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Five essentials checkpoints for successful buy-side due diligence

Date de publication : 03.04.19

acquisition & cession . droit des affaires . droit du tourisme et de l'hôtellerie . droit immobilier . hôtellerie . tourisme

The five keys to successfully negotiating an off-plan hotel lease, for hotel owners

Anne Epinat Christopher Boinet Christian Bardet

A proverb states that prudence does not avoid all misfortune, but a lack of prudence never fails to attract it. This is why due diligence is a vital step in buying a hotel. In a hotel acquisition context, the term « due diligence » refers to the investigations carried out by the prospective buyer. These investigations focus both on the hotel assets (i.e. the operating building as a whole) and the company that owns these assets or operates the hotel. Due diligence must also enable the buyer to fully appreciate the hotel’s business, understand its structure, environment and market, and analyse the long-term viability of their project.

Due diligence is often carried out further to the drafting of a letter of intent and a non-disclosure and exclusivity agreement that define the key points of the transaction. Any letter of intent protecting the parties’ interests should stipulate that the results of the limited investigations undertaken were satisfactory, and in particular, did not reveal any material misstatement or departure from the information provided by the seller.

It should not be assumed that the seller’s warranty [or legal guarantees] will protect the buyer as much as effective due diligence would.
Buyers are advised to scrupulously perform due diligence (as if the seller had not issued a warranty). Since the contractual indemnities due by the seller under the seller’s warranty are limited in time and amount, they will never replace successful independent due diligence conducted by the potential buyer.We have reviewed the five essential checkpoints to be examined by the potential buyer of a hotel (or group of hotels) below:

1 – Legal due diligence

The potential buyer will ensure that the hotel operation complies with the regulations in force by examining current operating contracts (franchises, management contracts, service provision contracts, commercial leases, etc.), as well as contracts in place with suppliers, licences, potential brands or agreements concluded with financial institutions. In particular, due diligence must identify all contracts whose continuation is likely to be affected by the proposed transaction, taking into account an intuitu personae clause.

The risk of immediate repayment of the company’s financing (leasing contracts in particular) in the event of disposal of the shares and ownership interests of the hotel operating company or owner of the premises must also be carefully examined and dealt with before a promise to sell agreement is signed.

A legal audit of the company that owns and operates the business is required, as is an investigation into the owner of the hotel premises, if applicable, in order to verify the seller’s ownership rights and capacity to sell. Legal due diligence will also uncover any disputes initiated by or filed against the hotel, and the commercial and financial consequences thereof that may impact the final price or the seller’s warranty.

In addition to these habitual legal checks, a new subject has also recently arisen: protecting the personal data of guests and staff under the GDPR [1] which came into force on the 25th May 2018. Due diligence should cover all the procedures implemented within the hotel and actually used, hotel and staff management software, contracts involving confidential data processing such as those negotiated with OTAs, supplier contracts and hotel management agreements [2]. In addition, data processing management must also examine the compliance of those entities that process data on behalf of the hotel, in particular through SaaS software, i.e. software hosted by suppliers and accessed via the Internet.

To be monitored: the current franchise contract or hotel management agreement.

When a hotel operating company has entered into a management agreement with a hotel brand, the buyer should carefully review the history of the relationship with the brand and the investments made. There are often clauses requiring the prior agreement of the hotel group with regard to the transfer of control of the company/ business or premises. Lastly, if the potential buyer wishes to terminate the contract early, the cost of such and the contract terms will have to be assessed. A lawyer can advise the buyer on the most practical way to approach the hotel group in this respect – a direct approach is often best. The same considerations apply to hotel franchise contracts or hotel consortia membership agreements.

To be foreseen: the commercial hotel lease and its renewal with a capped rent.

Instructing a legal expert and a lawyer experienced in valuing rent can be judicious. Capex (if possible) and the lease should be carefully examined, taking into account the regulations in force [3] in order to avoid any unpleasant surprises with regard to the financial conditions of renewing the hotel lease that arise from the property’s single use status and its capped rent. If the difference between the current indexed rent and the rent under the renewed lease is too significant, the hotel’s profitability can be affected, as can the negotiations surrounding the sales price.

2 – The operational component of the hotel

The potential buyer will have to understand all the operational characteristics of the hotel and its positioning on the market. The buyer will focus investigations not only on the characteristics of the existing client base, but also on its resilience, the contribution of each segment (leisure, corporate, individual, group) and the weight/ cost of each distribution channel in the marketing of rooms and the revenue structure. A detailed understanding of the yield management strategy employed, the IT systems used (CRM, database, POS) and the professionalism of the management in place should make it possible to identify areas for improvement in order to boost the property’s competitiveness vis-à-vis its competitors. It may be advisable to seek the advice of a consultant specialised in benchmarking in order to verify the hotel’s positioning and performance (OR, ADR, RevPAR) with regard to its competitive set.

Similarly, the analysis of each expense item and the comparison of expenditure levels with industry norms or averages is a source of valuable information. This will reveal the business model (subcontracting or in-house management of maintenance, cleaning, security, etc.), growth drivers (improvements in management), and even internal control procedures that call into question the proper functioning of the establishment.

These operational investigations can be completed by an estimation of the property’s « as-is » value. Taking into account potential improvements, the future value of the property can also be determined for the buyer, once the identified efforts (management, Capex, marketing, etc.) have been instigated.

