In the final article in his series on corporate real estate transactions, Paul Chases considers the key issues relating to joint ventures in their creation, governance and management of conflicts
Property investment and development joint ventures (JVs) have always featured in the UK property market as they enable the parties to share finance risk and equity exposure.
However, as a result of the financial crisis and lending banks retreating from the property finance market, the number of equity funds, institutional or overseas investors, sovereign wealth funds and property companies entering into JVs has increased significantly.
Each JV tends to be different as a result of the specific commercial parameters of the deal, the differing bargaining power of the parties, the degree of control to be exerted by each party and each party’s economic interests – for example, this article assumes a two-party JV where control and economic interest is shared 50:50.
Control and conflict
Given that the JV parties will be contractually committed to funding the ongoing business of the JV, each party will want to ensure that it is able to exert a sufficient degree of control over its management.
In order to achieve this, the JV agreement will include a list of reserved matters that cannot be actioned without the approval of both parties. Such matters would usually include activities that change the scope or financial landscape of the JV, for example:
- Acquisition of assets;
- Sale of assets;
- Procurement of third-party debt;
- Commencement, compromise or settlement of litigation or arbitration;
- Material changes to the JV agreement or constitution; and
- Winding up or dissolution of the JV.
If the JV engages a manager for the provision of asset or development management services in relation to the property, it is likely that the JV will delegate day-to-day operational and management matters to that person. However, the JV should retain the appropriate degree of control over important decisions such as expenditure over a certain threshold, significant changes to development specifications or material business plan departures; these must be referred by the manager back to the JV for approval.
The extent of such a referral will be particularly important if one of the JV parties is also the asset or development manager. In these circumstances, robust conflict clauses should be included in the JV agreement, prohibiting the JV party (who is also the manager) from voting on JV decisions that conflict with asset or development management matters.
Deadlock
Deadlock is dangerous territory: it arises because the JV parties disagree on a 50:50 decision that must be made jointly. It can disrupt the otherwise smooth operation of the JV, lead to relationship breakdown and JV failure. Such failure could spell financial disaster if it occurs during the development phase of a significant project before the parties reach practical completion and fully realise property values. It is therefore crucial that the parties consider the circumstances in which deadlock may arise and how the JV agreement deals with it.
Broadly there are two types of mechanics that can be included in a JV agreement to resolve deadlock. First, mechanics that seek to resolve the deadlock while ensuring that the JV survives intact. Secondly, mechanics that result in the JV terminating – the “nuclear” option.
The multitude of deadlock options are not mutually exclusive: a JV agreement can include a mix of mechanics. While prospective JV parties often understand what deadlock exit actually means in practice, they are not always clear on how one deadlock exit option differs from the other. The nuclear options (roulette and shoot-outs) are therefore covered in more detail.
Intact: escalation
Deadlock is referred to a predetermined senior management group or individuals with particular expertise within each party’s business organisation. The threat of referral to a senior authority generally focuses minds at JV level and can encourage the parties to find a mutually acceptable solution. In reality, though, a fundamental difference of opinion between the JV parties could well remain unresolved at a higher authority level.
Intact: third-party determination
Deadlock is referred to an arbitrator, mediator or expert who will take into account each party’s submissions. The determination will be final and binding on the parties. This is a good solution if the deadlock relates to a tax, accounting, legal or technical matter. However, it is of much less use if the deadlock stems from a commercial issue that the third party cannot opine on (because it is not commercially interested in the JV).
Nuclear: Russian roulette
- A notifies B that it wishes to sell its JV interests to B (or that A wishes to buy B’s JV interests);
- The notice will specify the price at which A is prepared to sell (or buy) the interests;
- B decides whether to buy A’s interests (or sell B’s interests) at the price in the notice.
This is a common method of breaking deadlock in a 50:50 JV, especially where both parties are of equal financial strength and are indifferent as to whether they sell their interests or buy the other party’s. Pricing is, to a degree, regulated here: A will likely offer a fair and reasonable price because it could end up paying that price for B’s interests (if A’s offer to sell to B is rejected by B).
However, if there is a disparity in the financial standing of the parties, the stronger party could manufacture the deadlock and manipulate the financial position of the other party to its advantage. Also, the party that jumps first (serving the initial notice) has no control over the ultimate outcome.
Nuclear: Texan shoot-out (auction)
- A notifies B that it wishes to buy B’s JV interests;
- The notice will specify the price at which A is prepared to buy B’s interests;
- B may elect to sell its interests to A or notify A that it wishes to buy A’s interests and set out the price at which it is willing to purchase A’s interests;
- A can elect to sell its interests to B or offer an increased price for B’s interests;
- A and B continue to offer and counter-offer for each other’s interests until one party agrees to accept the price offered by the other party.
This is favoured by parties who are both intent on remaining in the JV; they each have the opportunity to decide whether or not to sell their shares and to determine at what price they would ultimately be prepared to exit the JV. Again, this process is open to manipulation if one party is in a financially stronger position than the other.
Nuclear: Texan shoot-out (sealed bid)
- As with the Texan shoot-out (auction), A notifies B that it wishes to buy B’s JV interests;
- The notice will specify the price at which A is prepared to buy B’s interests;
- B may either elect to sell its interests to A or notify A that it wishes to buy A’s interests and sets out the price at which it is willing to do so;
- If A does not accept B’s counter-offer, a sealed bid process is put in place and whichever party submits the higher price is entitled to buy out the other party.
The position is the same as for the Texan shoot-out (auction) but with the advantage of a more certain outcome given that, at the sealed bid stage, one price will prevail.
Final word
The JV has always been a popular option for parties to an investment or development project, and will be for the foreseeable future. Care and diligence in their formation, documentation and management will help to ensure that deadlock is avoided or resolved with minimal loss to the parties.
Paul Chases is a senior associate and head of corporate real estate at Herbert Smith Freehills LLP
