Before we start the discussion on Joint Ventures (JV), let’s review the differences between Opportunistic Funds and Joint Venture transactions. There is a distinct and significant difference between a fund structure and a JV structure. The first area of distinction is the discretion. A fund structure has discretion to make investment decisions without approval from investors. On the flip side, a JV does not have discretion to make investment decisions without approval from investors.
The second area of distinction is what these structures promote and how they profit. A typical fund promote structure is 1.5% management fee and 20% of the profits after a 9%-10% hurdle. A JV promote structure can vary dramatically. A typical JV structure might include the following:
- 50bps Origination Fee
- 1% Management Fee
- 20% After a 10% Preferred Return
- 30% After a 15% IRR
- 40% After a 20% IRR
The third area of distinction is investors. A fund has a set group of investors. A JV will have different investors to each transaction. The fourth area of distinction is leverage. A fund typically uses leverage, but most put all the assets of the fund up as collateral. A JV is typically leveraged at the asset level by project debt. In some cases, the General Partner (sponsors) may have to guarantee the debt.
The fifth area of distinction is crossed promotes. In a fund structure, the sponsor promotes (profits) are crossed, meaning that one bad deal can cause a loss of promote on the good transactions. In a JV structure, promotes are not crossed, and each deal stands alone. The final area of distinction is the realization timeline. In a fund structure, the manager does not receive its promotes until the last asset is liquidated. In a JV structure, the promote is paid out on a deal by deal basis, when that transaction is sold or refinanced.
Now, let’s turn our focus to JVs.
When you look for a JV partner for your project, you will likely come across many different equity investment sources. These sources will include high net worth individuals, family offices, and broker dealers. Another source will be the institutional investors. These are organizations that pool together large sums of money and invest those sums in real property. During these transactions, you may be introduced to a variety of players!
For this course, we will focus on three main JV equity partners. The first is the General Partner. The General Partner is also known as the sponsor. They are responsible for the day-to-day operations of the project and all of the decisions that are made. The success or failure of the project depends on the expertise of the General Partner.
The second main JV equity partner is the Limited Partners. The Limited Partners are passive investors with little or no say in the project’s day-to-day operations. They are along for the ride, provide the money, and wait for the pay day!
The third main JV equity partner is the Institutional Equity. These are the big money players! These players look for co-investment from the General Partner, which may include an investment from the Limited Partner.
Joint Venture Equity is also known as “pari pasu” equity. This can be thought of as the “Even Steven” equity, which means that all of this equity is treated equally. One of the keys to a successful JV “pari pasu” venture is to have an alignment of interests. This is the key to the appropriate equity structure.
The equity investor must understand the alignment of interests of its sponsor in their structure. This normally means understanding where the borrower’s equity is coming from, and these interests are aligned within his/her own company. In other words, the company needs to have the equity available to “give” to the JV equity partners.
Due diligence is a must for all possible JV investors. These investors need to dig deep into the ownership structure to understand the motivations of the company. Below are a few questions that should be considered:
- How is the ownership structured?
- Where is the sponsor risk? (Cash equity, personal guarantee, etc.)
- Who has the upside potential? How is this shared?
- Who has the downside risk? How is this shared?
In most deals, the provider of the JV equity will have two basic requirements. The first requirement is that the financial interests between the equity and the operator must be aligned. Second, the equity partner is involved in all operating decisions at the property level.
Even though equity partners go into deals hoping they are successful, it is important to understand the exit strategy. At the first loss piece in the capital stack, typically a sale is the only exit strategy. This is when it is important to have conducted the due diligence to understand the property’s value and also the value of the company as a whole where the investors now have an equity stake.
Most equity investors are looking for partners that have as much to lose as they do and they want to work with partners who are vested in this business on a day-to-day basis and have solid information of the daily operations of the company where the property is being held.
This is where the conversation gets “good’ because we start talking about profit and what the profit participation will look like for the deal. The first participant is the sponsor’s co-investment. This is also known as the “skin in the game.” This is the amount of capital that the sponsors are putting into the transaction. Typical co-investments are from 5%-20% of the equity amount of the transaction.
The second participant is the co-investment amount from the general partnerships. Many sponsors raise money from limited partners to act as their co-investment. Most Institutional JV partners will want to know how much of that money is coming from the General Partners.
The third consideration is to determine whether the General Partnership equity subordinates or is pari pasu with Institutional Equity. In most cases, General Partnership equity is treated the same (pari pasu) as the institutional equity. In some instances, the General Partnership may choose to subordinate its equity to the institutional partner in hopes of getting a larger promote.
The fourth consideration is the sponsor promote. This is the profit/participation/fee/kicker, etc. that the General Partners receive for putting the deal together and bringing it to fruition. This can be based on an IRR waterfall, a percentage of the profit, or a fixed fee.
Within the profit participation, there are two main pricing options and features that are available. The first option is non-accrual pay. Similar to a preferred return, this option would include a minimum rate to be paid current to investors.
The second option would be accrual pay. Interest is not paid current, but accrues. This means it “builds up” in an account until there is sufficient cash flow. It has a priority over return of capital.
When a JV partnership is undertaken for these real estate transactions, there are multiple equity players that will be involved. They all come together to accomplish the same goal of developing or acquiring a property or operating already established properties. All of these equity partners have a joint risk…if the deal goes bad; they all stand to lose something.
Where the partnership gets “tricky” is the setup of the contractual structure. This structure will govern how each of their equity contributions will go into the transaction and also how cash will come put in terms of both return of capital and return on capital. These structures are also known as a “waterfall.” In this course, we will consider two types of structures: Full Stack and Normal Stack. The Full Stack would include all of the possible partners coming together to make the deal happen, including all of the participants we discussed earlier in the course. The Normal Stack would include fewer partners and not all possible participants would be involved in the structure.
Regardless of the “stack” that is used, the participants have four options for payout once the project is complete. These include the following:
- Straight Line Participation of Profit
- Look Back IRR
- