Hotel due diligence: what do UK investors and capital providers need to consider?

In 2013, we have seen three major UK hotel groups changing hands (Marriott UK, Malmaison/Hotel du Vin and Principal Hayley), as well as the refinancing of the LRG Holiday Inn assets. In addition, a number of other portfolios are currently in the process of being sold. There seems little doubt that, while not at the highs seen in the pre-recession glory years of 2005–2007, we are seeing what appears to be a sustainable resurgence in demand for UK hotels, provincial as well as London. North American, Middle Eastern, Far Eastern and domestic investors all have significant equity to put to use, while seller expectations as to price appear more realistic. Taken together with the prospects of genuine economic recovery, which one would expect to benefit hotel trade generally, the transactional outlook appears more favorable than it has for some years.

2 | Hotel due diligence: what do UK investors and capital providers need to consider?

Nevertheless, a large number of hotel assets that have been brought to market in the last year have failed to sell at the hoped — for prices, or have been withdrawn from sale entirely. To our mind, this reflects a prevailing caution on the part of investors and lenders. Many memories are still scarred by experiences of the pre-recession “glory years,” when the combination of a ream of asset disposals as the big brands adopted asset-light strategies, the availability of cheap debt, and a mistaken belief that the long-term cyclical pattern of “boom and bust” had finally been broken contributed to an explosion of deals in the UK hotels sector. In hindsight, it appears many (if not most) of these deals were done at unsustainably high levels of leverage: indeed, there scarcely seems to have been a portfolio hotel deal completed at this time that has not since been subject to some form of financial restructuring process. Frequently, this has led to the holders of the post-restructuring equity being virtually wiped out.

In all too many cases during this period of hubris, we saw deals concluded with minimal due diligence and debt funding provided with what in retrospect seem incredibly loose financial covenants. In contrast, in the current more cautious investor environment, vendors need to recognize that purchasers and capital providers alike will require a degree of comfort above the level of a “vanilla” asset valuation. They are looking intently at the robustness of the target entity’s financial position, identifying latent liabilities and examining the assumptions underlying the business plan — all of which are at the heart of financial (and tax) due diligence.

While not all due diligence processes will comprise the detailed and expansive exercises that come with the sales process for a major portfolio, certain key areas of focus are common to all hotel businesses, whether one site or one hundred. Not only do potential purchasers need to ensure that they properly address the key questions and areas of potential risk through appropriate levels of diligence, but vendors need to prepare themselves adequately for a sale process. They need to preempt the likely areas of purchaser sensitivity and ensure that they can rapidly provide supportable responses to questions raised with an appropriate degree of granularity. An inability to do so will potentially sow uncertainty and doubt in the mind of a purchaser, which will likely result in renegotiated terms or withdrawal of interest.

A final observation is that good due diligence should never be confused with taking dictation from management — one should always seek to speak to as wide a selection of individuals as possible. Hotel general managers can be a particularly rich source of information, and meetings with them can be invaluable in obtaining a truly complete picture of a business.

Some specific areas of financial due diligence where we have seen a particular focus in recent transactions are as follows:

Revenue Conventional wisdom suggests that you often need more information to sell a business than you do to run a business, and nowhere is this more true than for analysis of a hotel’s revenue profile. Occupancy, average room rate (ARR) and revenue per available room (RevPAR), the most frequently quoted metrics, represent the mere tip of an iceberg. Today’s astute investor requires far more granular information, and standard-form hotel accounts will not suffice. Generally, the more granular the available information, the more ways a purchaser is able to cut and slice the data and hence obtain more information and comfort.

With regard to room revenue, for instance, what volume of bookings and what ARRs are being derived from which guest types (corporate, leisure, transient, group bookings, government, etc.)? Consider what seasonality of hotel revenue (and profitability) look like — not just monthly or weekly trends over the course of the year but also intra-week: the ability to fill the difficult Thursday and Sunday “shoulder” days can be the difference between 70% occupancy and 90% occupancy. Aside from the pure numerical data, a full understanding of yield management strategy and its degree of success (or otherwise) in translating through to room departmental profit is essential. This information will be important for any consideration of future growth prospects as well as an understanding of who the customer is, or is likely to be. In recent years the growth of online travel agents (OTAs) has placed greater importance on being able to split room volumes and ARR by sales channel — whether direct with the hotel, global distribution systems, hotel website or third-party agents. However, accurate information in this area tends to be the exception.