3 – Technical inspection of the hotel building and its equipment

This is one of the points that hotel neophytes often fear the most. The potential buyer’s technical consultants and lawyers will carry out a detailed document and on-the-spot study of all the physical elements of the hotel building and associated reports. This includes installations and equipment such as electrics, plumbing, building structural aspects, IT systems, decorative elements and hotel material.

A close examination will be carried out to ensure that the hotel, which falls under the category of public-access buildings, complies with fire safety and health standards. Particular care will be taken to ensure compliance with the recommendations indicated by the Health & Safety Commission and the various control authorities as part of their mandatory periodic checks. Lastly, due diligence can make it possible to verify, prior to the transaction, whether or not rooms can renovated or capacity increased in accordance with current urban planning rules.

If the due diligence reveals that regulatory compliance work has to be carried out – in particular with regard to disabled access – the financial cost will in principle be borne by the seller [point to be negotiated]. Yet the question of which party is responsible and when the works should start does remain: if it is the seller, this may result in a further delay in signing the final sales act.

4 – Hotel tax, finance and accounting issues

Due diligence enables the buyer to check whether the hotel is up to date with its tax obligations and to assess the tax risks of the previous hotel operation by examining the various mandatory reporting that has been carried out. A tax and accounting audit of the hotel and/ or the operating company or the hotel operating group will help determine in particular the amount of the seller’s warranty, the acquisition plan and the timing and structuring of the transaction (business or shares of the operating company).

This part of the due diligence process requires a detailed study, notably an examination of the business’ accounting documents and tax returns, as well as all legal documentation in order to assess financial coherence. In this respect, the verification of revenues and declared results makes it possible to check that there is no risk of a tax adjustment for VAT or corporate income tax purposes. Due diligence will also assure the buyer that the accounts are true and that the hotel is not in a precarious financial situation. In addition, it guarantees that the sale will not be called into question in the context of the fight against money laundering. Further, the potential buyer will examine operating expenses and their relevance in relation to the standard hotel industry ratios, which also provides a good indicator of how well the property is being managed.

Lastly, accounting and financial due diligence is essential to evaluate the coherence of the proposed sales price in relation to the book value of the assets or shares acquired. In this respect, care must be taken with regard to the cut-off date, if set. Indeed, forgetting to rigorously account for accounts receivable or inventories can have consequences that are all the more significant since the hotel being sold is substantial. Provisions must also be verified. The proposed buyer must be able to identify all the risks related to the operation and then measure the repercussions on the accounts. They must also check that there are no fictitious assets recorded, such as non-existent inventories or receivables with a long history.

5 – Hotel human resources and social aspects

Due diligence lists are generally exhaustive with regard to human resource issues. Legal due diligence will ensure compliance with labour law regulations and verify the hotel’s HR management. It is therefore advisable to obtain information on employment contracts, the list of employees with an indication of seniority, the amount of salaries and the various benefits granted to staff collectively or individually.

With regard to HR issues, it is the risk of litigation brought before the Industrial Tribunal by a former employee that is the most frequently observed. Human resources due diligence will make it possible both to assess the buyer’s HR obligations and to evaluate any necessary reorganisation and restructuring with regard to the collective Hotels – Cafés – Restaurants labour agreement (in principle) and the company’s agreements in place.

In addition, it is crucial for the buyer to be able to anticipate future costs given the age pyramid of the staff and the existing skills versus the skills required in the future for the successful development of the hotel, after having identified key employees. The potential buyer is invited to examine the positioning of jobs in the classification of the labour agreement in place, gender equality, subcontracting contracts (housekeeping, for example), the frequency of use of fixed-term contracts (casual staff) and the risks of requalification. This is definitely not about conducting a Prévert-style inventory, but rather about identifying risks (financial and legal, not to mention the seller’s reputation amongst staff).

Perhaps a sixth condition for successful due diligence is related to the due diligence method itself. For example, properly coordinating the team of due diligence consultants, meeting deadlines and preparing the due diligence checklist in advance so it can be carried out within the specified timeframe.

The potential buyer will have to conduct hotel due diligence in accordance with an often tight schedule, while rapidly identifying the key priority points to be covered. Effective due diligence is based on the proper coordination of the various parties involved and the exchanges between the various consultants and experienced lawyers (generally organised by the law firm, which already has its specialised lawyers and tax specialists).

No checklist has been annexed to this article, since no standard list exists – the list must be adapted to each transaction. Indeed, we sometimes come across hotel due diligence checklists that are not necessarily appropriate for the hotel transaction in question. Some are too short or generic. Others result in the creation of voluminous data rooms which are time consuming to process on the buyer’s side (and thus unnecessarily costly) – these create delays and are counterproductive since they fail to get to the heart of the matter. In short, let us not forget, « Hell is truth seen too late » (Thomas Hobbes).

[1] General Data Protection Regulation on data privacy – European regulation n°2016/679 and law n°78-17 – French Data Protection Act, modified on the 20th June 2018

[2] Reference: our article published in Deloitte – In Extenso’s 2019 Tourism and Hospitality Trends publication : Personnal data processing and the hotel industry in France: hotel management agreements will need to be revised and currently found at https://www.hospitalitynet.org/opinion/4089147.html

[3] Reference: our article published in Deloitte – In Extenso’s 2017 Tourism and hospitality trends publication: French hôtel, tourist residence and apart-hotel leases are evolving and currently found at https://www.hospitalitynet.org/opinion/4084138.html

Cet article est également paru sur Hospitalitynet.

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