Multi-party joint ventures: a complex affair

Micky Yang considers the challenges involved in negotiating a multi-party joint venture agreement, in the last article of the latest corporate real estate series from Herbert Smith Freehills We have explained in previous article series how joint ventures (JVs) have become a common feature in the real estate sector, particularly (but not exclusively) in projects involving development. There are several reasons for this. JVs allow parties with on-the-ground knowledge and expertise to work alongside investors who may or may not have experience in the sector or a particular geography. They are also a way of sharing cost and risk as well as the rewards, which can be particularly appealing in these unpredictable times. JV negotiations between two parties can be difficult at the best of times, but can quickly become exponentially more complex where there are three or more parties involved, particularly where they all wish to take part, at least to a degree, in the management of the affairs of the JV. This is to be distinguished from a fund structure with multiple passive investors, where the management of the investments is entrusted to a manager or general partner. These have their own challenges and the additional veneer of regulatory considerations to take into account, but are not the subject matter of this article. In the paragraphs below we aim to provide a glimpse into some of the challenges in a multi-party JV, in the traditional sense. Who are the JV parties? The question here is what kind of outfit the JV parties are. For example, are they institutional investors, private equity houses, listed companies, family office vehicles, pension funds or high-net-worth individuals? Do they all know the relevant investment market or sub-sector to the same degree? Cultural and geographical factors and sensitivities cannot be underestimated, either. It may be obvious, but the reason this is important is that who the investors are will inform their level of risk appetite/aversion, their view on investment cycles, their priorities, their own internal decision procedures, and regulatory considerations, to mention just a few of the aspects that may be at play and may impact the positions adopted by each JV party. Of course, this is also important in a two-way JV, but it can have particular relevance in a multi-party scenario where some of the players may, precisely because of who they are, have more affinities and common interests and create a dynamic where they can act as a block, for example in exercising veto rights on certain strategic matters. What is the equity split between them, and how are material decisions to be made? Having the above in mind, how the equity is split between the parties will determine how the JV’s decision-making is structured. Let’s take the example of a four-way development JV where the equity split is 25:25:25:25 and the partners are a private equity house, an institutional investor/developer, and two pension funds. In a scenario where an attractive offer is received for 100% of the underlying assets of the JV soon after the practical completion of the development, the private equity house would be likely to prefer that the JV vehicle accepts the offer so it can realise its investment and maximise returns. Conversely, the pension funds may regard the asset as a long-term investment and as a safe source of income, and prefer to hang on for longer. With only a 25% stake, the private equity house would be unlikely to be able to force a disposal of the whole, but in negotiating the JV agreement it may want to push for a full divestment decision to require not more than 50% of the votes (ie two out of the four parties), while the pension funds would probably prefer that such decisions require at least more than 50% of the votes (three out of the four) such that they would, in effect, hold a veto right for so long as they act together as a block. Note how, particularly in the latter case, the institutional investor would be likely to hold the key to determining the outcome. The dynamics and majority thresholds would probably look fairly different if the equity split were, for example, 55:15:15:15. In this case, the minority parties would probably hold less weight in the decision-making, both individually and collectively, and the 55% holder would be more likely to have a bigger say on the issue (or simply have the benefit of drag-along rights which would allow it to force the disposal, perhaps subject to certain safeguards for the minority parties such as a floor return threshold). These sorts of dynamics may arise in respect of a number of other material or strategic matters reserved to the investors. It is not unusual for various majority thresholds to apply depending on the level of materiality of the matters concerned. These will be finely balanced having regard to the parties’ respective stakes, commercial interests and the particular sensitivities at play in each case. The importance of having a future-proof agreement This fine balance can easily be destabilised by changes in the number of JV parties and changes in the holding stakes between them, resulting, for example, from the below: Deadlock resolution mechanisms – In the case of a deadlock on a fundamental matter it is common to see resolution mechanics, the result of which would allow a dissenting party to exit the JV, sometimes referred to as shoot-out or buy-sell processes. It is easy to see how these could become increasingly complex the more parties are involved, and how they may give rise to unpredictable outcomes. It is precisely due to this unpredictability that investors in some cases may decide to bypass these sorts of mechanics altogether and agree an alternative way forward. However, these contractual deadlock resolution mechanics still play a role in providing a resolution of last resort as well as, at the very least, constituting an incentive to find a consensual resolution. Liquidity/pre-emption rights – Often JV arrangements will allow the parties to dispose of their interests (sometimes only after a lock-in period) to a third party, subject to the other parties first having a pre-emptive right to acquire such interest (whether at a price set by an independent valuer or by matching the price offered by a third-party purchaser). The non-selling parties may or may not exercise this right and, typically, where more than one does exercise it, they would each be acquiring a portion commensurate to the size of their existing stake. If they do, the end result will be one less JV party and possibly a change in the relative equity stakes of the remaining investors. Default consequences – Those familiar with JV negotiations will be aware that, typically, JV agreements contain certain adverse consequences for JV parties that commit one of a pre-determined list of events of default. For example, a failure to fund pursuant to the funding commitment contractually agreed by a JV party would usually constitute an event of default, sometimes subject to the defaulting party first being given a chance to cure its default. Once a default has occurred, often the consequences for the defaulting party will be severe, such as their disenfranchisement from decision-making at board and/or shareholder level and/or (in the case of a funding default) the right of the other JV parties to fill the funding gap by providing to the JV priority high-interest loans, which may be subsequently converted into equity, therefore having a diluting effect on the defaulting party – in some cases at a punitive rate of 1.5x or more. In some instances the non-defaulting parties may even reserve the right to buy out the defaulting party altogether, often at a price below market value. As a result of applying these types of provisions, a four-way JV may become a three-way or two-way JV and/or end up with uneven holdings. The possible permutations and outcomes will need to be explored at the outset, and the governance and liquidity provisions will need to be stress-tested to make sure they continue to work. At times, there may be a sense of looking into a crystal ball to try to legislate for the possible scenarios. There is obviously a limit on how far one can go in anticipating what may or may not happen in the future and a point at which too much complexity may mean that the contractual mechanics are not workable in practice. The key will usually be trying to keep things as simple as possible and building in mechanics that are flexible and can work with different numbers of JV parties and stakes. As previously mentioned, often commercial reality will prevail, and the parties may prefer to sit at the table at the relevant time to agree an outcome. An agreement, of course, may be more difficult to reach between multiple parties than between just two, so having a well-drafted JV agreement in place that sets out clearly what the respective default rights and obligations of the parties are in the absence of agreement may prove invaluable. Micky Yang is an Of Counsel in the corporate real estate team at Herbert Smith Freehills LLP Joined-up thinking – previous JV articles from Herbert Smith Freehills Six key factors for any JV  The minority report The European dimension Corporate JVs – what you need to know How to structure a JV Photo: Food And Drink/Shutterstock