Incentive Fees: Aligning the Owner's and Manager's Interests
Do you get what you incentivize?
By Tara K. Gorman Partner, Perkins Coie LLP | August 28, 2011
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.