AFTER DOWNTURN, INVESTORS SEEK MORE CONTROL OVER JOINT VENTURES
By Scott Fisher
After each commercial real estate downturn, the real estate industry tries to learn from its mistakes and take the hard lessons learned into the next cycle.
An important lesson learned by investors in the most recent real estate downturn was that they need more control of crucial decisions when a joint venture is in critical economic condition. At that juncture, the perspective of the partners in the venture may be quite different.
The promoter/developer (the “promoter”) may be looking for ways to preserve its increasingly distant back-end “promoted economic interest” while avoiding personal liability. Its judgment may be influenced by the absence of an economic upside.
Simultaneously, the partner(s) that provided the equity to the venture (the “investor(s)”) is trying to preserve its investment and maximize the likelihood of a return on that investment. The impact of the investor’s preferred course of action may be to push the promoter’s interest further down the capital stack.
The perspective that prevails ultimately depends on the terms of the management sections of the joint venture agreement.
Before 2006, typical real estate joint ventures allocated to the promoter the right, subject to “major decisions” requiring investor approval, to run the day-to-day business of the company. This arrangement allowed a promoter to do what it does best, subject to giving investors a rein on the promoter with regard to important issues such as leasing, financing and the disposition of the venture’s assets.
This worked well in good times. When things went badly, investors learned that promoters weren’t willing to simply cede authority to the investors, or acquiesce to what investors felt was necessary to protect their interests.
In fact, promoters often clung to whatever authority they had in order to create leverage to protect their downside and, in many cases, to rewrite the deals to create an upside where one no longer existed.
For example, many joint venture agreements, as part of the promoter’s authority, gave the promoter, and not investors, authority to initiate capital calls. If a capital call enhances the position of the investors while simultaneously diluting the interest of the promoter, the promoter could refuse to initiate the capital call without adjustments to its ongoing interest in the entity.
Similarly, if a joint venture agreement gave the promoter exclusive authority to initiate a lease, the promoter could elect to reject a leasing opportunity containing economic terms that diluted or deferred its economic interest. The promoter could also insist on investor concessions as a condition to moving forward with that lease, even if an investor with a long-term perspective was willing to accept the lease.
As a result of their experience during the downturn, investors have now become more particular about who can initiate actions by the venture and who has the final say on the venture’s decisions. Specifically, while the promoter may still be delegated the right to run the day-to-day operation of the venture, investors want to retain a right to initiate any actions of the venture.
In the examples above, the promoter could create leverage by electing not to make a capital call that would dilute its interest, or by not pursuing a lease it deemed undesirable. In today’s documents, both the promoter and the investors would have the right to unilaterally initiate those actions, thereby eliminating the ability of the promoter to create leverage by doing nothing.
The unilateral right to initiate actions does not mean that the joint venture agreement no longer identifies the typical “major decisions” that require both parties’ consent. It merely ensures that the investor now has the ability to initiate the process that requires the partners to consider a “major decision.”
This new authority of the investor, however, does not stop with its ability to initiate “major decisions.” Investors are now asking for the right to unilaterally resolve any deadlock over major decisions.
In this scenario, regardless of who initiates the action, if the parties cannot agree upon a “major decision,” the investor makes the final determination. Ideally, this only comes after the parties have had time to discuss and debate the issue.
Needless to say, promoters have pushed back against this investor request, and parties often accept various dispute resolution mechanisms to resolve deadlocks, such as expedited arbitration, a “springing” board of directors, or a pre-agreed upon dispute resolution party.
The inclusion of these dispute resolution mechanisms is particularly prevalent in joint ventures where the promoters have a meaningful investment in the transaction, or where there are multiple investors.
There are, however, a number of investors who, after getting burned in the downturn, have made it their policy that, as a condition to making an investment in a joint venture, they must be granted ultimate authority to make all decisions.
That includes “major decisions.”
Like the underwriting standards of the financial markets, the management requirements of investors will moderate as the leverage shifts back from those who have the money to those who have the deals.
Until that time, however, the ultimate control of real estate joint ventures has clearly swung away from the promoters to the investors.
Scott A. Fisher is a partner in the real estate practice group at Atlanta-based Arnall Golden Gregory LLP.