Managing Managers

In the wake of a number of management agreements going sour, it is best to understand what one is getting into before signing on the dotted line says Mihir Thacker of Knight Frank India

Hotel management agreements have evolved over the years from their humble beginnings in the 1950s. The concept of managing a hotel for owners was developed and refined by today’s dominant American brands such as Hilton, Marriott, Holiday Inn etc as far back as the sixties.

During the rapid growth phase of the American economy, these hotel operators sought to reduce their exposure to real estate investments and leverage their management expertise. At that time, they were in a dominant position while negotiating agreements as a new breed of hotel owner was emerging who was not exposed to the complexity of managing a complex real estate asset such as a hotel. This is the same reason why an operator with a strong brand name and reputation was of paramount importance to most owners as at that point hotel developers in the seventies and eighties were targeting the affluent traveller. Lenders too felt comfortable and reassured that their hotels would perform satisfactorily if managed by a company with sufficient brand and management strength. In certain cases particularly in India, lending institutions would advance funds only if the owner had entered into a management agreement.

The Taj Land’s End, Mumbai, was the Regent, the only one in India and part of an exclusive global chain, before management issues among other things compelled its sale to the Taj Group

These factors led to the management agreements being biased in favour of the operator. With owners now becoming more proactive and exercising more control over their assets, the agreements now tend to be more evenly balanced. Negotiating management agreements these days has now developed into a fine art and the new age owner should be aware of the implications of various clauses.

Broad negotiating points

Hotel owners at times are too focussed on trying to negotiate the management fees that important details are often overlooked. There are several negotiation points both legal and commercial in nature that need to be addressed. The failure on the part of the owners to recognise these due to their overriding concern on fees to be paid to the operator has a long-term effect. This could impact the property valuation, return on investment to the owner and critically affect the hotel performance.

Negotiations between the owner and operator must therefore incorporate the following clauses:

• Technical and pre-opening services
• Financial plan and budgets
• Capital expenditure plan and FF&E replacement reserve
• Human resource policy
• Financial control and bank accounts
• Management fees
• Definition of gross income and profit
• Reimbursable expenses
• Operator performance clause
• Termination provisions
• Dispute settlement

Hotel management agreements - General

The IHCL is the ideal example of a company moving from an asset heavy operation to asset light by taking up management contracts

Whilst considering an operator for the hotel, the owner should be fully aware of the responsibility of the operator. Relevant terms of hotel management agreements should constitute the following:

• The management company has responsibility for the day-to-day operations. This shall include authority to establish the rates and charges, discounts, promotions, control of all cash receipts, etc
• Personnel policy regarding training, recruitment, pay scales etc. Owner would exercise control on union negotiations
• Prepare and submit annual operating and capital expenditure budgets
• The operator is required to manage and maintain the hotel in line with other hotels operated under the same brand
• Operating income is expected to meet all operating expenses including management fees, salaries and wages, provide for adequate reserves to the FF&E fund, etc. The owner is responsible for providing working capital, interest on loans, ground/building rentals, etc
• Termination of the agreement is only possible in exceptional circumstances such as non-performance by operator (this needs to be very clearly defined in the agreement), monetary default, failure to meet operating standards, etc

Operator selection criteria

Selecting the correct operator for the hotel is probably the most critical decision to be made by the owner. This decision will not only impact the performance of the property but will also determine the return on investment to the owner. Several factors need to be considered while inviting management companies to bid for the operation of the hotel. The key issues that need consideration are:

