Real Estate Joint Ventures: Crafting an Enduring Partnership. Nicole Mesard, Esq. Debevoise & Plimpton LLP New York, New York. And

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1 Real Estate Joint Ventures: Crafting an Enduring Partnership by Nicole Mesard, Esq. Debevoise & Plimpton LLP New York, New York And Jay Neveloff, Esq. Kramer Levin Naftalis & Frankel LLP New York, New York 93

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3 Real Estate Joint Ventures: Crafting an Enduring Partnership Nicole Mesard, Debevoise & Plimpton LLP Jay Neveloff, Kramer Levin Naftalis & Frankel LLP December 7, 2015 Formation and Structure Type of entity Typically LLCs or LPs Delaware LLC is preferred type of entity» Familiarity» Allows modification or elimination of fiduciary duties of manager Property owner is typically a single purpose entity (SPE) required by lender so that it is bankruptcy remote (also serves as an additional liability shield/separation) Property Owner SPE (typically an LLC) will be owned (directly or indirectly) by JV Promote: Negotiated deal-by-deal Separate management, construction and/or development agreement Liability Limited Partnerships (LPs) limited liability for limited partners, only GP is exposed Limited Liability Companies (LLCs) all members have limited liability

4 Capital Contributions and Capital Calls Initial Capital Contributions to be contributed or accounted for as of the day of closing Matters to consider:» Is there a true-up for pre-closing cash spent by the Developer/Managing Member or will they get credit for a capital contribution in that amount?» Agreeing upon valuation of property contributed» Will one member make all capital contributions until the members hit a pre-agreed split? (i.e or 90-10)» Sometimes just start from scratch with contributions at closing of purchase of property in accordance with percentage interests. 3 Capital Contributions and Capital Calls (cont d) Additional Capital Contributions Per an agreed upon budget or as otherwise agreed by the members as a major decision Matters to consider:» Which members can call capital?» Capital call typically considered a major decision» Timing of funding of capital» Draw packages and approvals» Emergencies/non-discretionary expenditures (i.e. taxes, insurance, debt service, utilities)» Cost overruns Investor Members may want to require Developer/Managing Member to contribute all (or a higher percentage) to encourage Developer/Managing Member to stay within project budget» Usually made in accordance with percentage interests» Sometimes contributions are made in accordance with the waterfall in effect at that time» Sometimes made to accomplish an equalization/achieve desired percentage interests

5 Capital Contributions and Capital Calls (cont d) Failure to Fund Required Capital Preferred return on capital contribution by funding member with preferred distribution of return and capital contribution Capital contribution by funding member with dilution of nonfunding member s interest (can be pro rata or punitive squeeze down ) Member Loans (see next page) Funding member can recall their contribution Any combination of the above 5 Capital Contributions and Capital Calls (cont d) Member loans» Loan to the joint venture in the amount of the non-funding member s share of a capital contribution» Loan to a non-funding member loan must be used by the non-funding member to fund its capital contribution» Priority from distributions» Matters that will be negotiated: Loan rate regular rate, default rate Loan term, right to extend Collateral (pledge of membership interest/guaranties) Loan to Member payments from non-funding members distributions Conversion to capital with squeeze down

6 Capital Contributions and Capital Calls (cont d) Treatment of non-discretionary capital contributions:» Non-mandatory capital call not a default if member does not pay, but non-funding member may be subject to dilution of its interest» Priority capital contributions priority distribution with preferred rate of return» Loan to the joint venture priority distribution with preferred rate of return» Loan to member collateralized with pledge of membership or personal guarantees» Options less punitive 7 Distributions Distributions Types of Distributions» Net Cash Flow cash generated by the day-to-day operation of the JV after payment of operating expenses, debt service, and reserves» Net Capital Proceeds cash generated from capital events (such as the sale of Property, refinancing of debt, or receipt of casualty proceeds or condemnation award) after payment of third party debt and related expenses Timing of distributions» Cash Flow periodically, as agreed by the members, typically monthly or quarterly» Capital Proceeds when received

7 Distributions (cont d) Allocation of Distributions ( Waterfall ) Cash Flow and Capital Proceeds (See Exhibit B for a Waterfall Example):» Return on, and then of, default loans and/or default capital contributions» Return of capital contributions and/or preferred return/irr» Promote splits Types of returns» Preferred return percentage return on capital invested» Internal rate of return (IRR) compounded return on investment Promote right to receive distributions in excess of ownership interest granted to a Developer/Managing Member in recognition of it s role in locating, promoting and undertaking day-to-day management of the project and taking certain risks (for example, completion guaranty and/or payment guaranty obligations during construction) 9 Distributions (cont d) Clawback mandatory return of a distribution. Examples include the following:» On a multiple phase property/project, the Developer/Managing Member s promote or other fees received upon completion of earlier phases may be subject to clawback» Tax distributions not paid to taxing authorities are subject to clawback

