is acquiring the Australia-based StayWell Hospitality Group, delivering 18 existing hotels under management and a further 12 under development. Congratulations to the StayWell team and to Seibu/Prince. Not a simple transaction - the properties are in 21 cities across seven countries. TTG Asia has covered the deal here:

The due diligence that needs to be worked through before these transactions proceed is often confronting, both in terms of scale and cost. A prospective buyer will need to conduct commercial, legal, financial, tax and technical/ physical diligence, aside from any corporate/ M&A advice or competition/ antitrust analysis that might be running in parallel, particularly on a public to private/ takeover deal. 

That is a lot to get through, and in a competitive environment, being efficient and targeted with your efforts is critical.

Hotel & hospitality specialists

Our team of corporate, commercial and real estate lawyers focusses solely on the hotel and hospitality sector in the Asia Pacific region. This gives us a unique and deep understanding of these transactions and the assets underlying them: hotel leases, management agreements, franchise agreements and management rights/ condo structures.  Those instruments, together with a management team, collectively determine the earnings capability and downside exposure of any platform.

We have diligenced a number of hotel operating businesses for clients in the past, including spending 3 months in a deep review of what is now a complicated publicly traded US$700m platform.  We know what to look for and to focus our time on, and wanted to share some of our observations and learnings. 

Identifying key value drivers

Acquisition pricing will be driven largely by group-wide earnings, but of course some properties will generate a better fee income than others. In a time-constrained diligence process, identify the most profitable properties in the estate, and prioritise those. Overlaying an analysis on remaining tenure will then highlight the segment of the estate that will drive overall business performance in the short and medium-term.

That work will also inform the approach to deal conditionality, where landlord or owner consents are required in connection with the change of control. Those may arise both on the target side, and with the buyer's estate where target hotels fall within an existing area of protection/ exclusivity.

On some branded management businesses, substantial value is driven (or lost) not only at the property level, but also through the distribution and loyalty systems. As hotel managers and owners alike focus on distribution costs and net guest stay revenue like never before, this should be a key area of attention.

Hotel Management Agreements

Particularly where target groups have been in a growth phase, their development teams will have been under pressure to grow inventory. In competitive markets, they will have needed to offer enticements such as key money, soft loans, income guarantees/ underwrites, fee stand-asides and brand exclusivity. Some of these arrangements are designed with specific accounting treatments in mind. Even on individual hotel deals, we have seen the true nature of structures like these being misunderstood. On a portfolio acquisition, the risk of failing to properly characterise these arrangements could be material.

Deals with these features, which will probably comprise operating hotels and pipeline projects, should be assessed to determine and map their real commercial and financial impact, including the capital they may tie up.

Hotel Operating Leases

Whilst not common structures in Asia Pacific, some management groups are tenants under operating leases as a legacy from a particular transaction or relationship, and more recently where a lease commitment has been the price of securing a key property.

A buyer will need to quickly understand tenure, the capacity for rent to increase (upcoming rent reviews), capital expenditure obligations (including compliance with historical ones to identify any overhang) and end of lease/ exit obligations. Also under these structures, the target will own the business of the leased hotels, so will be the employer of staff, will need to provide working capital and, for example, will own the operating supplies and equipment, and perhaps some FF&E. 

Together, these obligations will be material, and can take some time to digest by a management team or acquirer that is used to dealing with hotel management contract structures.

As a more structural issue, operating leases with base rent commitments are not the ideal instrument for listed/ publicly traded hotel operators. They give rise to contingent liabilities on balance sheets which drag on the value of stock/ shares. So if the buyer is a listed platform, and the target has a significant leased estate, as part of the transaction or as a swift follow-on, a third party may need to be brought to take on the lease liability and grant management contracts back to the operator. 

Pipeline deals

You will pay for them, but today they only exist on paper. In the absence of aggravating circumstances, global operators do not often enforce contractual obligations to build and open hotels where developers cannot get their projects to stack up. So are these deals real, likely, contingent, approved, funded? Is the sponsor/developer reliable? Local know-how, contacts and connections will be invaluable in making a fully informed assessment. 
Overlapping with the points made above in relation to HMAs, a buyer will also want to understand the economics - are these pipeline deals accretive?

Assumptions and synergies

Challenge any key assumptions you have made. As an example, we looked at a platform that had a strong management rights/ condo component, where individual apartment owners could opt out of the management arrangement on 90 day's notice, without penalty. That knowledge would lead most buyers to factor in some heavy potential attrition across that inventory, particularly where a deal involves a branding change. 

But historical data on those apartment owners showed that the attrition rates over time were in fact very low and so tenure had been very solid in practice.  That platform did go on to transact, albeit without a branding change, and our understanding is that the management rights segment of the business has held up very well. 

In today's environment, on a deal involving a management rights / condo component, a buyer might want to consider the impact of AirBnB on growth potential in that segment as well as owner retention.

And those synergies? Test them. Are they really there to unlock? Particularly for a trade buyer, they look obvious and enticing, but are often not fully exploited or exploitable post-acquisition. 

That's enough for now!

We hope this paper has been of interest. 

The points we have highlighted are largely transaction management and commercial matters, rather than purely legal ones, but we hope these emphasise the importance of combining sophisticated and industry-savvy legal review with the financial and business analysis.

Please reach out to me, or one of my partners in the region, David Mallinson ([email protected]), Justin Gross ([email protected]) or Lada Shelkovnikova ([email protected]), if you would like to discuss how we can help on your transaction.