• The type of hotel development and target market segments envisaged for the property. Hotels generally are operated in a similar fashion. However different grades of hotels located in specific areas require a certain level of expertise. For example, a luxury resort in Bali vis-a-vis a convention centre hotel in Mumbai will require different levels of expertise not only in operation but also in their distribution systems in order to effectively reach out to their target markets.
• Brand awareness in the market area of operation. If the hotel is largely dependent on the domestic market v/s the international market, it may make sense to consider a strong domestic operator with an established sales and marketing system in the region. The target segment for mid-market hotels in emerging Indian cities such as Pune, Baroda, Surat etc, is the intra-Indian traveller. This would mean that the efforts of a large international chain with its base overseas might be largely undermined, especially since business would be sourced from within the domestic market. The large international chain may have little effect on the overall business into a particular property although the costs associated with the operator will have to be paid for.
• To clearly state the operator’s involvement in the functioning of the hotel is very critical. Too often management companies are unable to give sufficient attention to a small hotel in a large city or a large hotel in a secondary city. It is often difficult for the top management of an operating company to give the required care and attention if they are based in a location far removed from the property. They are often unable to understand and deal with cultural sensitivities and geographic difficulties of a hotel in another part of the world.
• Distribution systems are an important tool in order to maximise revenue. In today’s dynamic and fast changing market place, it is important for any management company to have an evenly spread and effective sales and reservation system. Owners need to compare various management companies to determine their contribution to the overall occupancy for the hotel through the various distribution channels. Most hotels source their business from the local markets in which they operate. However the difference for the owner would be the ability of the management company to deliver room nights to the hotel through their GDS systems, web sites, sales offices etc, and the source markets from where this business is generated.
• Affiliations and loyalty programmes are a key source of business. For example, a strong loyalty programme for Shangri-La delivers upto 20 per cent of the room nights for certain hotels. Obviously, if as a hotel owner one were to compare various operators, Shangri-La would be at the forefront to be considered. In most cases loyalty programme members do tend to pay higher rates.
• The human resource policy is crucial as it will determine how a hotel will perform. In India we have seen the case of a luxury hotel property in Mumbai suffering due to an unusual hiring policy. The hotel choose to create subsidiaries which would employ personnel and then award a sub-contract to the subsidiary. This did not create a feeling of belonging and ownership among the employees, which led to high staff turnover, lack of motivation and efficiency. This resulted in differing standards of services. Eventually the owners sold the property, as the desired returns were not generated. A good example of effective human resource practice is the Four Seasons chain, ranked by Fortune Magazine amongst the top 100 corporates in North America to work for. This rank is based on feedback by employees based on the company’s human resource policy, sensitivity to employee needs, working environment and culture. Four Seasons hotels due to their various initiatives, service standards and adherence to quality have consistently outperformed other luxury hotel operators in RevPAR yield terms by nearly 12 per cent in the North America market.
• Owner relationship and transparency by the management company in communication is the base of a strong long-term working arrangement. It is imperative that the management company recognises the owner as the true beneficiary of the hotel. The management company must align itself with the long-term objectives of the owner. It is strongly recommended that owners establish a good rapport with the operator. Certain operators such as Shangri-La have gone a step further and established a Policy Implementation Committee (PIC) for each hotel it manages. Both, owner and Shangri-La nominate representatives on this committee. Decisions that have a material impact on the operations of the hotel are only implemented after the PIC has given its approval. This level of transparency and liaison creates trust and faith in the mind of the owner.
• The ability to terminate an agreement by the owner and the effects thereon needs careful examination at the initial stage. Certain operators insist on the uninterrupted right to operate the hotel incase of a sale or foreclosure by debt holders. This could lead to the new owner being forced to continue with the current management and complete the tenure of the agreement.

Termination provisions generally provide for payments to be made by the owner to the operator in case of sale or premature termination of the management company’s right to operate the hotel. These payments are based on the loss of future earnings to the operator and are calculated on the average fees paid over past years. These restrictive clauses diminish the value of the property on sale. Owners should negotiate to minimise the monetary loss caused to them or insist on the right to sell the property unencumbered with the management agreement.

Ensuring operator performance

ITC’s hotel division widely regarded as some of the best managed operations in the country are predominantly company owned. But the company has taken the management route in managing heritage properties through its Welcomheritage

There are several checks and balances an owner can put in place within the agreement to ensure performance by the management company. However management companies are generally averse to inserting performance clauses in the agreements and it does take a fair amount of negotiating on the part of the owner to structure a fair and workable arrangement.

The right to take action by the owner in cases of default or non-performance by the operator under such clauses will only help in keeping the management company in check. There is nothing more frustrating to an owner but to be forced to continue with incompetent management. Just recently, the owner of two prominent hotels in South India terminated the management agreements of an operator due to non-performance. The management strong objected to this and took recourse in the court, but obviously the owner’s ability to take such action could only be done since performance clauses stipulating the level of expected performance were inserted into the original agreement.

Owners making investments in hotels require a certain return on equity and sufficient funds to cover debt costs. Management companies could be asked to subordinate their fees to debt service. This will ensure that certain statutory payments such as employee payroll and benefits, insurance premiums, other operating expenses, debt repayment, etc, will receive priority in payment to management fees. Only if surplus funds are available during that fiscal year will the management company receive their management fees (normally the management company will be entitled to receive fees based on gross income irrespective of gross profits). This acts as an incentive for the management company to maximise revenues while controlling costs.

• Ensure that the subject property performs at parity in terms of RevPAR yield to the competitive set of hotels in that market. If the management company fails to perform in line with the previously defined competitive set of hotels, the owner can seek termination post the cure period if the performance of the hotel continues to suffer.
• As stated above, owners invest in hotels expecting a certain return on equity. The owner could insist on the operator achieving a pre-defined minimum level of income that will provide the owner with his desired returns. Agreements can be structured so as to ensure that incase of a shortfall in the pre-defined income in excess of certain values, the operator should bridge the gap to the owner through their own resources.
• Enforcement of performance standards can be non-financial in nature too. If owners desire certain quality standards to be maintained in product and service performance, clauses can be linked to achieving specified ratings from audit firms and classification bodies.
• These clauses are enforced by owners or in default situations by the operators. However they are subject to force majeure circumstances whereby the owner cannot seek termination. Force majeure is described as circumstances beyond the control of the operator such as Acts of God, riots, terrorists strikes, fire, war etc. It is always recommended that owners insist on the inclusion of performance clauses as this gives them the right to change ineffective management.

(The author is head, leisure & hospitality advisory services, Knight Frank India Pvt Ltd. He can be contacted at mihir.thacker@knightfrankindia.com)