8 Choosing a Management Structure There are multiple structuring options for management, including: Investor Member as manager with broad decision-making authority» Developer/Managing Member as operations or administrative member tasked with specific duties and limited authority Developer/Managing Member as manager» Developer/Managing Member has day-to-day management authority» Investor Member has approval rights with respect to certain actions and decisions ( Major Decisions )» Developer/Managing Member Concerns Ability to make day-to-day decisions Investor Member should have limited approval rights, (Developer/Managing Member doesn t want Investor Member looking over their shoulder) especially with respect to execution of the agreed upon Annual Plan and Budget (i.e., signing leases, entering into service contracts or non-material development plans) 11 Choosing a Management Structure Investor Member Concerns Developer/Managing Member should have not just authority, but various duties and obligations with respect to the joint venture and property (for example, pursuant to a separate management and/or development agreement), should also be devoting the appropriate amount of time and energy and running the property up to certain standards Being adequately informed regarding the progress of the project Approval rights, especially with respect to specifically identified decisions and actions such as capital events, and entity and tax related decisions

9 Major Decisions Material Major Decisions Sale of the Property Financing Leasing (sometimes only major leases) Calls for additional capital contributions Entering into construction/management/development agreements Entering into material contracts Budget/Annual Plan approval Commencing/settling/defending litigation 13 Major Decisions (cont d) Development Related Major Decisions Development budget modifications Selection/replacement of general contractor Plans and specifications, development and design plans, project schedule Expenditures above variance Entity Related Major Decisions Modifying the purpose of the joint venture Mergers or consolidations Bankruptcy related decisions Hiring employees Making a tax election on behalf of the joint venture See Exhibit A for a list of common major decisions

10 Developer/Manager Defaults/Removal Rights Investor Member will want ability to remove Developer/Managing Member if Developer/Managing Member is not performing/bad acts Types of Managing Member Removal Events (heavily negotiated) Non-permitted transfers Failure of controlling principals to maintain control/ownership Failure of Managing Member/Developer to maintain an ownership threshold Bankruptcy Failure to implement a major decision Bad acts (e.g., fraud and negligence; misapplication or misappropriation of funds; intentional misconduct; intentional violation of law or criminal misconduct) Failure to repay a member loan Other defaults (sometimes excluding monetary defaults) Termination of an affiliate agreement for cause Guarantor loan default 15 Consequences of Manager Removal Removal as Managing Member Loss of decision making and voting/consent rights (sometimes rights are retained with respect to material major decisions, i.e. acquisition/disposition of the property, financing, changing the business of the company, admitting additional members, calling for additional capital contributions) Loss of promote Loss of rights to initiate a buy-sell, forced sale or other exit Right of Investor Member to purchase interest of Developer/Managing Member (price calculation may be punitive) Termination of contracts with affiliates of Developer/Managing Member Sometimes, these penalties are only applied for significant bad acts

11 Consequences of Manager Removal (cont d) Removal considerations Project completion issues if Developer/Managing Member is no longer directing construction Finding a replacement manager (terms including promote) Lender concerns» sponsor loss of control of borrower» Important to negotiate permitted transfers in the loan documents in a way that matches the JV removal rights» Negotiate a Qualified Manager concept with lender so it is clear who can step into the shoes of the removed manager partner Completion Guaranty issues/replacement?» When removed, Managing Member wants as a condition to such removal their release from all guaranties» Investors usually offer a replacement guarantor or a back-stop indemnity if Managing Member cannot be released 17 Exclusivity and Non-Compete Provisions Exclusivity/Non-Competes Investor Member will want Developer/Managing Member to agree to commit to the property/project and not develop competing projects, poach tenants, spread itself too thin Typically structured with an agreed upon radius (distance will depend on geographic location) and project type Sometimes Developer/Managing Member agrees to provide Investor Member with right of first offer/right of first refusal for certain other development transactions

