Hotel operators may be prepared to submit to a Performance Test which gives the hotel owner the option to terminate the services of the hotel operator in circumstances where actual performance of the hotel falls below the standard established by the test agreed between the parties. The precise detail of any Performance Test is a function of the underlying commercial drivers of the transaction and the parties' respective financial objectives. That said there are a number of tried and tested Performance Test formulations commonly found in hotel management agreements.

Baker McKenzie acts for hotel owners and a broad cross-section of domestic and international hotel operators in many jurisdictions globally. Advising our clients in this industry over a long period of time has enabled us to gain a perspective and make some observations on the intricacies of Performance Tests.

The negotiation and drafting of any Performance Test is generally complex and time consuming. The parties need to take into consideration the competing objectives at play. The hotel owner is looking for a Performance Test which will provide it with the ability to terminate the hotel operator if there is profound and sustained underperformance of the hotel which can be attributed to the hotel operator. The hotel operator is keen to ensure that the test cannot be used to terminate its services for reasons unrelated to its performance.

The Performance Tests

In our experience, the most common Performance Tests are:

The Budget Test

The Budget Test looks at financial matters relevant to the specific hotel. It seeks to measure actual financial performance of the hotel against an approved budget in relation to an operating year. The budget is typically formulated by the hotel operator subject to the owner's approval.

If the parties cannot agree on the budget, there is usually a mechanism to refer the dispute to an independent expert (although we are seeing an increasing number of certain expense-line item that are not open to dispute, such as costs relevant to complying with brand standards).

The test is normally couched against actual and budgeted Gross Operating Profit (GOP) such that the test is failed if actual GOP performance is less than a specified percentage of budgeted GOP. Typically, the test requires that such underperformance occurs in two or more consecutive years (with two consecutive years the most common). The test usually does not apply or can be varied or adjusted if performance is affected by events outside of the operator's control (generally referred to as force majeure events) or a material default of the owner. Another exception to the test can be where the owner undertakes major works or renovations to the hotel.

The operator may be able to overcome a failure of the test by paying the shortfall amount to the owner, which is otherwise generally described as a "cure right".

The RevPAR Test

By contrast to the Budget Test, the RevPAR Test is outward looking and measures the hotel's revenue per available room (RevPAR) by reference to a set of hotels that are perceived to be its peers, commonly characterised as the "competitive set".

Generally the test is failed if the hotel's RevPAR is less than a specified percentage of the average RevPAR of the competitive set and the failure must occur in two or more years (with two consecutive years the most common) before the owner is entitled to exercise a right of termination.

The hotels which comprise the competitive set are usually identified at the time that the management agreement is executed, with the facility to remove or add hotels from time to time. The mitigating events and cure right features that apply to the Budget Test generally also apply to this test.

The GOP Test

The GOP Test seeks to compare actual GOP to Gross Revenue outcomes of the hotel. It specifies that the test is failed if GOP falls below a specified percentage of Gross Revenue. Typically, the test must be breached in two or more consecutive years (with two consecutive years the most common) with similar mitigating and cure rights described above.

Some Observations

  1. It is open to the parties to use just one or a number of Performance Tests, although we do not normally see more than two used in conjunction. Some owners may require that the two tests are used in the alternative rather than as a combination.
  2. When two tests are used, it is typically the RevPAR Test combined with one of the other two tests.
  3. The parties should consider when a Performance Test commences. For example, should it be after a period of time from commencement of the management agreement (particularly where the hotel is newly built or carries a new brand) or only apply for a particular period of the operating term?
  4. If there is a dispute as to the application of any test then this can be resolved by mediation between the parties, mandatory expert determination and/or arbitration either with respect to the Performance Test as a whole or discrete aspects (i.e. disputes with respect to some parts of the test resolved by expert determination and the remaining aspects by arbitration).
  5. A Budget Test may impact on the operator's focus on optimising the hotel's operational performance.
  6. If the management agreement contains a provision which allows for the operator to revise the budget during the Operating Year then the parties should query how or if this should impact the Budget Test.
  7. If the hotel is to be constructed, then the parties should consider how the initial competitive set is to be selected and the criteria for selection. It would be logical for the selection to occur at the time that the hotel is opened.
  8. How often and are there circumstances in which the competitive set is to be reviewed? For example, if the hotel is to be renovated or repositioned then this may trigger a revision of the competitive set.
  9. Should the cure payments be repayable to the operator and, if so, under what circumstances?
  10. Who should bear the tax liability on the cure payments and any repayments?
  11. Should the percentage thresholds in the tests remain the same for duration of the management agreement?

Summary and Conclusions

In this newsletter we have sought to identify the prevailing Performance Tests in the market today and also to raise some salient issues with respect to these tests.

The way each Performance Test is drafted needs, in our opinion, to take into consideration the interests of the owner and the operator that may ostensibly be competing but are really aligned in key respects to ensure that the tests are balanced so that the operational performance of the hotel is enhanced and maximised. A high performing hotel underpins its value as an investment asset to the owner and a successful hotel brand for the operator.

Please look out for our next newsletter where we discuss the various forms of dispute settlement mechanisms found in contemporary management agreements.

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