Baker & McKenzie Comments on Performance Tests in Contemporary Hotel Management Agreements - By Graeme Dickson, Baker & McKenzie
In this article, we explore currently available performance tests in hotel management agreements, identify the most significant defects in these tests, outline the only viable alternative that is currently considered, without cause termination clauses, and offer an alternative approach to solving these issues, via expert determination.
It is said that democracy may not be the perfect solution, but it beats all the other known alternatives. It has also been said that money may not bring you happiness, but it can certainly bring you contentment.
The reason why we allude to each of these sayings will become clear once we get to the nub of this article.
As the global financial crisis enters its third year, it is becoming increasingly clear that the choice of a suitable hotel operator is a case of "horses for courses".
In most other activities, once the service provider loses the confidence of the client, the client usually has the discretion to terminate the service arrangement. This fundamental act of choice generally does not exist in the hotel industry. If a hotel owner loses confidence in its manager then, in the case of most (if not all) of the major operating companies, it is practically impossible to terminate the service arrangement.
In recent times, we have been asked to advise on a number of situations, which are remarkably similar – albeit involving a range of operators. The hotel has not been performing to the owner's expectations for a significant period, the owner considers that the under performance is primarily due to the operator's lack of competence, the operator has run out of ideas, the owner wants to terminate and can't …the owner is slowly heading toward financial oblivion.
As we have been at pains to point out in previous articles, this is not an attack on the operator community. In the vast majority of cases, each of the major operating companies is the right operator for that particular property. In other words, it is operating the hotel in a manner which meets or exceeds the owner's reasonable expectations – which, in a fickle and subjective world, we have come to believe is the most reliable performance indicator available. However, if asked honestly and off the record, all operators would acknowledge that there are a small number of properties, which they are unsuited to manage.
The inability to terminate an operator in the face of profound and sustained under performance is, we would suggest, an industry problem. In all likelihood, it will eventually result in scarce capital – whether it be debt or equity or both – rejecting investment in the hotel industry in favour of other property asset classes where such strictures do not exist (such as commercial property).
In this article, we will summarise the current crop of performance tests, identify the most significant defects in these tests and outline the only viable alternate which is currently considered – being without cause termination. We will then offer a suggestion as to a possible radical, but balanced approach to the resolution of the under-performance issue, which overcomes many of the defects of the other alternatives discussed.
Current performance-based tests
In our experience, the current performance tests are:
- benchmarking actual hotel profit against budgeted hotel profit;
- measuring the hotel's revenue per available room (RevPAR) against its competitive set; and
- benchmarking hotel gross operating profit (GOP) as a percentage of hotel gross revenue.
There are probably other test alternatives but these are the only ones we have experienced. The first two tests identified are the most common and can either appear in a management agreement as an individual test or in combination (i.e. termination can only be triggered by the owner if both tests are simultaneously breached).
We should add that in more than 20 years of hotel practice, and being involved in a multitude of separate contracts, we are not aware of any instance where an owner has successfully been able to terminate an operator based on any variant performance test.
We will now discuss each of these tests in detail.
Actual v/s budgeted profit
This test is totally inward focussed as it only looks at factors relevant to the specific hotel under management.
The test typically has the following features.
- It seeks to measure actual performance against an approved budget on an operating year.
- The budget is formulated by the operator subject to approval by the owner.
- If the parties cannot agree on the budget, there is usually a mechanism for referral to an independent expert (although increasingly with certain expense-line item carve outs such as costs relevant to complying with brand standards).
- Typically, the provision must be breached in two or more consecutive years (with two years the most common).
- The clause is normally breached if actual performance is less than 80% of budget (the Performance Hurdle).
- The clause's applicability is usually invalidated if performance is affected by events outside of the control of the operator (generally referred to as force majeure events).
- The operator may be able to override the clause by making a cure payment. Generally, this is a payment made to the owner, which equates to the difference between actual profit and the Performance Hurdle with respect to one of the relevant years usually selected by the operator.
This test suffers from a number of significant deficiencies.
First, because the budget is formulated by the operator, it is potentially subject to manipulation. The most common instance occurs when the test has been breached in one year. The budget for the second year is susceptible to being low-balled by the operator in an attempt to minimise the prospect of a breach in the second year. Though, of course, this may properly reflect the prospect of lower revenue in a poor economic environment. There is recourse to the independent expert, but the prevailing view is that an independent expert determination will usually throw up a compromise result somewhere between the positions advanced by the owner and the operator. We have also seen an instance where the budget was struck very conservatively and, on closer analysis, it was determined that the senior executives' bonus entitlements were based upon the extent to which the hotel performed above budget.
Secondly, it is incredibility difficult to gauge with precision the impact of force majeure on hotel performance. Some clauses provide that, once force majeure has been determined, then the relevant operating year is no longer eligible to qualify for the provision. In an extreme example, the hotel's actual performance may be, for instance, 50% of budget and, of the 30% which represents the difference between such performance level and the Performance Hurdle, only a relatively small percentage may be attributable to force majeure. Nonetheless, the relevant operating year is disqualified.
