Look at CNL Hospitality Properties Inc. Proposed IPO
|August 2, 2004 - In the coming days, CNL Hospitality Properties Inc.
["CHO"] is proposing to sell 35,000,000 shares of stock (at a proposed
price range of $19-21 per share) and list on the New York Stock Exchange
under the ticker "CHO." CHO has ownership interests in 130 hotels and resorts
across the United States and Canada. The research department of UNITE HERE!
– the merged union of hotel and textile workers – has taken a critical
look at this IPO and the transactions accompanying it, and presents the
following analysis for consideration by prospective investors.
Now the second largest hotel REIT in the United States, CNL Hospitality Properties Inc. has an eight-year history as an unlisted, "private" REIT based in Orlando, Florida. CHO is widely known as an acquirer of hotels; less well known is how accountable this company will be to the public capital markets going forward. We explore that question by examining the REIT’s merger with its affiliated advisor, history of fees to affiliates, other potential conflicts of interest, and questionable independence on the company’s Board of Directors.
CHO has been widely marketed for several years through CNL Securities, an affiliate of the privately-owned CNL Financial Group, and is not listed on a public stock exchange, although it is owned by over 100,000, mostly retail shareholders. Its operations are conducted by an external Advisor, CNL Hospitality Corporation, owned primarily by CHO’s directors and officers. CHO has had a history of paying substantial fees to affiliated companies for commissions and services to the REIT. The capstone of that history will be the costly Merger between CHO and its external Advisor, which is subject to shareholder approval and a precondition to the IPO.
This analysis looks closely at the following issues:
CNL Hospitality Properties Inc. ["CHO"] – the unlisted, hotel
ownership REIT, which is offering shares in this IPO and will list on the
Is CHO’s Merger with its Advisor too Costly?
In conjunction with its IPO, CHO is merging with its external Advisor – a merger that exemplifies why this company is used to operating in a manner that may not live up to the standards of institutional investors.
CHO intends to merge with its external Advisor, CNL Hospitality Corporation, once it obtains approval from existing shareholders. Under the Merger Agreement, CHO will pay over $300 million to the Advisor’s owners. This purchase price is in addition to over $200 million in fees the REIT has paid to the Advisor over the past five years.
CHO’s operations are currently conducted by the external Advisor, who employs the executives and staff to run the REIT and charges CHO fees as a percentage of assets, acquisitions and loan arrangements. Publicly traded REITs generally do not carry the burden of paying an external Advisor to run their companies, and CHO’s competitors, like Host Marriott Corporation, have simpler structures: they employ their executives and operating staff internally. CHO has stated that: "We believe that public equity investors and market analysts could view us less favorably once our shares are listed if we remain externally-advised…."
The question is not whether CHO should merge with its Advisor, but on what terms. We believe the merger terms are not favorable for CHO shareholders for multiple reasons.
1) The Purchase Price is too high—buying the Advisor will cost the Company over $300 million. Owners of the Advisor will receive $267.3 million worth of common shares and approximately $29.7 million in cash. CHO will also repay another $10.98 million of debt associated with the merger. This cost represents 10% of shareholders’ total investment in the company, or capital in excess of par value. Considering that it was always CHO’s disclosed intention to list on a public exchange, and that CHO had generously compensated the Advisor for its services over the years, we question the $300 million value paid by shareholders in this merger.
2) Shareholders already Paid Over $200 million in Fees to the Advisor.
The Advisor was well compensated for the services it provided CHO over
the last five years: between 1999-2003 CHO paid fees equal to $206,053,000
to the Advisor.
3) The Advisor’s owners are CHO insiders. The Advisor is 90% owned by certain officers and directors of CHO. These persons will receive, directly or indirectly, an aggregate of approximately 12,750,000 split-adjusted common shares of CHO as a result of the merger, or approximately 8.4% of the company’s pre-IPO shares. Prior to the merger, CHO’s directors and officers as a group owned only 1% of the company’s shares.
