structuring real estate jvs: capital contributions, distributions, allocations, taxes...
TRANSCRIPT
Structuring Real Estate JVs: Capital Contributions, Distributions, Allocations, Taxes, Governance and Exit Strategies Negotiating Joint Venture Deals In Property Development to Minimize Financial and Legal Risks
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THURSDAY, JUNE 26, 2014
Presenting a live 90-minute webinar with interactive Q&A
Virginia S. Boliek, Of Counsel, Dominick Feld Hyde, Birmingham, Ala.
J. Michael Pickett, Partner, Bingham McCutchen, Washington, D.C.
Jeffrey J. Temple, Partner, Morrison & Foerster, New York
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Formation and Structure Type of entity – LLCs, LPs, S-Corps, C-Corps
Matters to consider o Liability
Limited Partnerships (LPs) – limited liability only for limited partners
Limited Liability Companies (LLCs) – all members have limited liability
S-Corps & C-Corps - all shareholders have limited liability o Control
LPs – to preserve limited liability, limited partners permitted only limited control over operations of LP
LLCs – No limitations on member or manager control to retain limited liability
Corps – Like LLCs, shareholders can participate fully in management
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Formation and Structure o Tax Consequences
C-Corps – Taxed at corporate level and at shareholder level
S-Corps – taxed only at shareholder level, but have other limitations that make them undesirable choice for real estate JVs, for example - Corporations, LLCs, LPs not permitted shareholders (only
individuals, estates, certain trusts, ESOPs, 501(c)(3) organizations allowed as shareholders)
Only one class of stock permitted Delaware LLC is preferred type of entity
o Familiarity o Allows modification or elimination of fiduciary duties of
manager Foreign investors - may require LP to avoid adverse tax
consequences in investor’s home country; sometimes coupled with a upper tier “corporate blocker”
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Formation and Structure Property owner is typically a single purpose entity (SPE) - required by
lender so that it is bankruptcy remote, particularly if loan to be sold as CMBS
Property Owner SPE (typically an LLC) will be owned (directly or indirectly) by JV
Developer Member and Investor Member also entities (typically LLCs) Getting to joint venture structure
Letter of Intent or Term Sheet Contribution of real property should be done through a contribution
agreement - similar to a sales contract with conditions to closing and representation and warranties
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Formation and Structure Assumed structure for purposes of discussion:
Developer Member o 10% Capital Interest o 25% Residual Interest
Investor Member o 90% Capital Interest o 75% Residual Interest
Promote to Developer Member – 15% (difference between Residual Interest and Capital Interest)
Development/construction transaction Separate development agreement Key principals Preferred Returns, compounding quarterly, at rate of
o Initial and Additional Capital - 10% o Default Capital – Greater of 18% or Prime +6%
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Capital Contributions and Capital Calls Initial Capital - to be contributed or accounted for as of the day of
closing Matters to consider:
o Is there a true-up for pre-closing cash spent by the Developer Member?
o Valuation of property contributed o Consider the structure of each deal (for example, are any special
distributions required at closing?)
Required Capital Per an agreed upon budget or as otherwise agreed by the
members Matters to consider:
o Which members can call capital? o Capital call typically considered a “major decision” o Timing of funding of capital o Draw packages and approvals
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Capital Contributions and Capital Calls Failure to Fund Required Capital
Default by non-paying members can trigger force sale provisions and other remedies
Preferred return (interest at default rate) on capital contribution by funding member with preferred distribution of return and capital contribution
Capital contribution by funding member with dilution of non-funding member’s interest (Can be pro rata or punitive “squeeze down”)
Member Loans o Loan to the joint venture in the amount of the non-funding
member’s share of a capital contribution o Loan to a non-funding member - loan must be used by the non-
funding member to fund its capital contribution o Matters to consider:
Loan rate – regular rate, default rate Loan term Collateral (pledge of membership interest/guaranties) Loan to Member - payments from non-funding members distributions Conversion to capital with squeeze down
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Capital Contributions and Capital Calls Discretionary Capital
Which members can call discretionary capital? o Investor Member will want power to call o Developer Member will want limitations on call power so that call cannot be
used arbitrarily to dilute Developer Member’s interest in JV For what can discretionary capital be called?
o Emergencies o Cost overruns – Investor Members may want to require Developer Member to
contribute all (or a higher percentage) to encourage Developer Member to stay within project budget
o Default under mortgage loan Treatment of discretionary capital contributions
o Non-mandatory capital call – not a default if member does not pay, but non-funding member may be subject to dilution of its interest
o Priority capital contributions – priority distribution with preferred rate of return
o Loan to the joint venture – priority distribution with preferred rate of return o Loan to member collateralized with pledge of membership or personal
guarantees
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Distributions and Allocations Distributions
Types of Distributions o Net Cash Flow – Cash generated by the day-to-day operation of the
JV after payment of operating expenses, debt service, and reserves o Net Capital Proceeds – Cash generated from extraordinary 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 o Cash Flow – periodically, as agreed by the members, typically
monthly or quarterly o Capital Proceeds – when received
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Distributions and Allocations Amount of Distributions (“Waterfall”) - Cash Flow and
Capital Proceeds (typical) o Return on, and then of, default loans and/or default capital
contributions o Return on, and then of, additional capital contributions o Return on, and then of, initial capital contributions o In accordance with Residual Interests
Tax distributions – distributions to Developer Member to pay net tax due on phantom income due to ownership of the JV interest
Types of returns o Preferred return – percentage return on capital invested by Investor
Member o Internal rate of return (IRR) – compounded return on investment
sought by Investor Member
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Distributions and Allocations Promotes – right to receive distributions in excess of ownership
interest granted to a Developer Member in recognition of Developer Member’s locating and promoting the project and taking certain risks (such as completion guaranty and/or payment guaranty obligations during construction) Clawback – required return of a distribution or fee. Examples
include the following: o If Investor Member fails to receive its IRR, Developer Member may
be required to make up the difference from distributions or fees (such as development or management fees) paid to the Developer Member
o Tax distributions not paid to taxing authorities are subject to clawback
o On a multiple phase project, the Developer Member’s promote or other fees received upon completion of earlier phases may be subject to clawback to meet capital needs of subsequent phases
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Distributions and Allocations
Allocations of Profits and Losses for Tax and Accounting Purposes Book and paper allocation of taxable income and loss Goals is for allocation provisions of operating agreement to create
an allocation of profits and losses that reflects the business deal of the parties and complies with IRS regulations.
Have reviewed by expert tax advisors to ensure will be upheld if challenged by IRS
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Choosing a Management Structure
There are multiple structuring options for management, including:
− Investor Member as manager
Investor Member has broad decision making authority
Developer Member as “operations” or “administrative” member tasked with specific duties and limited authority
− Management Committee
Appointed individuals from each of Investor Member and Developer Member serve on a committee responsible for decision making (typically with Investor Member majority)
− Developer Member as manager
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Developer Member as Manager
Developer has day-to-day management authority
Investor Member has approval rights with respect to certain actions and decisions (Major Decision Rights)
Developer Member Concerns
− Ability to make day-to-day decisions with respect to the completion of the development project
− Investor Member should have limited approval rights, (“don’t get in my way”), especially with respect to execution of the agreed upon Development Plan and Budget
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Developer Member as Manager (cont’d)
Investor Member Concerns
− Developer Member should have not just authority, but various duties and obligations with respect to the joint venture and Project (see separate development agreement)
− It is the 90% owner and has an vested, economic interest in the Project it is “buying”
− Being adequately informed regarding the progress of the development project
− Approval rights, especially with respect to specifically identified decisions and actions such as capital events, and entity and tax related decisions
Pros and cons of Developer Member’s use of an SPE manager which is separate from its equity member
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Major Decisions
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Development Related Major Decisions − Budget Modifications − Changes to Plans − Selection/Replacement of General Contractor − Major Contract Approvals − How to address cost overruns
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
Project Related Major Decisions − Sale of the project − Financing and modification − Leasing
Process for approval of Major Decisions Ability of Investor Member to propose a major decision
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Role of Business Plan and Budget
Business Plan − Scope − Agreement on a business plan can affect major decisions list − Mechanism for annual updates
Budgets: − Pre-Development − Development/Construction − Operating
Annual operating budget for stabilized project Submittal and approval process Mechanism for disagreement
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Developer Manager Defaults/ Removal Rights Investor Member will want ability to remove Developer Member
if Developer Member is not performing Types of Manager Defaults (negotiated)
− Non-permitted transfers − Failure of controlling principals to maintain
control/ownership/time on task − Bankruptcy − Failure to implement a major decision − Failure to maintain insurance − Failure to achieve development milestones/completion − Failure to repay a member loan − Bad acts (e.g., fraud and negligence; misapplication or
misappropriation of funds; intentional misconduct; intentional violation of law or criminal misconduct)
− Project performance tests 23
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Consequences of Manager Removal
Removal as Manager
Loss of decision making and voting/consent rights
Loss of promote (“freezing”)
Loss of rights to initiate a buy-sell, forced sale or other exit
Right of Investor Member to purchase interest of Developer Member (punitive price calculations)
Termination of contracts with affiliates of Developer Member
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Consequences of Manager Removal (cont’d)
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Removal considerations
− Lender issues – control of Borrower
− Project completion issues if Developer Member is no longer directing construction
− Finding a replacement manager (terms including promote)
− Lender concerns
“sponsor” loss of control of Borrower
transfer of interest issues
− Completion Guaranty issues/replacement?
