The global race for scale and distribution strength among hotel brand companies continues to charge forward. Like other economic sectors, two primary growth strategies have emerged within the hotel brand sector: growth by brand acquisition and growth by organic development efforts.
The case for growth by brand acquisition is driven by hotel brands’ unquenchable thirst for rapid and significant growth and, in some cases, public capital markets’ rewards for delivering this growth. Relative to other sectors, and even after recent headline-grabbing M&A deals such as the Marriott International/Starwood Hotels & Resorts Worldwide combination and the AccorHotels/Fairmont Hotels & Resorts combination, the hotel industry remains highly fragmented without a single player having significant global market share. Market analysts estimate that the top hotel chains only account for approximately 33 percent of traditional hotel rooms on a global basis. This fragmentation will likely drive continued M&A activity in the hotel brand sector. While not without challenges with integration of multiple operating platforms and corporate cultures, growth through brand acquisitions is generally viewed as more efficient than growth by organic development efforts.
Beyond sector fragmentation, there are both offensive and defensive drivers spurring hotel brand M&A activity. The race for earnings and market-share growth is a key offensive driver. As hotel brand companies pivot away from ownership of the bricks and mortar and now define themselves by their brands, brand acquisitions immediately broaden and deepen loyalty program participation while increasing scale and customer touchpoints, which all accelerate earnings and market share growth.
Defensive drivers include improved bargaining power with online travel agents, an increasingly powerful group within the hospitality eco-system. As customers have become comfortable and savvy at shopping online for lower room rates, online travel agents have gained significant market power vis-à-vis the hotel brands when setting commissions for their booking services. Greater scale and market share, underpinned by sophisticated booking engines and robust marketing budgets, improves a hotel brand’s leverage during the commission negotiations with online travel agents. In addition, greater scale and market share also serves as a further defense against the rise of, and rapidly growing threat presented by, alternative lodging companies such as Airbnb and OneFineStay.
What Drives Value in Hotel Brand M&A?
Beyond strategic value drivers (such as broader customer offering, deeper penetration into key existing markets, opening key new markets, etc.) and operational value drivers (such as consolidation of corporate teams, expanded loyalty programs, improved marketing budgets and reservation systems, etc.), three other key items drive value of a hotel brand:
- Global trademark portfolio;
- Value of potential management and/or franchise agreements; and
- Value of existing management and/or franchise agreements.
As part of assessing “brand value” or “goodwill” it is important to analyze the integrity of a hotel brand’s trademark portfolio. This assessment focuses on understanding (a) the scope and strength of, and possible threats to, the existing trademarks, and (b) whether the reach of the trademark portfolio could limit growth expectations. For example, are there any strategic markets where the trademarks cannot be obtained? Or are there existing key markets where the trademarks could be susceptible to attack? This prong of the analysis informs both existing enterprise value and future enterprise value.
The pipeline assessment focuses on (a) the number, scale and strategic value of potential projects, (b) the location of such projects and (c) general status of each project such as (i) the stakeholders involved, (ii) the path and timing to completion, (iii) the economics of each potential project and (iv) the probability of converting the pipeline to actual operating hotels (e.g. the “realization rate”). A firm understanding of the viability of the pre-acquisition pipeline is another item that shapes a target’s enterprise value.
The Existing Portfolio
At the most basic level, the value of a hotel or franchise agreement is a function of the discounted present value of the fees expected to be generated over the term of the agreement. While estimated fees and contract term are critical to the equation, this is only the start of the analysis. Various other terms impact value (e.g. the discount rate applied to value the agreement), including the following:
1. Defining the Actual Portfolio
An analysis of the assignment provisions is critical to defining the target’s actual portfolio as well as uncovering potential obstacles to completing the deal. For example, if third parties (such as the hotel owner, the lender, or the third party operator in a franchise context) have approval rights over the assignment of the agreement to a potential acquirer, consideration needs to be given to the strength of those approval rights and, thus, whether such rights could result in (a) certain hotels not being included in the acquisition, (b) a delay in completing the acquisition and/or (c) unintended costs to complete the acquisition.
2. Sensitivity analysis of discounted present value of the fee stream
There could be threats to the “fee prong” of the basic value equation noted above if (a) the hotel owner has a priority return or guaranteed return ahead of the hotel operator’s right to its management fees or (b) there is any subordination of the hotel operator’s fees to hotel debt service. In addition, calibrating any performance thresholds that must be met in order for the hotel operator to receive all or any portion of its fees could also represent a further threat to the “fee prong.” A review of these items will improve the precision of the value being placed on the estimated fees of an agreement.
3. Security of Tenure
There could be, and likely are, threats to the “term prong” of the basic value equation noted above. Understanding the presence and intensity level of these threats requires a thorough review of the hotel owner’s termination rights. For example, is there a performance termination right and, if so, on what terms:
- Is it a single prong market test or a two prong market and budget test and then what are the actual thresholds of the prong(s)?
- Does the hotel operator have a right to “cure” a failure of the performance test?
- Are there any circumstances that would excuse the hotel operator from satisfying the performance test such as force majeure events or other circumstances outside the control of the hotel operator?
Beyond an analysis of the performance test, are there any other unilateral rights of hotel owner to terminate the agreement? Once the initial analysis is completed on the nature and scope of the termination rights of the hotel owner, specific consideration should be given as to whether any of the agreements are actually “at risk” of being terminated. Furthermore, a review of the non-disturbance protections vis-à-vis third party lenders is critical as this could represent a further threat to the “term prong.” An understanding of these provisions will improve the precision of the estimated term assigned to each agreement and, together with the fee analysis noted above, will sharpen the value (e.g. the discount rate) being placed on the agreement.
4. Potential Growth Inhibiters
Beyond the basic value equation, does the agreement have other terms that could harm value? For example, a broad and restrictive radius restriction could serve to frustrate or inhibit future growth of the acquired brand as well as the legacy brands of the buyer. So while an agreement acquired through an M&A transaction could have the intended consequence of “unlocking” certain key strategic markets that same agreement, via the radius restriction, could have the unintended consequence of “knocking out” other key strategic markets and/or impairing future growth in the newly “unlocked” strategic market. A clear understanding of the radius restriction provisions is, therefore, an important component to the valuation exercise.
5. Ensuring Product Quality
Again, beyond the basic value equation, does the agreement have provisions to ensure product integrity over the entire term of the agreement, including ongoing obligations of the hotel owner to fund capital projects and maintain a funded FF&E reserve? If not, a higher discount rate should be applied to the future fee stream, particularly with a long term agreement where several capital expenditures programs will be required over the agreement term.
As noted above, the initial value of an agreement can be quickly determined by calculating the discounted present value of the fees expected to be generated over the term of the agreement. A detailed review of the agreements, in the manner outlined above, will (a) likely result in agreements not being valued equally notwithstanding possible equivalency in the basic fee levels and stated contract terms and (b) ultimately yield greater precision in the valuation exercise.
Consolidation in the hotel brand sector will likely continue as the pressure on hotel companies to drive earnings growth and gain global market share continues to intensify in the face of growing competition and increasing threats from online travel agents and alternative lodging companies. A thorough and early stage consideration of the key value drivers of a target hotel brand will establish a strong foundation for success in valuing, structuring and completing a hotel brand acquisition.
Matthew Pohlman is a partner in Goodwin’s Real Estate Industry Group and a member of its Hospitality & Leisure Practice, and focuses on the development, operation, management, acquisition, disposition and financing of hotels, resorts and other mixed-use hospitality assets around the world.