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Bigger money, smaller deals in Europe

The story of Europe’s near-term M&A pace isn’t going to be told in billions. It’s the small and mid-sized hotel platforms that have the biggest targets on their backs.

Vulnerable even pre-COVID-19 because of European market fragmentation and the classic problems inherent in limited scale, a significant number of pandemic-beleaguered owner-operators and niche brands in this bandwidth will be at the negotiating table well before a recovery projected for 2022 to 2024.

Hotel investors may find small and mid-sized hotel owner-operators and niche brands in Europe are attractive acquisition targets – “provided that they have good story and a clearly defined product,” one consultant says. | Getty Images
Hotel investors may find small and mid-sized hotel owner-operators and niche brands in Europe are attractive acquisition targets – “provided that they have good story and a clearly defined product,” one consultant says. | Getty Images

Contributed by Mary Scoviak

The good news for capital circling Europe for a year or more is that some interesting hotel assets finally will come to market. How many initially depends on the banks and, of course, coronavirus. Lenders pretty much have to extend forbearance into 2021 to keep economic recovery on course. However, their noblesse may be finite as they face down problems of their own. Standard & Poor’s (S&P) Global Ratings is projecting US$228 billion in credit losses for western European banks over the next two years. Most will survive, predicts the report, but their capital buffers will be thinner.

‘The reality of the situation’

“When we move into Q4 2020, the reality of the situation will be clearer to lenders,” said Nick van Marken, managing director of advisory van Marken Ltd., London. “They’re going to be looking at cleaning up their loan books.” They also may be revisiting whether they want further exposure in the hotel sector. If Fitch Ratings’ prediction – no full recovery of 2019 occupancy rates until 2023, if all goes well, or 2025 in a stress-case scenario – more banks may be looking to offload portfolios and limit their hotel exposure only to the Accors, IHGs, and Whitbreads, and a few select customers.

An added twist could drive transactions. As S&P Global pointed out, “For banks reporting under International Financial Reporting Standards (IFRS), a crucial question is whether loans under forbearance measures are experiencing a significant increase in credit risk since origination, because that is the trigger for the loan moving from a 12-month expected credit loss (ECL) provisioning requirement to a lifetime ECL.”  

That could be problematic for hotel borrowers that can’t demonstrate a long-term record of over-achieving and are having trouble getting average occupancies north of 20%. They face double exposure because of their individual risk profile and that of the hotel sector. Industries “with limited scope to reshape for an era of social distancing,” such as airlines, hospitality and high street retail may be at the severest risk, according to Ralph Hollister, travel and tourism analyst at GlobalData.

Workouts and work-arounds have kept distress levels manageable. “They haven’t played through to any collapses,” van Marken said. At least, not yet.

That could change near term as more companies such as the U.K.’s Travelodge Hotels Ltd. find they cannot outwait Europe’s slow hotel recovery — as in average occupancies of 15% compared with 47% in China and 38% in the United States, as reported by STR.

Currently, the U.K.’s largest independent hotel company with 570 hotels totaling 40,000 rooms, this limited-service operator suspended rent payments after failing to pay its Q2 bill and launched a proposed Company Voluntary Agreement in June that seeks to halving rent payments for the remainder of 2020 and 2021 as part of its recovery plan. Just for context, a company statement pointed out, “Travelodge entered 2020 with a record level of cash reserves and delivered five straight years of strong growth, outperforming the midscale and economy sector and its peers.”

Limited-service and extended-stay brands are “immensely attractive” as acquisition targets “provided that they have good story and a clearly defined product,” van Marken added. “Both concepts have demonstrated a great deal of resilience [in downturns].” He also points to prospects for hostile takeovers.

These types of portfolios can fill offensive and defensive gaps for big brands that already have their worst-case financing. They also feed IRR for private equity players and institutions who like their low-cost business model and the affordable rates at a time when stir-crazy consumers are getting back on the road (albeit with flatter wallets). Money people with less risk aversion may also be looking to scoop up differentiated hotel-apartment flat hybrids, digestible luxury collections or groups with large-scale convention or group business hotels.

