Five Keys to Intelligent Joint Ventures
As the flexibility of joint ventures make them increasingly popular, there are some best practices that can aid in avoiding pitfalls. Christopher Mendez of Madison International Realty goes over five keys to a successful JV.
Joint ventures have become de rigueur in private real estate for their fee efficiency, transparency, and greater access to deals, all in a customizable format. Whether investor, operator, or fund manager, foreign or domestic, there are innumerable ways to structure JVs to allow a diverse base of stakeholders to work together. However, despite the buzz surrounding JVs, they are simply not turnkey solutions and definitely not for everyone.
“In a multi-investor, fully discretionary commingled fund, the rights of the investor are governed by the limited–partnership agreement,” says Christopher Mendez, a director with Madison International Realty, “and, with the exception of side letter agreements, are typically standard across the investor base. A joint venture structure often allows an investor more flexibility.” He also warns that “we’ve learned that without the right partner, it doesn’t matter what you put in the documents.”
Given the pitfalls that follow structuring a JV, here are five best practices to keep in mind.
1) Tackle major decision rights
Between major stakeholders such as investors, sponsors, and operators, it is critical to establish clarity on who has what rights. “You want to know what can be done without your say and what you can weigh in on,” says Mendez.
He lands on four key elements of decision rights—sale, refinancing, operating and capital budgets, and major leases—that should be tackled at the outset.
2) Conduct the same due diligence as an investor buying a property outright
For Madison International, joint ventures play a key role in the firm’s investment business. The flexibility of JVs allows for a number of designs to create points of access.
“We seek to provide liquidity to owners and investors in class A properties and portfolios,” Mendez says. “This includes capital partner replacements, equity monetizations, recapitalization, and other special situations.”
Although the Madison team is generally allocating capital and not operating properties, the level of due diligence required is no lighter or easier. “We conduct the same level and thoroughness of due diligence as an investor buying a property outright would,” he says.
3) Have “the appropriate teeth” and default provisions
Mitigating default issues in the document stage requires a healthy amount of give and take. “No one enjoys negotiating the default provisions,” Mendez comments. “It’s highly emotional. However, as fiduciaries to our investors, it is important we protect our investment in the event of bad acts or negligence by the sponsor.”
It is vital to ensure that default situations and their triggers are well thought out in the documentation process. “The provisions need to be clearly defined, and the document needs the appropriate teeth to provide protections and remedies, including the removal of the sponsor when necessary,” he says.
4) Make sure exits are aligned
Often investment horizons become the biggest hurdle to stakeholder alignment. Some investors fall in love with an asset and never want to sell, while others need to realize their gains and move onward.
“We are not forever holders of real estate,” he says. “In many instances, we establish a ‘for sale’ right and agree to a lockout provision that is consistent with the business plan developed collectively by the sponsor and Madison.”
However, in situations where Madison is stepping into existing structures and documents, a little more ingenuity is required. “In some deals, such as old syndications, we are limited in our ability to restructure the existing documents to create clean exit rights, says Mendez. “In these situations, we create a promote structure to the sponsor that economically incentivizes them to monetize our interest through a sale or recapitalization of the property. As always, we seek to create win-win scenarios for all parties.”
5) Create an alignment of interests between partners
Connecting with partners on a level that cannot be captured in documentation alone is crucial. There is no amount of legal language that can account for every outcome.
“At the end of the day, once the documents are negotiated and executed, you hope to never reference them again,” says Mendez. “Business plans change, and actual performance will never match the underwriting. Creating an alignment of interests at the outset will ensure partners work through issues together and create value for all. The alternative is partnership dysfunction and the likely destruction of property value.”
The central theme underlying these five best practices is to “know your partner,” Mendez advises. “Reference checks and track record reviews are important, but the best way to get to know someone is to spend time together. You can learn a lot about your potential partners as you negotiate the term sheet. Pay attention to how they respond and conduct themselves as you work through the sensitive issues. However, sometimes it really comes down to a gut check.”