Hotel Management Agreements: A Guide to Side Letters

What are side letters in the context of a HMA?

These are confidential agreements between owners and branded operators as a side agreement to an HMA. The side letter is intended to vary some of the provisions of the HMA, commonly as a personal concession to the current owner (although they may also record personal concessions to the operator). They can also apply to franchise agreements but are less common in this context. This article covers owner concessions in HMAs.

The side letter is one of the least transparent aspects of a hotel management transaction as the operator will want to ensure that the details are kept entirely confidential, even to a prospective buyer of the hotel. The side letter will be expressed to fall away on a third-party sale by the current owner so a buyer does not benefit from the special concessions. This means that the current owner would not have to disclose the side letter terms to a prospective buyer, which is made easier by the terms being contained in a standalone side letter. 

How common are side letters?

In short, it's not common and definitely not a “usual” part of any HMA transaction, but there is an increasing trend towards use of the side letter. They will usually only apply in circumstances where the owner has a high degree of leverage over the operator. An example of this is in an operator selection process for a hotel property which a number of operators are keen to manage. The offer of concessionary terms for the current initial owner/ developer could be a point of distinction for a brand over and above the financial terms. Operators may be more prepared to give concessions in confidential side letters than have variations to the key terms in their HMAs.

What do side letters cover?

The lack of transparency makes this quite hard to answer, but based on our experience and as examples, the side letter might contain any of the following:

• Special termination rights - it’s rare for any HMA to have a right for the owner to terminate the HMA other than for cause. Some side letters contain a special owner right to terminate the HMA on a set date or on an arm’s length sale where the third party wishes to acquire the hotel unbranded, where the operator does not wish the termination right to be included in the HMA. The provisions may provide compensation for the operator which is calculated by a multiple of annual fees. Other termination rights seen in side letters allow owners to terminate without any compensation to the operator if certain conditions precedent are not met (such as obtaining financing, acquiring land or securing planning permission).
• Revised performance termination rights - also rare in HMA relationships is a situation where the owner terminates the HMA because of the existence of performance termination provisions. This is because the performance usually has to fall below the required level for two consecutive fiscal years. In addition, the wording of the performance termination provisions will contain exclusions for the benefit of the operator, based on comparison to “comparative sets” of named hotels in the same market and to other circumstances outside the control of the operator. A side letter can contain a revised performance termination right which could lower the performance thresholds or amend the exclusions or requirement for the test to be failed for two consecutive years.
• Notional or “Virtual” FF&E reserve funds - most HMAs require the owner to reserve a percentage of gross revenues into a cash reserve fund which the operator can apply to the replacement or upgrading of FF&E for the hotel. A side letter could create a notional or “virtual” FF&E fund where the owner is not required to advance cash into the reserve fund but instead must supply the operator with appropriate funds when required. The operator may want to put strict limits on the timing of providing required funds and impose a right to terminate the notional or virtual nature of the reserve fund if the owner defaults in paying the required sums on an agreed number of occasions.
• Capital expenditure limitations - the owner could request a concession from the need to carry out a major renovation or upgrade of the hotel to comply with the brand standards for a set period of time following initial construction or refurbishment;
• Priority returns - the operator could agree that for a period of time the owner (who may have expended significant funds on construction or refurbishment) gets a priority return from the gross operating profits of the hotel ahead of any incentive payments to the operator.
• Flex to Franchise - the owner could have a right to require the operator to convert the HMA into a franchise agreement. It’s important that the terms of the franchise agreement that would be entered into in place of the HMA are set out in detail in the side letter.
• Other special rights - the owner could want approval provisions over and above that set out in the HMA such as on appointment of the general manager or over retail/ restaurant operators in the public areas.

Don’t expect an operator to agree all these points on your next deal - these are variations to the general owner-operator relationship terms, but hopefully this article gives a glimpse into the sorts of negotiations that can apply to some deals.

From an operator perspective, it is important to make sure side letters are carefully drafted to ensure that they do actually expire on a third-party sale of the hotel, including on a third-party change of control at the shareholder level. This can be challenging where an owner has a complex ownership structure.