By Jim Butler and Robert E. Braun
June 28, 2010

The hotel management agreement or HMA is one of the most important factors in the financial success or failure of a hotel, and the value of an owner's or lender's interests in the property. One of the many important provisions in the HMA can be the performance standard the Operator is required to meet, and the consequences of such a failure. This is the third article in the series on this subject.

In the first article, we talked about performance standards in HMAs. We explained why they are so important and discussed the respective concerns of Operators and Owners. 

In the second article, we looked at a typical hotel Operator performance clause and how it protected the Operator interests. For the Owner to have a termination right under such a clause, the hotel Operator must fail both prongs of a two-prong test: (1) the RevPAR test, which compares the financial results of the hotel to a competitive set of hotels, and (2) the budget test, which requires the Operator to achieve profitability based on the Operator's projections in a budget. We also pointed out some of the challenges posed by that test.

In this third article, we will look at a performance clause that takes better care of the Owner's concerns and which raises some issues with Operators. 

What is the interest that Owners want to protect with a performance clause? 

The bottom line is that Owners want to receive an adequate return on their hotel investment. Owners need the return because they are expected to pay debt service, provide working capital, fund capital expenditures and provide a return to their investors. If they don't get that return, Owners should have certain rights. There are a variety of tests, but we believe the most effective, meaningful and fair test is an Owner's Return performance test.

The concept of an Owner's Return performance clause is rather simple: Unless the Operator can manage the hotel to generate sufficient profit and distributable cash to provide the Owner with a specified return on investment, the performance clause has not been satisfied, and certain consequences follow.

Normally, we use the Owner's Return test for two purposes: 

1. Create a Viable Investment. Identifying the Owner's Return clarifies the expectations of the Owner and the Operator, and is an essential part of the "bargain" between the Owner and the Operator. Ultimately, if the Operator cannot fulfill its part of the bargain, the performance standard gives a hotel Owner the option to terminate the hotel Operator when the test has failed. Sometimes the ability to terminate an operator can be the only effective way to truly get the Operator's attention and redirection to take care of the Owner's concerns.
2. Hurdle for incentive compensation and subordination of fees. Independent of any termination right that may attach, no incentive fees should be payable to the Operator in any year unless the performance test has been satisfied. Often, a portion of the Operator's base fee - say anything over 1.5% of gross revenues, or perhaps anything in excess of half of the base fees - may similarly be conditioned on and subordinated to payment of the Owner's Return for the given year.

How Do I Measure Owner's Return? 

The required Owner's Return is determined by this formula, calculated annually:

Owner's Return = (Total Investment in the hotel) x (Agreed upon investment return)

For example, if the total investment in a hotel was $25 million, and the agreed upon investment return was 12%, the Owner's Return would be determined as follows:

Owner's Return = $25 million x 12% 
or
Owner's Return = $3 million

Total investment in the hotel 

The first key to measuring the Owner's Return is to calculate the Owner's total initial investment in the property, including all costs associated with the investment, both debt and equity, and all hard and soft costs. 

That initial investment should be increased each year to add all of the Owner's additional investments. We typically provide for the addition of three major items to the calculation of Owner's investment in the hotel:

• Contribution to FF&E fund, when contribution is made. Virtually all management agreements (and franchise agreements and loan agreements) require an Owner to set aside a reserve to pay for regular replacements of furniture, fixtures and equipment (FF&E). These reserves reduce the cash the Owner might otherwise retain from the operation of the hotel, and represent an additional investment by Owner.
• Capital expenditures not paid from the FF&E fund. As a hotel ages, the FF&E fund will not be adequate for the maintenance of a hotel. Major upgrades to its soft goods, replacements of furniture, fixtures, and equipment, or other capital projects will usually be paid out of hotel revenues (that would otherwise have gone to Owner) or from additional investment by the Owner. Unless these amounts came from the FF&E fund, they also represent additional investment by Owner.
• Any additional working capital contributed to the hotel, not otherwise included in the preceding items. From time to time, working capital may be required for various reasons, such as seasonal business needs or operating deficits from disasters or business cycles. 

Investment return. 

After the Owner's total investment in the property is calculated for a given year, the Owner's Return is derived by applying a percentage to that which must be paid out of profits to satisfy the test. 

A common goal of Owners is to achieve something on the order of a 12% return on their total investment in the hotel. Over the past 20 years we have regularly obtained a reasonable Owner's Return provision from almost every major brand -- at least when they really want to manage the particular hotel.

Their willingness to give this kind of performance test is a much truer reflection of their enthusiasm for a project and their belief in its success than all the laudatory fluff shared in the process of selling the Owner on hiring the Operator. 

What do Operators think of this test? 

Operators understand the importance of a return to the Owner, but often object to this test, particularly when it could allow an Owner to terminate a management agreement. As we have pointed out before, hotel Operators do not want to guarantee performance, and limit the tests of performance to those things that are within their control. Since Operators cannot control the net income from the property or the Owner's acquisition costs or continuing investments in the hotel, allowing an Owner to terminate the agreement if the test is not met may be problematic. 

On the other hand, if an Operator can't manage a hotel to provide Owner with a reasonable rate of return, the maybe Owner should at least have the option to change things up.

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Robert Braun is a senior member of the Global Hospitality Group® at JMBM. 
Mr. Braun advises hospitality clients with respect to management agreements, franchise agreements and spa agreements. He also advises on business formation, financing, mergers and acquisitions, venture capital financing and joint ventures, telecommunications, software, Internet, e-commerce, data processing and outsourcing agreements for the hospitality industry. Contact him at 310.785.5331 or [email protected].

Jim Butler is a founding partner of JMBM and Chairman of its Global Hospitality Group®. Jim is one of the top hospitality attorneys in the world. GOOGLE "hotel lawyer" and you will see why.  JMBM's troubled asset team has handled more than 1,000 receiverships and many complex insolvency issues. But Jim and his team are more than "just" great hotel lawyers. They are also hospitality consultants and business advisors. For example, they have developed some unique proprietary approaches to unlock value in underwater hotels that can benefit lenders, borrowers and investors. (GOOGLE "JMBM SAVE program".) Whether it is a troubled investment or new transaction, JMBM's Global Hospitality Group® creates legal and business solutions for hotel owners and lenders. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them. For more information, please contact Jim Butler at [email protected]. or 310.201.3526.