M&A in a Period of Uncertainty
The month of March 2020 unleashed the full impact of COVID 19 on the hospitality sector. Business had already started drying up at the start of the month but came to a grinding halt with the essential lockdown. It was almost like seeing an ascending vehicle, on a dream run (of 11 wonderful months), ultimately fall off a steep cliff.
Working Capital Challenges – Hotels almost function like a continuous-process industry like a steel plant or an oil refinery. They run 24X7X365 and never really shut down, even for maintenance. In doing so, they incur high fixed costs in the form of payroll, energy charges, licenses and maintenance. Due to the lockdown, most hotels across the country would have witnessed 2 months of nil or negligible revenues but still have 70%-80% of their costs intact. Furthermore, even in an optimistic scenario, business is expected to normalize only after 12-18 months due to the fear psychosis around travel. This brings to the forefront huge working capital inadequacy that hotels are grappling with. Most hotels have already taken extensive measures to minimize operating costs for the forthcoming months. However, fiscal needs of this magnitude cannot be overcome by austerity measures.
Hotelivate Recommendation – The sector needs access to fresh credit lines for its medium-term needs; a large part of which is spent in giving salaries to millions of workers. Existing lending institutions must provide for an additional working capital financing of 12-18 months. This could be appended to the existing term loan (back-ended). This solution could also include hotels with less-than-ideal credit history by using additional collateral from the owners.
Debt Distress – An estimated INR50,000 crores worth of outstanding loans are attached to hotel real estate. The Reserve Bank of India took a step in the right direction by announcing a 3-month moratorium on all debt payments. However, a longer-term hospitality sector-oriented debt capital solution is urgently required. Hotels run a plausible risk of protracted operating losses, making it virtually impossible for them to discharge their financial obligations. In the absence of fiscal engineering, almost all levered hotel projects run the risk of being classified as Non-Performing Assets (NPA) by the lending institution. RBI needs to step in with some decisive measures to prevent this massive implosion which can have a catastrophic impact on the Indian tourism industry & lodging market.
Hotelivate Recommendation – The sector needs a moratorium from all principle and interest payments for atleast 18 months via a notification by RBI. This will allow hotels to avoid a credit de-rating and help the lender operate with a lower capital (for provisioning) for a non-NPA account. Hotelivate also suggests that the tenure for all operating hotel’s term loans be extended by 5 years with accelerated prepayment clause. Banks and lending institutions must be sympathetic towards the special needs of hospitality, which along with airlines, is the worst hit sector. Hotel businesses with good credit history could also be allowed special loan re-structuring terms to tide over this systemic issue. Such meritorious businesses with special relief packages may, in turn, be instructed to guarantee a no-retrenchment policy.
Sale of assets – Deep demand shocks are expected to present an acute liquidity crisis over the next 6-12 months. While companies with stronger balance sheets or no leverage may be able to weather the storm, many run the risk of going belly-up and of a hostile take-over by lending institutions. Most hotels need a loan re-structuring plan or a significant equity infusion by the parent company. Failure to find valuable funds would make it inevitable for some hotels to change hands.
Market Outlook & Trends:
- Cash flow quandary will not ease out in a hurry. Hotels typically operate with 2-3 months of cash in hand to cover operating expenses. Most hotels would have exhausted their working capital by July 2020. This will also coincide with the expiration of the free-moratorium period for operating assets. Most hotel businesses are woefully unprepared to manage this double whammy and are truly expecting policy-level relief from the government at the time of writing of this paper.
- Selling pressure will only increase with time. Acute stress expected in short term (2 quarters) and medium term (3-8 quarters) for hotel owning entities. We believe many hotel owners would be unable to bear the pressure of a mounting debt scenario beyond two quarters. Such owners would need to explore options for part/ complete stake sale. Larger enterprises, especially conglomerates, may have a greater tolerance for cash-flow mismatches. Single asset owners will have lesser options to exercise.
- Buyers will be rare and selective. Over the next 12 months, fresh debt capital for hotels is expected to remain sluggish and highly merit-driven. Hotel transactions will be largely funded by equity capital, further limiting the buyer universe. Most private investors/ UHNIs looking into hotel deals are expected to withhold buying decisions due to a contraction in their own source of wealth. Conversely, long term institutional investors with strong balance sheets will intensify deal-making activity but would seek a judicious use of their dry powder to acquire hotel assets at discounted values. Deals that pass high standards of deal execution and due diligence are likely to get consummated with buyers refusing to go along with the ‘iffy’ ones.
- Quality may trump quantity again. While the presumption is to acquire hotels at seriously distressed valuations, battle-scarred investors prefer assets that come with an upside via active asset management. Valuations dependent on trailing 12 months EBITDA (and now forward 12 months EBITDA too) may not always be indicative of the inherent value in the asset. Deep investors would prefer to acquire high quality, high potential assets over cheaper but low-potential assets. Quantum of potential is superior to depth in discount.
- Terminal capitalisation rates to move northwards. Valuation struggles intensify during Black Swan events like COVID 19. Given the impending weak sectorial outlook, buyers in current times would want to factor in higher perceived risk, higher cost of capital and therefore seek higher capitalisation rates. During downturns, it becomes exceedingly difficult for buyers to assess fair value and premium for the target. Cognitive biases are often seen to cloud vision and judgement. Making two sides of the deal table see each other’s point of view was never easy; external event like COVID 19 will make it arduous.
- Sometimes it helps to arrive late. Under-construction hotels have the advantage of being able to time their entry in consonance with favourable tailwinds in the market. We expect hotel developers may choose to delay projects significantly; this may be preferred over opening in a choppy market and unsupportive macro-conditions. Having said that, additional or fresh equity or debt capital for unfinished projects may not be readily available.
- Mergers & Acquisitions may take a backseat. Over the last few years, strategic investors for hospitality focused companies have been emerging from within the sector like Louvre hotel’s acquisition of Sarovar Hotels and Keys portfolio by Lemon Tree Hotels. With a rapidly deteriorating fiscal condition of hotel companies, strategically motivated investors are likely to hibernate indefinitely. Any distress M&A activity will need to draw in funds from pure financial investors like PE funds; who may be focused on other real estate assets like warehousing, data centres or in digital/ technology led investments.
In closing, 2019 was one of the landmark years for hotel transactions in India. Buoyed by the exceptional operating performance of hotels since 2016, a total of 13 deals with a valuation of INR5,900 crores consummated last year; the highest ever in its history! The year 2020 also took off to a great start with the completion of 8 deals valuing INR1,400 crores within the first 2 months. Hotelivate Investment Advisory was exclusive advisor to three successful transactions in 2019.
We expect Q4-2020 to see intensification in deal pipeline because of this negative external event. The ratio of transactions involving rescue deals, restructurings, and distressed sellers will likely increase. It is imperative for hotel owners to conduct a careful assessment of their 12-months cashflow situation and have a plan for the worst-case scenario. Owners of ‘borderline’ hotels may have to reconcile with the sale of the assets and cut their losses. Sadly, not having a plan is not an option anymore.