Case study

Le Méridien Hotels

by Professor Ian H. Giddy
New York University

In early May 2001, Iain Robertson, Chief Executive, Corporate Banking and Financial Markets at the Royal Bank of Scotland, was preparing for discussions with the head of RBS's private equity arm. Later that afternoon, both were to meet with an M&A team from CIBC and Merrill Lynch, acting as as advisors to Japanese investment bank Nomura. The subject was the role RBS should play in the proposed financing of Nomura's bid for the Meridien luxury hotel chain. Nomura financier Guy Hands, head of its private equity Principal Finance Group, was on the verge of  beating a rival bid by U.S. Marriott in the auction of the chain being sold off  by Britain's Compass Group. Nomura's proposed £1.85 billion ($2.65 billion) bid was dependent on raising the required financing, and RBS was keen to play a key role in this closely watched deal. 

To win the financing mandate, Robertson proposed that Royal Bank take a lead by offering a sale-and-leaseback arrangement for the bulk of the purchase price. The bank had experience with this technique, having used it earlier in the year to finance a group of Hilton hotels. The remainder would be conventional loan financing, plus equity from Nomura and others. Robertson wished to raise the possibility of the bank's taking an equity stake; he felt that this might clinch the deal. Rival Bank of Scotland had recently financed a similar hotel acquisition by means of a 50-50 joint venture. Another possibility was mezzanine finance -- subordinated debt with a substantial equity participation.

From discussions with Guy Hands of Nomura, Robertson understood that financing in the region of £1.85 billion would be needed, of which about £400 million would have to be equity. Nomura was prepared to contribute at least £200 in order to retain clear control. The M&A advisors were seeking additional equity partners. The 17-strong Principal Hotels, which Nomura purchased in February for 255 million pounds, would be integrated into Le Meridien Group, bringing the chain's size to 164 hotels. Hands' stated intention was to grow the chain to around 200 units, creating a portfolio of hotels which are either leased, franchised or under management contract, and eventually to take the company public.

Background to the Acquisition
By May 2001 the race for Meridien, which includes London's Grosvenor House and Waldorf hotels, had become a two-horse race between Nomura and Marriott and was the final part of Compass's seven-month-long hotels sell-off process.

Compass, the world's biggest contract catering company, was seeking to unload its hotels in order to focus on on the faster-growing contract catering business. The group had already raised 1.36 billion pounds from the sale of its Posthouse, Heritage and Signature chains. Chairman Francis Mackay had targeted a price of 1.8 billion pounds to make sure the group's overall hotel auction comfortably beat his minimum sell-off price of three billion pounds for their hotel businesses. The bankers handling the sale were Schroder Salomon Smith Barney and Dresdner Kleinwort Wasserstein, 

The luxury global hotel group Le Méridien was established in 1972 by Air France “to provide a home-from-home for its customers”. The first Le Méridien property was in Paris: Le Méridien Etoile. Within two years of operation, the group had ten hotels (in Europe and Africa) and 21 hotels within the first six years, located in Europe, Africa, Caribbean (French West Indies), Canada, South America, Middle East and Mauritius. By 2001 the company had 146 four and five star hotels in 63 countries and territories. The portfolio was a mix of owned properties and managed hotels. The hotels made an operating profit of £170m in 2000 on sales of £493m. EBITDA was an estimated £147m. The proposed price was approximately 10 times historic earnings after central costs.

Indicative offers for the hotel chain had been as high as 2.2 billion pounds, but fears of a slowdown in the United States which would cut transatlantic travelers to Meridien's largely European hotels forced prices lower.

Issues for Discussion
1. What kind of financing package would enable Royal Bank to beat other commercial and investment banks in the Meridien deal? Who are potential rivals, and what strengths might give them a competitive edge?
2. If RBS offers sale-and-leaseback financing, what should be the structure and terms of the deal, terms that make sense for the client as well as for the bank?
3. If RBS offers equity participation, what form should this take? Common stock or mezzanine finance? Or should the bank avoid the risks of an equity investment?
4. Would asset-backed securities be suitable as a financing source for this acquisition?


Appendix 1. Hotel Financing Trends in Europe

Excerpts from an article by Stephen Potel, M.A (Oxon) F.R.I.C.S. Director InterBank Capital Partners Ltd. (London).

