From PLI S Course Handbook s9

From PLI’s Course Handbook Hotels 2009: Acquiring, Managing, Developing & Financing a Unique Property Type #18140

HOSPITALITY WORKOUTS AND RESTRUCTURINGS IN 2009

Peter D. Connolly Connolly & Co. HOSPITALITY WORKOUTS AND RESTRUCTURINGS IN 2009

I. Introduction and Workout Deal Principles

Workouts and restructurings are endemic to the cyclicality of the hospitality

business. Periodically, a hotel or a hotel market will go through a period in which

the net operating cash produced by the business is insufficient to meet the cash

requirements created by the sum total of operating expenses, debt service and

taxes. In any business, the approach to solving the cash shortfall problem can be

either increasing sales or decreasing expenses, but in circumstances in which there

is a market slowdown, increasing sales may not be a viable option. Thus, the

workout, a concentrated effort across numerous expense obligations to reduce

cash outlay, becomes the focus of fixing the business.

During the fall of 2008, the bottom fell out of the hospitality market, just as had

begun to happen in the economy generally. It often takes a number of months for

the retreat of business fundamentals to result in a cash default by a hotel on its

mortgage, or perhaps more problematically, an inability to meet its payroll. So

there is generally some opportunity to plan for how the various stakeholders in a

hospitality asset will deal with the shortfall. That time should not be wasted.

In creating a workout plan, there are five practical principles governing the deal

process that must be observed or the workout will fail. These are less legal issues and more issues of human behavioral management, and deal construction.

However, they are every bit as important to the success of the process as are the efficacy of the security interests and the strategic use of the bankruptcy code:

1. The stakeholders in the hotel need to be identified and each stakeholder needs

to accept the economic problem facing the hotel as his/her problem. Initially,

the lender will tell its borrower, the hotel owner, to simply pay the loan as the

market conditions are not the lender’s problem. The borrower will blame the

operator’s inefficiency for the lack of cash flow . The operator will blame the

market, and all three will try to push the problem off on each other. The fact

is that all three parties need each other to fix the problem. Otherwise, the

lender has a loan in default or worse owns the hotel. Without a workout, the

borrower loses its chance at an equity recovery and faces certain insolvency.

Without a workout, the operator loses distribution, its customers, and stature

in the eyes of its employees. Thus, the first task is to make each party

recognize what it has to lose without a workout solution, and as a result

recognize the hotel’s problems as his/her own.

2. Each stakeholder needs to make a material contribution to effecting a solution,

thereby “sharing the pain” of the economic failure. If any party believes that

it is being unfairly burdened by a proposed restructuring, the agreement will

fall apart before it is implemented. Each party needs to see that its

contribution to the solution, whether an interest forbearance by the lender, the

loss of equity interests and entity control by the owner, or reduced management fees or term security from the operator, is somewhat concomitant

in scope and relative value to the contributions made by the other parties.

3. The stakeholders need to understand that the workout is the only way to

protect their respective interests. No party will give up material value until it

concludes that doing so is the only way out of the existing dilemma. As the

workout plan solidifies, the workout practitioner must be prepared to stamp

out efforts by any party to “maintain flexibility in the process ,” as generally a

party expressing that sentiment is looking for an alternative to the workout

plan. Examine the alternatives early in the process and get the parties to

accept the solution as either the best way or the only way out of the problem.

4. The party with the plan should control the process. While the hotel owner

generally is the entity with the most to lose in a workout situation, and

therefore is naturally inclined to want to take over the process, it is also most

likely the party with the least experience in hospitality workouts. Hospitality

lenders and multi-unit operators are generally more experienced in the

process, will be able to more quickly and correctly diagnose the causes and

prescribe potential solutions for the asset, and are most likely to both

understand and be able to articulate appropriate, current deal technology for

the specific workout situation.

