In the negotiation of management agreements, owners take comfort from the performance test that in the most optimistic light will allow the hotel owner to terminate a management company that does not meet the standards of the performance test. But let’s look more deeply into the proposition that the performance protects the owner from the under-achieving management company.
The typical performance test these days, and they have become very standardized across the major US branded management companies (e.g., Marriott, Hyatt, Hilton, InterContinental…), looks like this:
The owner may terminate the management agreement if for two consecutive years the hotel has not achieved (a) [90 per cent] of budgeted revenue (or possibly gross operating profit) AND (b) [90 per cent] of the RevPAR of the agreed competitive set.
On face value, not bad. But here are the features that detract from the efficacy of the test to assure that the owner is getting the best possible performance from its management company:
The management company will have a cure right that usually is satisfied by the management company’s making a payment to cure one of the two year’s failures and one of the two prongs of the test, prong (a) or prong (b). Prong (a) is susceptible to cure, so the payment to bring gross revenue to within 90 per cent of budget is the route to cure. The cure payment is not an adequate substitute for hotel performance;
The cure can be a cure of either year, so the management company will choose the year in which a cure is accomplished by paying less;
The cure of either year negates both of the two years, and the slate is wiped clean;
If the management company perceived in the first of the two years in which the test was failed that it had budgeted gross revenue too optimistically, it can adjust the budget for the next year to make budgeted gross revenue more achievable. The owner must be wary of this;
The competitive may not be a high enough bar. It has to be made up of those hotels that are truly comparable and are doing well;
The test is not failed if the shortfall can be attributed to a broadly defined “event that constitutes force majeure”;
The test is not failed if owner is in breach (any breach), and this may include a failure to spend all the capex required to meet each and every brand standard;
Any termination of the agreement, whether because of a failed performance test or otherwise, is almost always conditioned on the owner’s repaying all amounts that are owed to the management company, and these can be very considerable where the management company has advanced key money or a made a loan to the owner, as are often the case with new hotels. A hotel that has been failing the performance test is not likely to have accumulated the cash to satisfy these obligations.
What can an owner do?
It would be better for the owner if the “AND” separating the two prongs were instead “OR”, but this is rarely agreed.
Make the years to which the test applies not two consecutive years, but any two of three consecutive years;
The percentages – 90 per cent in the examples – should be at least 100 per cent and arguably even more where the management company flaunts its ability in the negotiation leading up to the management agreement and has a new hotel at its disposal. The owner should seek to have the hotel under the supervision of the management company exceed the budget and the RevPAR of the competition, not just come within a respectable proximity to the budgeted revenue or the performance of the competitors;
The owner must insist always on aggressive, stretch budgets, not an easy-to-achieve “softball budget” that might be proposed by the management company after it has failed the first of the two consecutive year tests;
Be sure the competitive is a good one and that it is adjusted over time to remain truly “competitive”;
The right to cure should not be unlimited, and allow only one or two cure rights throughout the term of the management agreement;
Make the cure payment from the management company apply to the shortfall for both years, or at least negate only the year for which the payment was made (meaningful where the test applies to any two of three consecutive years);
If the management company has a right to extend the term at its expiration, condition that extension upon the management company’s not having failed the performance test, whether or not the failure was cured;
Tighten up the definition of “force of majeure” so that it applies only when there are extraordinary, unforeseen events, such as a tsunami. Do not allow a general economic downturn either globally or locally to be part of the definition of “force majeure”. The management company should be expected to manage through economic downturns;
Make only those owner breaches that directly impacted the management company’s ability to meet the performance test apply as excuses for the failure;
The obligation of the owner to repay all amounts owing to the management company as a condition precedent to termination of the management agreement should not apply where the termination arises from a failure of the performance test. This is a difficult one because the management company is not likely to agree to leave the property unless it is fully paid for all amounts owed;
Make the performance test measure the net income that flows to the owner. This is difficult because in a hotel P&L, management companies measure their performance only above those expense lines over which they argue that they have no control, such as the FF&E replacement reserve, property insurance, property taxes, capex and most importantly, debt service. But net income is ultimately the only performance outcome that is truly meaningful to the owner.
In short, if the owner is genuinely interested in having a meaningful performance test, the owner must think long and hard about what performance it wants to use as the test standard and what constitutes a failure of the test, and then negotiate hard to make the test meaningful and not an illusory cosmetic.
By Albert J. Pucciarelli, Esq.
Albert J. Pucciarelli is a partner in the law firm of McElroy, Deutsch, Mulvaney & Carpenter, LLP. He is Chair of the firm’s Hotels and Resorts and Aviation Practice Groups. From 1988 through 1998, he was a Director and Executive Vice President, General Counsel and Secretary of Inter-Continental Hotels. He has served as Chair of the Hotels, Restaurants and Tourism Committee of the Association of the Bar of the City of New York (2001-2004) and as Chair of the Aeronautics Law Committee of the Association of the Bar of the City of New York (1998-2001). He is a Director and immediate past President of the Hospitality Industry Bar Association. He has taught International Business Law as an adjunct professor at the Fordham University Graduate School of Business, and was member of that school’s Advisory Board (1996-2004). He is a member of the Cheyney University of Pennsylvania Hotel, Restaurant & Tourism Management Board. He is a Director of Skytop Lodge Corporation in Skytop, Pennsylvania, and a consulting member of Cayuga Hospitality Associates.