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Khaitan & Co-Due Diligence in Selection of Hotel Operators
Khaitan & Co-Due Diligence in Selection of Hotel Operators
OPERATORS
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:
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DUE DILIGENCE IN SELECTION OF HOTEL OPERATORS
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:
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.
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.
The interests of Owners and Operators are not aligned in a hotel management
appointment,
The Owner is in effect seeking the best performance that his hotel asset can
achieve; and
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.
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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DUE DILIGENCE IN SELECTION OF HOTEL OPERATORS
within a particular market than the Owner so the Operator has an information
advantage.
The Owners preliminary analysis of the project needs to extend to and include:
Site Analysis;
Market Analysis;
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.
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DUE DILIGENCE IN SELECTION OF HOTEL OPERATORS
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.
The process can be structured in whatever way you see fit but generally there
are 6 stages namely:
Operator Responses;
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DUE DILIGENCE IN SELECTION OF HOTEL OPERATORS
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 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.
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.
The contents of this email are for informational purposes only and for the reader’s personal non-commercial use. The views expressed are not the personal views of Khaitan
& 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
person for any loss or damage caused by errors or omissions, whether arising from negligence, accident or any other cause.
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