A lucrative structure

Posted On Friday, 12 December 2008 02:00 Published by eProp Commercial Property News
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You’d struggle to find a better emblem of the bubbling conflicts of interest that scar the property industry than the Hospitality Property Fund — symptomatic of a sector where “anything goes” is almost a mission statement.

Gerald Nelson







It might have come late to the orgy, but Hospitality clearly intends making up for lost time. It was created in 2005 as the brainchild of Grapnel — in which CEO Gerald Nelson holds 42% — and Hotel Tourism & Leisure (HTL) Asset Management — 100% owned by deputy CEO Youseph Aminzadeh. They struck on the idea of listing SA’s first property fund focused on hotels, rather than factories, office blocks and retail properties.

Nelson stitched together an impressive portfolio, buying blue-chip hotels. He acquired the four-star Rosebank Hotel for R70m, the five-star Radisson at Cape Town’s V&A Waterfront for R96m and the five-star Mount Grace in Magaliesberg for R122m.

Hospitality shot onto the JSE in 2006, splitting shares into A units (where distribution growth is fixed) and B units (which offer unlimited growth). It has done well, with the B units climbing 97% while the A units gained 10%.

But investors could have done better from Hospitality’s star-studded hotels were it not for a dinosaur of a structure that has provided a windfall for Nelson and the fund’s other bosses. A quirk of some property loan stock companies, which distinguishes them from virtually all other JSE-listed companies, is that they have an external management company (“Manco”). This Manco is owned by directors, and charges the fund a “fee” for running it, money which it uses to pay the staff and overhead costs. By contrast, the fund’s only expense is the Manco fee.

Compared with other industries, it seems undiluted robber baron stuff. It would be akin, one analyst says, to Standard Bank directors led by Jacko Maree putting together an external management company, and levying commissions on the bank for bringing in new clients.

Since listing, Hospitality’s Manco has milked R70m from Hospitality — returns that would otherwise have gone to shareholders. For this fee, the Manco has done little more than administration, finding deals and defining “strategy”. In short, doing what management and staff of any company should do.

Hospitality’s 2005 listing prospectus sets the terms of the Manco’s contract: not only is it paid 1% of Hospitality’s enterprise value every year (the value on the JSE plus the value of loans), but it also gets 2% of the value of properties bought or sold by the fund, and 2% of the refurbishment costs of the hotels. So when Hospitality listed, it paid a “promoter’s fee” to the Manco of R19,4m for assembling the portfolio. Last year, the Manco was paid R28m.

But the structure reveals glaring conflicts of interest. For example, Hospitality has embarked on a lavish R500m refurbishment of its hotels which was approved by the board and shareholders. But who is to say whether these refurbishments were necessary or simply a way to ensure the Manco got an extra R10m?

Who owns this Manco which earns such big fees? It turns out it is owned 53% by Grapnel and 47% by HTL.

Nice work if you can get it. But the Manco isn’t the only way in which Nelson and Aminzadeh get paid by Hospitality. The company’s Manco also appoints “hotel operators” to manage its hotels on a day-to-day basis. For example, it has appointed the Protea Hotel Group to manage five of its 24 properties.

But nine of its hotels are leased to a company called C-Corp (owned by Grapnel and HTL) which appoints operators to manage those hotels. For those nine, C Corp has appointed Hospitality Hotel Management Company (HMC) as the “hotel operator”. Who owns HMC? Again, it’s Grapnel and HTL.

Last year, HMC was paid R10,9m by the fund as a “management fee”, and R1,8m as “reimbursement of sales costs” — benefiting Nelson and Aminzadeh.

Consider the 32-year-old four-star Rosebank Hotel, in the middle of Johannesburg’s tourism district and near a key stop on the Gautrain route.

When Hospitality bought the run-down hotel for R70m in 2005, it reeked of outdated 1970s chic. But after a R305m overhaul, it’s an unarguably swish joint, dripping with the latest fads, from Sony iPod clock radios in every room to air conditioners that double as water heaters.

