August 1, 2008 - Private Equity Checks Out, Acqusitions Monthly

By Quentin Carruthers, Acquisitions Monthly

After a restructuring phase, how is the hotel and hospitality sector placed going into the downturn and where are the deals?

The high point for M&A in the hotels and hospitality sector was reached on July 1 2007, with the announced US$26.7bn acquisition of Hilton Hotels by US private equity firm Blackstone Group. In every way – size, quantum, price, global risk appetite – the Hilton deal was the biggest ever acquisition, and looks likely to remain so for some time.

Despite being a peak time deal – a stigma that can carry certain doubts over true value – the Hilton transaction remains well perceived.

“Hilton as a brand is an exciting place to be, delivering a US brand into the global market place,” says Richard Candey, director in the hospitality division at real estate adviser DTZ, who reckons that the success or otherwise of such a transaction cannot be tested for at least another two or three years.

Opportunities Lost

In 2007, private equity firms were in the vanguard of deal-making. According to a survey by HVS, the specialist hotel, restaurant and leisure valuation consultancy, 44% of single asset and hotel portfolio investments made in 2007 were by private equity firms, with Blackstone leading the pack. In 2008, a year that has yet to be evaluated, private equity firms appear to have slipped closer to zero involvement.

Of course, the retreat of private equity comes down to the credit crunch and the drying up of leveraged debt. Now, though, there is frustration that banks have become over-cautious.

Bruce Parmley, co-director of the real estate and hospitality practice in the Washington office of law firm Hogan & Hartson, laments that underwriting banks are scared of their own shadows, that credit committees are crossing every “t” and dotting every “i”, all leading to a loss of common sense.

Parmley has lived through previous cycles and sees no immediate end to this one, saying: “What bugs me about it this time is the impracticality.”

Candey of DTZ says that opportunities are being lost because of the heightened level of diligence required by credit committees. “Banks are flying the flag that they are open for business, but the reality is that they are being incredibly selective, and their choices are reflective of profitability and relationships,” he says. “Any hotel portfolio transaction over £75m is proving incredibly difficult to fund.”

For those deals that do secure finance, the terms of debt have tightened and tenures have shortened from around five or seven years to three years.

Cristina Badenes of Barcelona-based private equity hotel investor Meridia Capital, which recently surveyed 12 banks and two hotel consultancy firms for a report on debt markets and hotel financing published in June, says “financing conditions have undoubtedly hardened”.

In her report summary, Badenes concludes: “Loan-to-values have come down by at least 10 percentage points, risk spreads have increased by around 50–100 basis points and club deals have become more common as visibility in the syndication market has been reduced.”

She goes on to describe the problems typical across other sectors – such as the cautious approach adopted by credit committees – and says, furthermore: “Most banks consider that we have not yet reached the bottom.”

Encouragingly though, Badenes adds: “Most financial institutions still consider that hotels remain an accepted asset class among the investment community and the current turmoil in the world’s financial markets will not change investors’ perception of the sector.”

Fresh Capital

According to Parmley, there is now enormous potential to enter the mezzanine debt market and fill the widening gap between equity and debt – an opportunity not just for third party lenders but for hotel operators themselves.

“Mezzanine capital can come from the hotel operators,” he says, adding that mezz is happening and will continue to happen.

More widely, the search is on for new providers of capital.

“The search for buyers is increasingly eastwards, towards Central and Eastern Europe, Russia, and the Middle East,” says Nam Quach, co-head of European lodging and leisure, investment banking division at UBS, explaining that high net worth individuals and sovereign wealth funds and their related entities are examples of buyer groups who, for the right asset, remain keen to acquire in today’s market.

In fact, rich people, either self-made or with dynastic wealth, have always played a role in the hospitality sector. HVS found that high net worth individuals accounted for 7% of investment activity in 2007.

The leader of the hotel investor rich list is Prince Al-Waleed Bin Talal of Saudi Arabia, chairman of Kingdom Hotel Investments, although some bankers would view him as the face of a sovereign wealth fund, another class of investor showing an increased interest in hotels.

Other rich investors in hotels include Microsoft founder Bill Gates who, through his Cascade Investment vehicle, joined forces with Talal to back a US$3.7bn MBO of the Four Seasons Hotels in November 2006.

Even Roman Abramovich, the Russian owner of Chelsea Football Club, can be viewed as an investor with a taste for hotel-like properties following his recently reported purchase – confirmed so far by the cleaning lady – of the world’s most expensive and supposedly most desirable property, La Leopolda.

The US$500m chateau on the French Riviera near Monte Carlo was built for the mistresses of King Leopold of Belgium, and has already passed through the hands of Bill Gates and Gianni Agnelli.

Looking westwards, towards the US and Canada, bankers hope to see lost credit supply replaced by the increased involvement of pension funds, following the lead of Canadian pension funds such as Ontario Municipal Employees Retirement System (OMERS), British Columbia Investment Management Corporation (bcIMC) and Caisse de dépot et placement du Québec, which have all begun investing in hotels.

