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By: Thomas G. Maira, Reed Smith LLP.
As funds raised in the 2006–2008 heyday of private equity reach the ends of their 10 year terms, there has been a surge of restructurings of those funds utilizing a stapled secondarystructure. The widely publicized $1.2 billion restructuring in March 2016 of a 2008 vintage buyout fund managed by private equity pioneer Thomas H. Lee is the latest example of thistrend, showing that private equity fund restructurings have become mainstream.
REAL ESTATE JOINT VENTURES ARE ESSENTIALLY A WAY TO match capital needed or desired for a real estate acquisition or development by an operating party (referred to herein as the operating member) with a real estate capital provider (referred to herein as the capital member). The real estate capital provider’s business is to invest capital in real estate assets or projects but not necessarily to source and operate real estate assets.
Typically, a capital member is interested in entering into a joint venture with an operating member that is an expert in particular markets and/or asset classes as well as day-to-day management and reporting duties. The operating member of the joint venture usually has the ability to source, acquire, debt finance, manage, and/or develop properties in certain asset classes and/or geographic regions but may or may not have the ability to contribute material capital to the joint venture (hence the need for a capital member).
A common joint venture structure is a structure whereby the capital member and the operating member form a new limited liability company. The parties then enter into an operating agreement (also referred to herein as the joint venture agreement) for such limited liability company, which sets forth the parties’ agreement as to their respective rights regarding (1) distributions of profits, (2) management rights and control over decisions of the limited liability company, (3) exit rights and transfer rights with respect to the sale or transfer of membership interests in the joint venture, and (4) all other applicable rights and remedies. See Limited Liability Company Operating Agreement for a sample joint venture agreement. See Joint Venture Organizational Chart for a visual depiction of a standard joint venture structure.
There are several components of a joint venture agreement that are oftentimes heavily negotiated and a major focus of the parties to the agreement.
The joint venture agreement must clearly set forth the capital contribution obligations of the parties to the agreement. The purpose of the capital contribution provisions is to make clear what the parties’ respective responsibilities are to contribute capital to the joint venture. See Article IV of the Limited Liability Company Operating Agreement for sample capital contribution provisions.
First, the joint venture agreement must specify the mandatory initial capital contributions to be made by each of the parties to acquire the asset. The initial capital contribution is part of the basic business transaction and can of course be any negotiated amount. Some typical formulations for initial capital contributions can be 95%/5% or 90%/10%, where the operating member of the joint venture contributes a minor portion (5%–10%) of the equity capital and the other member provides most of the equity capital. A 50%/50% formulation is not uncommon where the operating member has sufficient capital and wants to retain more control and a larger share of the economics of the deal.
The joint venture agreement must also specify any mandatory additional capital requirements of the parties. The responsibilities of the parties with respect to their capital contributions are largely influenced by the type of real estate asset being purchased. Very often, in stabilized acquisition type transactions (for example, the purchase of developed real property that the parties have no plans to improve or further develop), the parties, particularly the party investing the larger portion of the cash equity, will not agree to be obligated to make additional capital contributions that are more than their percentage share of the initial amount of equity (the initial capital contribution) to acquire the asset.
If the transaction involves a transitional asset (meaning an asset where there are contemplated future capital expenditure items, for example where there are plans to improve or further develop the real property that is the asset) the parties may agree on funding their percentage share of such budgeted and contemplated amounts. In this case, the joint venture agreement should include a provision obligating the members to make additional capital contributions to the extent that the transaction involves future capital contribution obligations for which members are required to invest rather than just having an option to do so.
Where the transaction is more in the nature of a ground up development, the parties will likely need to agree to fund (1) budgeted amounts, (2) any cost overruns (meaning unforeseen costs in excess of the budgeted amounts), and (3) any other unforeseen costs (perhaps up to a maximum amount).
Another scenario where the parties often agree to contribute their share of future unknown expenses is where there are non-discretionary expenses. Non-discretionary expenses are expenses such as real estate taxes, insurance, compliance with law, and life safety issue costs. The main reason for these additional mandatory capital contributions is to provide a workable and practical process for one party to fund needed expenses even if the other party fails to fund and to provide an economic disincentive for a party not to fund their share (in each case pursuant to two typical remedies, member loans or dilution), as further discussed below.
Certain key issues to consider when drafting capital contribution provisions are:
As noted above, member loans and dilution are the two typical remedies for failure to fund a mandatory additional capital contribution. A member loan allows (but does not obligate) one party to fund their share of the expense as well as the other party’s share (if such party refuses to do so). The member making the loan is then entitled to the priority return, together with interest, of such additional amount funded (with such payments being made before any further payments to the non- funding party). To the extent that the joint venture agreement allows for member loans, the repayment mechanisms must be clearly stated.
Dilution has a similar effect (but can be more punitive depending on the applicable calculation formula). Dilution is a remedy whereby the funding member’s membership interest in the joint venture and thus the percentage of economics in the transaction increase, and the non-funding member’s membership interest in the joint venture and such non- funding member’s economics correspondingly decrease.