But consider how this has benefited Nelson and Aminzadeh. Besides the R1,4m “brokerage fee” for finding the hotel, the Manco gets R6m for organising the refurbishment. It also gets 1% each year of the hotel’s enterprise value. Because HMC operates the Rosebank, Nelson’s and Aminzadeh’s company also gets an “operator fee”, which is part of the overall R10,9m paid to HMC.

This creates many questions, like how did the Manco decide to appoint HMC to run the hotels, rather than others? How do shareholders know Hospitality’s bosses aren’t just appointing HMC because they stand to benefit in fees?

These questions were posed at Hospitality’s bad-tempered AGM at the Rosebank Hotel last month. There, Nelson and chairman Tim Sewell faced off against disgruntled shareholder Meago (an asset management company).

Hospitality isn’t comfortable with being questioned: a year ago, an FM reporter was booted out of a shareholders’ meeting. This time, the FM went armed with a shareholder proxy. And it was edge-of-the-seat stuff, with Meago’s lawyer Paul Coetser and director Anas Madhi spinning googlies, and Sewell tight-lipped.

Coetser: Can shareholders have access to the transcript of the previous AGM?

Sewell: I don’t think so, that’s the working paper of the company.

And later .

Coetser: On what basis was the Hospitality Management Company selected as the operator of the Holiday Inn Sandton? (This is newly acquired.)

Sewell: It was a commercial decision. We cannot go through the entire process of evaluating tenders and discussions of what went on at meetings like this.

Coetser’s point was well made: with so many conflicts of interest, how does the board police the performance of the Manco? And with how much rigour would the Manco police HMC’s performance, when Nelson and Aminzadeh have interests in both?

After the meeting, Nelson said the board takes the decision to appoint operators after looking at the proposals.

To add salt to the wound, the Manco’s fees are high. Whereas Madison charges a management fee equal to 0,5% of the enterprise value of the portfolios it manages, Hospitality’s Manco charges 1%.

When tackled on this, Sewell said: “The operation of a hotel is a whole lot more complex than the operation of an office block, and that would be one reason why the fee structure is different.”

Really? The Manco outsources the day to-day business to hotel operators anyway, so is it really twice as difficult to devise a fund strategy focused on hotels rather than one handling office blocks?

There is bad blood between Hospitality and Meago. When Hospitality listed, Meago director Sharif Hoosen was a director. But he quit last year.

Speaking to the FM, Hoosen wouldn’t reveal much. “Look, all we want is to know that our money is being looked after properly and avoid any loss of shareholder value due to conflicts of interest,” he said.

How do property companies justify “external management” that saps money otherwise destined for shareholders? Growthpoint chairman Francois Marais (a founding partner of law firm Glynn Marais), who was one of the architects of the listed property sector in the 1970s, says: “The model we decided to use wasn’t really much cleverer than simply basing it on how property unit trusts work.” By law, property unit trusts (like all unit trusts) must have external asset managers. Property loan stock companies simply followed suit.

He says the thinking was that “external management” would provide incentives for directors to increase the portfolio “as it creates value for themselves”. But the winds of change have upended this model. Partly, this is because treasury is preparing new laws on Reits (real estate investment trusts) that will drag SA’s property industry into line with global norms, where “external management” is frowned on.

Sensing the mood, in 2007 Growthpoint bought its Manco from Investec for a chunky R1,5bn. Marais says overseas investors prefer internal management. “An internal model also saves money. In [our] case, bringing the management company in-house saved R145m last year.”

This seems a compelling argument. An August 2006 report by brokerage Barnard Jacobs Mellet (BJM), “Pilots and air traffic Controllers”, painted a scathing picture of the bad governance and conflicts in the property industry.

“Overseas markets have moved away from external management companies. The introduction of Reits will put pressure on companies to conform to the international norm of internal asset management and transparency,” it says.

By holding shares in “external management companies”, bosses have different interests to shareholders, says BJM. “Both a pilot and an air traffic controller have the interests of passengers at heart, but only the fate of the pilot is intrinsically linked with that of the passengers. We need more pilots than air traffic controllers in charge of shareholders’ money.”