4) A member of the REIT’s independent Special Committee that negotiated the Merger Agreement was not truly independent. Given that some CHO’s officers and directors have a vested interest in the consummation of the merger, fair negotiations of the terms of the merger were central to protecting shareholder interests. The Board formed a "Special Committee" that negotiated the Merger Agreement with the Advisor. However, we believe that the independence of Craig M. McAllaster, one of the three Directors on the Special Committee, was compromised by a relationship with James Seneff, Chairman of CHO and also majority owner of the Advisor. Furthermore, the Directors that served on the Special Committee received substantial payments for service on the Committee that stand out in comparison to CHO’s traditional Board fees. [For details, please see Questionable Independence on the Board section, p. 7].
5) The Advisor’s only current revenues are generated by fees from CHO. Currently, the Advisor’s only income is derived from CHO’s fees. The Merger Proxy Statement notes that CHO will cease to pay fees to the Advisor upon consummation of the merger. Therefore it is logical to conclude that the Advisor’s primary business – servicing CHO – has come to its natural end. Why are the handsome fees already paid to it not enough to compensate it for its work?
Compensation by CHO to Special Committee Board Members
By tracing the use of capital contributed by current shareholders, prospective investors can assess whether their capital would be likely to generate a higher return by investing it in CHO, or by investing it elsewhere.
In addition to the substantial fees paid to the external Advisor, CHO has a history of paying commissions and other fees to other CNL-affiliated entities.
In sum, CHO’s historical fee structure translated into a significant percentage of investors’ capital being allocated to fees (including fees to the Advisor), not property acquisition.
For example, here is a chart from a prospectus from one of CHO’s earlier
best-efforts offerings, dated April 23, 2003:
Upon consummation of the merger with the Advisor, another 10% of investors’ paid in capital will leave the company, mostly in the form of additional shares issued to the insiders that own the Advisor.
Accountability in the Capital Structure
CHO’s growth has been fueled by expending substantial sums of capital on property acquisitions. Simultaneously, the company has borrowed significantly and has historically paid healthy distributions. As prospective investors assess how the company intends to balance those needs going forward, we suggest you look at their track record in this regard.
CHO proudly touts its record in paying distributions to shareholders. "Historically, we have paid cash distributions every quarter since our operations commenced." The company also intends to maintain a distribution policy of $1.40 per share, or approximately 7%, if the offering meets its current price range of $19-21 per share.
Maintaining this healthy distribution policy will be more difficult with the issuance of 35 million new shares in this offering (plus any underwriters’ overallotments) and the shares issued in conjunction with the merger. Subsequent to this offering and the merger, there will be 201 million shares outstanding, versus 152 million currently outstanding, a 32% increase in shares.
However, a sizeable portion of these historical cash distributions are a "return of capital" under GAAP rules, according to the company’s SEC reports:
"Approximately 79%, 60%, 26%, 30% and 18% of cash distributions for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively, represent a return of capital in accordance with generally accepted accounting principles ("GAAP"). Cash distributions treated as a return of capital on a GAAP basis represent the amount of cash distributions in excess of accumulated net earnings on a GAAP basis, including deductions for depreciation expense. The Company has not treated such amounts as a return of capital for purposes of calculating Invested Capital and the Stockholders' 8% Return."
Furthermore, in the past, the company has used debt to finance the payment of dividends: "Ending the March 2004 quarter, the REIT spent $9.5 million in proceeds from long-term debt to fund distributions, and supplemented cash from operations for the quarter with $9.8 million of cash from credit enhancements." CHO also states that the company expects to use future borrowings to fund distributions going forward:
"We expect this [$500 million Bank of America] secured revolving credit
facility to have a term of three years and be available to finance acquisitions
of hotels and resorts and for other working capital needs, including funding
distributions to our stockholders."
"there has been a degree of speculation revolving around how the share-purchasing public could react to what looks to be shaping up as a kind of blind pool. Specifically it has been suggested there seems to be no clear indication of how—or how much of—the monies raised would ultimately be spent. While one might naturally believe capital raised through the IPO would be earmarked for further property and portfolio acquisitions, readers of the fine print within the SEC document have suggested such a fiscal course of action for the company is far from a certainty."
