Mastering Hotel Deals in the Kingdom of Saudi Arabia: The Performance Test

This is the second article in our Mastering Hotel Deals series, which examines the key provisions that shape the relationship between asset owners and hotel operators in Saudi Arabia. In this instalment, we focus on performance tests, a crucial mechanism that enables owners to monitor operator performance and, in some cases, trigger termination when minimum performance thresholds are not met. As a key contractual lever for owners in long-term management arrangements, the performance test is central to aligning operator incentives with the owner’s commercial objectives.

Understanding the Basics

A performance test in a Hotel Management Agreement (“HMA”) is a critical mechanism designed to measure whether the operator has achieved a minimum level of financial performance over a defined period. These tests serve as a crucial tool for owners to monitor operational effectiveness and provide a basis for intervention, or even termination, if consistently unmet. The negotiation of these tests is pivotal as they directly impact the long-term alignment of interests between the owner and the operator. The performance test typically constitutes two main components:

1. The Revenue per Available Room (“RevPAR”) test:

• What it is: This test compares the subject hotel’s RevPAR against the aggregated RevPAR of a pre-defined competitive set of comparable hotels (“Competitive Set”). The Competitive Set would typically include a group of hotels considered direct competitors to the subject hotel, typically similar in terms of location, product quality, service standards, target market, and amenities.
• What it Reflects: The RevPAR test is primarily an indication of the operator’s effectiveness in revenue generation, market penetration, and overall sales and marketing strategy relative to its direct competitors or the broader market. It indicates how well the hotel is capturing its fair share of available business.
• Benefits:
  • Provides an external, market-based, and objective benchmark.
  • Reflects how well the hotel is performing against similar properties in terms of occupancy and average room rate.
  • Highlights any issues with sales strategy, branding, or market positioning.
• Drawbacks:
  • Highly dependent on the accuracy and fair definition of the Competitive Set and selecting appropriate and comparable hotels.
  • Can be influenced by external market factors beyond the operator’s direct control (e.g., new competitors entering the market, localised economic downturns affecting only a subset of the market).
  • Does not directly measure profitability, as high revenue doesn’t always equate to high profit.

2. The “Budget Test” (often the Gross Operating Profit (“GOP”) test):

• What it is:This test compares the hotel’s actual GOP against the mutually agreed annual operating budget.   
• What it Reflects:The Budget Test focuses on the operator’s ability to manage expenses effectively and convert revenues into actual profit. It assesses overall operational efficiency, cost control, and financial stewardship.
• Benefits:
  • Directly measures profitability and the operator’s ability to manage the bottom line.
  • Reflects the operator’s skill in managing operational costs, labour, and other expenses.
  • Is based on an internally agreed-upon plan, setting the operator clear targets.
• Drawbacks:
  • The budget can itself become a point of contention. An overly conservative or optimistic budget may distort the outcome of the test. While the budget is typically subject to the owner’s approval, it is usually prepared by the operator, who therefore shapes its initial assumptions. As the GOP test is benchmarked against the approved budget, this gives the operator a degree of influence over the test’s results, which may disadvantage the owner.
  • Operators might be tempted to cut costs at the expense of service quality or long-term asset maintenance to meet the budget in the short-term.
  • May not reflect missed revenue opportunities if the hotel is profitable but underperforming relative to its market potential (which the RevPAR test aims to capture).

An operator is typically deemed to have failed the performance test if the hotel:

• fails to achieve a certain percentage (usually around 80-85%) of the RevPAR of its Competitive Set;
• fails to achieve a certain percentage (usually around 80-85%) of the agreed annual operating profit budget; and
• both these conditions are met for two or more consecutive test periods (typically on a rolling two- or three-year basis).