For example, if asset managers benefit from buying property rather than from performance, “they could be tempted to churn a portfolio for their own benefit instead of that of the fund”. The risk is that if property firms don’t change, regulators like the Financial Services Board could challenge “practices that are legal but not fair”. That could be costly.

Someone who has had his own share of controversy is Niki Vontas, founder of struggling property firm Bonatla. Vontas’s research shows that shareholders effectively give up between 9% and 10% of rental income by having an external management company. “Does having an external manager add value? Most of the time, no. You effectively take away value that should go to shareholders to pay management costs.”

Vontas believes that in three years, all property funds will have in-house management — including Bonatla.

Madison is listed on the JSE, and its business model consists of being a third-party “asset manager” for three funds — Hyprop, Apex-Hi and Redefine. It collected R140m from these companies as “management fees” last year.

Whereas Madison reported a 53% return last year, ApexHi’s return was -13%.

Madison director Marc Wainer realises “internal management” could pose a serious threat to his company. “It would destroy our whole business model. Sooner or later, we see most companies taking asset management in-house. But when that happens, we will look at our options. For example, we could sell Madison to one of the property funds.”

Word on the street is that Madison will most likely be bought by ApexHi. But Wainer says external management does have benefits. “An external asset manager is motivated by knowing he is doing his own thing, and he can make profits. If you’re the kind of person who is entrepreneurial, the external model provides extra motivation.”

Greed, it seems, still has its place. Wainer says the trend to abandon external management is dangerous: if done badly, funds will become less competitive.

But Wainer pulls no punches when it comes to the Hospitality model, saying: “You can’t be the jockey and the horse.” He adds: “Their fee structure is crazy. To my mind, you shouldn’t charge an asset movement fee when you buy and sell properties, and any fee they get for refurbishments should be market-related, not simply a percentage of the value.”

Perhaps, it is just bad luck for Hospitality that it listed amid this new zeitgeist of accountability. Or perhaps questions are emerging only now because investors are bracing themselves for lower returns.

Speaking to the FM after Hospitality’s AGM, Nelson denied what almost everyone else admits: that internal management is the way of the future. “The jury is still out as to where the industry will go. There is some sense that the new Reit legislation will permit either internal or external asset management. But ultimately, it will depend on what shareholders want,” he says.

Throughout the discussion, Nelson emphasised that his Manco “has value”. This isn’t surprising, as he is a major shareholder of Hospitality’s Manco.

Nelson says he is “inclined to agree” that external management creates conflicts of interest. “But Mancos have a value for their shareholders. I don’t dispute it may be preferable to internalise the Manco, but there needs to be some compensation for this,” he says.

He and Aminzadeh could make huge sums of money if Hospitality exercises its option in February to buy the Manco. The prospectus says Hospitality would have to pay six times the Manco’s annual profit. Using last year’s revenue, the Manco would be worth nearly R163m. But Nelson says this is misleading as any buyout would be based on net profit.

Nelson wasn’t keen for the FM to access the Manco’s accounts. “It doesn’t publish accounts. There is no requirement as it is a privately held company,” he says. This isn’t exactly helpful, considering companies with conflicts of interest should be doing more — not less — to ease shareholders’ concerns.

There is an obvious solution. As BJM argues: “The existence of in-house management teams will largely eliminate the conflicts of interest that arise in external management structures.”

It has become a hackneyed Warren Buffett cliché that you notice who has been swimming naked only when the tide goes out. Until now, the SA property industry has been protected from having its cowboy practices exposed, partly because prices have escalated so dramatically in the past decade that it has created enough wealth to silence critics.

But with the US and UK lurching into a recession, it will become harder for companies like Hospitality to keep hotel occupancy rates high (72% on average now) after the 2010 World Cup. It will be too late then for investors to complain that those property barons have gorged at their expense.

Last modified on Friday, 18 April 2014 16:39

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