5. The workout plan must offer hope to each of the stakeholders. Workout plans

are only effective if the parties contributing to the solution can see that there is some hope in the relatively near term (3 to 5 years) that the contribution a

party is making now may be rewarded by future market changes in

circumstances. Whether in the form of a “kicker” for the lender, a “hope

certificate” for the owner, or an enhanced fee or equity participation for the

operator, each party must leave the deal table believing that it has preserved

some of the current value of its position and that it has a chance to “get

lucky.”

Following are some issues inherent in most hospitality workouts, and some

thoughts on how to approach the process.

II. Identify the Problem—What Cannot be Paid?

A. Debt Service Shortfalls;

1. Senior Debt;

2. Subordinated Debt;

B. Real Estate and other Non-Income Tax Issues;

C. Below the Line Operating Issues;

D. Brand Standard and other CapEx Issues;

E. Negative Operating Profit and Working Capital Shortfalls;

F. Are these systemic, long term issues or short term problems?

III Identify the Cause(s), both Internal and External.

A. Sales Efficiency and REVPAR; B. Operating Efficiency and Asset Management;

C. Debt to Equity Ratios;

D. Debt Service Step Up Issues;

E. Market Issues;

F. General Economic Issues.

IV. Who are the Stakeholders and What are Their Interests?

A. Borrower and its Constituents;

B. Senior Lender;

C. Subordinated Lender(s);

D. Local Government, Other Public Bodies, and local Corporate Entities;

E. Hotel Operator.

V. What are the Respective Leverages and Sensitivities of the Stakeholders?

A. Can the Borrower Reorganize?

B. Is the Senior Debt Recourse?

C. Does the Junior Lender have Partnership Leverage?

D. How “Bankruptcy Remote” is the Borrower really?

E. Can the Operator be Terminated by Contract?

F. What does “Performing Loan” versus “Non-Performing Loan” mean to the

Lenders?

G. Who can Bring New Capital to the Deal?

H. What does Potential Failure Mean to the local Community Constituents? I. What are the Reputational Effects of Default on the Borrower Constituents?

J. What are the Reputational Effects of Failure on the Operator and its Brand?

VI. Holding Hands Around the Campfire—Prerequisites to Fixing the Problem

A. Which Stakeholders are Motivated to Contribute to a Solution?

B. How Real and Immediate is the fear of Failure?

C. How Realistic and Immediate is the Hope for a Restructured Success?

D. Can All Stakeholders see Contributions Being Made by All Other

Stakeholders?

E. Does every Stakeholder Perceive that the Financial Problems of the Hotel are

Shared Problems?

VII. Structural Tools of the Trade

A. Operating Cash Flow Improvements at the Hotel Level;

B. Operating Expense Deferrals;

C. Operating Accrual Deferrals;

D. Debt Principal Write-Offs;

E. Debt Retranching;

F. Debt Pay or Waive;

G. Debt Pay or Accrue;

H. Debt Principal Conversion to Equity;

I. Debt Interest Rate Changes;

J. Equity Redistribution;

K. Equity New Investment Priority; L. Equity Preferred Provisions;

M. Equity Carried Interests and Other “Hope” Certificates;

N. Operator Fee Reductions;

O. Operator Fee Deferrals;

P. Operator Fee Conversion to Equity;

Q. Operator Shortfall Loans;

R. Operator Shortfall Guarantees;

S. Operator Termination on Sale/Foreclosure;

T. Government RE and/or TOT Tax Deferral;

U. Government RE and/or TOT Tax Reduction;

V. Government RE TIF/Special Tax District Contribution.

VIII. Process Principles

A. The Guy with the Plan Drives the Bus;

B. Going Broke Costs Money so Set a Workout Fund Aside;

C. Make Every Stakeholder Accept the Problem as its Own;

D. Share the Pain;

E. Create Temporary Solutions for Short/Medium Term (3-5 years) Problem;

F. Identify and Get the Easiest Stakeholders on Board First;

G. Offer Hope/Reward at the End;

H. Threaten Hostilities as a Last Resort.