What is due diligence?
Particularly in the context of a hotel acquisition, “due diligence” generally refers to the investigation conducted by a potential buyer of the hotel that is the target of the acquisition. The investigation covers both the physical asset (i.e. the hotel structures, parking, systems, equipment, inventories) as well as the operating business conducted at the hotel facility, and the relevant markets and environment.
The purpose of the investor’s due diligence is to understand and evaluate the potential investment in the hotel. It is the analytic review of the real and personal property, the business operations and potential of the specific hotel. This effort all seeks to validate the investor’s reasons for buying the hotel and to avoid surprises after the purchase has closed.
Perhaps the most significant element in the buyer’s calculation of a bid or purchase price is the analysis of the potential earnings to be derived from the hotel. To develop the proposed acquisition price, the buyer must make assumptions as to future market conditions and the hotel’s performance within that market. These assumptions will be reflected in a discounted cash flow on stabilized operating projections. Thus, a preliminary business plan which reflects assumptions as to physical facilities and condition, management, affiliation and other factors must be developed in order to assess the potential acquisition realistically.
Because your bid or purchase price is based upon a calculation of anticipated revenues and expenses, the due diligence process is critical to validate or gain comfort with your assumptions on these cash flow analyses, and to avoid unnecessary surprises. Unforeseen expenditures to replace leaking window systems, replace boilers or cooling towers, demolish a portion of the hotel which encroaches on adjoining property, or meet a new property improvement program from the brand — these can all play havoc with purchaser’s expectations if they weren’t anticipated.
What are the biggest complaints from buyers about hotel due diligence?
The complaints we hear usually go something like this:
- I wish I had done more due diligence sooner!
- If I had found this out two weeks ago, I would have had better options.
- We could either have renegotiated the deal or saved a lot of money before we walked from the deal.
In today’s seller’s market, the time allotted for due diligence, deposits going nonrefundable, and closing has been greatly compressed. All sophisticated buyers know they have to act fast. But it bears repeating:
- Assemble your due diligence team. Coordinate your team with detailed due diligence checklists. And control the process or have a quarterback do it for you.
- Start your due diligence as early as possible.
- Prioritize and push critical areas of due diligence so potential “show stoppers” and other important factors can be identified and evaluated early.
Great due diligence begins with properly drafted seller’s representations and warranties in the purchase agreement.
Because most hotel purchase agreements are written with strong “as is” language, and express provisions that a buyer must rely on its own due diligence, many buyers do not spend enough time focusing on seller representations and warranties. This is a mistake. Regardless of significant disclaimers in the purchase agreement, having a set of properly drafted representations in the purchase agreement by experienced hotel counsel can significantly help flush out critical issues concerning the physical and operational hotel issues that only a seller or its management company would understand.
A few buyers may rely upon a seller’s representations and warranties in place of their own due diligence plan, but that too is a mistake. A buyer must execute on its own due diligence plan as if the seller made no representations. A fundamental part of a buyer’s due diligence plan should be in the discussions, negotiations and tailoring of the seller representations. Even if the seller is unwilling to make a specific representation and warranty on a particular condition, focusing on the issue up front will help frame the buyer’s post-signing due diligence.
Some buyers erroneously believe that the indemnification clauses of a purchase contract will protect the buyer.
However, indemnification clauses usually are inadequate to protect a buyer from additional costs that could have been avoided with proper due diligence. Indemnification generally applies only for breaches of representations and warranties, and if the seller limits or qualifies its representations and warranties, the indemnification provision may not be triggered.
In addition, indemnification is often limited by deductibles, buckets, caps and expiration dates, any of which may exclude indemnification. Further, in many cases, once the seller sells the property, the seller (or selling entity) will distribute the proceeds of sale and may have no assets left with which to pay any indemnification. Finally, even if none of the above limitations apply, the seller may simply refuse to pay the indemnification, and the buyer will then incur the cost of suing the seller to obtain the indemnity.
While indemnification can have limited value, it is no substitute for the buyer’s independent due diligence.
Because of these issues, the buyer’s first line of defense from unexpected loss is solid due diligence, accompanied by a process of working through representations and warranties in the purchase and sale agreement. Indemnification is the last line of defense. By performing due diligence in the early stages of a contract negotiation, the buyer will have more alternatives, less costs and more negotiating power to deal with the issues.
Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.