Thirdly, in those cases where the operator has cure rights, the test may be unavailable notwithstanding manifest under performance. For example, in the first relevant operating year, actual performance may be, for instance, 50% of budget and, in the second operating year, it is 75% of budget with an 80% Performance Hurdle. A payment by the operator of 5% of profit with respect to the second operating year (representing the difference between 75% of budget and 80% of budget) would remove the owner's ability to terminate notwithstanding the fact that the hotel has only performed to 50% of budget in the first year and 80% of budget in the second year (taking into account the cure payment). Furthermore, the budget for the second year could have been devised on a very conservative basis, in any event, resulting in a real cost to the owner of a significantly larger amount.
Measuring the hotel's REVPAR against the competitive set
We describe the abovementioned test as totally inward focussed as it looks at the hotel's performances in total isolation from the other hotels with which it competes. By contrast, this test, below, is totally outward looking by measuring the hotel's performance by reference to its perceived competitive set.
This test typically has the following features.
- It seeks to compare RevPAR of the hotel against that of a group of competing hotels (Competitive Set).
- Typically, the provision must be breached in two or more consecutive years (with two years the most common).
- The test is normally failed if the hotel's RevPAR is less than 80% of the average RevPAR of the Competitive Set (Performance Hurdle).
- The hotels, which comprise the Competitive Set, are usually specified at the outset, with the facility to remove or add hotels from time to time. This is usually made with the ability to refer to an independent expert if the parties are unable to agree.
- The force majeure and cure right features described above.
This test overcomes a major shortcoming of the budget to actual test by excluding the budget and, instead, comparing the hotel's performance against its competitors.
Despite this perceived improvement, the test still contains some major impediments to the owner's ability to terminate even in the face of obvious significant and sustained under performance.
First, its proper operation depends crucially on the identification of a true competitive set. In many situations, this is very difficult to achieve. In one situation of which we are aware, the subject hotel was a clear market-leader in circumstances where the only hotels, which could realistically be included in the competitive set by and large, struggled to attract the same rack rate. This was largely because of the subject hotel's unique location and, in any event, the subject hotel had substantially fewer guest rooms than the members of the competitive set. In reality, the hotel's historical RevPAR was so far above the Performance Hurdle that it was practically impossible for it to fail the test. In other words, the test does not work if the Competitive Set is not composed of true competitors. This is particularly difficult to determine in the case of a new build hotel and, even more difficult, where the new build is in a newly developed location.
Secondly, the test also suffers from the practical defect that the RevPAR data, which the owner is seeking to rely upon, is not publicly available. It may be capable of being relied upon in an anecdotal sense. But in a court of law, or other independent dispute settlement body which is bound by the rules of law, it generally constitutes hearsay evidence and, hence, is generally inadmissible. There are ways to overcome this defect, but they all have issues which go to the reliability of the data used to calculate RevPAR.
This test also suffers from the same force majeure and cure right shortcomings referred to with respect to the previous test.
To reinforce the point, it is common for the two tests to be incorporated, with the result that they both need to be triggered in each of the test years before the owner can consider termination.
Hotel GOP as a percentage of gross revenue
In our opinion, this test has emerged largely as a means of seeking to deal with the shortcomings of the above two tests.
This test typically has the following features.
- It seeks to compare actual hotel GOP to hotel gross revenue.
- It specifies that the test is failed if GOP falls below a specified percentage of gross revenue (for example, 40% of gross revenue) (Performance Hurdle).
- Typically, the test must be breached in two or more consecutive years (with two years the most common).
- The force majeure and cure right features described above.
Whilst this test overcomes the major shortcomings of the first two tests, it still comes with its own issues.
The major defect of this test is the difficulty inherent in agreeing upon the specified percentage. In other words, for the life of the management agreement (which may have a term of 10 – 20 years ) what quantum of GOP represents a fair and reasonable percentage of gross revenue? This is particularly difficult to determine for a new build hotel, which may not become operational for many years after the specified percentage is determined (usually at the time the contract is negotiated). This is even more so if, at the relevant time, it is unclear what the competitive environment will look like over the operating term of the contract (which may last for decades after the execution of the contract).
The provision also contains the same force majeure and cure rights issues of the other two tests.
As will be evident from this analysis, while all these tests seek to give the owner the ability to terminate an operator in the face of profound and sustained under performance, each test contains a potentially fatal flaw which stands in the way of implementation.
So, with owners unable to secure a test that does what it purports to do, to give the owner the clear and unambiguous ability to terminate in the face of profound and sustained under performance, owners have turned to the only other means currently available of effecting premature termination – without cause termination.
Recourse to without cause termination
Prospective owners, when faced with the shortcomings of the current crop of performance termination tests, have asked advisors to suggest what are the other alternative solutions available to deal with operator under performance. In the absence of any viable alternative remedy, advisers have been drawn to the only alternative solution currently available, that being without cause termination.
Such clauses deliver certainty to the owner. If, at any time, during the term of the management agreement (or after a specified start-up period) the owner wishes to terminate, then it is entitled to do so without justification usually on payment of a specified termination fee.