Ten Key Negotiation Points

Below are ten key negotiation points to consider when addressing performance tests in HMAs, especially from the owner’s perspective:

1. Mutual Agreement on Competitive Set: The Competitive Set plays a critical role in the RevPAR test, making it essential that both the initial selection and any subsequent changes are subject to mutual agreement rather than determined solely at the operator’s discretion.
2. Objective Criteria for Competitive Set: Establish clear and objective criteria for the inclusion or exclusion of hotels in the Competitive Set (such as star classification, room count, available meeting facilities, brand affiliation, and overall positioning) to ensure transparency and prevent bias.
3. Competitive Set Review Rights: Include provisions for periodic review and adjustment of the Competitive Set (e.g., annually or biennially) to reflect market changes. This is crucial as new hotels open, existing ones renovate, or market dynamics shift.
4. Operator vs. Owner Selection: Owners typically seek substantial input (if not final approval) over the composition of the Competitive Set, whereas operators often favour being benchmarked only against properties they consider appropriate. A balanced approach is to allow both parties to propose hotels, supported by a clear mechanism for resolving any disagreements.
5. Performance Thresholds: The percentage of RevPAR or GOP above budget that must be achieved (e.g., 80-85%) is a key point of negotiation. Owners will push for higher thresholds, operators for lower.   
6. Owner Approval of the Budget. As the GOP test often uses the approved budget as its baseline, it is important that the owner retains approval rights over the annual budget. To avoid deadlock, the HMA should include a dispute resolution mechanism (such as expert determination) if the parties cannot agree. This approach helps prevent the operator from having undue influence over the assumptions that underpin the performance test.
7. Testing Periods: Specify whether the performance test will be conducted annually and define the number of consecutive periods of failure that would trigger a default (typically two or three years on a rolling basis). An operator may also request to defer the commencement of the performance test for an initial period (typically two to four years) to allow the hotel’s revenue and profits to stabilise following the hotel opening date.
8. Cure Rights with Time Limits: Some HMAs permit the operator to “cure” a performance test failure by compensating the owner (for example, by covering a GOP shortfall). If such rights are included, it is important to limit the number of times they can be exercised and to set clear timelines and procedures for implementing the cure. This ensures the remedy is used appropriately without weakening the overall purpose of the performance test.
9. Excusable Events/Carve-Outs: Defining events that might excuse a test failure (e.g., force majeure, owner-mandated capital expenditure disrupting operations, and significant market-wide events not just affecting the Competitive Set). These should be narrowly defined to protect the owner’s interests.   
10. Preserve Termination Rights: The core purpose of performance tests is to provide the owner with a clear exit mechanism if the operator consistently underperforms. From an owner’s perspective, it is essential that failure of the performance test results in an enforceable termination right. The agreement should also avoid making termination contingent on arbitration or expert determination to confirm the test result, unless necessary.

Commercial Realities and Market Dynamics

While performance tests are a vital tool for owners, it is important to acknowledge that the negotiation of this mechanism is not a one-size-fits-all exercise. The strength and flexibility of these provisions often depends on the relative bargaining position of the parties. Where an asset owner is highly motivated to secure a particular brand (especially a top-tier or niche luxury operator) the operator may be successful in pushing back on aggressive termination rights, longer cure periods, or broader carve-outs.

Conversely, where the operator is seeking a strategic foothold in a new market or is bidding against other operators for a flagship asset, the owner may have more latitude to secure performance protections aligned with its investment expectations.

In the Saudi market, this dynamic is further influenced by the fact that many HMA negotiations involve sovereign-backed or government-affiliated asset owners, including portfolio companies of the Public Investment Fund (“PIF”). These institutional owners typically adopt a structured and strategic approach to negotiations, often aiming to ensure consistency and alignment across their hospitality platforms. As a result, owners are increasingly focused on incorporating market-standard protections, drawing on precedents established within the PIF portfolio and similar transactions. Given their market visibility and bargaining power, such owners are well placed to benchmark operator proposals against prevailing terms. In this context, asset owners often remain firm on key performance-related clauses and leverage competitive tension among operators to secure commercially favourable outcomes.

Tailoring Performance Tests to the Saudi Market

In major international cities with established hospitality markets, benchmarking against a competitive set is relatively straightforward. In contrast, in many parts of Saudi Arabia (particularly in secondary cities or within Giga Projects) identifying a stable and relevant Competitive Set is often a challenge where the local hospitality market is nascent or non-existent.

To address this, parties frequently negotiate bespoke testing mechanisms, such as:

• Phased Approach: Agree to use a budget-only test initially, or a modified RevPAR test against a broader market segment (e.g., city-wide data where available from sources like STR), with a commitment to define a more representative Competitive Set once the market matures and comparable hotels emerge.   
• Index-Based Comparisons: Use publicly available performance data adjusted for relevant factors. This can be more reliable than a poorly defined Competitive Set.   
• Deferral of RevPAR Test: The parties may agree to defer the RevPAR limb of the performance test for an extended period (e.g., three to five years post-opening) to allow for the local market to mature with envisaged hotel developments to allow for a more representative Competitive Set. The Budget Test would still apply.   
• Greater Emphasis on Budget Test: In such scenarios, the Budget Test naturally carries more weight as it relies on internal projections and operational efficiency rather than external comparisons.   
• Proxy Competitive Set: Identify hotels in other, more established but comparable markets, adjusting for relevant differences. This is less ideal but can be a temporary measure.