12 Transfer Rights/Restrictions: Developer/Manager Member Investor Member wants tight restrictions given Developer s/managing Member s role in the project/property Principals of Developer/Managing Member must maintain a minimum percentage of interest/control Typically more restricted than Investor Member Sometimes allow minority interest transfers, provided principals still involved Developer/Manager controlled affiliate transfers Family and estate planning Transfers to Investor Member Important to negotiate the same transfer rights and restrictions in the loan documents as in the JV Usually transfers to a competitor of Investor Member will be prohibited 19 Transfer Rights/Restrictions: Investor Member Often greater flexibility in transferring interest than Developer/Managing Member Right to transfer provides Investor Member with liquidity Transfers of minority interest to third parties Affiliate transfers of majority interest/intercompany transfers Sometimes there is a lockout period until all capital is funded and/or construction is completed or the project is stabilized (with JPM, typically 3-4 years after completion to avoid broker-dealer issues) Developer/Managing Member requires some limitations on transfers by Investor Wants to be certain new Investor Member is creditworthy Business relationship concerns/prior history Qualified Transferee concept

13 Other Transfer Provisions/Exit Opportunities Right of First Offer (ROFO) One member is interested in selling their shares, must give the first offer to their partner, who will have a limited period of time to elect to buy the shares before the sale is opened to third parties. No sale can be for less than ~95% of the proposed share price (negotiated). Soft tag-along rights Right of First Refusal (ROFR) Transferor finds a third-party buyer of his interest, then must send notice of the terms of sale of his interest to the other members. Members are given a limited period of time to accept /reject the offer. Tag Along Rights Non-selling member can require that their interest is sold at the same price as the selling member Drag Along Provision Selling member (usually Investor) has the right to package the entire JV as one interest if a third party offer is large enough, effectively dragging the other member into the sale 21 Other Transfer Provisions/Exit Opportunities Buy/Sell Forced Sale Some are tied to trigger events such as:» Major decision deadlock» Member default Notice must be given to all members and include:» Purchase price of the asset» Member receiving notice must decide to sell its interest or purchase the other parties interest at the price stipulated in the Buy/Sell Notice Initiating Member is required to give notice to the Receiving Member of intent to force a sale/sell its interest Receiving member can typically agree to sell the property at the applicable price or buy the Initiating Member s interest Valuation of property and interests Time Frames for Offers and Closing Closing Mechanics

14 Partition Every Delaware LLC should include the following provision: Each of the Members irrevocably waives, during the term of the Company and during any period of its liquidation following any dissolution, any right that it may have to maintain any action for partition in kind with respect to any of the assets of the Company If there are restrictions on transfer, the Member that is potentially restricted (usually Developer/Managing Member) may try to partition the property, which would lead to a forced sale. This provision prevents that, and limits exits from the property to only those enumerated in the Operating Agreement. 23 Related Party Agreements Typically the JV retains an affiliate of the Developer/Manager Member to handle initially the development work and property management Opportunity for Developer/Managing Member to earn an additional development/management fee Fee amounts and quality of work must be comparable to that of an unaffiliated third party Investor Member is sole decider in the event of default by the affiliate developer Cross defaults under JV agreement Agreements must be carefully drafted to account for Developer/Managing Member s natural conflict of interest (and acknowledge Major Decisions )

15 Guaranties Who provides required guaranties to lender? Allocation of guaranty payment obligations/reimbursement obligations amongst the members Treatment of guaranty payments Sometimes reimbursement obligations only apply to certain guaranties Priority capital Guaranty called due to the bad act of one Member (whichever Member caused the liability will be responsible for payment thereof, sometimes spelled out in a reimbursement agreement between the parties 25 Exhibit A: Common Major Decisions

16 Exhibit A continued 27 Exhibit B Waterfall Sample 1.1 Distributions. Subject to the provisions of Section 9.2, undistributed Cash Flow, if any, shall be distributed to the Members monthly (or soon as possible with respect to undistributed Cash Flow from Excess Financing Proceeds or Dispositions) as follows: (a) First, to the Members in proportion to their respective Percentage Interests until the cumulative amount distributed to Investor pursuant to this Section 8.3(a) results in Investor realizing a 9% Internal Rate of Return; (b) Second, to Manger until the cumulative amount distributed to Manger pursuant to this Section 8.3(b) results in Manager receiving a return of all amounts funded by Manger with respect to Sponsor Hard Cost Over-Runs; (c) Third, 81.25% to the Members in proportion to their respective Percentage Interests and 18.75% to Manager until the cumulative amount distributed to Investor pursuant to this Section 8.3(c) and Section 8.3(a) results in Investor receiving a 14% Internal Rate of Return; and (d) Fourth, 62.5% to the Members in proportion to their respective Percentage Interests and 37.5% to Manager. Notwithstanding the foregoing, if Manger has been removed as the Managing Member prior to Substantial Completion (or, if the Members have agreed not to proceed with the Development in accordance with the terms hereof, then if such removal occurs prior to Substantial Completion), then all undistributed Cash Flow, if any, pursuant to Sections 8.3(c) and 8.3(d) above shall be distributed from the Company to the Members in proportion to their respective Percentage Interest