DUE DILIGENCE IN SELECTION OF HOTEL

OPERATORS

January 2017 Introduction

The appointment by a hotel owner (“Owner”) of a hotel operator (“Operator”)

to manage a hotel is one of the most important decisions that an Owner can
make in relation to his or her hotel investment.

Selection of the Operator impacts many aspects of the Owner’s hotel

investment not the least of which are:

ƒ The marketing of the hotel;

ƒ The nature and type of guests attracted to the hotel;

ƒ The room rates and occupancy achieved in the hotel;

ƒ The revenue of the hotel;

ƒ The profitability of the hotel;

ƒ The investment return to the Owner on the hotel; and

ƒ The financial sustainability of the hotel.

Most importantly, because of these impacts, the Operator’s appointment also

materially influences the value of the hotel. . This is because usually the value of
a hotel is a function of its present and expected future profitability.

It is therefore essential that Owner’s do proper due diligence on the Operator

before the Operator is appointed in order to inform the Owner’s appointment
decision so that the Owner understands the implications and consequences of
the appointment of this particular Operator for this particular hotel and the
other options then available to the Owner.

Owner Hotel Objectives & Plan

Hotels are high risk investments because hotel cash flows are subject to adverse
impacts from a wide variety of factors outside of the control of the Owner.

Owners need to have absolute clarity around their financial objectives and plans
for the hotel project including:

ƒ Total project cost;

ƒ A sound financing plan – leverage, equity and debt;

ƒ Minimum return requirements for funding; and

ƒ Equity return requirements.

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Owners need clarity around these issues because they are the basis for
assessing a range of factors which arise in the diligence process including
whether this hotel and this brand will generate sufficient profit and returns to
meet equity return and debt service/repayment requirements.

The Operator and Owner need to develop financial objectives and plans on a
conservative basis to reflect those risks.

High leverage in a high interest rate environment like India will only lead to
stress, distress or worse at some point in the ownership of a hotel.

The Owner’s holding strategy should also be clear – is it short, medium or long
term. Short and medium strategies are difficult because market conditions can
change quickly and being forced to sell at the wrong time will produce a bad
outcome.

Being very clear about the standard of hotel that the Owner wishes to develop
is also of critical importance. This is an economic decision not an emotional one
for example:

ƒ An Owner may want to build a luxury hotel on his site but the location of
the hotel and the market for that location may simply not support that
standard of hotel because the room rates and income that will be achieved
will not produce any sensible return on the capital cost required to produce
a hotel of that standard.

ƒ The cost or value of the hotel site may be too high for the standard of hotel
that the Owner wishes to develop. For example, a very well located piece
of land which could be developed for retail or office use may be just too
valuable for a budget hotel. These are difficult issues and need to be dealt
with dispassionately based on economic fundamentals and a good
understanding of the relevant hotel market and the potential of the
proposed hotel in that market.

Understanding What Owners Do Not Know – Due Diligence

The interests of Owners and Operators are not aligned in a hotel management
appointment,

In the appointment of an Operator:

ƒ The Owner is in effect seeking the best performance that his hotel asset can
achieve; and

ƒ The focus of an Operator is to extend its brand reach and network and to
generate income in the form of fees and expense recoveries.

The financial risk and consequences of under performance or failure of the hotel
are more severe for Owners for obvious reasons whereas an underperforming
hotel typically means that the Operator earns less fees than it otherwise would.

So how does an Owner evaluate a proposal from an Operator to manage and

operate a hotel?

The negotiating balance between the parties in these deals is heavily skewed in
favor of the Operator.

First the Operator usually has much greater knowledge and understanding of
present and expected future market conditions and the position of the hotel

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within a particular market than the Owner so the Operator has an information
advantage.

Secondly the Operator’s representatives will have negotiated tens or even

hundreds of these deals before and there is therefore an experience advantage
over the Owner. Indian Owners rarely have the internal resources to compete
effectively with Operators in this regard.

The Owners preliminary analysis of the project needs to extend to and include:

ƒ Area analysis – local and regional;

ƒ Site Analysis;

ƒ Market Analysis;

ƒ Operating Financial Analysis including detailed financial forecasts;

ƒ Investment Financial Analysis including ROI, ROE and financing

requirements;

ƒ Completion Valuation Analysis.

This information is essential to inform essential decisions to be taken by the

Owner in testing its own financial objectives and in selecting an Operator.
Owners need a sound objective base or benchmark on which to base their
decisions.

As a starting point, an Owner needs to conduct its own independent financial

feasibility study for the proposed hotel project. In this feasibility study the
external consultant will research, investigate and report in detail on:

ƒ Specific market demand and supply dynamics, both existing and

prospective, for the type of hotel proposed;

ƒ The appropriateness of the site;

ƒ The appropriateness of the proposed hotel standard and design;

ƒ The standard and scope of facilities in the hotel; and

ƒ Likely cash flows, revenues and profits from the proposed hotel.