In addition to member loans or dilution, a failure to fund could also expressly constitute a default by the non-funding member and entitle the funding member to all other rights and remedies (e.g., damages).
The most important economic and business provisions of a joint venture agreement are the waterfall provisions. These provisions set forth (1) which party receives what portion of any net operating proceeds and/or capital proceeds from the asset and (2) the relative priority of distribution of such proceeds. See Section 6.2 of the Limited Liability Company Operating Agreement and Distributions Clause (Joint Venture Agreement) for a sample waterfall provision.
Often, the waterfall distribution is structured such that the capital member will receive a return of its capital invested first, prior to the return of any capital invested by the operating member. The capital member may then also receive a return on its capital invested (often calculated on an internal rate of return basis). However, the economic agreement may instead call for distributions to go to both parties based on the parties’ respective percentage of membership interests until both parties receive the return of and/or on their invested capital. Thereafter, further proceeds are often distributed on a promote basis (see Preferred Return, Hurdle, and Promote below).
Other important issues to address when drafting waterfall provisions are:
The respective economic interests of the parties to the joint venture agreement will often directly correlate to the respective percentage of capital contributions made by each party. This may include a capital contribution credit to the operating member in the amount of the agreed value of a real estate asset that the operating member already owns and is contributing to the joint venture. Typical structures as to economic percentages may be 90% capital member and 10% operating member, 95% capital member and 5% operating member, or 50% each. The more capital an operating member contributes to the joint venture, the more an operating member may be able to negotiate control and/or protective rights with the capital member. See Management of Limited LiabilityCompanies for further detail on control rights and their correlation to capital contributions.
Often, the operating member of the joint venture will be entitled to certain fees based on their sourcing, management, and services relating to the real estate asset that is owned by the joint venture. The joint venture agreement (or an ancillary agreement such as a property management agreement) should therefore clearly set forth: (1) the type of fees that will be paid and to whom they should be paid, (2) the amount of such fees, and (3) the timing of payment. The list below sets forth examples of common fees and amounts paid to the operating member (or an affiliate thereof). See Section 7.5 of the Limited Liability Company Operating Agreement for a sample provision describing the fees to be paid.
As part of the waterfall provisions, the amount of proceeds distributed to one party (usually the capital member) before and in priority to the other member (usually the operating member) is often referred to as the preference or pref. The aggregate amount of such pref is often based on a stated internal rate of return (IRR) percentage amount. For example, a pref is paid to the capital member until the capital member receives the return of its capital and a return thereon such that the capital member has received a 7% IRR thereon. In that example the 7% IRR is often referred to as the hurdle. Once the hurdle is met, the operating member may catch up on any unreturned portion of its capital as well as an agreed IRR thereon, and/or the operating member is often entitled to receive an increase in the percentage of the distributions it gets above the operating actual percentage interest in the joint venture. This increase is often referred to as the promote.
Prior to selecting a management structure, the jurisdiction of formation of the company must be determined for purposes of confirming that the management structure selected is appropriate under the relevant state statute governing limited liability companies. See Selection of Jurisdiction of Formation for a Limited Liability Company for further discussion of jurisdiction selection. As discussed in Selection of Jurisdiction of Formation for a Limited Liability Company, limited liability companies are frequently formed in Delaware because of Delaware’s business-friendly statutory scheme, which allows for great flexibility and provides a large base of precedent governing company matters. State law should also be consulted to see if there are any restrictions and/or requirements concerning fees, fiduciary duties, and non-compete obligations that are commonly imposed upon managers unless expressly waived (to the extent possible) in operating agreements.
Once it has been confirmed that the jurisdiction of formation does not restrict how the limited liability company can be managed, then the following management structures should be considered as to which will best achieve the goals of the members:
The type of management structure is usually determined by the extent of the members’ capital contribution to the company. For further discussion of the advantages and disadvantages of each management structure as well as additional details regarding selecting a management structure, See Management of Limited Liability Companies.
The management structure of the joint venture will often provide for certain decisions to be made by the joint venture that require either the approval of the capital member or the joint approval of both members. As such, the joint venture agreement must clearly indicate: (1) which decisions are major decisions and (2) that with respect to such decisions, no act will be taken without the express approval of the capital member or both members, as applicable. Typical examples of joint venture major decisions are:
The list above is not exhaustive but rather should serve as a starting point. See Article VIII of the Limited Liability Company Operating Agreement for a sample provision regarding major decisions (which includes an expansive list of major decision types).
The significance of deeming a decision a major decision is that it requires the consent of someone other than the party managing the joint venture. There is a potential that parties could fail to come to an agreement on a major decision, which is commonly referred to as a deadlock. Thus, it is important to carefully draft procedures for resolving potential disputes. See the section below entitled Major Decision Deadlock Resolution Mechanisms for further discussion of deadlock resolution options and provisions.
