Hotel Management Agreements: Incentive Fee – The Stuff of Negotiation
Hotel management agreements among the large branded management companies follow what by now has become the standard formulation for fees, at least before the negotiation commences. The base fee and incentive fee are now well known in the industry and expected as the starting points in most manager-owner negotiations.
The incentive fee is intended to incentivize management efficiency because it is a percentage of some level of "operating income" (often referred to as "gross operating profit" or "GOP") that is "gross revenue" minus certain operating expenses. The "operating expenses" - i.e., the usual departmental expenses - that are subtracted from "gross revenue" are typically referred to as "deductions". In the 'standard' formulation, "deductions" do not include the so called "below the line" expenses - the FF&E reserve, debt service, property taxes, common charges, land rent (if any) and property insurance. If the standard definition of "deductions" is used, an incentive fee will typically be in the range of 8%-10% of "operating profit" and "operating profit" will hopefully be in the range of 30%-35% of "gross revenue."
While management companies try to adhere to the standard incentive fee formula of approximately 10% of "operating income", a management company may be earning and paid a handsome incentive fee while the hotel owner is experiencing a negative cash flow and perhaps even writing checks to cover a net deficit after when all other expenses are considered. For this reason, hotel owners seek to avoid payment of incentive fees until the owner has realized a satisfactory level of return on investment after payment of all expenses associated with the hotel, including those that are traditionally "below the line." In this way, the owner seeks to make the management company a co-venturer in the entire real estate enterprise that comprises the hotel, rather than just a participant in those elements of the operation over which the management company has direct operating control. Where the incentive fee is a percentage of net cash flow, the incentive fee may be as high as 25% of the hotel's net cash flow.
A hybrid formulation would be to include among the basic "deductions" in arriving at "operating income" some items that traditionally are "below the line" – i.e., not typically subtracted from "gross revenue" - to arrive at "operating income." A typical item in this category is the FF&E reserve. By subtracting the 4% or 5% of "gross revenue" that is required by most management companies to be set aside as a replacement reserve, the "operating income" is thereby reduced and the incentive fee also will be reduced if the percentage amount is not increased above the usual 8%-10% amount. This is a refinement of the traditional incentive fee formula, but still falls short of the owner's expectation to see a return on investment before paying any incentive fee.
A common alternative to address the owner's desire to see a return on investment before paying the incentive fee is to also provide for the payment from "gross revenue" of an "owner's priority" that is some agreed amount, typically tied to project cost as a percentage thereof (10% is common). The "owner's priority" conceptually is an agreed return that the owner must have in hand before the management company takes an incentive fee. If the management company accepts the concept of an "owner's priority", it will be inclined not to allow it as a "deduction" to determine the income amount upon which the incentive fee will be calculated. Rather, it may be allowed as a payment to the owner before the incentive fee is paid to the management company, but the management company will nevertheless insist upon an incentive fee that is a percentage of "operating income" (e.g., 10% of "operating income"). In this way, the "owner's priority" is not a payment calculation but a payment prioritization. Payment of the incentive fee is either reduced or postponed entirely if the hotel has not generated enough "operating income" so that there is cash available after payment of the "owner's priority". In this instance, the unpaid incentive fee amount will either be deemed unearned or, more commonly, be deemed earned but unpaid, and the unpaid amount will accumulate as a future obligation of the hotel owner to the management company, and may even accumulate as a secured subordinated loan.
The incentive fee can be an area for very creative and contentious negotiation. The resulting formulas (that depart from the standard 10% of "operating income") can be quite complex. For example, incentive fees may be tiered – that is, the percentage increases as operating income increases beyond historic or forecast levels to incentivize the management company to exceed past performance or budgeted operating income. The possibilities are unlimited and the best outcome for each party really depends upon the hotel's financial particulars. If a hotel is very successful as an operating hotel – high "gross revenue"/ low "operating expenses" - and therefore it has high "operating income", but is carrying too much onerous debt or is unduly burdened by capex requirements or high property taxes, the management company is best served by using the traditional incentive formula and taking its incentive fee as a percentage (in the 8% - 10% range) of "operating income". If the same hotel is not overly burdened "below the line", then the management company may do better by taking a higher percentage of net cash flow as its incentive fee. Where the management company's incentive fee is based upon cash flow after debt service (and all other owner obligations with respect to the hotel), it is reasonable to expect that the management company will demand a say in the amount and terms of all debt obligations.
As management company's counsel, I prefer the basic percentage of "operating income" formulation because the management company has little or no control over those items that are "below the line". Even some of the basic "operating expenses" are really not within the management company's control, to any significant degree, such as the cost of utilities or labor costs pursuant to existing collective bargaining agreements. As owner's counsel, I am willing to share a much higher percentage of net cash flow from the hotel – even as high as 25% - because this formula aligns the management company's and the owner's incentives to drive profit right down to the level of owner distributions before income tax.
There are other areas of management agreements that can be ripe for negotiation, such as performance tests, budget approval and key employee selection, but the incentive fee goes to the heart of the hotel's financial performance and determines where in the hotel's P&L the management company will derive its reward for the services it renders.
Albert J. Pucciarelli is a Cayuga Member and chair of the Hotels and Resorts Practice at McElroy, Deutsch, Mulvaney & Carpenter. LLP. He served as a Director and Executive Vice President, General Counsel and Secretary, of InterContinental Hotels (1988-98) and is a Director and President-elect of the Hospital Industry Bar Association. He may be contacted at www.mdmc-law.com.
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