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Exclusivity and Non-Compete Provisions Exclusivity/Non-Competes
− Investor Member will want Developer Member to agree to commit to Project and not develop competing projects, poach tenants, spread itself too thin
− Typically structured with an agreed upon radius and product type
− Sometimes Developer Member agrees to provide Investor Member with right of first offer/right of first refusal for certain development transactions
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Books and Records
Designation of member keeping books and records
− Confirm accounting methodologies. Developer Member typically not GAAP; Investor Member typically GAAP
− Confirm software compatibility (e.g., Yardi)
Negotiate time periods for books and records retention
− Note Investor Member will want to use its accounts, but Developer Member may still be obligated to deliver reports
Audit rights and costs
Designation of tax matters member
− Clarify what TMM has authority to do (see tax major decision above)
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Joint Ventures
June 26, 2014 Jeffrey J. Temple
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Transfer Rights: Developer Member
• Typically more limited than Investor Member
• Sometimes allow minority interest transfers
• Typically allow transfers between individuals within the
development company
• Developer controlled affiliate transfers
• Family and estate planning
• Transfers to Investor Member
• Lender concerns and restrictions
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Transfer Restrictions: Developer Member
• Investor Member wants tight restrictions given
Developer’s role in the project
• Must maintain a minimum percentage of interest/control
• Majority interest transfers are prohibited
• Third party transfers of control will almost always require
approval by the Investor Member
• Affiliate transfers require that notice be given to the
Investor Member
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Transfer Rights: Investor Member
• Often greater flexibility in transferring interest than Developer
Member
• Right to transfer provides Investor Member with liquidity
• Transfers of minority interest to third parties
• Transfers of majority interest between members of the Investor
company
• Affiliate transfers of majority interest
• Sometimes there is a “lockout” period until all capital is funded
and/or construction is completed
33
Transfer Restrictions: Investor Member
• Developer Member requires some limitations
• Wants to be certain new Investor Member is creditworthy
• Business relationship concerns/Prior history
• Majority interest transfers to third parties
• Notice of transfer to Developer Member
• Citizenship Restrictions (must be U.S. “Person”)
• Limitation of transfers that alter the company structure such as:
• Publicly Traded Partnership
• ERISA: “Plan Assets”
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Other Transfer Provisions
• Notice Requirement for both Developer and Investor Members
• Right of First Offer (ROFO) • Developer Member must receive notice of transfer by Investor Member
• Developer has a limited period of time to buy the interest before the sale is opened to third parties
• Right of First Refusal (ROFR) • Transferor sends notice of the terms of sale of his interest
• Members are given a limited period of time to accept /reject the offer. If rejected, third parties may purchase the
interest for a price greater than or equal to original terms
• Tag Along Rights • For transfers of interest above a set percentage the Development Member can require that their interest is sold at
the same price as the Investor Member
• Drag Along Provision • Investor Member has the right to package the entire JV as one interest if a third party offer is large enough
35
Related Party Agreements • Typically the Joint Venture retains an affiliate of the Developer Member to
handle initially the development work and later property or asset management
• Opportunity for Developer 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 Member’s
natural conflict of interest
36
Exit Strategies: Buy-Sell • Some Buy-Sells have lock-out periods
• Typically the lockout period lasts until after the substantial completion or “stablelization” of the project
• Some are tied to “trigger events” such as:
• Major decision deadlock
• Member default
• Notice must be given to all members and include:
• Net Enterprise Amount
• Purchase price of the asset
• Member receiving notice must decide to sell its interest or purchase the other parties interest
• Valuation of property and interests
• Time Frames
• Offers
• Closing
• Closing Mechanics
37
Exit Strategies: Forced Sale • Timing – triggers and lockouts
• Investor Member is required to give notice to the Developer Member
• Typically a short period is given for Developer Member to invoke the terms of any
Tag-Along provision
• If Investor Member is selling its entire interest, the Developer Member can be
forced to sell his entire interest
• Closing Mechanics
• Investor Member has a negotiated period of time to execute a contract for the sale
of the company
• Investor and Developer Members pay their respective pro-rata shares of all real
property and/or transfer taxes
• Transfer of all necessary documents between Investor and Developer Members
38
Dispute Resolution • Jurisdiction and Venue
• Binding Arbitration
• Waivers
• Jury Trial
• Governing Law (Delaware is typically selected)
• Forum
• Deadlock
• Notice of Deadlock
• Good Faith Negotiations.
• If not solved, leads to arbitration or Buy/Sell
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Guaranties • Who provides required guaranties to project lender
• Allocation of guaranty payment obligations amongst the members
• Treatment of Guaranty Payments
• Capital to the Joint Venture
• Priority Capital
• Guaranty called due to the bad act of one Member
• Back–Stop Indemnities