Marriage of equals

Although aligning interests is the most critical element in a joint venture, other issues require careful consideration—and a bit of negotiation. By Paul Fruchbom

Imagine a father dispensing the following advice to his young son, the father having just finished a loud and contentious argument with his wife:

“Son,” he might say. “Choosing a wife is the most important decision you'll ever make. Pick the right one and your life will be wonderful. Pick the wrong one”—here he might pause and take a deep breath— “and it will be a living hell.”

Though the terms of courtship are decidedly different, the same could be said for selecting a joint venture partner. After all, a typical JV lasts as long, if not longer, than many marriages. And perhaps nothing is more important to the ultimate success or failure of a particular property than the local partner managing its day-to-day operations.

“The old saying is true,” says Charles Wu, cofounder of Boston-based private equity real estate firm Baynorth Capital. “A great building can be butchered by a terrible operating partner and a terrible building can be turned around by a great one.”

Like any long-term relationship, of course, the first step in building a joint venture is building trust—in a partner's capabilities, their market knowledge, track record, professionalism and ethical behavior. Yet establishing trust, no matter how important it may be, is only one intangible part of creating a successful partnership. For once the wooing process is over, the difficult business of negotiating an acceptable JV agreement—once could call it the prenuptial agreement of the real estate world—begins.

While there are many items that need to be hammered out when structuring a joint venture, industry practitioners note that the most important issues deal, understandably, with control and economics.

As with any relationship between an equity partner and an operating one, the guiding principle is the oft-used phrase “alignment of interests.”Typically this manifests itself in the legal documents by limiting the up-front fees paid to the operating partner, pushing their compensation to the back-end of a deal and requiring that partner to put a significant amount of their own money into the transaction.

The definition of “significant,” however, is where things get tricky. For private equity real estate firms, a tension exists between offering their partners too little, in which case they aren't financially motivated, and offering them too much, in which case the equity player's own profits are diminished.

“From an economic point of view, the idea is to align the interest of you and your partner,” says Bob Lee, an attorney in the Chicago office of Jones Day. “There are always different views and tensions as to how you get there. I'm not sure that ever goes away.”

While the typical size of a co-investment is approximately ten percent of the equity check, several market participants note that this percentage varies substantially depending on the particulars of the deal, the tenor of the negotiation, the historical relationship of the two parties and, perhaps most importantly, the financial wherewithal of the parties involved.

Less well-capitalized partners, for example, might not have enough free cash to make a meaningful contribution. One solution, according to Lee, is for the operating partner to re-invest any interim distributions back into the JV, thereby increasing their ownership stake—something he refers to as “buying into their interest.”

In today's market, however, a more common problem for private equity real estate firms is a partner with too much capital. Given the strong performance of real estate in recent years, operating partners who may have been cashstrapped in the past now find themselves with much stronger financial capabilities.

“Developers now have a lot of capital,” says James Kelleher, senior vice president of Boston-based real estate firm New Boston Fund.“It's not as lopsided as it used to be. More and more, the developer wants to put in more money.”

And more and more, private equity real estate firms are willing to take it. Notes Jennifer Morgan, a New York-based partner for Kirkland & Ellis: “One thing that has happened over the past fives years or so is that firms expect [their] partners to put in more money.”

This may be a reflection of several different factors. First, as operating partners grow their capital base, the size of what constitutes a meaningful investment grows as well—a standard ten percent may not compel the same level of motivation it did five or ten years ago; sources note that in certain instances, an operating partner may put as much as 50 percent of the equity into the deal. Even if a smaller percentage is invested in the deal, however, the operator effectively becomes an equal partner once certain hurdles are reached and the back-end promotes are realized.

The second, and perhaps more important, factor guiding the willingness of private equity real estate firms to encourage greater commitments from their joint venture partners is the competitiveness of today's real estate market. As equity capital increasingly becomes a commodity, local operating expertise becomes even more critical. Fund managers are therefore more willing to give up some economics in order to get the most experienced operators—and ensure that they don't stray to greener pastures.