The feasibility study also helps to bridge the information gap between the
Owner and the Operator with respect to the future operating performance of
the hotel. It provides the Owner with baseline information to evaluate Operator
proposals. This addresses one of the negotiation balance weaknesses of Owners
referred to earlier.

For some reason Indian Owners are reluctant to engage expert consultants for
independent feasibility studies. Cost concerns, which are often cited, are really
false economy. There is no point in saving money on feasibility costs at the risk
of not having a reasonable understanding of the project or its prospects of
success or failure.

Operator Selection Process

Fundamentally there are two different approaches to operator selection namely

either:

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ƒ a bilateral negotiation with one specific Operator; or

ƒ a competitive bidding process involving multiple Operators.

Often Indian Owners engage in bilateral negotiations with an Operator without

really canvassing the Operator market or understanding what is on offer from
other Operators in the market. Also, there is no competitive tension in bilateral
negotiations and this impacts not only the negotiation timing but more
importantly the terms as Owners do not have any leverage other than to walk
away.

The alternative is to conduct a time bound process where multiple operators

are invited to submit proposals for operation and management. The Owner
receives and evaluates those proposals and then negotiates with the preferred
Operators. In this way, the Owner is aware of what is on offer in the market at
the time and ensures that participating Operators put forward their best
proposals at the time. The process is designed so that there is competitive
tension at all times.

Our recommendation is that Owners should engage independent hotel, real

estate and legal advisers to assist them in these appointments unless the Owner
has its own staff with equivalent qualifications and experience that external
consultants would provide. Often cost is cited again as a reason for not
engaging external experts but this is false economy and fails to recognize the
critical financial significance to the Owner of the Operator terms of
engagement. Also through the use of external consultants the experience gap
between Owners and Operators in negotiation imbalance referred to earlier is
addressed. Owners will be able to match the experience of the Operators in
negotiation of the terms of the appointment.

However, whatever approach is adopted our view is that the entire process is
better managed by a person independent of the Owner so as to put distance
between the Owner and the pitching Operators. An independent transaction
manager experienced in hotel management contracts enables the Owner to
maintain distance from the Operator in what is typically a difficult negotiation
at the start of an important business relationship.

It may be that in some specific circumstances a bilateral negotiation is desirable

but in our experience appointing an Operator through a competitive bidding
process has so many advantages to the Owner that it is by far the preferable
approach in most cases.

Outline of Competitive Operator Selection Process

The process can be structured in whatever way you see fit but generally there
are 6 stages namely:

ƒ Request for Proposal (RFP);

ƒ Operator Responses;

ƒ Evaluation of Responses & Short listing;

ƒ Short List Operator Final Proposals;

ƒ Evaluation of Final Proposals; and

ƒ Final Negotiation & Agreement

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The RFP is a document which outlines the hotel project and seeks proposals
from the Operator to manage the hotel. The RFP will ask the right questions of
the Operator and specify the information which the Operator must provide in
its proposal. It will also specify the time table for the process to be followed.

Operators then submit their responses. The RFP will call for a formal written
response including specific information by a deadline date. The Operator is also
usually required to make a presentation of its proposal in person to the Owner
so that the Owner understands the proposal and the people the Owner is
dealing with.

The Owner then conducts a detailed evaluation of the Operator proposals to

assess the strengths and weakness of those proposals and which should be
preferred. The preferred proposals are selected and those Operators are
shortlisted to proceed to the next stage.

The shortlisted preferred Operators are then asked to submit a final proposal
to the Owner setting out their last and final submission. Those final proposals
are evaluated and a preferred Operator is selected to enter into the final
negotiation stage.

The purpose of the final negotiation stage is to reach agreement on a Letter of

Intent or Memorandum of Understanding for the management of the hotel by
the preferred Operator.

Conclusion

Hotel management agreements are long term agreements which bind owners
and have serious financial consequences for the Owner’s hotel investment.

Owners need to invest significant time, effort and energy in selecting the right
Operator for their project and failure to do so may have a material adverse
effect on the Owner’s investment.

Owners are often heard, after the event, to complain about Operators and their
business practices but in many cases the Owners themselves are responsible
for failing to exercise proper care in selecting the Operator in the first place. On
many occasions this is because the Owners did not know what they did not
know and went ahead anyway.

Today in India there is no reason for Owners to find themselves in this position.

For private circulation only

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& Co and do not constitute legal advice. The contents are intended, but not guaranteed, to be correct, complete, or up to date. Khaitan & Co disclaims all liability to any
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