With a history of five best-efforts offerings over its short life-span, CHO is used to a mode of constant fundraising, with a stable share price (set by the company), that is likely to contrast with its future life in the public markets. With high expectations for future distributions, CHO will need to commit itself to balancing the use of capital for debt service, new property acquisitions, and paying distributions.
The IPO Share Price Range – Can it be More than the Sum of its Parts?
CHO’s preliminary registration statement notes a price range of $19-21 per share. Historically, CHO issued shares to investors at a set $10 per share price (pre-stock split), in a series of best-efforts offerings. Giving effect to the reverse stock split, each $10 share previously issued would be the equivalent of a $20 share in this offering – the midpoint of CHO’s hoped-for price range – all things being equal. Because the shares do not yet trade, the price has remained stagnant over the years.
After accounting for the payment of fees outlined above (approximately
15% of each $10 invested), the merger (which will have the effect of issuing
8.4% additional shares to insiders), the issuance of 35 million new shares,
and the payment of distributions at an historical rate of 7.75%, there
is a pressing question of whether CHO is now worth $20 per share.
Add to that the company’s aggressive distribution goals and one should question how sustainable a $20 listing price would be.
In this regard, it is important to note one of the risks disclosed by CHO in its prospectus. There is a large base of existing shareholders, over 100,000 mostly retail holders, who have been unable to sell their shares without penalty since buying them, because they were not listed. These shareholders will now be free to sell their shares. CHO says:
"As of July 9, 2004, after giving effect to the proposed reverse stock split, 151,820,546 shares of our common stock were outstanding and freely tradable. Following our listing on the New York Stock Exchange, or NYSE, a large volume of sales by our existing stockholders of their shares, or even the perception that these sales could occur, could decrease the prevailing market prices of our common stock and could impair our ability to raise additional capital through the sale of equity securities in the future."
Questionable Independence on CHO’s Board of Directors
In preparation for the public listing, CHO has "revised our organizational
structure and corporate governance," including requiring five of nine Directors
to be independent. The REIT imposed this new standard in order to comply
with the requirements of the New York Stock Exchange. But potential investors
should look closely at the people named "Independent" and ask: Is there
adequate independence on the Board to truly represent shareholders?
While the Company claims its new Board consists of five independent directors, we believe that the independence of two of the directors should be questioned. We question whether two directors’ ties to CNL management and executives prevent the independent directors from truly representing shareholders’ interests.
James Douglas Holladay, a recent elect to the Board of Directors, also serves as an independent director at Sunrise Senior Living, a company that has a substantial relationship with CNL Retirement Properties, a CNL affiliate. According to 2003 year-end numbers, Sunrise operates 79% of CNL's retirement portfolio and accounts for 76% of CNL Retirement's revenue. CNL Retirement is the property owner of at least 98 of Sunrises' 373 properties (26%).
Craig M. McAllaster, also considered an independent director by CHO, serves as Dean of the Roy E. Crummer Graduate School of Business at Rollins College. As Dean of the Crummer business school at Rollins College, Mr. McAllaster's independence is potentially compromised by an undisclosed relationship with the Company's Chairman, James Seneff. CHO Chairman Seneff serves on the Board of Overseers at Rollins College, Crummer Business School where he "advises the dean of the school." CNL is also a major donor to the business school: CNL has contributed such funds to Mr. McAllaster's employer as to warrant a renaming of one of the campus classrooms to "CNL Lecture Hall."
Potential Conflicts of Interest in Future Transactions
The Proxy discloses that CHO will potentially be competing for acquisitions with two other new CNL REITs, CNL Income Properties (CIP) and CNL Hospitality Properties Inc. II (CHP2). Given CHO’s history of insider transactions, it is important for prospective shareholders to assess the relationship the company will have with these two newly-formed REITs, as the target markets of all three companies overlap. Moreover, CHO intends to be the Advisor for CHP2, directly influencing acquisition and disposition opportunities of that new REIT.
