Corporate joint ventures: what you need to know

In his third and final article on corporate real estate, Paul Chases teams up with Jeremy Walden and Micky Yang to focus on “what is market?” in relation to 50:50 real estate development joint ventures The joint venture (JV) is becoming an increasingly common feature of UK real estate development projects. Often, on-the-ground knowledge, development and management expertise (on the one hand) is matched with the financial capacity and willingness to invest (on the other) to see a development project through from gestation to completion. This is known in the market as “stabilisation” – the point in time when the relevant property development is said to be substantially completeand sufficiently let. In times of economic uncertainty and market volatility, the sharing of cost, risk and reward (by way of JV) is often seen as an attractive proposition by property companies, private equity funds, pension funds, sovereign wealth funds and individuals alike. Choice of structure What do parties take into account in the current market? There is no one-size-fits-all JV structure in the UK real estate market. The choice of JV structure will depend on a multitude of factors – a structure that may work for a US private equity house may not be suitable for a UK developer or a Canadian pension fund. The decision on structure will usually involve consideration of the following: the identity and tax status of the JV parties; the nature of the underlying property assets (residential, commercial or mixed-use); whether the parties intend to develop and sell the underlying property or hold on to it as an investment; how the JV will be funded (eg via equity, shareholder debt, external debt, on-shore funding or off-shore funding); and the level of control and integration sought by the JV parties. Below is a chart showing a common English limited partnership (ELP) structure used for real estate development JVs. The structure includes a separate development company (referred to as DevCo), which will be the contracting party for the various construction contracts.   This approach enables the JV parties to ring-fence the liabilities and obligations arising in connection with the development (in relation to DevCo) separately from the ownership of the beneficial and legal interest in the relevant property. This can generally improve liquidity if the parties come to sell the property. In practice there are various approaches that can be taken to JV structures for the purposes of a real estate development JV. Such structures could include, in addition to limited partnerships, limited companies, unit trusts or tiered lease structures. JV parties are well advised to discuss with their respective lawyers the various options available as early as possible to maximise the chances of securing the best outcome from a practical, legal, commercial and tax perspective. Governance and conflicts of interest It would be impractical for 50:50 JV parties to agree and approve all decisions (relating to a real estate development project) on a unanimous basis. To assist, typically a development manager or asset manager will be appointed and given delegated authority to act (in respect of day-to-day matters) in order to assist in delivering the business plan agreed between the JV parties. On this basis, the strategic and material decisions (often referred to as “reserved matters”) will be reserved to, and require the unanimous approval of, the JV parties. Where one JV party is also the development or asset manager (which is very often the case in relation to UK real estate development JVs), a natural tension exists between: that party’s aim to retain as much flexibility as possible to deliver the development (by way of a broad scope of delegated management authority); and the other JV party’s commercial interest in ensuring it still retains (by way of reserved matters subject to unanimity) sufficient control to ensure the development is completed within budget, on time and to specification. It is quite common to see areas of conflict arising where a JV party is also fulfilling the asset or development management role (particularly in relation to a JV decision to terminate such a role). It is generally a market-acceptable position for the JV party that also undertakes management to be excluded from voting on the JV decision to terminate the management role itself. Deadlock In the event of a fundamental disagreement between the JV parties, matters are usually escalated to senior executives of the JV parties. In the absence of agreement, the JV documentation is likely to include a deadlock resolution mechanism. Different resolution mechanisms may apply depending on the nature of the matter concerned. In certain circumstances, it may make sense for the status quo to simply stay the same (in other words, if the JV parties cannot agree on a particular matter then nothing is done in relation to it). In other circumstances the JV parties may be happy to refer the matter to expert determination (although we are increasingly seeing JV parties approach this option with caution, as it ultimately hands the relevant decision to a third-party expert that is not financially invested in the development JV). Where the deadlock in question relates to a fundamental matter, a mechanism facilitating the exit of one or both of the JV parties from the investment may be the most appropriate resolution. There are a number of different exit mechanisms including buy-sell options, forced sales, internal auctions and sealed bid buy-outs. Their common objective is to unlock a situation that is not tenable for either or both of the JV parties by providing them with an exit route.   Failure to fund The JV parties will be expected to commit funding based on a pre-agreed business plan (which will include a budget of development costs). This will usually be refreshed and approved by the JV parties on a periodic basis. In the absence of agreement, typically the previous business plan remains in place subject to price adjustments linked to indexation. This is normally on the basis that the JV agreement deals separately with how budget overruns and emergency funding is dealt with. If a JV party fails to fund, this is serious for a development project and will generally constitute an event of default. Options in such circumstances are as follows: the funding party may be allowed to fill in the funding gap by providing to the JV a high-interest loan (commonly referred to as a “shortfall loan”) which the non-funding party will be given a chance to pay back within a specified period – if not repaid, the shortfall loan may be converted into equity (thereby diluting the JV interest of the non-funding party); or the funding party may be able to elect to buy out the non-funding party at a discounted price (it would not be unusual to see a discount of up to 15% here). Bankability of JV interests Even when JV parties are planning to fund the JV out of their own equity, it is important to retain flexibility for external debt financing to be procured at a future date. To assist, the following could be included in the JV documentation: a loan-to-value limitation; appropriate information and reporting rights to any future third-party funder; ability for security to be granted over a JV party’s interest or the property; the need for bank consent on certain JV matters; and how an event of default under the JV documentation may (or may not) trigger an event of default under any banking documentation. Paul Chases is a partner and head of corporate real estate, Jeremy Walden is real estate partner and Micky Yang is a senior associate in corporate real estate at Herbert Smith Freehills LLP. Webinars on this topic will be available via the HSF website. Part 1: CRE: acquisitions and disposals Part 2: Know your W&I policy options