The Hotel Cycle

Apart from the impact of the credit crunch, hotels have their own cycle. Andrew Sangster, editor of Hotel Analyst, describes the volatility typical of upscale hotel chains.

“It’s a wildly cyclical industry, exhibiting the classic features of luxury goods – overshooting on the upturn, undershooting on the downturn, but over 20 years providing the best return of any real estate asset class,” he says.

However, as Sangster can testify, the industry has been through a long phase of separating the bricks (the real estate) from the brains (the hotel brand operators), a restructuring essentially, which has helped reduce volatility.

Initiated by Marriott in 1993, the process was taken up more thoroughly by Intercontinental, concluding with several large portfolio sales in 2006. Intercontinental now retains the real estate of just a handful of trophy hotels in “gateway” cities, although there are reports that its New York hotel property may be sold and replaced by a new building.

Hilton, acquired by Blackstone, remains a mixed bag of owned and divested properties.

In the more defensive, less volatile budget hotel sector, a similar and very profitable bricks/brains split – or “bifurcation” as others call it – was carried out at Travelodge by private equity firm Permira, which first sold off the property to investors including Sir Tom Hunter and then sold the branded operations to Dubai International Capital in August 2006 for US$1.2bn.

Travelodge is the main competitor to the UK’s number one budget hotel operator Premier Inn, owned by Whitbread, which by contrast retains ownership of the vast majority of its properties – considered not such a great liability in the budget sector, but still looking like a bifurcation ripe to happen.

Nam Quach at UBS believes that the hotel sector’s increasing shift in business model, from owned and leased assets (where the assets, under some accountancy regimes, remain a balance sheet liability) towards management contracts and franchises, has left hotel companies with less debt and more earnings stability.

“Furthermore, the hotel sector is more sophisticated now, with much better yield management systems – like low cost airlines – and the flexibility to switch focus between business and leisure customers,” says Quach. “The industry is cyclical, but has proven before that it can bounce back quickly.”

Ultimately, with its more stable brand-based focus, the hotel management sector has its long-term sights set on rolling out rooms into a highly fragmented market, where in the US, just for example, 70% of hotels are reported to be so-called “Mom & Pop” owner-operator businesses.

Fairmont versus Carl Icahn

One merger story that illustrates well the pressure faced by hotel businesses before the credit crunch is that of Fairmont Hotels & Resorts, the hotel management business headquartered in Toronto, Canada. Originally a rail company, it was based on a string of sumptuous hotels built out along the Canadian Pacific rail line in the nineteenth century.

Trouble struck in 2005. After making two strategically important acquisitions in 1998 and 1999, which consolidated the group’s new global hotel focus, Fairmont failed to seal a third acquisition, that of Raffles. Instead, private equity investor Colony Capital – which was able to access leveraged debt far more cheaply than publicly traded and credit rating-constrained Fairmont – won the deal.

Activist investor Carl Icahn seized the opportunity, quickly building a 9.3% stake and then launching an unsolicited bid at a far higher price than the average of his purchases and applying pressure on the Fairmont board to sell assets, buy back shares or change its representation.

The mandate for lead defence adviser was given to Avington, the boutique investment bank established in 2005 by David Mongeau (previously vice-chairman of CIBC World Markets and global head of M&A, and before then a senior executive at Four Seasons Hotels) and Piers Talalla (previously senior M&A banker at CIBC World Markets, and before then at Schroder Salomon Smith Barney and Dresdner Kleinwort). Their previous client relationships included Kingdom Hotels, Colony Capital, Permira and Whitbread .

Fairmont’s defence involved an auction attended by 10 potential white knights and the eventual sale of Fairmont to a consortium consisting of Kingdom Hotels International and Colony Capital, a US$3.9bn deal struck at a 12.5% premium to Icahn’s bid price, followed immediately by a US$5.5bn merger with Raffles.

The by-then massively leveraged group had to advance its business plan quickly and shortly after deal closure Avington advised Canadian pension fund OMERS on its acquisition of a US$1.5bn portfolio of Fairmont’s Canadian hotel properties, a deal that was successfully done in September 2006 and followed in October with the acquisition by OMERS of a minority stake in Fairmont Raffles Holdings International.

Deal Activity

Isolated from the credit crunch, new-build developments in the Middle East – where each looks to be bigger and better than the other – are keeping advisers in the hotel and hospitality sector very busy.

“The Middle East is booming,” says Hogan & Hartson’s Parmley, who is involved on drawing up management contracts for the owners developing Abu Dhabi’s Saadiyat Island, the future home to a new Guggenheim, Louvre and several five-star hotel and resort attractions.

Central and Eastern Europe, while viewed as a source of high net worth individuals, is also a target for hotel brand-building and resort development.

