In the current UK property market one investment or development project can vary considerably from another. However, the prevailing feature that many such projects share is the corporate real estate joint venture (the “JV”).
The JV has become central to investment and development activity undertaken by the likes of property companies, private equity funds, institutional/overseas investors, pension funds, sovereign wealth funds and individuals as parties look to share financial risk and reward, especially following the recent Brexit vote.
This article considers six fundamental areas that should be at the forefront of each party’s mind when contemplating a new JV. Over the next two weeks, further articles will cover JV minority rights and the application of EU merger regulation to JVs as it currently applies.
Structuring
The headline point to consider upfront (and ideally before, or at least in parallel with, the heads of terms) is JV structuring. A structure that works for a US private equity fund domiciled in Luxembourg may have significant disadvantages for a pension fund based in Canada or a sovereign wealth fund operating out of the Far East.
Structural differences should not be responsible for ending an otherwise commercially viable relationship between overseas parties before it has even begun.
It is therefore crucial that the parties collaborate in considering the key
factors that may impact on structuring, such as:
• whether the investing parties are UK resident, non-UK resident, taxable or tax exempt;
• whether the investing parties intend to acquire and hold the property or acquire, develop and sell the property;
• whether the underlying JV property is commercial, residential or mixed use; and
• how the JV will be funded (whether by equity, shareholder debt, third-party funding, offshore funding or onshore funding).
Future bankability
JV parties will also want to look at how debt finance can be used at the outset or during the life of a JV.
It is not uncommon in the current market for JV parties to fund a development with their own equity up to practical completion/stabilisation of the development (once a rental income stream has been established) and then seek to refinance the project, as third party debt may, at this stage, be cheaper and more attractive than each party’s own cash pools/equity.
It is therefore important at the outset of a project (and while reviewing structural options) for the JV parties to consider the “bankability” of the proposed JV so that if third party debt is required (at a later date) the JV is already operating in a manner consistent with the debt providers’ expectations. This avoids the need to make structural changes to the JV that may turn out to be unviable if proposed too late, or costly if such changes impact on project progression.
To ensure “bankability” the parties should consider including the following in their JV:
• a mechanism enabling the parties to grant security over the corporate interests in the JV structure and (if the parties unanimously agree) the property;
• waterfall provisions that provide for the priority repayment of third party debt (in advance of distributions to the parties);
• detailed clauses that cater for what happens if a party becomes insolvent by carefully defining what is meant by insolvency (which is usually triggered by actual enforcement proceedings against the relevant party rather than just changes in that party’s balance sheet solvency position); and
• evidence of compliance with applicable law and regulation (which is dealt with further below).
Funding
Most JVs will require the parties to provide their own funds to a greater or lesser degree (particularly in relation to a development JV). As mentioned above, how the parties actually fund the JV – whether by interest or non-interest bearing loans, acquisition of partner interests, subscription for shares, subscription for units or capitalisation of debt (which involves turning debt owed by a vehicle into shares or units issued by that vehicle) – should feed directly into JV structuring considerations. The parties must also agree the commercial parameters applicable to funding and, most importantly, what happens if a party fails to fund.
A failure to fund is not necessarily linked to JV party default. It may be that, for reasons relating entirely to process and administration, it takes a week or two before an overseas sovereign fund is able to actually make funds physically available in London (for example, in circumstances where emergency project funding is required).
It is therefore sensible (and in the current market, commonplace) to build in JV provisions that enable one party to shortfall fund in place of another for a temporary period and at a higher interest rate than standard JV funding. If one party is domiciled more locally and better placed to procure funds for emergency expenditure (for example, in order to preserve property values or to comply with applicable law/regulation) then shortfall funding can prove to be a neat solution to an otherwise significant problem.
If a party’s failure to fund constitutes a genuine default, the JV clauses must deal with this situation in sufficient detail. JVs have become sophisticated in dealing with the failure to fund scenario as parties increasingly want recourse to multiple (and often complex) solutions within a single JV. This enables the innocent party (that is funding) to choose how it deals with the other party’s failure to fund. Such solutions may include:
• disenfranchising the non-funding party on certain or all matters relating to the JV (during the failure to fund period);
• recourse to a non-funding party’s parent guarantee;
• diluting the corporate JV interests of the non-funding party (by the amount of the failure to fund) while increasing the corporate JV interests of the party that has shortfall funded; or
• buyout at a discount (whereby the funding party buys the corporate interests of the non-funder for a substantial discount).
Applicable law and regulation
There are a multitude of provisions that the parties may need to consider. However, there are certain areas that should always be considered in relation to JVs.
• The scope and application of current EU merger regulations or the national merger control regimes of particular EU member states (the third article in this series will cover this in detail).
• Whether or not the JV constitutes a collective investment scheme (for the purposes of section 235 of the Financial Services and Markets Act 2000). If it does, an authorised operator may need to be appointed to operate the JV.
• Whether or not the JV structure amounts to an alternative investment fund (for the purposes of the currently applicable EU Alternative Investment Fund Managers Directive, as transposed in the UK) that requires the appointment of an authorised alternative investment fund manager.
• If a party is listed on a major stock exchange (for example, the London Stock Exchange) then the application of the relevant listing rules should be considered to check whether they cut across what the parties are proposing to agree contractually (for example, relating to exit if the listed party must seek shareholder approval before the exit provisions in the JV can be exercised).
Exit
It is common for parties to differ in their approach to JV exit strategies. A private equity house may look to develop the relevant property and exit shortly after practical completion of the project, whereas a sovereign fund may want to hold its corporate interests in the JV for a much longer period. The JV will therefore need to provide a clear exit mechanism that is acceptable to all parties and deals with the following:
• Lock-in: Provision for a certain period during which no exit is permitted (other than in relation to default or intra group transfers) gives the parties the best chance of completing the development, realising property values and establishing a valuable rental income stream.
• Pre-emption: Once the parties are allowed to exit, it is common for the exiting party to offer its JV corporate interests for sale to the non-selling party before any third party sale is permitted. Only if the non-selling party turns down this offer is the selling party free to sell to a third party. The commercial rationale for this is that the non-selling party has taken the funding risk during the development phase and should, in recognition of this, have the right to buy out the selling party before any third party.
• Longer-term drag rights: In certain circumstances some parties argue that a sale of the whole property or all the corporate JV interests will achieve a higher sale price than a sale of part. It is therefore down to the commercial negotiation between the parties in order to determine whether the party with the shorter-term strategy can drag the party with the longer term strategy (in a sale of the whole property or all the JV corporate interests) after a certain period.
Paul Chases is a senior associate and head of corporate real estate at Herbert Smith Freehills LLP
