Stephen Potel, M.A (Oxon) F.R.I.C.S. Director InterBank Capital Partners Ltd. (London), writes:

One of the most important recent trends in the European hotel financing world over the last year is the increased interest from the larger funds and particularly from banks to participate with equity into the hotel and leisure sector. Until recently the investment funds have shown a very limited appetite for investing in hotel assets and most finance had to be raised the traditional way, namely through senior mortgage debt or corporate bonds and -for the public listed companies - equity issues.

So, gone appear to be the days when banks made loans and investors invested equity. "Nowadays, lenders that used to tiptoe quietly into mezzanine territory (calling it quasi-debt or quasi-equity depending on their credit committees) are boldly crossing over into fully fledged equity investment" says Chris Eddis, Managing Director of Mornington Capital ltd.

"But that's not what banks do!" exclaims one prominent English banker, with expertise in the hotel sector. Well, they have been doing precisely that for many years in other countries, such as Germany, so it's nothing new.

"And banks are there to help their customers, and this is a different way of doing just that" says Trevor Ward, Managing Director of TRI Hospitality.

In the USA, according to Brendan Sullivan, President of Interbank Brener Hospitality, "It is almost unheard of for a commercial bank to make a direct equity investment in a single asset, portfolio or hotel company. In the States the traditional sources of equity are pension and opportunity funds, investment banks such as Lehman Brothers, insurance companies, high net worth individuals and the public markets."

In Europe there are three main conduits for the commercial banks and equity investment funds to put equity into this sector - Sale and Leasebacks, Joint Ventures and Limited Partnerships.

Although the sale and leaseback structure has been widely used for the property sector for decades, it is only recently that this method has been openly embraced by lending banks for the hotel sector. Already in 2001, over £2.5 billion has been invested through variations of the Sale and Leaseback structure.

The most electrifying instance of the surge in sale and leasebacks was shown by Nomura's sale and leaseback of the major part of the Meridien chain last month. The Royal Bank of Scotland invested £100 million of equity in the portfolio and entered into a £1.25 billion sale and leaseback of the hotel assets, thus enabling Nomura to win the hotly contested public bid to acquire this chain. Shortly before this transaction was the Hilton sale and leaseback, again backed by RBS, where Hilton's rent is based on 25% of turnover of which only just over 4% is guaranteed. The new and interesting feature of these transactions is that the linking of the lease rental obligations to turnover, with a low guaranteed rent, enables RBS to benefit from the above average growth prospects they see in the hospitality sector.

So, rather than just sit back and collect interest payments, the banks that are wise to the hotel sector - as RBS and BoS certainly are - appear to be merely benefiting from their insider knowledge of the sector and familiarity of management, and in turn are rewarded by earning returns on their own equity that are far in excess of those earned from straight lending.

The downside from the operator's point of view is that it is committed to a 20 year lease obligation, which in the States would need to be classified as a contingent liability on its balance sheet, plus such a structure would result in the operator losing out on the capital growth of the asset. Marriott makes a good job of hoarding the best of both worlds by using its pure asset-owning company Host Marriott to enter, as owner, into a straightforward management contract with its operating company Marriott International, wherein there are no long term financial obligations of either entity which might adversely affect the credit rating of either.

Joint Ventures present another means of achieving a similarly symbiotic relationship between financing the "bricks" (property assets) and incentivising the "brains" (management skills) of the hotel business.

Typical recent examples of JV's include the £140 million fund established between Thistle Hotels and Morrison construction, or the 50/50 JV of MacDonald Hotels with Bank of Scotland to acquire Heritage Hotels, where each side invested £31.25 million, in which instance the bank also has the chance to provide senior debt (in this case, £210 million) , and the operator is able to book long term management fee income. Other examples are the JV between Hanover International and Bank of Scotland, called Tweed Investments, which has already acquired a hotel in Manchester; Bank of Scotland last year also backed the Scotsman Hotel Group, owner of the famous boutique hotel 42 The Calls in Leeds, and current developer of the Scotsman Newspaper building in Edinburgh. In this instance BOS have provided debt, equity and mezzanine finance. RF Hotels, Sir Rocco Forte's carefully groomed hotel company, has also recently announced a £270 million JV with Bank of Scotland, with each side investing £35 million, supported by a further £200 million of debt (primarily from.... Bank of Scotland) in order to continue expansion of the luxury chain of hotels across Europe. We await with bated breath news of similar JVs, including that of a similar JV involving Jarvis Hotels.

The relative lack of liquidity for buying and selling partnership interests has not hampered the growth of LP's in recent years. The advantages of tax transparency, and the higher gearing that the LP structure affords for the larger equity funds (who are not able to borrow on their own balance sheet) often make this a more attractive play for large equity investors than buying of a hotel company's shares on the stock market, particularly when the majority of hotel companies trade at a discount to net asset value. The quality of the management team is clearly of vital importance in this equation, as a means of unlocking capital gains and equity value growth for the underlying hotel portfolio. Marylebone Balfour Warwick and BAA Lynton have pioneered this form of institutional co-investment, in the UK at least. In particular, this method has enabled BAA Lynton to exploit the value of its Airport real estate - at the effort and with the expertise of hotel partners - without having to relinquish control. BAA Lynton's Airports Hotel Partnership was launched in 1999, anchored by a 30% passive investment from Scottish Widows, plus the Coal Industry and the Shell Pension Fund. BAA has taken 10% and is the general partner, while BAA Lynton acts as the investment manager. So far the portfolio consists of 8 hotel assets, including three airport Hiltons (at Heathrow, Stansted and Gatwick Airports),the Meridien at Gatwick and a Travel Inn and Stakis at Edinburgh airport.

The banks, especially Scottish lenders Bank of Scotland (which will soon be further empowered with an even greater war chest after its proposed merger with Halifax) and the Royal Bank of Scotland, appear to have been neck and neck in leading the charge of lending banks intohotel equity investment territory. One of the questions being asked by lenders and potential borrowers sat south of the border is, is this just a two horse race, or rather a sign that the floodgates are due to open to larger and ever more innovative forays by banks into equity investment? Stay tuned.

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