Incentive Fees: Aligning the Owner's and Manager's Interests
Do you get what you incentivize?
By Tara K. Gorman, Partner, Perkins Coie LLP
In this economic environment, hotel owners and managers alike are doing all they can to ensure that their hotel is profitable. The structure of the Incentive Fee is a key element to aligning the interests of the hotel owner and the hotel manager. Does the Incentive Fee structure get what it is intended to incentivize?
The Hotel Management Agreement is the key document that governs the relationship between hotel manager and hotel owner. Typically, the compensation to the manager is split into two components: Base Fee and Incentive Fee. The Base Fee is usually a percentage of gross revenues of the hotel. The Base Fee percentage typically ranges from 2.5% of gross revenues to 4% of gross revenues. Some hotel managers even negotiate a minimum base fee on a dollar figure per room per annum. This way no matter how the hotel does, going into the deal, the manager knows it is guaranteed a minimum fee. Clearly, the minimum fee - or the floor - is far less than the manager expects to make, but in the event that the hotel doesn't do well, the manager has minimized its risk by negotiating a minimum fee from the outset.
Gross Revenues - No Incentive to Keep Costs Down
What is interesting about the structure of the Base Fee is that it is calculated on a percentage of gross revenues. This inherently provides the manager with no incentive to minimize the operating expenses. To illustrate the point, we will use an absurd example and strip away all the factors that make a manager a good manager, such as being fiscally responsible and capable at its job, and complying with the annual budget. For easy math, in the event that the hotel achieves gross revenues of One Million Dollars and the Base Fee is three percent (3%) of gross revenues, the Base Fee due to the manager would be $30,000. Using that same example, there is no change in the Base Fee if the manager is incredibly frugal, pinches every penny and keeps the operating expenses to $75,000, or if the manager is fiscally irresponsible, money burns a hole through its pocket and racks up operating expenses of $1,000,000. The operating expenses have no impact on the Base Fee whatsoever because the Base Fee is based on gross revenues - i.e., how much money comes into the hotel, not how much money goes out of the hotel to pay operating expenses. To go back to our example, both the penny pinching manager and the fiscally irresponsible manager are still entitled to a Base Fee of $30,000. Clearly, the fiscally irresponsible manager has failed any performance test, and is terminated, but for our absurd example, there is no change in the Base Fee. The bottom line is that the structure of calculating the Base Fee as a percentage of gross revenues gives the manager no incentive to minimize the operating expenses. Therefore, the interests of the owner and the manager are not aligned - as the owner is focused not only on gross revenues, but also on profits - simply, revenues less expenses.
Basic Structure of Incentive Fee - Profits
Unlike the structure of the Base Fee, the structure of the Incentive Fee is designed to align the interest of hotel manager and hotel owner. Over the past two decades the hotel industry has focused more on the Incentive Fee and has used the Incentive Fee as a vehicle to align the interests of hotel owner and hotel manager. The negotiation of the Incentive Fee can be quite contentious, as there are a variety of factors that can go into the calculation of the Incentive Fee. The basic structure of the Incentive Fee is a percentage of gross profits - gross revenues less operating expenses. Before we even add in the other factors, it is clear that this structure gives the manager an incentive to minimize the operating expenses. To go back to our example, in the event that the Incentive Fee is fifteen percent (15%) of gross profits, the Incentive Fee for the penny pinching manager would be $138,750, while the fiscally irresponsible manager would be entitled to nothing. The definitions of "gross revenues" and "operating expenses" are critical even in this basic Incentive Fee structure. Hotel managers and owners can spend hours negotiating which items will be included and excluded in these definitions. That discussion is beyond the scope of this article.
Incentive Fee - Raising the Bar
Many owners have raised the bar on managers by requiring the managers to meet a certain level of profits before the manager is entitled to share the wealth and earn an Incentive Fee. The "Owner's Priority" or "Incentive Fee Threshold" is designed to ensure that the owner is rewarded for taking the financial risk of developing and owning the hotel, prior to the manager sharing in the profits. Sometimes the Owner's Priority or Incentive Fee Threshold is a hard number, and sometimes it is a percentage of the debt on the property. The negotiation of the where to set the bar is often a long and arduous process. No matter how the Incentive Fee is structured, the idea is that all of the profits below the Owner's Priority or Incentive Fee Threshold belong to the hotel owner. In the event that the manager runs a tight ship and is able to meet or exceed the bar set for the Incentive Fee calculation, the manager is then entitled to an Incentive Fee.
The More the Merrier
Some owners and managers structure the Incentive Fee as a "sliding scale" -- the greater the profits, the greater the Incentive Fee percentage. This sliding scale option can be used with the basic Incentive Fee structure, or with the Owner's Priority or Incentive Fee Threshold structure. The owner and manager negotiate several breakpoints and as the manager meets or exceed these breakpoints, the Incentive Fee percentage increases. Therefore, the greater the profits, the higher the percentage of profits are earned by the manager. This structure clearly incentivizes the manager to increase the gross revenues and minimize the operating expenses, in order to increase the profits to the greatest extent possible - to increase the Incentive Fee percentage - and thereby, sharing the wealth.
Another approach is the Income Before Fixed Charges (IBFC) calculation for Incentive Fee. This approach is widely used in Europe and Asia. Income Before Fixed Charges generally is calculated by deducting from gross profits manager's Incentive Fee, debt service on any mortgage, capital repairs and other expenditures which are normally treated as capital expenditures under the Uniform System or GAAP, insurance, taxes and deposits into the reserves. In order to incentive managers to keep the hotel stabilized in distressed hotel situations, the Incentive Fee may be based on an improved IBFC. Therefore, much like the Incentive Fee Threshold, the Incentive Fee is based on a hard number or a threshold that the manager must meet or exceed prior to earning an Incentive Fee. The idea is to incentivize the manager to improve the situation. So even if the IBFC is negative, if there is an improvement from the prior year, an Incentive Fee is earned.
No matter how owners and managers structure the Incentive Fee, taking into consideration operating expenses, and profits aligns the interests of owners and mangers and therefore incentivizes the managers to minimize operating expenses and to be fiscally responsible. The often difficult negotiation the Incentive Fee structure and calculation is well worth the effort to ensure that owner's and manager's interests are aligned and that both parties are incentivized to make the hotel profitable.
Real estate attorney Tara Gorman represents sellers, owners and licensors in the acquisition, disposition, finance, development, management and leasing of major hospitality, resort and commercial properties. Her property deal portfolio includes domestic and international hotels, office buildings, condo-hotels, water parks, casinos, restaurants and retail stores. Additional areas of practice depth include telecommunications and finance. Ms. Gorman can be contacted at 202-654-6253 or firstname.lastname@example.org Extended Bio...
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