In our experience, the standard of food and beverage key performance indicators (KPIs) tend to be far more variable than those for room revenue, despite food and beverage revenue being close to the level of room revenue in some cases. Ideally, a business should be able to cut the revenue easily by each of a hotel’s different outlets (whether bar, restaurant, lounge or room service) and to provide average transaction values and the number of covers — again, split by day of the week, if possible — to be able to identify precise “problem sittings” and possible upsides through focused promotional or other initiatives.

One particular area where we’ve seen vendors struggle to provide meaningful data is the allocation of “mixed” revenue. If, for example, a conference guest is charged £150 for one night’s accommodation, dinner, breakfast and seminar attendance, where is the £150 allocated within the hotel’s books, how much is attributed to food, how much to room hire, etc.? Ultimately, this will be a judgment call made by management, but it can skew KPIs, particularly if these decisions are applied inconsistently (across a portfolio or period of time).

3Hotel due diligence: what do UK investors and capital providers need to consider? |

Cost baseObtaining an accurate view of the cost base of the hotel will be fundamental to understanding how changes in rate and occupancy will drop down to the bottom line earnings. While the impact of changes like minimum wage movements and food input prices may be easy to analyze, understanding the cost base below departmental profit may not be so straightforward. It is important to understand how much discretion a hotel has over areas such as marketing and promotional spend, as opposed to how much of this activity is incurred centrally and simply recharged downward. The true level of hotel stand-alone costs and those allocated or apportioned from the head office can be opaque, but it is important to understand, particularly if the new owner of a portfolio plans to divest individual hotels and hence needs to appreciate the residual level of costs.

Similarly, understanding the timing of rent reviews/rate cycles (including the appeal and rebate process) is key, as is analyzing the hedging/forward positions taken on utility contracts, as the historical level of cost incurred may not be representative of the current or future levels.

A further complication for hotels operating under franchises or management contracts is identifying the basis for charges being paid to the brand owner, which can be myriad and complex. While there will be a headline fee generally based on a percentage of total revenue and potentially furniture, fixtures and equipment charge, overlaid may be a host of “hidden” charges throughout the P&L (e.g., room booking fees, website usage, loyalty program payments, marketing contributions), all of which may impact the underlying profitability of the asset, while deferred incentive payments linked to hotel profitability can be cumulative and present an unexpected and potentially significant liability. Being able to identify and categorize these costs accurately can be a challenge even for the most sophisticated management information programs.

Capital expenditure and working capital requirementsClear information in these areas is often overlooked by management teams who are not focused on reporting these items, given the high levels of cash generated by most hotel businesses. As a result, it is frequently unclear precisely what the working capital requirement of an individual hotel or portfolio is. However, a new owner needs to understand the day-one funding requirement and what an owner’s requirements in the quieter January/February period will be.

Equally important to investors is the capex profile of the estate in recent years. What does the expensed versus capitalized ratio look like, how well invested is the estate, and has capex been distributed across the estate or restricted to a minority of sites? While using the rule of thumb “4% of turnover equals an appropriate level of maintenance spend” could be appropriate for many assets in the UK, hotels operating at the top end of the market and those that have not benefited from significant refurbishment spend in recent years may have to invest at higher levels for a period of time.

As the market outlook improves, we are increasingly seeing expansionary capex projects returning to management agendas, such as room extensions, new conference facilities or improved leisure/spa facilities. Given the general paucity of such projects in recent years, it can be extremely difficult to support the anticipated returns. Detailed analysis of all aspects of the planned projects, including construction costs, incremental overheads and potential new local competitor developments, is desirable, particularly if the projects in question are already committed.

The ability to adequately satisfy an investor’s questions and information requirements — ideally before they have even been raised — can make the difference between a successful diligence process and an investor simply walking away from the table.

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ContactsCameron Cartmell Head of Hospitality & Leisure, UK&I and Partner, Assurance Ernst & Young LLP (UK)

T: + 44 20 7951 5942 E: ccartmell@uk.ey.com

Matt Maltz Partner, Real Estate Tax Ernst & Young LLP (UK)

T: + 44 20 7951 1886 E: mmaltz@uk.ey.com

Nam Quach Director, Real Estate Corporate Finance Ernst & Young LLP (UK)

T: + 44 20 7760 9264 E: nquach@uk.ey.com

Christian Mole Executive Director, Transaction Support Ernst & Young LLP (UK)

T: + 44 20 7951 3034 E: cmole@uk.ey.com

Max Westerman Assistant Director, Transaction Support Ernst & Young LLP (UK)

T: + 44 158 264 3357 E: max.westerman@uk.ey.com