Investor and developer joint ventures have grown in popularity. James Spence and Adnan Bhaiji highlight the details to get right
It is not uncommon to see joint ventures (JVs) between operators and investors to acquire and develop real estate. These JVs bring together capital and expertise, where the investor has the capital to invest and the operator has the expertise to source the investment, arrange debt finance and undertake the operational management.
The operator also typically enters into a management agreement with the JV, which records the terms of the operator’s appointment, the list of asset/development-management services to be provided to the JV and the commercially agreed fees.
There are key negotiation points when entering into JVs. It is important to clarify the parties’ respective funding obligations at the outset. These usually fall into two categories.
• Committed funding: This comprises the initial funding to acquire the assets and any funding required during the life of the JV. Committed funding obligations, which are typically capped, are heavily influenced by the type of real estate involved. For example, in the case of core and core-plus assets, where there is no intention to improve or develop, the parties might resist any mandatory funding obligations beyond the initial funding. For value-add or opportunistic assets, where there are budgeted future capex items, parties usually treat such budgeted amounts as additional funding obligations.
• Emergency funding: This is funding for emergency spending on the assets or spending not contemplated in the JV’s business plan – for example, payments to a third-party lender required to remedy a debt default, and emergency repairs for value preservation or to mitigate health and safety risks.
If a party fails to fund its share of a committed-funding drawdown, the other party usually has a right to fund the shortfall by way of a priority loan at a punitive coupon, with the payment of the coupon and the Principal having priority over all other distributions to the parties. Another consequence could be a dilution (including, in some cases, a penal dilution) of the non-funder’s ownership interest in the JV and thus its economics in the transaction.
The consequences of failure to make emergency funding tend to be less severe – for example, a right for the funder to make a priority loan on the same terms as above, but at a less severe coupon. A funding failure may also be treated as a default by the non-funder and give the funder certain contractual rights and remedies (eg, damages) or trigger expressly agreed default provisions.
The ‘distribution waterfall’ allocates and prioritises distribution of net proceeds from a JV to each party. The parties first receive a return of their respective invested capital. The investor then receives a preferred return on its invested capital – calculated on an internal-rate-of-return basis, but sometimes also incorporating an equity return multiple, or preferred return.
Once the investor has received their preferred return, the operator is entitled to an increased share of any further distributions by way of performance incentive (or the promote). To further incentivise the operator, we have seen investors agree to tiered promote levels, triggered at different levels of preferred return (hurdles).
The investor usually has control over the JV’s investment decisions, with certain key decisions requiring the joint approval of both parties (reserved matters). The operational decisions (including, updating the business plan, sourcing of investment opportunities, debt finance or making strategic recommendations on the asset) are delegated to the operator under the management agreement.
Typical examples of reserved matters are: sale/acquisition of the assets (sometimes limited to a sale of the asset at an undervalue or on non-arm’s-length terms); entry into any third-party debt financing; material capex; altering the capital structure of the JV; and winding up or effecting any insolvency procedure in respect of the JV.
Transfer of the operator’s interest to a third party usually requires investor consent. This reflects the principle that the investor is partnering with the operator for its particular skills and experience. Certain transfer rights might also be triggered on a termination of the management agreement, depending on whether or not the termination arises from the operator’s breach. Conversely, an investor does not usually restrict its ability to transfer any of its interest. As such, the parties normally agree a combination of these transfer rights:
• Drag-along rights: The investor can ‘drag’ the operator (without its consent) into a sale of its interest on the same terms as the sale of the investor’s interest, enabling the investor to market the entire JV/assets for sale (without a minority interest in place), which tends to be more attractive to a purchaser.
• Tag-along rights: The operator can tag along to any sale of the investor’s interest so that any purchaser of its interest also acquires the operator’s interest on the same terms. This enables the operator to avoid being locked in a JV with a new counterparty against its wishes.
• Put right: In the event of investor default, the operator can compel the investor to buy its interest at its fair market value (either as agreed between the parties or as determined by a third-party appraisal), plus its crystallised promote (if any). In the case of an investor default, the parties may apply a premium to the fair-market value.
• Call right: The investor can compel the operator to sell its interest to the investor at its fair-market value. In the case of an operator default (including a termination of the management agreement for fault), the parties may apply a discount to the fair-market value and provide for the loss of some or all of the promote (if any).
Where the operator is exiting the JV prior to the end of the hold period, the parties may agree to crystallise any promote earned by the operator on exit – based on a hypothetical realisation of the assets on that date and a deemed distribution of the resulting net proceeds in line with the distribution waterfall. The crystallised promote is usually payable at the end of the venture or after a capital event – for example, the investor selling its interest, or a sale or refinancing of the assets.
Typical JV defaults include fraud, negligence, wilful misconduct, insolvency, a material unremedied breach of the JV agreement and/or an unsanctioned change of control of any of the parties. In the case of the operator, this may include a cross default under the management agreement and/or any key persons ceasing to be involved in the operator’s business.
As a baseline, a defaulting party would be liable to the other party for actual damages under law. However, that might not be particularly useful as the other party will likely be a special purpose vehicle without any other assets, so other contractual remedies include:
• Put/call rights;
• Disenfranchisement – a suspension of the defaulting party’s governance rights (including the reserved matters regime);
• An offset of any losses against distributions otherwise payable to the defaulting party;
• In the case of the operator, a default under the JV agreement could trigger a cross default under the management agreement enabling the JV to terminate the operator’s management agreement.
In conclusion, parties entering into JVs should take great care to carefully lay out and agree the terms of their investment partnership to ensure that it runs smoothly.
James Spence (above left) is a partner and Adnan Bhaiji is an associate at Goodwin Procter