Potential Conflicts with CNL Income Properties (CIP)
The CHO Merger Proxy Statement describes the possibility of conflict with CIP:
Certain of our other Affiliates could seek to acquire properties that, while not directly in our industry segment, could satisfy our acquisition criteria. One such Affiliate, CNL Income Properties, Inc. ("CIP"), is seeking to acquire leisure properties, such as marinas, golf course operations and ski resorts. Although those properties are not in the industry segment we have pursued and intend to continue to pursue, a leisure property could contain a hotel or resort operation that satisfies our acquisition criteria. CIP has given us a right of first offer for properties in which 50% or more of the revenues during the prior 12 months on a GAAP basis were derived from the hotel or resort operation. As a result, we may decide not to pursue acquisitions of properties we would otherwise seek to acquire in order to avoid bidding against an affiliated company. CIP may revoke this right of first offer at any time.
CIP’s focus on golf and marina properties potentially conflicts with CHO’s primary property market, in that CHO’s most recent acquisitions include luxury golf course resorts. The KSL Resorts purchased by CHO in April 2004 feature golf courses at 5 of the 6 properties: The Grand Wailea boasts "championship golf and tennis" on site; La Quinta and PGA West advertise the "excitement of its championship golf courses," and are a regular professional tournament play location;Emerald Pointe Resort describes "18-holes of championship golf," as well as a marina, "the lake’s largest fleet of rental boats"; the Miami Doral is "surrounded by green fairways" of its golf course; and the Arizona Biltmore website lets you reserve tee-times at "the adjacent Arizona Biltmore Country Club".
CIP will be advised by CNL Income Corp., which is owned primarily by Mr. Seneff. CIP will pay fees to CNL Income Corp. and other CNL-related companies, similar to the historical fee structure of CHO, including fees based on a percentage of acquisition costs. Such fee structure raises the possibility that there may be a financial incentive to CIP’s Advisor to allocate acquisitions that may satisfy both CIP and CHO’s criteria to CIP.
Two of CHO’s Directors also serve as Directors of CIP – CHO Chairman Seneff and Vice Chairman Robert Bourne – further complicating the potential for conflicts of interest between these two companies.
Conflicts with CNL Hospitality Properties Inc. II (CHP2).
CHO’s Prospectus discloses that CHP2 will specialize in properties in the upper, midscale, and economy classes. CHO’s prospectus also discloses the potential for conflict with acquisitions: "The possibility exists that an available property or portfolio of properties could satisfy both our acquisition criteria and those of CHP2."
While there is the potential for conflicting interests in future acquisitions, the largest potential for conflict in this relationship is in the body of upper and midscale hotels currently owned by CHO. CHO currently owns 90 upper and midscale hotels, according to its Prospectus, and there is an obvious possibility that CHO could enter into a transaction with CHP2 to sell some or all of those hotels to CHP2. Complicating this transaction would be the fact that CHO will be CHP2’s Advisor, and therefore would be negotiating with itself.
Prospective investors should explore with CHO how such a transaction would be handled, were it to occur, and whether the six midscale properties currently targeted for disposition could be sold to CHP2.
Additionally, CHO could potentially own hotels in the same markets as
CHP2 that compete with each other.
UNITE HERE! – the merged union of hotel and textile workers – represents approximately 3,000 employees who work at hotels and resorts owned by CNL Hospitality Properties Inc. Generally we believe that investors and workers are on common ground when it comes to company accountability, shareholder value and good corporate governance.
|Also See:||CNL Real Estate Empire Built on Careful Choices / Feb 2002|
|CNL Hospitality Completes Acquisition of Six KSL Resorts for $1.4 billion in Cash and Assumption of $794 million Debt; KSL Appointed Interim Management Company / April 2004|
|Hotel and Restaurant Employees Union Local 2 Issues Report Analyzing Strategic Hotel Capital's Pending IPO / April 2004|