One of the most important recent trends in the European hotel financing world over the last year is the increased interest from the larger funds and particularly from banks to participate with equity in the hotel and leisure sector. Until recently the investment funds have shown a very limited appetite for investing in hotel assets and most finance had to be raised the traditional way, namely through senior mortgage debt or corporate bonds and -for the public listed companies – equity issues.

So, gone appear to be the days when banks made loans and investors invested equity. "Nowadays, lenders that used to tiptoe quietly into mezzanine territory (calling it quasi-debt or quasi-equity depending on their credit committees) are boldly crossing over into fully fledged equity investment" says Chris Eddis, Managing Director of Mornington Capital Ltd.

“But that's not what banks do!” exclaims one prominent English banker, with expertise in the hotel sector. Well, they have been doing precisely that for many years in other countries, such as Germany, so its nothing new.

“And banks are there to help their customers, and this is a different way of doing just that" says Trevor Ward, Managing Director of TRI Hospitality.

In the USA, according to Brendan Sullivan, President of Interbank Brener Hospitality, “It is almost unheard of for a commercial bank to make a direct equity investment in a single asset, portfolio or hotel company. In the States the traditional sources of equity are pension and opportunity funds, investment banks such as Lehman Brothers, insurance companies, high net worth individuals and the public markets.”

In Europe there are three main conduits for the commercial banks and equity investment funds to put equity into this sector – Sale and Leasebacks, Joint Ventures and Limited Partnerships.

Sale and Leaseback Transactions.
Although the sale and leaseback structure has been widely used for the property sector for decades, it is only recently that this method has been openly embraced by lending banks for the hotel sector. 

An interesting instance of the structure was the Hilton sale and leaseback financing, backed by Royal Bank of Scotland, where Hilton’s rent is based on 25% of turnover of which only just over 4% is guaranteed. The new and interesting feature of the transaction is that the linking of the lease rental obligations to turnover, with a low guaranteed rent, enabled RBS to benefit from the above average growth prospects they see in the hospitality sector.

So, rather than just sit back and collect interest payments, the banks that are wise to the hotel sector – as RBS and BoS certainly are - appear to be merely benefiting from their insider knowledge of the sector and familiarity of management, and in turn are rewarded by earning returns on their own equity that are far in excess of those earned from straight lending.

The downside from the operator's point of view is that it is committed to a 20 year lease obligation, which in the States would need to be classified as a contingent liability on its balance sheet, plus such a structure would result in the operator losing out on the capital growth of the asset.

Joint Ventures.
Joint Ventures present another means of achieving a similarly symbiotic relationship between financing the “bricks” (property assets) and incentivising the “brains” (management skills) of the hotel business.

Typical recent examples of JVs include the £140 million fund established between Thistle Hotels and Morrison construction, or the 50/50 JV of MacDonald Hotels with Bank of Scotland to acquire Heritage Hotels, where each side invested £31.25 million, in which instance the bank also has the chance to provide senior debt (in this case, £210 million), and the operator is able to book long term management fee income. RF Hotels entered into a £270 million JV with Bank of Scotland, with each side investing £35 million, supported by a further £200 million of debt (primarily from Bank of Scotland) in order to continue expansion of the luxury chain of hotels across Europe.

Limited Partnerships.
The relative lack of liquidity for buying and selling partnership interests has not hampered the growth of LPs in recent years. The advantages of tax transparency, and the higher gearing that the LP structure affords for the larger equity funds (who are not able to borrow on their own balance sheet) often make this a more attractive play for large equity investors than buying of a hotel company's shares on the stock market, particularly when the majority of hotel companies trade at a discount to net asset value. The quality of the management team is clearly of vital importance in this equation, as a means of unlocking capital gains and equity value growth for the underlying hotel portfolio. Marylebone Balfour Warwick and BAA Lynton have pioneered this form of institutional co-investment, in the UK at least. In particular, this method has enabled BAA Lynton to exploit the value of its airport real estate – at the effort and with the expertise of hotel partners - without having to relinquish control.

Appendix 2. Mezzanine Financing in Europe

What is mezzanine finance?
Fitch defines mezzanine as filling “the gap between senior secured debt and equity.” The mezzanine ranks just below the senior debt in a default situation. Covenants are usually similar to those on senior debt, but tend to be more flexible.