The termination fee historically, was an amount which equated to approximately three years' management fees. It is probably fair to say that for the time being those days are over. Currently, if the operator is prepared to agree to the concept of such a provision, then the quantum of the fee is usually significantly larger and at the upper end of the range. This is an approximation of the fee stream that would otherwise have been available to the operator for the balance of the term.
Before anybody reading this article believes we have identified a fairly easy solution to a vexing problem, a few words of caution are needed.
First, operators are extremely reluctant to agree to without cause termination and will only do so in exceptional circumstances. This is usually where the hotel constitutes a trophy and there is fierce competition to operate the property. Operators will argue that they have negotiated a contract for "X" years and they don't want to find themselves prematurely terminated for factors unrelated to their performance. Strong arguments are made to downplay the shortcomings of the performance tests. If this issue is raised after the Letter of Intent has been finalised, the claim can be made that the owner is seeking to re-negotiate a major commercial term after the deal has been struck.
Secondly, operators consider that there is very significant odium attached to premature termination from a brand perspective. In other words, any premature termination will be considered by the market to be a result of an inability to perform which may not necessarily be the case.
Thirdly, operators, particularly those that are publicly listed, argue that a termination payment based on the fee stream for the unexpired term of the contract may not necessarily be a true measure of the real cost of the premature termination. This is an argument we are still trying to understand.
Fourthly, and perhaps most importantly, operators argue strongly that if such a right is granted to the owner, then there should be a corresponding right granted to the operator. Leaving aside issues of determining the appropriate termination fee payable by the operator, operators assert that, in such an environment, there would be little incentive to work through troublesome issues and deal constructively with the problems that beset a hotel business on a day-to-day basis. It would also mean that the relationship could be susceptible to abrupt termination if either an owner or operator wakes up one morning "on the wrong side of the bed" and elects to terminate for totally capricious reasons. Operators argue that this is a too simplistic approach and more time and effort needs to be put into those of the contract provisions. This will give the owner greater operational control of the business during times where operator performance is perceived to be unimpressive.
This is where we return to the two sayings we started this article with. A without clause termination provision may not be the best way to deal with under performance but, from an owner's perspective, it is the best outcome currently available (subject to the comments we make under the next heading). And, as the second saying suggests, a premature termination is generally not an outcome that any operator is happy with but, in our view, the receipt of a lump-sum up to an amount, which equates to the fee stream over the balance of the term, is not a bad consolation prize.
A possible way forward – expert determination
One of the aims of this newsletter is to suggest alternative solutions for our clients in instances where there has been a general lack of research into new contractual solutions or the development of new industry principles. One of these unresolved issues is developing a fair and reasonable way to deal with perceived operator under-performance.
In our view, a reasonable and intelligent person would consider it is inconceivable that a hotel owner should not be able to terminate an operator's services in the face of profound and sustained under performance.
Unless this issue can be dealt with effectively, we cannot assume that sufficient capital (both equity and debt) will continue to flow into the hotel industry in the way it has done traditionally.
As industry insiders, we need to devise a better solution – and the following is a suggestion.
If, after all intermediate steps are exhausted, the owner remains dissatisfied with the operator's performance, it would have the right to refer the matter to mandatory dispute resolution which, for the purposes of this article, we will assume to be an independent expert.
The intermediate steps could include mediation at the hotel's operations level and/or an ability to refer the owner's dissatisfaction to one or more operator senior executives not involved in day-to-day hotel operations.
Once all relevant information is presented to the expert, and all other procedural matters are dealt with, the expert would be required to make a determination which would be final and binding on the parties. Broadly, the expert would have the power to make one of two determinations:
- that the owner's claims that the operator has under-performed has not been proved, in which event the contract continues on foot; or
- that, on balance, the owner's claims have been proven and the contract is terminated.
In making his/her determination, the expert would expect to be given a number of riding instructions or guidelines upon which his/her decision is to be based. These could include reference to one or more of the performance tests. As guidelines, many of the rigidities and imperfections of the tests could potentially be overcome.
In circumstances where the determination is to terminate, the expert should also have the power to award a termination payment of such amount as it considers fair and reasonable up to a specified amount - this being an approximation of the fee stream for the balance of the term. We would strongly urge including such a discretion, based on the view that very few, if any, situations will be clear cut and the expert needs some latitude to account for the grey that pervades these disputes.
The discussion above provides the skeleton of an entirely new approach to this issue and, as such, we would welcome industry discussion of its merits. However, we believe that fundamentally, it is a better model to work with than the current approaches referred to above, which in the case of performance tests, are flawed and, in the case of without cause, susceptible to capricious use.
Further information
We will soon send a further newsletter dealing with the competing owner and operator agendas increasingly impacting on hotel sales.
These issues, together with a run down of other current hot topics in hotel management agreement negotiations, will form the basis of discussions at the upcoming MasterClass, which Baker & McKenzie will present as part of the HICAP Update Southeast Asia 2010 to be held in Singapore on 26 and 27 May 2010.
About Baker & McKenzie
Founded in 1949, Baker & McKenzie provides sophisticated advice and legal services to many of the world’s most dynamic and successful organizations through more than 3,900 locally qualified lawyers and more than 5,800 professional staff in 67 offices and 39 countries.