The deadlock resolution mechanisms often involve one party exiting the joint venture so that the joint venture can proceed to operate under the control of the remaining party. The parties to the joint venture have taken great care to come together to create a venture and likely contributed a great deal of time and assets to the joint venture. It is important to carve out from triggering the deadlock resolution mechanisms certain more minor disagreements that may arise during the life of the joint venture so that it is possible for the joint venture to continue to operate with its initial members. An example of a type of major decision that may not warrant a full deadlock resolution process (as described below) is the failure to agree on a new operating budget for a given year, which instead could be resolved by using the prior years’ approved budget plus increases based on the consumer price index (CPI) and/or increases to fund actual growth in non-discretionary expenses (e.g., real estate taxes and insurance).
Certain important issues to address in drafting the Major Decision provisions include:
The joint venture agreement typically sets forth several resolution mechanisms should the parties be unable to agree on a major decision that requires the approval of both members. Below is a summary of typical resolutions. A resolution mechanism is important so that the real estate asset or project is not stuck in limbo based on a failure of the parties to agree on a particular action indefinitely. Certain important issues to consider in drafting the provisions described below include: (1) what “lock-out” periods are appropriate for the transaction (e.g., what minimum period of time, if any, should elapse prior to any of the below being triggered); and (2) the inclusion of detailed closing mechanics such as (a) time period to elect, (b) posting of any at risk deposits, (c) providing for representations and warranties from the transferring party, (d) requirement to convey good title to the interests free and clear of all liens and encumbrances, and (e) closing date.
It is typical for the joint venture agreement to restrict the operating member from transferring any controlling or other material interest in the joint venture. From the capital member’s perspective, this restriction is preferable because the capital member is making an investment with reliance upon a particular operating member’s skills and experience. Therefore, the joint venture agreement will typically require the consent of the capital member to any such transfer of a controlling or material interest.
Conversely, a capital member does not often agree to restrict its ability to transfer its interest in the joint venture since the capital member needs greater liquidity (and in any event the capital member does not hold the operating expertise). However, since the operating member may have similar concerns as to who their partner in the joint venture may become, an operating member may have the ability to trigger certain rights similar to those listed in the section entitled Major Decision Deadlock Resolution Mechanisms so that the operating member has a right to buy out the capital member as an alternative to having to accept a new capital member.
Often, parties that are capital members are capital members in many different transactions through a variety of entities and have a large and complex corporate structure. Capital members often require the flexibility to move investments to different entities depending on their needs at the time. Even if a capital member were to agree to certain transfer restrictions restricting its ability to transfer its interest in the joint venture to a third party, a capital member will usually require the right to transfer its interest to any subsidiary or any other entity owned, controlled, or managed by the initial capital member and/or its principals. This provides the capital member some flexibility to manage its business while still providing the operating member comfort that its partner in the joint venture will continue to consist of an entity under the same umbrella of ownership, control, and/or management as its current partner.
As a basic matter, a defaulting party would be liable to the other party for actual damages. However, that may not prove to be a particularly effective remedy as the other party is often a single purpose entity without other assets other than its interest in the joint venture, which may or may not have value at any given time. Thus, other typical remedies may include:
If it is anticipated that the joint venture will obtain third-party financing, it is likely that one or more members (or principals thereof) will need to execute one or more of a payment, completion, performance, and/or non-recourse carve-out guaranty and an environmental indemnity in connection therewith. It is common for the parties to the joint venture to enter into an indemnity agreement allocating the share of any potential liability with respect to any losses incurred under any such guaranty or indemnity. Further, if one party exits the joint venture pursuant to one of the major decision deadlock resolution mechanisms or otherwise, such party should seek to be released under any guaranty for any liability occurring after the date they have exited the venture. If a lender will not agree to that point, the parties can also allocate liability pursuant to an indemnity agreement.
Parties to a joint venture agreement should take great care at the beginning of the business transaction to carefully lay out and draft an operating agreement that clearly reflects the parties’ obligations and rights with respect to the joint venture. Particular time and attention should be paid to the following sections: (1) percentage interests, (2) capital contributions (including remedies related to failure to fund the same), (3) distributions, (4) tax, (5) fees, (6) management and control, (7) transfer restrictions, (8) deadlock and exit mechanisms, and (9) remedies.
Thomas G. Maira is a partner in the New York office of Reed Smith. His practice focuses on advising private equity investment funds, lenders, real estate investors, real estate owners and operators, investment banks, financial institutions, public and private companies, REITS, governmental agencies, and entrepreneurs in real estate private equity, real estate acquisition and sales, and real estate finance.
RESEARCH PATH: Real Estate > Joint Ventures > Joint Venture Agreement > Practice Notes > Joint Venture Agreement
For a sample joint venture agreement, see
For a visual depiction of a standard joint venture structure, see
For further detail on control rights and their correlation to capital contributions, see
> MANAGEMENT OF LIMITED LIABILITY COMPANIES
RESEARCH PATH: Real Estate > Joint Ventures> Joint Venture Agreement > Practice Notes >Management and Control
For further discussion of the advantages and disadvantages of each management structure as well as additional details regarding selecting a management structure, see
For additional drafting notes and considerations, see
> BUY/SELL CLAUSE (JOINT VENTURE AGREEMENT)
RESEARCH PATH: Real Estate > Joint Ventures > Joint Venture Agreement > Forms > Buy/Sell Provisions