These dynamics have led to some interesting discussions around the negotiating table. As operating partners become as heavily invested in the deal as the private equity real estate fund supposedly backing them, they are gaining more and more leverage in dictating terms. For example, equity sponsors often look to tie up their joint venture partners in exclusivity arrangements—as Kirkland & Ellis' Morgan points out, opportunity funds are pushing for such agreements even more so in today's capital-rich environment. Yet that same level of capital is giving developers and property managers room to negotiate a compromise. Instead of a blanket exclusivity deal, operators are often able to push for a less restrictive arrangement, say a specific property type in a specific region of the country for a specific period of time.

Another area where the tenor of the negotiation has shifted is completion guarantees, a binding promise made by the operator to meet certain benchmarks by a set date at a set cost. Any cost overruns or delays are borne disproportionately by the on-the-ground partner. Yet in today's market, one typified by intense competition, the rising cost of materials and a developer with a significant voice at the table, it has become more and more difficult for fund managers to push those risks onto their JV partner.

“Typically, every developer has their own hot-buttons,” says Frank Rooney, managing director of Washington, DC-based private equity real estate firm Partners Realty Capital. “Guarantees are big issues. Completion guarantees, for example, used to be a given, but now they're not always happening—particularly with rising construction rates, developers are getting leery of that pretty risky proposition.”

n addition to aligning economic interests, a successful joint venture must also align the investment horizons of the two parties. Given that private equity funds have a finite life and that all major decisions— from modification and approval of annual business plans to the refinancing of a property to the timing of a sale—need to be reached by mutual consent, understanding each partner's timeline is vital.

“The biggest thing you have to be aware of is that your hold period and business plan is similar to the developers,” says Rooney. “That can be one of the biggest sources of conflict. You have to make sure you have a consistent view of the world in terms of when you want to sell.”

Of course the world changes over the life of an investment. While some joint ventures negotiate lock-up arrangements—a period of time during which the property cannot be sold—in order to maintain that initial consistency, many others simply move to sell the asset whenever the two parties agree to proceed. It is when a decision cannot be reached consensually that any significant problems may arise—and when the marriage metaphor may be the most apt.

“In scenarios where we can't agree on major decisions or where we are ostensibly voting no, we look for a mechanism that allows us to divorce each other,” says Eric Jones, a principal at New York-based private equity real estate firm NDC Capital Partners.

One of the most common mechanisms is a buy-sell arrangement, where one party has the right to buy out the other at a certain price. It's a complicated process requiring a determination about how the sale price is calculated (via fair market value, a third-party appraisal or another method) and which party will be the seller and which one will be the buyer. Even more than being complicated, however, such provisions are unnaturally harsh, forcing a sale that will, more likely than not, fail to yield an optimal price. Therefore, while such structures are necessary from the standpoint of legal protection, they are typically not a practical means for winding down an investment.

“All the mechanisms are nice, but what they're usually used to do is compel a negotiation,” says Rooney.“You can hopefully negotiate a friendly exit before you follow every step in your documents.”

Kirkland's Morgan agrees, noting that enforcing such remedies is rare. “A buy-sell is a typical structure, but that's a pretty strong weapon,” she says. “Usually, the two parties are going to work something out. [A forced sale] is a very draconian remedy.”

Equally draconian may be the possibility of losing a relationship that both parties have spent significant time and effort cultivating. As any private equity real estate practitioner will tell you, finding—and keeping—good help is not easy these days. And once you've gone through the trouble of structuring and negotiating a (hopefully) profitable relationship, both parties are often eager to make sure the relationship lasts.

“The goal is to do multiple deals with a partner,” says Rooney. “The first negotiation is always the most difficult, but once you get to the second and third deal, those elements drop away and you have that level of trust. That's really where you want to go.”