Introduction – the region's hospitality market

Raising a flag over a Middle East hotel was for many years achieved largely by a hotel management agreement (HMA). This assisted owners (then unfamiliar with the ins and outs of operating international brand hotels) to quickly establish their properties and gave the brands access to a new, exotic and growing market without compromising on brand standards.

Though still considered emerging, the region's hospitality market is rapidly maturing and diversifying. Coupled with an increasing range of brands across all scale ratings, there has been a noticeable shift to franchise (including third-party operators and heightened owner engagement).

Franchise, predominant in North America and widespread in Europe, may not have been considered when HMAs for most Middle East hotels were first entered. But as these agreements approach expiry or renewal, their owners may have a golden opportunity to explore alternatives.

This could include a switch to franchise or a half-way step in the shape of a manchise agreement. Some forward-thinking owners may already have a manchise agreement in place and find themselves considering when to make the switch to franchise.

Against this backdrop, the benefits of franchise can be significant. Numerous studies expound the advantages, including lower fees, greater control over budgets and operations, and potential economies of scale. So how can the owner of a Middle East hotel best realise such advantages?

The rise of franchise – drivers for change

The gaining popularity of franchise and manchise in the Middle East is partly driven by the desire of local owners to realise additional benefits from leveraging their operational expertise and local knowledge gained through years of investment and exposure to the hospitality market. Some owners may have amassed a portfolio of assets with home-grown as well as international brands and concepts.

Simultaneously, international brands are increasingly confident in the ability of local hotels to thrive under a franchise arrangement. Thinking has moved beyond cookie-cutting to embrace maximisation of the unique resources available to each owner and property. In addition, many brands have set aggressive growth targets, to add flags above more and more properties, requiring a range of strategies beyond HMAs.

Whilst there are many positives, it is important to recognise at the outset that franchise may not be suitable for all. Each owner must realistically assess its own abilities, strengths and weaknesses before proceeding. Equally, not all brands and scale ratings will be available. For example, some international brands will not entertain franchise for their premium or lifestyle offerings.

Making the switch – key considerations

For those owners wishing to make the switch, there are a range of commercial, financial, practical and legal factors to consider. To better understand these factors and their interplay with wider strategic objectives, an owner may supplement advice from its internal teams with specialist hospitality consultants and professional advisers. This team should include specialist hospitality lawyers because all these factors will intersect (in some way) in the new agreement with the brand.

If an owner has a manchise arrangement in place, some principles may already have been addressed (e.g. conditions for conversion) and the form of franchise agreement may have been agreed. Whilst this may impose some limits on negotiations, there may still be room for manoeuvre, and it is wise to review the agreement to ensure its terms are current and appropriate before signing.

Some key considerations (non-exhaustive) for the owner may include:

Brand selection

The foundation for a mutually rewarding long-standing relationship often lies in the first steps. Proper analysis of the available brands, including pros/cons and fee mechanisms, is critical. Focus should then move to fundamental principles of agreement and recording them (with advice from hospitality lawyers) in the heads of terms. Failure to do this can severely undermine the owner's position.

Capital expenditure

The brand may require that the hotel is upgraded to meet its latest brand standards. The property improvement plan (PIP) and scheduled refurbishments can raise serious concerns for money-conscious owners. Key points for negotiation may include the extent of any works, mandated contractors/suppliers, timeframe for implementation and any assistance the brand will provide.

Key money

The brand may be willing to provide a financial incentive known as key money. This often takes the form of an upfront payment to help secure the new agreement and support the owner (for example, to implement the PIP). Key points for negotiation may include the structuring of payments and any repayment obligations of the owner (e.g. amortisation and burn-off period).

Consents and approvals

The owner should seek to understand the degree of flexibility under the franchise agreement and how this aligns with its own vision for its business. Some franchise agreements afford much greater discretion to the owner on what it can and cannot do. Key points for negotiation may include pre-approval (in the heads of terms and franchise agreement) and clarification of the approvals process.

Executive team

The owner will need to arrange an executive team for each hotel. This may involve "recruitment" of personnel who are considered to be seconded from the brand to owner. Retaining the existing team often makes sense where the same brand continues as franchisor. Key considerations may include brand approval of the executive team (particularly where a new brand is being introduced), recruitment timelines and any complications from clustering arrangements at the property.

