HMA Bites: Performance Tests

In HMAs performance tests are used to set out a minimum level of acceptable financial performance, and to give the hotel owner a right to terminate if the hotel underperforms against the agreed benchmark.

They can be formulated in a number of ways (and often in combination).  Common test methods include:

• RevPAR-based (i.e. did the hotel meet or exceed a specified percentage of the average RevPAR of an agreed set of comparable hotels?)
• Budget-based (i.e. did the hotel meet or exceed a specified percentage of its budgeted gross operating profit set out in its annual budget for the given year?)
• Return-on-investment-based (i.e. did the hotel owner achieve at least a certain return on its equity investment?)
• Business Plan-based (i.e. did the hotel meet or exceed a specified level of gross operating profit for the given year set out in its initial business plan?)

Performance tests are not a "boilerplate" clause – they are complex, and need careful consideration.  Whatever methodology is used, it must be clearly articulated, and it must achieve the intended result.  The parties to the HMA should always run some example calculations using dummy figures to ensure that the methodology achieves their desired result – and it is best practice to include a worked example in the HMA  itself to avoid any potential misinterpretation.

When negotiating a performance test, hotel operators will want to ensure the test is narrowly defined and fairly applied.  Common negotiation points for hotel operators include:

• The use of a multi-limb performance test (i.e. combining two or more metrics), and a requirement to underperform all of limbs in order for the test to be failed (rather than an "either/or" approach) – and ideally on a multi-year basis (i.e. both limbs must be failed in multiple years)
• A right to "cure" a failure of the performance test by making a top-up payment to make good the underperformance 
• Exemptions where the underperformance is caused by breaches by the owner (e.g.  under-investment in the hotel) or an event of force majeure

Conversely, hotel owners will want to ensure the test gives them a meaningful way of removing an under-performing operator.  Common negotiation points for hotel owners include:

• A "one strike and you're out" approach to the performance test (i.e. a single failure of the performance test in any year permits the hotel owner to terminate)
• A mechanism to review and update the competitive set from time to time to ensure the hotel is always evaluated against comparable hotels 
• A limit on the number of times the hotel operator can exercise its right to "cure" a failure of the performance test

Performance tests have historically proved difficult to enforce, and are not the only approach to driving performance and mitigating against under-performance.  Instead they should be seen as part of a range of contractual tools to drive performance.  Other such "tools" include:

• The ability for the Owner to approve the annual budgets (on which the performance test may be based), and a robust approach to budgeting which focuses on aspirational rather than "lowball" targets
• Offering incentive-based fees to hotel operators to encourage successful financial performance
• Subordinating the payment of incentive-based fees to payment of an agreed level of return on investment to the hotel owner (known as an "owner's priority" or a "hurdle")
• The inclusion of other termination rights for the owner– such as a right to terminate without cause (usually contingent upon the hotel owner paying an agreed termination fee to the hotel operator), or a "key man" termination right (triggered by the exit of an identified person agreed as being indispensable to the hotel operator's brand or business – more commonly seen in agreements for boutique hotel brands). These rights would supplement the more common termination rights for material breach by the hotel operator of the terms of the HMA and insolvency of the hotel operator. 

Giovanni Forni of Cedar Capital Partners says of performance tests: "Although rarely enforced, performance tests are a necessary safeguard in a hotel management agreement.  The key is to make them commercial relevant and workable in practice, and to ensure they work for both parties".