hospitality news Winter 2008
Hotel management contracts - commercial issues for owners and operators
In recent years, there has been a growing trend for hotel operators to seek to dispose of the bricks and mortars aspects of their hotels so that they can stay focused on what they do best – running them. It has also become more common for financial investors and private equity funds to invest in hotel assets, and such investors usually seek to separate ownership of the real estate assets from the operation of the hotel business itself so that it can obtain a capital sum for the sale of the hotel property, which can then be ploughed back into its business.
Management contracts are a popular way for hotel owners and investors to achieve their commercial aims. This trend, together with factors such as the changing role of technology in hotel operations and the market forces which drive hotel performance, has highlighted the need for hotel owners and hotel operators to reassess their contractual relationships.
A hotel management or operating contract seeks to formalise the relationship between the hotel owner/investor (‘owner’) and hotel operator (‘operator’). Under such an agreement, the owner calls on the expertise of the operator (in terms of its previous experience, brand portfolio, and established methods and procedures) to ‘run’ the hotel; the owner remains responsible for funding the operation of the hotel, maintenance of the building and all other aspects of the operation and pays a management fee to the operator. The operator will endeavour to ensure that it has control over all matters necessary to ensure that the hotel is maintained and operated to the relevant brand standard, in order to protect and enhance the value of its brand.
Management contracts are usually drafted by the operator and generally, if the operator is an established hotel chain, it would be difficult for the owner to make substantial amendments to the agreement as the operator would not want the owner to interfere with the operational side of the business.
The key legal and practical issues for both parties to watch out for in a management contract include the following:
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Fees – the fee structure is usually divided into a base fee (calculated by reference to total revenue), an incentive fee (based on a percentage of profits) and various other fees and contributions to the operator’s costs. Typically, the operator’s basic fee will be around 2–4% of total revenue, and the incentive fee around 10–15% of the profit generated from the hotel. The incentive fee is usually based on the net operating profit from the hotel, which is calculated by deducting from the hotel revenue generated from room charges, bars and restaurants, conference suites and leisure centres, the cost to the operator of running the hotel. The owner is also expected to meet some of the operator’s costs, including its stock, employees and an allocation of the cost of central office facilities such as reservation call centres. However, the owner should appreciate that changes in operating standards and centralised services (for example resulting from a merger) may lead to expensive IT upgrades and equipment replacement. It is therefore advisable for the owner to negotiate a position whereby, in certain specified circumstances, certain costs will be borne in whole or in part by the operator.
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Guarantees – the operator may be prepared to give the owner an assurance that it will receive a certain level of profit, either by agreeing to make up any shortfall in any minimum profit level agreed, or through the claw-back or waiver of the incentive fee.
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Performance standards – the parties will want to be clear as to the standards to which the hotel will be operated. Performance standards are usually detailed in the operator’s manuals, but the owner will also want to ensure that standards of the prudent experienced operator are adhered to, with the aim of maximising revenue and profit. The owner will want to ensure that the operator’s performance is measured by crafting standards which accurately measure such performance (for example standards based on achievement of projected profit, net operating income, or return on investment). Emerging hotel brands as well as changes in hotel standards mean that performance measures may need to be revisited during the term of the agreement. Consideration should also be given as to whether the operator should be entitled to cure any failure of any performance test or whether the owner wishes to restrict such right and provide for termination of the agreement in the event that the operator fails any such performance test.
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Capital expenditure – it is usual for the operator to seek to force the owner to comply with its request for capital expenditure for structural changes, standard repairs and works to the hotel that are necessary to maintain the operating standards of the relevant brand. From the owner’s perspective, the operator should be allowed to use funds in the case of an emergency or to comply with legislation but in all other cases, provision should be made for consent to be obtained from the owner before expenditure can be incurred by the operator. In addition, the operator will endeavour to control all bank accounts to enable it to operate the business to a standard without undue interference by the owner. The owner should ensure that the operator is required to account to the owner for any surplus.
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Right of approval – the owner may also seek an increased role in any major decisions which affect the hotel’s operations through the use of approval clauses. These may include approval of the budget, employment and removal of key personnel (for example general manager), outsourcing, capital expenditure above an agreed level, leases and concessions.
Human capital – it is customary, and indeed advisable, for the owner to ensure the employees of the operator are the owner’s. The owner should have the contractual right to review the standard form of contract produced by the operator and have some input regarding group and other benefits, as these terms may subsequently impose liabilities on the owner (for example if the hotel is sold and a TUPE transfer is triggered). It is also important to ascertain what pension schemes and other benefits are offered to any staff of the owner seconded to the operator.
Due to the peculiar employment arrangements in a hotel management contract (that is, the employees of the owners are under the direct control of the operator) and the associated risks of liability, for example for negligence and employment tribunal claims, the owner should ensure that it has control over employment-related policies and procedures produced by the operator. Specialist employment advice should always be sought. Please contact Julian Yew.
To minimise the commercial risks, the owner should use an experienced asset manager to review the performance of the operator during the currency of the management contract.
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Ownership of data – the growth of technology in hotel operating systems has forced the need to consider data ownership and compliance. The contract should be clear as to whether the owner or operator owns guest information, as obtaining guest databases is crucial in the event of a potential purchase of the hotel. Given that data security is currently a hot potato, it is also wise to ensure that the contract sets out the parties’ respective obligations under applicable data protection legislation.
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Non-compete provisions – the owner will want to ensure that no other hotel with the same brand can operate within a certain radius of its hotel and that the operator does not give priority to its own hotels or its other brands in the surrounding areas. The owner should ensure that this is addressed in the operator’s reservation system.
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Term and termination – it is common for management contracts to provide for an initial term of around 20 years, together with rights of renewal in multiples of 5 years. Termination rights must also be considered. The owner will in particular want the opportunity to terminate (on payment of some form of compensation to the operator for any unexpired period of the agreement) in the event it wishes to sell the hotel. This enables it to sell the hotel unencumbered. The owner should also ensure that on termination or expiry, the operator cannot withhold all customer lists and/or other information that is vital to the goodwill and ongoing business of the hotel.
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Transitional procedures – the growth of the use of technology in the running of hotels has also led to the need for cooperation of the operator with respect to the transfer of the operation of the hotel on termination or expiry of the management agreement. Transitional procedures for the handover of the hotel’s books, records and operating systems to the new owner or operator should be negotiated and set out in the agreement in detail. The operator will of course seek to ensure that its involvement (in terms of management time and expense) is capped in some way.
As the balance between hotel owners and operators continues to shift in response to technological and economic factors, one key theme remains a challenge for the parties when negotiating their management contract. The operator will want to ensure that its brand is protected by keeping the hotel in a high state of repair and decoration, whereas the owner will want to ensure high revenues and low costs.
The Hotel and Leisure Group has considerable experience in drafting and negotiating hotel management contracts and can advise owners or operators in these contractual arrangements. If you need any assistance in this area, please contact Aisha Dickson from our IP and Commercial Group.
Aisha Dickson
IP and Commercial