Area of protection

Protection may have featured in the HMA, but owners should still pay close attention to these provisions in the new agreement. The number of sub-brands and concepts managed by the international brands is constantly growing. Consequently, replicating an old approach or standard wording may not afford the comfort envisaged by the owner. Key points for negotiation may include the area, duration and any loss of protection in certain circumstances (such as owner default).

Transition arrangements

The provisions of a template HMA on what should happen at the end of the term often represent the minimum to protect the brand's primary interests and may be inadequate to deliver an orderly handover. Consequently, transition planning should begin well in advance, particularly when bringing in a new brand, with the key terms set out in a conversion or termination agreement.

Key considerations may include notice periods for termination or preventing renewal of the HMA, termination payments, final reconciliation, handover of IT (passwords, social media accounts, etc.), books and records (including future reservations), communications with vendors (including OTAs) and joint public announcements on changes affecting the hotel (to be issued at an agreed time).

Legal regime

The owner should seek to understand the legal regime for franchising in the location of its hotel. For example, at the time of writing there is no requirement in the UAE for the brand to provide a franchise disclosure document. This contrasts with the regime in Saudi Arabia where the disclosure document will contain important information otherwise difficult to obtain (e.g. ongoing litigation).

Pitfalls and perils – common challenges

There can be risks and pitfalls for the unwary. For the owner, this can result in dissatisfaction, loss of revenue and increased potential for dispute with the brand. These problems can be compounded by the relatively long term of the franchise agreement (although it may be shorter than an HMA).

An owner can mitigate these risks through careful analysis and negotiation of the term sheet and franchise agreement. This process requires astute judgement, balancing risk and reward, because the brand will have competing concerns and resist wide-ranging changes to its standard terms.

However, as with any long-term business relationship, there will always remain the potential for disputes to arise. Some key areas (non-exhaustive) of concern for owners may include:

Clean break

The task of transitioning from an HMA to franchise (particularly where a new brand is being introduced) should not be underestimated. The parties should pay close attention to specified timelines (notice periods, etc.) and obligations (including any termination payments, account reconciliations and IT handover). Clear and accurate communication and cooperation are critical. Failure can quickly result in escalating tensions and disagreements that may require legal intervention.

Brand standards

Where brand standards are not clearly defined or determinable, or can be changed at the brand's discretion, there is a risk of requirements being imposed that the owner could not anticipate or meet. This could have an impact at the outset (e.g. failing conditions for conversion to franchise) and during the term. Key considerations may include clarifying the way the brand controls the standards, any reserved matters (e.g. structural changes) and means for deciding disagreements (e.g. expert referral).

Loyalty programmes

These programmes represent a significant draw for owners, relative to their popularity and ability to drive business. However, the brand will have significant control over how the programme is operated. Key concerns may include the value an owner receives for honouring rewards, costs incurred in redemption and how the brand uses its programme to generate revenue (e.g. sale of points).

Transfers

The franchise agreement may impose restrictions on transfers, with conditions for the owner to satisfy, discretion for the brand and fees/costs payable by the outgoing and new owners. This can be an exacting and unwieldy process at the time the owner is trying to complete a complex sale transaction.

Termination

Because of the way hotel franchises operate (essentially, a right to use a hotel brand and system for a period, provided conditions are met), the owner's ability to terminate may be very limited. This can make it difficult and costly to achieve termination without a claim for default or wrongful termination.

Dispute resolution

During negotiations on the franchise or manchise agreement, it may be possible to modify the approach for resolving disputes. For example, instead of hearings in the English courts or arbitration in Paris, alternatives could include arbitration in the Dubai International Financial Centre under the rules of the Dubai International Arbitration Centre, or in Riyadh under the rules of the Saudi Center for Commercial Arbitration. This may deliver proximity for both parties (many brands have a corporate office in the region) with proceedings conducted confidentially under the English language.

What next – prepare for success

Successfully navigating the shift from management to franchise will be critical for many owners. This is easy to say, but hotel franchise is undoubtedly a complex area involving sophisticated documentation and a wide range of practical, commercial and legal considerations.

The multi-disciplinary hospitality team at Dentons would be delighted to assist with your hospitality transactions, whether that involves advising on franchise or manchise arrangements, HMAs, dispute avoidance or dispute resolution.

Please do not hesitate to contact us should you wish to discuss any of the issues raised in this article or require further information on the support we can provide.