Be Smart When You Negotiate

Lodging Hospitality recently spoke with Albert Pucciarelli on the subject of the second-tier incentive fee that is common in hotel management agreements — a major potential deal complicator. Armed with a comprehensive understanding of the different ways to formulate these fees and their trade-offs, owners/developers can strengthen their negotiating positions — and find formulas that align the management company's interests with their own.

Pucciarelli is chair of one of the leading hotel and resorts practices in the country for New Jersey's third largest law firm, McElroy, Deutsch, Mulvaney & Carpenter, LLP. Pucciarelli was a member of the board, executive VP and general counsel of InterContinental Hotels from 1988-98.

Q LH: What is the second-tier incentive fee?

A Pucciarelli: Hotel management agreements among the large branded management companies follow what by now has become the standard formulation for fees — the base fee that is a percentage of total revenue that rewards the management company's revenue generating capability, but not efficiency. Three percent is typical. However, total revenue is not an indicator of what bottom-line distribution will be available to the owner. The incentive fee is intended to incentivize management efficiency because it is a percentage of some level of operating income after certain expenses are deducted. Not too surprisingly, these expenses that are subtracted from total revenue are typically referred to as deductions. If the standard definition of deductions is used, an incentive fee will typically be in the eight- to 10-percent range.

Q LH: What is the posture of the two parties — the management company and the owner — when negotiating the incentive fee?

A Pucciarelli: Management companies try to keep to the standard formula of about 10 percent of operating income, while owners seek to find ways 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 “below-the-line” items such as ff&e reserve, debt service, property taxes, common charges, land rent (if any) and property insurance. After percentage amounts for the base and incentive fees have been agreed on in principle prior to drafting the letter of intent to embody the key deal terms — such as the typical three- and 10-percent formula — the owner will then seek to have some items included as deductions in addition to the basic departmental operating expenses, such as the ff&e reserve amount, while the management company seeks to limit deductions to just those departmental operating expenses as listed in the Uniform System of Accounts for the Lodging Industry (published by the American Hotel & Lodging Educational Institute).

Q LH: Do owners succeed in varying the standard incentive fee formula?

A Pucciarelli: A sophisticated owner with bargaining leverage may argue to have debt service or an owner's priority return on project cost included as deductions — in which case the management company will, at a minimum, seek a higher incentive fee percentage than the standard 10 percent. Alternatively, the management company may not agree to have these additional below-the-line items included as deductions, but may agree to stand aside, i.e., defer payment of the incentive fee until cash flow is available (after payment of debt service or the owner's priority) to pay the current and all or some portion of the accumulated deferred incentive fees.

Q LH: What in your view is the best formula for determining the incentive fee?

A Pucciarelli: 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 and 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 percent. 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.

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