The economic fallout and reduction in travel caused by the COVID-19 pandemic have caused significant dislocation within the hospitality sector. In doing so, this has created opportunities for investors to acquire hotel investments from distressed sellers and lenders at attractive prices. Over the last year, our team has reviewed a number of private opportunistic hospitality funds. These programs often provide the potential for attractive returns. Still, they include significant risks given the distressed nature of the targeted assets and the possibility that market conditions or asset-specific recoveries are delayed or never come to fruition.
This post will touch on some of the common themes we’ve seen with opportunistic funds over the last year and provide questions you should be asking when evaluating whether an opportunistic fund is appropriate for your investment platform.
Does management have experience in the hospitality sector?
One common risk we’ve come across with opportunistic programs is that many product sponsors are making their first foray into the hospitality sector but do not have a meaningful track record of acquiring, managing, or disposing of hotel properties, let alone distressed properties and debt. In our previous post, the Top Five Attributes of a Successful Alternative Investments Sponsor, we touched on how a strong management team with significant experience in the targeted investment strategy class is imperative. Here are a couple of questions you should be zeroing in on:
- Does the sponsor have any track record of investing in hotels, or other asset classes, across different economic cycles or in challenging markets?
- If a sponsor is new to the hospitality sector, who have they hired, or who are they partnering with, that has experience with hospitality transactions and operations?
How broad is the fund’s investment strategy?
We’ve found that many opportunistic funds have a relatively broad investment strategy. These investments usually include equity and debt, may be located throughout the capital stack, and often include non-performing loans, rescue capital, and assets involved in bankruptcy or reorganization proceedings. Many opportunistic funds can also target development projects, including projects that have previously failed or stalled. Wide-ranging investment criteria provide management with the flexibility to pursue a variety of opportunities as they arise. Still, the focus on distressed assets also includes a number of risks, including the pace of market recoveries, unforeseen property defects, and the potential need for additional capital expenditures and maintenance. A few questions we like to ask when evaluating whether a strategy is reasonable include the following:
- What type of experience does the management team actually have with workouts, investing in distressed debt positions, or navigating bankruptcy and foreclosure proceedings?
- What type of experience does management have with value-add or renovation projects?
Is the fund well positioned to deploy capital in quality assets at attractive prices?
Opportunistic funds rely on a manager’s ability to source and acquire non-performing assets below their inherent values, which can be stabilized and brought to the highest value through various means, including improved market conditions, capital improvements, and improved property management. We expect there to be significant competition in the market for distressed hospitality investments. This could potentially drive up prices and cause some programs to buy lower-quality assets with a higher risk profile.
In addition, delays in deploying capital could significantly impact investor returns. Capital deployment for many opportunistic funds we’ve looked at has been slow. We’ve had a few sponsors express to us that they do not expect to see attractive investment opportunities until early 2022, as government stimulus and lender forbearances have extended a temporary lifeline to many distressed assets, causing a lack of current opportunities.
As discussed in our prior post, successful alternative investment sponsors typically have seasoned leaders who have extensive industry relationships and hold an edge in terms of sourcing and negotiating opportunities. Given these considerations, it’s important to evaluate how a sponsor sources investment opportunities and what sets the management team and program apart from its competitors.
Is the distribution waterfall reasonable given the strategy?
In our previous post on evaluating alignment of interests in private placements, we discussed the importance of assessing whether investors are being compensated adequately for the risk they are taking by investing in a particular structure or strategy. Opportunistic programs that we’ve seen over the last year have included various waterfall structures, with preferred returns ranging anywhere from 6% to 10%. Some of these structures include escalating payments to the manager upon investors reaching various return hurdles, which are often reasonable but could also limit investor upside to some extent.
We have also come across a few programs that calculate the waterfall on an individual investment basis rather than an aggregate basis. We typically view an investment-by-investment calculation less favorably because the manager will receive distributions with respect to a particular investment even though investors have not received a return of capital or preferred return on other investments or in the aggregate. It’s also possible that the individual investment calculation could incentivize the manager to take greater risks, trying to hit home runs, knowing that underperforming assets will not impact its participation in investments that do perform well.
We also want to understand the program’s anticipated timeline for distributions, given they are typically targeting underperforming assets and assets that require capital improvements. For example, some programs don’t intend to make distributions until the substantial majority of the portfolio is stabilized. Other programs don’t project making distributions until a liquidity event.
Does the anticipated hold period allow the program sufficient time to execute its investment strategy?
Ultimately, the success of an opportunistic hospitality fund will depend largely on the asset acquisition prices, recovery in travel, and related increases in occupancies and RevPAR. According to a recent article, CBRE has forecasted U.S. hotel average occupancy rates to be 65.7% in 2025, approximately 98% of pre-pandemic levels, with RevPAR projected at 99% of pre-pandemic levels by 2024 and exceeding pre-pandemic levels by 2025. As such, when evaluating an opportunistic fund’s exit strategy, we want to ask whether the liquidity time frame appears reasonable based on economic forecasts for the hospitality sector and whether the fund has flexibility if the market recovery is delayed or comes under additional stress. We also want to ask whether the anticipated liquidity time period provides management with enough time to complete its operational and capital improvements and whether management has any history of achieving liquidity events on a similar time frame.
What’s my next step?
Hopefully, this post has provided you with a little bit of guidance on questions you should be asking when evaluating an opportunistic fund. If you’re looking for more information on opportunistic funds or private placement due diligence, please reach out to our team of analysts. In addition, you can get more information on the strengths and risks of specific opportunistic funds on the FactRight Report Center.