Signed, sealed, but not always delivered
Signed, sealed, but not always delivered
30 SEPTEMBER 2013 7:54 AM

Hotel management contracts continue to evolve, especially in light of recent litigation and shifting industry dynamics.

REPORT FROM THE U.S.—Hotel owners and management companies are perpetually locked in a contractual tug-of-war—especially when brands are tied to the operator—with both sides aggressively negotiating greater protection should the relationship head south.

In light of several recent high-profile lawsuits (notably Marriott International’s fight with the former Edition Waikiki and its former Ritz-Carlton in Palm Beach), the struggle has only intensified in recent years.

The nature of management deals can vary greatly depending on whether a hotel owner chooses to partner with large branded operators, a smaller brand or an independent third-party manager. In general, sources said partnering with a larger brand tends to be more of a black-and-white proposition for owners who don’t enjoy as much negotiating leverage as they would when building a hotel with a newer, fledgling brand.

“It’s just a question of leverage—who needs who more,” said David Neff, partner with Perkins Coie LLP, who counts Hilton Worldwide among his clients. “You’ve got the economic issue of how much are you going to give by way of incentives to the owner, and the more the brand is expected to in essence invest in obtaining the contract, the more it’s going to look to preserve its rights to obtain the benefits from that. It’s kind of a trade-off there. It all comes down to leverage, like much of life.”

The branding equation
Brand expectations can take center stage in management contracts. The heart of the recent legal battle surrounding the former Edition Waikiki lay within the embryonic brand’s alleged failure to meet its ambitious original growth projections, which Marriott attributed to the ensuing economic downturn. But despite the cause, in order for a brand to thrive, experts agree a sizeable critical mass must be reached. Thus, owners are now increasingly negotiating for brand growth clauses in their contracts with newer brands, especially in light of the Edition Waikiki case.

“It’s very common in shopping center leases that if one of the anchored tenants leaves, the other tenants will have their rent reduced. So, negotiating for some concessions should the brand not grow is not really a foreign concept to real estate developers,” Neff said. “The question is how bad the brand wants to grow, versus how much they don’t want to establish that type of a precedent. The focus still tends to be on the economics: How much are you willing as the brand put into the deal to get the deal, either by way of cash or (discounting) management fees. It’s still economics.”

And the issue will only gain in prominence over time, according to sources, as the industry continues to sub-segment itself into a greater number of highly specific niche and boutique brands. New products are perpetually coming to market, as well as ongoing changes in more established brands seeking to reinvent themselves. Whatever the case may be, owners need to be prepared for the inevitable growing pains, from the growth rates for the chain to the brand standards.

“What you’ll often see is a requirement that the new brand has a certain number of hotels in existence by certain milestone dates, and the number could ratchet up over time,” said Teresa Goebel, partner with Goodwin Procter. “You sometimes see that for established brands also, but I think more in the new brand context, people want assurances that the brand’s going to be a substantial force and that there’s going to be brand awareness and marketing. If there’s not, the owner has the right to terminate the agreement and go in a different direction, if they’re not happy with how the brand is going.”

Performance-driven criteria
One aspect of management contract negotiation that transcends all market segments, brand affiliation and company type is the increased emphasis owners are placing on including performance clauses within their contracts, according to Andrew Pace, senior VP for Strand Development, a third-party management firm. This is a much more clear-cut aspect of the owner-manager relationship, predicated on tangible revenue numbers and operations data. It is one area where owners are specifically enjoying greater leverage in their contracts.

“Owners are demanding and getting more performance guarantees. If the management company doesn’t perform, it allows the owners an exit,” Pace said. “What’s changed is the performance guarantees. (Management) must hit certain (revenue per available room) indexes; they must also hit their budget, and the budget’s negotiable every year. I’ve even seen sometimes where the owner demands a certain profit over the debt service.”

Pace said Strand recently launched an initiative called “Fair Five Guarantee,” capitalizing on another growing trend in management contracts: shorter terms. Essentially Strand is offering owners a 5-year deal, with the option of walking away after the first five quarters if Strand doesn’t hit budget. Should owners opt out, they receive a $5,000 rebate on their management fee; if owners stay despite the shortfall, they receive a 5% reduction in future management fees.

“Nowadays owners want a no-nonsense management company to offer some type of performance guarantee that isn’t tied to a long-term arrangement. Five quarters is enough time for an owner to figure out if we’re the guys for that,” Pace said. “There are a lot of strong competitors and we need to set ourselves apart, so we’re willing to offer that guarantee.”

Big names still dominate
Negotiating a management agreement is a much different proposition when it’s a third-party manager versus a large branded operator, according to sources, with the latter throwing around a lot more weight at the bargaining table. And with ongoing consolidation, the few brand conglomerates that remain only grow in power over time. For owners of large full-service hotels in particular, it’s just the inherent nature of the relationship.

“I think there’s a consistent trend over the last 20 years where the branded hotel companies continue to tighten down all of their franchise agreements, and the management agreements, continuing to make them more favorable to the operator,” said Jim Butler, partner and chairman of the Global Hospitality Group at Jeffer Mangels Butler Mitchell. “If Hilton is going to manage your hotel, their agreement is going to be much tougher than it was a year ago, or five years ago, or 10 years ago. It keeps getting tougher and tougher.”

Even if owners legally maintain the right to fire their managers, in most cases they face hefty fees in order to do so, which may or may not make sense, depending on the situation. And should a dispute eventually end up in a courtroom, the owner will then have to contend with the brand’s usually daunting legal team, sources said.

“Typically the owner wants to be in the court of law just for the very reason that it’s public and viewed as more of a public relations risk to the brand. Frankly, I don’t think with the strongest brands—which I view as Hilton, Marriott, Starwood (Hotels & Resorts Worldwide)—that you’re going to get a lot of mileage out of that,” Neff said. “They’re just not going to be intimidated by you saying, ‘Well, we’ll take you to court.’ They’re going to say, ‘If that’s what you want to do, bring it on.’”

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