Bank of Scotland's Graham Sturrock has a more prosaic definition: “Mezzanine reaches the parts [of the deal] that senior debt cannot and equity will not.” And with the buy-out market becoming increasingly competitive, these gaps are getting larger and more frequent.

Users of mezzanine finance have traditionally paid for the capital in three ways. Firstly, there has been the coupon payment, which has usually paid about 400 basis points above LIBOR (London InterBank Offering Rate). Secondly, an additional 400 basis points of interest payments – known as payment-in-kind (usually abbreviated to PIK) – is charged. This payment is receivable at the end of the mezzanine term, enabling a greater proportion of the cash flow to be reinvested in the ongoing business, rather than used to service the debt. 

The final element of payment comes in the form of equity warrants. This can represent up to six per cent of the amount lent. Mezzanine providers are looking for returns in the high teens and low twenties, but the warrant portion can push the returns beyond this. 

Christian Marriott of Mezzanine Management cites the example the Quadriga-led DM310m acquisition of the German facilities management and contract catering business, NWG. MM underwrote a DM70m mezzanine facility, though only DM30m was drawn down. A year later the business was sold to a Danish strategic buyer, netting Quadriga a stunning return, while MM recorded a time-weighted IRR of 54 per cent from a pure mezzanine investment. 

The move to bigger deals
Providers of mezzanine finance come from several sources. The independent finance houses, such as ICG, Mezzanine Management, Indigo Capital and Pricoa Capital, have been sources of financing. Their main competition has been from several of the lending banks, notably Royal Bank of Scotland and Bank of Scotland in the UK, which are now moving into continental Europe. 

Both the bank-backed providers and the independent houses have been forced to change their modus operandi in recent years. First, because their customers’ needs have changed and second, because the market has become increasingly competitive.

In simple terms, leveraged buy-outs have become bigger, and over the past year the size of the mezzanine tranche has grown with them. The buy-out of Irish packaging group Clondalkin at the end of 1999 used a €120m tranche of mezzanine, which was not refinanced through bonds. Five months later, the refinancing of French laundry company Elis attracted a €130m tranche. In the same month Goldman Sachs provided a FFr1.8bn tranche of mezzanine to finance the ill-fated buy-out of the Anglo-French auto parts company Autodistribution. 

Yet even as Autodistribution was falling apart, the market was still prepared to do bigger deals. The recent buy-out of German chemical business Messier Griesheim was almost financed by an unheard of €600m tranche of mezzanine. Only an exceptional demand for high yield paper outside the telecoms sector, and subsequent attractive pricing caused Goldman Sachs and Allianz Capital Partners to plump for a bond issue. 

Existing mezzanine investors have responded by stepping up the size of their investments. ICG now lends up to €150m, though some of this may be syndicated. Likewise, Royal Bank of Scotland, which has traditionally dominated UK mezzanine finance with its cross-town rival Bank of Scotland, has stepped up the size of its offering, with backing from its newly-enlarged balance sheet. BoS will up the ante when the Halifax merger goes ahead.

New kids on the block
Meanwhile, the mezzanine market has attracted a number of new players. GSC Partners, which runs private equity and high yield funds in the US, has come over to Europe to set up a mezzanine fund. The investment banks have also entered the market. Goldman Sachs, Merrill Lynch, Lehman Brothers and Donaldson Lufkin & Jenrette (now part of Credit Suisse First Boston) have all raised mezzanine funds of over $1 billion. However, only Goldman’s fund has a mandate to invest a significant proportion of its fund outside the US.

The most radical of the new players is AIG MezzVest, a new fund founded by several Bankers Trust executives and backed by US insurance giant AIG and private equity house CapVest. The fund is set to have about €1bn to invest. But while other funds make the majority of their mezzanine financing using equity investment, perhaps borrowing the equivalent of about 30 percent of the overall investment, CapVest takes a more aggressive approach, borrowing up to 70 per cent of the overall amount invested.

Managing director and founder Lemy Gresh describes the overall fund as similar to a Collateralized Debt Obligation (CDO) devoted solely to mezzanine, but with several differentiating factors. Gresh says: “A CDO is set up and invested within a matter of weeks. It uses lots of leveraged instruments, is actively traded, more diversified, and uses ratings to secure loss minimization. We will use substantial due diligence on fewer investments.”

