The onset of COVID-19 has hit the hospitality industry especially hard, with potentially devastating effects for some companies. Industry participants are facing an uncertain path back to normalcy for the hospitality business, with some questioning whether travel patterns will suffer long-term effects. This crisis, however, will also provide significant merger and acquisition opportunities for those hospitality companies with strong balance sheets, a clear strategic vision and the willingness to take disciplined risks in these uncertain times.
The pre-COVID-19 M&A drivers (such as market fragmentation, benefits of scale and multibrand/product platform, improved bargaining power with online travel agencies and expanded loyalty programs) will continue to be the fundamental strategic rationale for post-COVID-19 M&A. The benefits of geographic scale and multibrand/product platforms were demonstrated by the financial performance of the large, publicly traded global hotel operating companies in the run up to COVID-19. Furthermore, these companies have been quick to take substantial measures to mitigate the severe adverse operating impacts due to COVID-19. While the situation remains highly fluid and uncertain, these initial and ongoing measures will likely put these companies in a position of strength as the recovery begins to take hold. The largest hotel operating companies still account for only approximately 33 percent of traditional hotel rooms on a global basis—the hotel operating sector remains very fragmented relative to other economic sectors, with ample opportunity for consolidation.
Any hotel operating company M&A strategy demands a clear vision and strong conviction about how an acquisition will drive enterprise value. Achieving the necessary level of clarity and conviction can be difficult in ordinary times. In today’s risky and uncertain landscape, achieving strong clarity and conviction is nothing short of exceptional. The top five U.S. publicly traded hotel operating companies are down, on average, approximately 39 percent for the year while the largest 10 hotel real estate investment trusts are down, on average, approximately 49 percent for the year.
With the vast majority of hotels across the U.S. and Europe fully closed or repurposed for use by health workers or others displaced by COVID-19, the disruption and adverse shock to performance in the hotel sector in recent weeks is unprecedented. Given this near-term and severe hit to hotel operator valuations, particularly for small/midsize hotel operators, well-capitalized players likely will have an opportunity to acquire hotel operating platforms at a deep discount to their pre-COVID-19 valuations.
The uncertainty around the shape, velocity and geographic variance of the sector’s recovery will test any potential buyer’s conviction about the strategic imperative of a hotel operating platform acquisition in the near- to mid-term. The key considerations in testing this conviction include the following:
- Does the target operate/franchise hotels in markets that are either (a) underserved or unserved by the existing platform or (b) expected to recover more quickly or more robustly relative to other markets?
- Is the domestic leisure traveler a significant demand driver of the target’s hotels? This is particularly relevant during the recovery phase as the domestic leisure traveler is likely to be the primary initial demand driver in the recovery phase.
- Related to the role of the domestic leisure traveler, does the target’s geographic platform, when combined with the existing platform, help mitigate the enterprise-level risk from the next COVID-19 moment through geographic scale?
- Is there an “offensive gap” in the existing operating platform that would be solved by the acquisition? IHG’s recent acquisition of both Regent and Six Senses or Accor’s recent acquisition of Fairmont Raffles Swissotel helped solve IHG’s and Accor’s “offensive gap” in the luxury hotel space.
- Is there a “defensive gap” in the existing operating platform that would be solved by the acquisition? Group business/convention travel is likely to be the last demand driver to return post-COVID-19. If the existing platform is heavily weighted toward group business/convention travel, targets that are heavily weighted, for example, to the domestic leisure traveler would provide a “counterweight” to the existing platform’s continued, disproportional exposure to business/convention travel.
- Other product opportunities and/or threats that the acquisition would help solve? Early indications are extended-stay models may be an early demand driver during the recovery phase. A platform that is either overweighted or underweighted in this space likely will face commensurate tailwinds or headwinds during the recovery phase.
- Are there operating efficiencies that can be achieved through the acquisition, including increased shared services/staffing, shared sales and marketing costs and procurement activities?
- Will the scale of the post-acquisition platform shift the negotiation power/leverage in commission discussions with OTAs and other distribution channels to drive incrementally higher operating margins?
- Does the broader and/or deeper offering improve the market position of the combined platform’s loyalty program?
- Can further operational efficiencies be achieved by the expanded scale combined with a disproportionate decrease in corporate level expenses through consolidation of the two corporate platforms?
M&A Value Drivers
Once the strategic considerations are calibrated and potential targets identified, the key items that drive enterprise value of a hotel operating platform include the following:
- Value of potential management and/or franchise agreements—the platform’s development pipeline. This assessment focuses on (a) the scale and strategic value of pipeline projects, (b) the path and timing to completion/opening of the pipeline projects—a particularly important analysis in the COVID-19 era, and (c) evaluating the stakeholders involved and the probability of converting the pipeline into actual operating hotels (e.g. the realization rate).
- Value of existing management and/or franchise agreements—the integrity of the operating platform. At a basic level, the value of a hotel or franchise agreement to the hotel operator or franchisor is a function of the discounted present value of the fees expected to be generated over the term of the agreement. This valuation exercise is sensitive to a number of the contractual terms in the agreement, including (a) priority or guaranteed returns for the benefit of the hotel owner, (b) third-party approval rights in connection with a potential transfer of the agreement, (c) the performance test structure (if any) and (d) any other unilateral termination rights for the benefit of the hotel owner.
- In the branded operator context, the strength of the global trademark portfolio. This assessment includes understanding (a) the scope and strength of, and possible threats to, the existing trademarks, and (b) whether the reach or potential reach of the trademark portfolio could materially limit growth expectations.
The M&A players expected to be active, early participants include mid-to-large-sized international hotel operators that are relatively well-capitalized as well as private-equity platforms, in each case, who have access to private and/or public debt markets. With respect to each group, Tony Ryan, managing director of global mergers & acquisitions in JLL’s Hotels & Hospitality Group, recently noted prior to the onset of COVID-19 (yet we believe this view is equally relevant, if not more so, in the COVID-19 recovery phase):
With respect to hotel operators: “Most of the larger platform deals have already been done, so the big operators are now seeking out unique concepts and locations to complement existing product offerings—particularly as consumer demand changes. Those transactions will occur primarily in Europe and Asia, where there is greater opportunity for consolidation.”
With respect to private equity: “Rather than just buy an individual asset and have someone else manage it, acquiring an existing operating platform allows these investors to scale the business by adding new assets and develop the management business. That way they can both enhance the performance of the assets and create a management company as another vehicle of value to sell down the track.” As Ryan observed Brookfield, Queensgate Investments and KSL Capital all have pursued this strategy in recent years, and more private equity investors are likely to follow.
While the path ahead for the global hotel sector remains uncertain, strategically focused and thoughtful players in the sector will be able to capitalize on this historic moment by executing acquisitions of hotel operating platforms that drive mid-to-long term enterprise value at a price that is meaningfully discounted in the face of the severe near term sector disruption caused by COVID-19.
John Haggerty is an M&A partner and Matthew Pohlman is a Hospital and Leisure partner at Goodwin Procter.