Performance tests in owner termination rights
Most HMAs include some form of owner termination right where an operator is performing badly. HMAs currently in use generally base that right on the operator’s financial performance only. The two most common tests are:
- a comparison of achieved gross operating profit (“GOP”) against the GOP forecast by the operator in the annual budget process; and
- a comparison of the revenue per available room (“RevPAR”) achieved by the hotel against the RevPAR achieved by a selected group of comparable and competing hotels.
Operators typically must fail both of these financial tests before an owner can trigger its termination right.
What is the issue with performance tests in their current form?
Frankly, the typical performance tests outlined above offer a fairly impotent tool to owners seeking to terminate the operator for underperformance, as they are generally too difficult to fail. This can be for a number of reasons. For example, whilst the owner is involved in, and ultimately approves, the GOP forecast as part of the annual budgeting process, the operator is the one operating the hotel and producing the relevant figures, and can therefore heavily influence the benchmark against which they are tested.
How can an owner address these issues?
There are a number of ways that performance based termination rights could be improved:
- non-financial performance tests: so look towards tests which measure other areas in which operators are expected to perform or add value;
- shorter operating terms: reducing the operating term to, say, five to ten years, would motivate operators to focus more on their performance. If they don’t, owners will be less inclined to renew their HMAs;
- owner no fault/termination for convenience rights: if sought, operators can be expected to seek a compensatory payment. Query also the feasibility of changing operators more regularly given re-branding costs;
- real cure payments: if financial tests are retained (and we are certainly not arguing for their complete removal/irrelevance), operators should properly compensate owners for their poor performance by making good the whole shortfall, not just a percentage of the budgeted figures or comparative set RevPAR; and
- convertible HMAs: making HMAs convertible to franchise agreements at the owner’s option would give an owner the flexibility to bring in a third party operator to replace an underperforming operator, whilst still retaining the branding of the hotel. However, this would increase the length of HMAs (and the time and cost of their negotiation) to include the terms of the optional franchise arrangements.
A re-think and re-balancing of the relationship between owners and operators is long overdue; rethinking performance based termination rights would be a good place to start.