CapVest is adopting a different structure for its investments. It has dismissed the use of equity warrants as simply diluting the equity returns: “Warrants are like death by a thousand cuts to equity investors,” says Gresh. Also, warrants are not tax deductible, unlike the Payment-in-Kind, which can be offset against tax. CapVest plans to focus solely on cash coupon and PIK. Not one of the ten or so investments will have an equity portion. While a traditional mezzanine fund would typically have equity warrants representing between three to six per cent of the amount lent, CapVest’s investments will have a PIK returning between ten and 15 per cent, compared to the more usual PIK returns of between three and seven per cent.

In addition, the high level of leverage – initially made up with bank facilities – will ultimately be financed by an asset-backed bond issue. However, investors in the bond will want the predictability of cash flows, not the potentially high but risky rewards from equity warrants.

The end of the warrant?
But not everyone wants to see the end of equity warrants. First, the PIK-style structures suck more cash out of a deal. PIK notes take at least 20 per cent of the cash back, compared to the high teens for traditional mezzanine structures. If the mezzanine is being used to finance the buy-out of a highly-rated business, the additional equity financing from the warrants becomes more attractive.

Private equity investors also like the alignment of interests with lenders that equity warrants provide. With the warrants, the mezzanine provider has an interest in seeing the value of the company grow, rather than simply seeing the debt repaid. However, others point out that the mezzanine provider will usually side with the lender and not the equity investor: “If the deal gets to the stage where the repayment is in doubt, the equity warrants are going to be pretty low on the list of concerns,” says one private equity investor.

Meanwhile, despite frustration that the high yield market has never really taken off in Europe, it does have one big advantage over mezzanine: price. The Messer Griesheim high yield bond cost 14 per cent, compared to the near 20 per cent that alternative financing might have cost. Even considering the fees of around three per cent charged by the bank to arrange the deal, the cost is still attractive. Also, the borrowers face less supervision from the lenders and, provided they avoid breaching the usually fairly unrestrictive financial covenants, they can avoid interference from meddling bankers. 

However, mezzanine – which is usually syndicated to around 15 to 20 investors – is, from a lender's perspective, easier to handle, because if there are problems the syndicate can negotiate as a unified body. If a bond defaults, there may be thousands of (often anonymous) parties trying to recover their capital. 

Moreover, if the buyer does find itself in trouble, mezzanine finance is less likely than high yield bonds to lead to exposure in the press. Stringent SEC filing requirements for bonds mean a high level of public disclosure – arguably (at least in terms of frequency) even higher than the levels required for a European equity listing. Indeed, investment bankers even promote high yield bonds as a prelude to a public listing.

It is not just potential users of high yield bonds who have turned to the mezzanine market. Traditional users of securitized finance are also turning to alternative – and more flexible – sources of finance.  Mezzanine is here to stay.

Case study: Picard Surgelés
When Candover Investments bought French frozen food retailer Picard Surgelés in February, the buyers hoped that an opportunity to exit the investment would arrive within the next three years.

This ruled out the possibility of using high yield bonds, because any early repayment of the bonds with cash raised from an IPO would have triggered onerous penalties. Candover director Christopher Spencer says: “High yield bonds are not as cheap as people think, especially if you might float the company in a few years.”

Instead, Candover’s bankers, UBS Warburg, joined up with Intermediate Capital Group to provide a debt package, with several varieties of mezzanine making up a significant proportion of the overall finance.

Of the €920m purchase price, more than €160m of the financing was mezzanine products. Of this, €122m came from mezzanine bonds and €40m from PIK mezzanine. 

The mezzanine bonds – which are equivalent to traditional mezzanine debt in all but name – pay four per cent cash margin and four per cent capitalized margin and include equity warrants that represent about six per cent of the ordinary shares. The PIK has LIBOR plus three per cent payable rolling up to payout after three years, plus seven per cent capitalizing interest.

“The reason we put the PIK in was to get more leverage in the deal. It is a highly leveraged deal in terms of multiples, though not in terms of debt to equity,” says James Davis, assistant director at ICG.

However, ICG is holding on to some elements of the traditional mezzanine structure. The PIK tranche carries warrants representing four per cent of the equity. For some mezzanine houses, the equity is still where the action is.

By Ben Wootliff of the Daily Telegraph.

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