The Consequences of Failure

When a hotel operator fails to meet agreed-upon performance tests over the stipulated period, the HMA will typically provide the owner with specific remedies. However, the exercise of these remedies is often subject to cure rights granted to the operator. These provisions are among the most critical in the HMA, offering the owner recourse against underperformance while also providing the operator with opportunities to rectify the situation. These provisions are designed to balance the owner’s right to performance protection with the operator’s interest in preserving long-term contractual stability.

The typical consequences of failing the performance test can be broken down as follows:

1. Owner’s Termination Rights

The primary remedy available to owners following a failed performance test is the contractual right to terminate the HMA. This is typically characterised as a termination “for cause” and may be exercised without the payment of a termination fee. However, negotiations often arise in relation to wind-down costs, transitional support obligations, and the operator’s accrued but unpaid fees (such as base fees up to the termination date).

The right to terminate is almost always subject to specific conditions, which are frequently and heavily negotiated. These are generally as follows:

• Dual Failure: Typically, the operator must have failed both limbs of the test (e.g., RevPAR and GOP tests).
• Consecutive Failures: The failure must usually persist for two or more consecutive test periods (e.g., two or three full fiscal years). Owners might negotiate for a shorter period or include provisions for frequent failures over a longer period (e.g., failure in three out of five years).
• Absence of Excusable Causes: The failure should not be due to a force majeure event, market-wide downturns, necessary major renovations or other excusable causes. Owners should aim for a narrow and precise definition of these “Excusable Events”. Operators will usually seek broader definitions.
• Exclusion of Stabilisation Period: The failure should not have occurred during a stabilisation period that starts from the date of opening of the hotel (potentially a period of up to two or four years). The length of this period is a key point of negotiation.
• Compliance with Procedural Formalities: The owner must comply with procedural formalities, such as providing written notice, allowing for a cure period, and obtaining any required third-party consents (e.g., lender consent, if applicable).

2. Operator’s Cure Rights and Remedial Options

To balance the owner’s termination rights, operators are usually granted opportunities to “cure” a performance failure and avoid termination. The scope and limitations of these rights are critical negotiation points.

Common cure mechanisms include:

• Financial Cure: The operator may pay the shortfall in GOP or RevPAR to bring performance within the required thresholds and “buy out” the performance shortfall.
• Managerial Cure: The operator may propose remedial actions such as replacing key personnel, revising the business plan, or enhancing brand support.
• Remedial Action Plans: Some HMAs allow operators to present a performance improvement plan, which must be approved by the owner.

3. Impact on Incentive Fees

A critical area of negotiation, and a significant and practical consequence of a performance test failure, involves the operator’s entitlement to incentive fees. These fees are typically calculated based on hotel profitability (e.g., a percentage of GOP above a certain threshold or owner’s priority return). A failure in the performance test, which often includes both revenue (RevPAR) and profitability (GOP) components, signals that the operator may not be delivering the overall financial results anticipated by the owner. Therefore, HMAs often include provisions to adjust incentive fee entitlements in such circumstances. The primary goals for the owner are to ensure that incentive fees are only paid for genuine, sustainable over-performance and that the operator is not rewarded when the hotel is broadly underperforming against agreed benchmarks. This may take the form of:

• suspension of incentive fee payments during underperformance periods;
• subordination of incentive fees to the satisfaction of performance test metrics; and
• clawback mechanisms, whereby incentive fees paid during prior periods may need to be refunded or offset.

4. Reputational and Strategic Implications

From a practical perspective, the exercise of termination rights following a failed performance test often signals a breakdown in the owner-operator relationship.

Even where the HMA provides for an orderly termination process, the consequences can include brand reputational impact, disruption to hotel operations, and lender considerations.