In Bulgaria last year, for example, the State Fund of Oman bought a one-third stake for €600m in expanding the winter resort at Borovets, already Eastern Europe’s largest ski resort.

Landminster, a UK developer active in Bulgaria’s boutique hotel sector since 2001, and which is currently marketing an all-seasons hotel property in Borovets, expects any buyer to be Bulgarian, Russian or from the Middle East.

Away from the Middle East boom, there is clearly a gap between the aspirations of some owners and the harsher realities and fears felt by buyers. Richard Candey at DTZ says that certain deals remain on the block as a result of the expectation gap, such as the proposed disposal by Alternative Hotel Group of its Malmaison and Hotel du Vin hotels, which despite good offers failed to go to a buyer in 2007.

Seller expectations have been maintained by a continuing growth in occupancy rates. However, there are reports that hotel management companies are beginning to see a slowdown in forward booking and reservations in the third and fourth quarters of 2008.

London may still be holding up in terms of room rates and occupancy, but provincial UK and Continental Europe figures are said to be weakening.

Negative news may actually begin to free up deal stalemates, and one of the indicators to watch is the HotStats survey from TRI Hospitality Consulting, which reviews the business performance of UK chain hotels.

In its May review, TRI found that occupancy was steady but that profits had dipped. “Although increasing, neither room not total sales growth is keeping pace with the rate of inflation,” it said. “Hoteliers are struggling with rising costs and flat or stagnating occupancy, so the pressure on profitability is inevitable,” according to Jonathan Langston, managing director of TRI Hospitality Consulting.

Deals may also emanate from the stress on the real estate owners of hotel properties. Sangster of Hotel Analyst reckons that the imminent resetting of private equity loans will cause a “reshuffling” of hotel real estate ownership.

Banks – big investors in hotel real estate – are also expected to sell properties to help recapitalise their balance sheets, and significant potential disposals might include the likes of Grosvenor House on Park Lane, managed by Marriott and owned by Royal Bank of Scotland.

However, some banks appear to have had difficulty in selling hotel property portfolios, such as Goldman Sachs’ Whitehall Funds, which was in advanced discussions to sell its former Queens Moat Houses properties (which came out of the twice-collapsed and restructured QMH hotel business) to aAIM, the property investment company chaired by Sir David Frost. The transaction fell through towards the end of 2007 – reportedly hit by the credit crunch.

Other deals that may be driven by a reduction in banks’ real estate holdings include Spanish hotel group NH Hoteles, 30% owned by Spanish savings banks, a situation being watched by Hotel Analyst’s Sangster, who believes that any disposal could provide an opportunity for private equity funds to build stakes (given that leveraged, full takeover bids are close to impossible in the current debt markets).

Accor, the French hotel group, already has Colony Capital and TPG-Axon as significant investors on its shareholders register.

Nam Quach at UBS says that since volatility and costs associated with property have been passed over to the real estate landlords of hotel management companies, it is possible that “any transaction in the last two years could be distressed”.

Vulture-like funds have already emerged, ready for opportunities. Realstar Group, the Canadian real estate and hotel investor, has just raised €300m of equity for Realstar European Capital I fund, designed to provide capital injections into the alternative property sector, including hospitality.

Among the European hotel groups – such as Accor and Belgium’s Rezidor – deal activity is expected to continue, given their balanced approach of owned and managed assets, and the periodical real estate disposals and rebalancing of assets. They could also emerge as buyers of distressed hotel property assets.

Corporate hotel groups are ranked by industry sources such as Hotels magazine, which in its 2008 survey places InterContinental Hotels Group (IHG) as the company present in the most countries (100), followed by Starwood (95) and Accor (90), each with a differently ranked balance when it comes to hotel management and franchising.

Common to all, and driving deals and corporate strategy, is the pressure to keep feeding the pipeline of projected hotel room growth.

One class of asset that will always retain its allure is the five-star trophy asset. According to HVS, the five most expensive cities to acquire a hotel in are London, Paris, Moscow, Rome and Milan, in that order.

High net worth individuals, in particular, are drawn to the trophy hotels. However, Quach at UBS says that with any owner looking to sell a hotel in the current market, there is always the suspicion of why now?

Going into the next phase of the hotel and hospitality cycle, Piers Talalla, chief executive officer of Avington, points out that capital investment programmes are best made in a downturn, when there is lower room occupancy and less disruption caused.

Some private equity firms have hotel professionals on board who understand operational requirements, such as Morgan Stanley Real Estate, which hired André Martinez in 2006 as chairman of its global lodging practice, having been a member of the management board at Accor.

However, looking at hotel REIT structures, while some may be lauded for bringing best practice to bear upon hotel managers, they may also lack the flexibility to invest and upgrade properties in an appropriate, counter-cyclical way.

In matters such as these, Talalla describes his role as “helping clients think one cycle ahead”. And when it comes to advising on actual transactions, he compares the banker to a hotel’s concierge, saying: “If it’s legal and it’s ethical, then we can arrange it.”