Restructuring

Contributed by Jordan Bryk
The July 31 bench decision in In re MSR Resort Golf Course, LLC by Judge Lane of the U.S. Bankruptcy Court for the Southern District of New York provides a useful review of valuation principles in connection with the estimation of a claim for damages for the rejection of hotel management contracts.
The dispute arose out of a motion by debtor MSR Resort Golf Course, LLC to estimate the damages resulting from the rejection of Hilton Worldwide Inc.’s management contracts for three luxury resorts – the Grand Wailea Resort Hotel & Spa in Maui, Hawaii; the La Quinta Resort & Club in Palm Springs, California; and the Arizona Biltmore Resort & Spa in Phoenix, Arizona.  MSR seeks to escape from the Hilton contracts at minimal cost in order to enter into more lucrative contracts with other hotel managers.  MSR intends to pay its creditors in full, but the potential rejection damages would cut down on the recovery for MSR’s owners, hedge fund Paulson & Co. and Winthrop Realty Trust.
The court noted that the parties did not disagree on the applicable law for measuring contract damages in this case – Hilton’s lost profits – but they strongly disagree on how the law should be applied.  Hilton contended that it was entitled to $334 million, including $165 million for management fees that it expects to receive if the contracts remain in place.  Hilton used an 8% discount rate to calculate the present value of future payments owed under the management contracts.   MSR argued that Hilton was entitled to the management fees alone, which it calculated to be approximately $46 million, using discount rates of 13.6% and 14.6%, depending on the property.  All else equal, an increase in the discount rate will decrease the valuation of future cash flows.
The court found, among other things, that the discount rate should be calculated at the time the contract was entered into, as opposed to the market rate at the time of the damages adjudication.  Judge Lane also found that Hilton’s weighted average cost of capital, or the “WACC,” was a reasonable starting point for determining the discount rate, but must be adjusted to account for the risk of the specific cash flows being measured.
Hilton’s proposal of 8% was based, in part, on data from Bloomberg, which reported Hilton’s WACC as 8.2% in the first quarter of 2006, when Hilton first acquired the resorts.  Hilton also contended that 8% is the industry standard, and that it uses this figure regularly to value its own management contracts.  MSR argued that the Bloomberg WACC information was calculated using a default beta value of 1.0.  According to MSR, Hilton’s actual beta, which measures stock price volatility versus the market as a whole, was 1.29.  Plugging in 1.29, MSR calculated Hilton’s actual WACC as 10.6%.  MSR then adjusted this figure to 13.6% or 14.6% to account for the specific risk profile of each resort.
The court found MSR’s approach more persuasive and concluded that Hilton’s WACC at the time of entering into the management contracts was 10.6%.  The court also agreed with MSR that the three resorts in question are riskier than most Hilton properties, and as a result, an upward adjustment to WACC was necessary.  For instance, the Grand Wailea is especially risky given its remote location, natural surroundings, dependency on air travel, and dependency on group travelers.  According to Judge Lane, however, these risks are not as high as MSR claims.  Ultimately, Judge Lane adjusted Hilton’s WACC to 11.6% for the Arizona Biltmore and the La Quinta and 12.6% for the Grand Wailea.  Judge Lane encouraged the parties to recalculate their rejection damage estimates using these court-ordered discount rates.
As this blog has previously noted, judges often take a hands-on approach to the valuation arithmetic, and the results can be difficult to predict.  While Judge Lane’s approach to this valuation dispute is consistent with that of other bankruptcy judges in the Southern District of New York, the court’s conclusions are a reminder that valuation metrics are subjective, and the keys to success are credible expert witnesses, as well as evidence to support the judgments of the experts on each variable of the valuation calculation.