How to Structure a Performance Test in Untested Territory
By Tara K. Gorman Partner, Perkins Coie LLP | March 26, 2010
What is the point of a performance test anyway? Traditionally, a performance test was designed to determine whether the hotel operator was "keeping up with the Joneses" and the hotel was "performing" well under the hotel operator's management and came within striking distance of the annual budget. Historically, the hotel operator held the position that there was no guaranty under the hotel management agreement for a minimum return on the owner's investment. The hotel operator would operate the hotel to the standards required under the hotel management agreement, and in the case of branded hotels, to the brand standards dictated by the brand. In fat times, this seemed to work fairly well, and while the performance tests were heavily negotiated upfront they were rarely street tested. Typically there was no compelling reason for a hotel owner to exercise its rights under the performance test and to terminate the hotel operator. The hotel owner was making a reasonable return on its investment, the hotel operator was being paid its base management fee and in some cases its incentive fee, and the lender was being timely paid. All was well. Usher in a global economic collapse and this untested territory has hotel owners, operators and lenders taking a long hard look at traditional performance tests.
- Gross Operating Profit Test - Grossly Ineffective
At the negotiation table a performance test whereby the hotel's performance is measured against an agreed upon annual budget seems fair and reasonable. If the actual budget meets a minimum percentage threshold - typically 80 - 95% - then the hotel operator has passed the gross operating profit test (GOP Test). But the effectiveness of the GOP Test is directly correlated to how well the hotel operator can predict the future and the extent of the hotel owner's approval rights over the annual budget. Believe it or not, some hotel owners simply have the right to comment on the annual budget proposed by the operator, and the operator must "consider" the hotel owner's comments - but that's the full extent of the owner's approval rights. In this case, if the operator "considers" the hotel owner's comments to the proposed annual budget, the hotel operator has met its obligations under the hotel management agreement. Therefore, the hotel operator could potentially "game the system" by presenting an extremely low budget, and an easy threshold to meet. At first blush, because the GOP Test is tied to the annual budget, it appears to measure the financial performance of the hotel. But in reality the GOP Test is not a test of the financial performance of the hotel, but rather the ability of the hotel operator to develop a budget which the operator can meet and which owner will approve, if the owner is "lucky" enough to have approval rights over the budget. In theory a hotel operator could pass the GOP Test even when the hotel is not performing well. In order for the GOP Test to have any teeth, the hotel owner must have meaningful approval rights and the percentage threshold should be as close to 100% as the owner can negotiate.
- Competitive Test - Not so Competitive
Like the GOP Test, at the negotiation table a performance test whereby the hotel is measured against similarly situated hotels seems fair and reasonable. The "keeping up with the Joneses" competitive set performance test is designed to ensure that the revenue per available room (RevPAR) in the measured hotel does not fall below the negotiated threshold as measured against at least five similarly situated hotels also known as the "competitive set". The idea behind the competitive set test or RevPAR test is that if a similar hotel down the street is doing well, so should the measured hotel, and if it's not doing well - well, it must be the operator's fault. Maybe it is, and maybe it isn't. With the onset of the global economic collapse, and the drastic reduction in both business and leisure travel - keeping up with the Joneses just isn't sufficient. The competitive set isn't doing well either. So hotel owners are finding themselves using their own capital to keep the hotel afloat. Incentive fees are clearly out of reach of operators. In some cases, base fees are being reduced, and in a drastic effort to protect their brand, branded operators are fronting the cost of operating expenses in the hopes of being reimbursed by the owner. And many lenders are not being timely paid, if at all. These days keeping up with the competitive set, just isn't cutting it. However, because the competitive set isn't doing well either, the operator does not fail the competitive test prong of the performance test, and this leaves the owner with no right to terminate the operator under the competitive set performance test. Even hotel owners who were extremely careful in choosing hotels to place in the competitive set, and required a minimum threshold of 100% or greater, are finding that their hotel operators are passing the competitive test performance test.
- General Loopholes to Traditional Performance Test