5. Alternative Remedies

Where termination is not commercially desirable, some HMAs provide for alternative remedies upon failure of the performance test, including:

• conversion of the management agreement into a franchise arrangement;
• increased owner approval rights or operational oversight;
• operator to fund specific improvement initiatives or shortfalls;
• appointment of a third-party asset manager to oversee performance, at the operator’s expense;
• liquidated damages for continued underperformance;
• option to rebrand or reposition with operator cost contribution; and
• renegotiation or amendment of HMA terms.

Why Operators Resist Early Termination Rights

A common question we receive from asset owners during HMA negotiations is: “Why can’t we include a right to terminate early for convenience?” While this seems commercially reasonable from the owner’s perspective, particularly when they are willing to pay liquidated damages in connection with such termination, operators typically resist broad early termination rights unless tied to specific events (such as performance failure or breach). Their resistance is grounded in both valuation and operational considerations:

1. Impact on Operator Valuation and Cash Flow Modelling

Hotel operators frequently resist early termination rights because the value of their management platform is intrinsically linked to their portfolio of HMAs. From a corporate finance perspective, operators are typically valued based on a discounted cash flow (“DCF”) analysis, in which future cash flows under each HMA are projected, discounted, and aggregated to determine the enterprise value of the management company.

The DCF model assumes the operator will receive a stable stream of base fees and incentive fees over the life of each HMA (often 15 to 30 years). Even modest increases in the probability of early termination (e.g. through performance failure or termination for convenience) materially affect the terminal value calculation and, consequently, the implied valuation multiple.

In the context of listed hotel companies or hotel companies preparing for capital markets events, analysts and investors will closely scrutinise the operator’s contractual fee income visibility, treating stable HMAs as analogous to long-term concession assets. Termination flexibility on the part of the owner undermines this predictability and is thus viewed as a valuation risk, often triggering higher discount rates or prompting asset managers to exclude the hotel from comparable valuations entirely.

2. Early-Stage Investment and Resource Allocation

Operators also resist early termination rights due to the level of investment typically made prior to and during the initial years of hotel operation. These early-stage investments are both tangible and intangible, and may include:

• pre-opening services, including brand positioning, technical assistance, and systems implementation;
• recruitment, training, and deployment of qualified personnel, especially for flagship or luxury assets;
• marketing and distribution efforts, such as integrating the hotel into global sales channels and loyalty programmes; and
• development of operational infrastructure, such as standard operating procedures, IT systems, and audit mechanisms tailored to the property.

While these investments are often non-capital in nature (i.e., not booked as assets on the operator’s balance sheet), they nonetheless represent significant internal costs. Operators generally amortise these efforts over the term of the HMA, expecting to recoup them through fee income over time. Early termination compresses this recovery horizon and can leave the operator in a negative return position on the property.

Additionally, the deployment of senior leadership or branding resources to a particular hotel often comes at the expense of allocating those resources elsewhere. From the operator’s perspective, early termination may represent not just lost revenue but also a missed opportunity cost.

Key Takeaways

Performance tests serve both as a protective mechanism for owners and a catalyst for operator accountability. Given the long-term and largely operator-favourable nature of most HMAs, the performance test stands out as one of the few enforceable levers through which an owner can respond to sustained underperformance. When structured effectively, it provides both a benchmark for operational expectations and a contractual basis for early termination—without having to prove fault or misconduct.

Our key takeaways from a Saudi context include:

• Benchmarking Challenges Require Bespoke Solutions: In many parts of the Kingdom, traditional market-based RevPAR tests are impractical. Owners should therefore consider modified or index-based comparisons, or place greater emphasis on budget-based testing.
• Deferment Periods are Critical: Performance tests should account for a realistic stabilisation period, especially for newly launched or destination-driven assets.
• Cure Rights Must be Tightly Negotiated: While cure mechanisms offer fairness to operators, they should be clearly defined, capped in frequency and quantum, and not used to indefinitely defer termination rights.
• Coordination with Other Owner Protections is Key: The performance test works best when embedded within a broader matrix of owner rights (such as budget approval, incentive fee subordination, and termination for convenience) ensuring operators remain commercially aligned with ownership interests.

In the next article of our Mastering Hotel Deals series, we will shift our focus to the broader rights of owners under HMAs, including approval rights, access to information, key personnel oversight, and asset protection tools. These provisions, which are often overlooked in early-stage negotiations, are essential to preserving control, managing downside risk, and ensuring long-term alignment between the owner and the operator.