There will be a few trophy assets up for sale, as usual. But the majority of deals will more likely be struggling small to mid-sized portfolios that had done well only because the market was rising. They and got swamped by COVID-19. Companies that got “overstructured” are also on the watch list.

Anders Nissen, CEO of Pandox AB, likes the prospects for “complicated” deals and portfolios of underperforming assets with potential to add value. where value can be added.
Anders Nissen, CEO of Pandox AB, likes the prospects for “complicated” deals and portfolios of underperforming assets with potential to add value. where value can be added.

Anders Nissen, CEO of Pandox AB, Stockholm, sees a pipeline of assets coming from owners who want to redeploy their capital to steadier industries.

“Quite a number of investors got their fingers burned because they failed to understand how the hotel market works and how to create value,” he said. “Passive owners who bought hotel properties at low yields with fixed leases are now realizing it was much riskier than they thought.” They’ll be looking to exit, he predicted.

Although he’s waiting to shop seriously until the banks take action and he has a better read on how Europe will manage recovery, Nissen likes the prospects for “complicated” deals and portfolios of underperforming assets where a seasoned owner-investor can add value.

They shouldn’t be hard to find. Only 38% of Europe’s room market falls under hotel chains’ flags, creating opportunities to leverage brand marketing and operational impact. Other opportunities range from the upside of expanded scale to the value of their pipeline — if and only if they can prove these deals have financing and will get done.

Shift in structure

The pandemic has also opened up some new profit options for current buyers. European hotel owners squeezed by COVID-19 are looking to swap long-termed fixed leases with turnover-based agreements. That would mark a major change, especially in Germany, Italy and Spain. Investors with strong banking relationships could be persuasive enough to get landlords to shift their structure.

While not a fit for Pandox’s portfolio, Nissen agreed that for other investors limited-service and extended-stay could be better plays than lifestyle concepts. “The only exceptions would be lifestyle resorts,” he said. “Some lifestyle resorts are running at 100% occupancy.”

As for where the deal drivers will be, van Marken noted that Germany is leading Europe’s recovery. “I think the hotel market will follow suit,” he said.

Conventional wisdom is betting on deals in major urban centers to fuel the M&A pipeline, but Nissen disagreed. He likes the prospects of deal-making for assets in cities “that have an ambition to grow as business and leisure destinations.” That would include regional cities such as Manchester, Leeds and Sheffield in the U.K. (Brexit isn’t a near-term hurdle at a time when local travel is a high priority), growing cities in Germany such as Hanover and destinations throughout the Nordic countries.

Both van Marken and Nissen are studying southern Europe as well. “There’s been a bit of a north-side divide on reopening in Europe,” van Marken said. “Southern Europe was more exposed to the virus, but I don’t think anyone in Spain is thinking, ‘Offer me half price and I’ll take it.’ That’s not going to happen.”

The question is, what is half price? Valuations have nosedived throughout Europe as they have everywhere else. Lack of distress has kept the bid-ask gap fairly wide, but that may be closing as the ill effects of the pandemic linger.

“Buyers are thinking values are down 30% to 40% minimum. Sellers are thinking more 10% to 15%,” van Marken said. Most industry watchers predict that narrowing will be closer to the low end unless hotel performance turns around well ahead of schedule and puts some cash into operators’ coffers.

One thing is clear: There’s no lack of interest. “Private equity, including some of the big U.S. firms, is salivating at the prospect of what might come across their desks. In the widest possible interpretation, Europe looks like a pretty appealing hunting ground,” van Marken concluded.

Don’t count out other big players, especially in central Europe. While private investors dominated transactions in the region in 2019, institutional and listed investors still managed to acquire hotels worth US$732 million, representing 43% of the total volume, according to Cushman & Wakefield. All three are still in the hunt, as are global businesses looking for an affordable avenue for diversification.

Does all of that add up to a banner year for M&A? Probably not. But, it does mean the European hotel landscape will be much more tightly consolidated in time for the next upcycle.

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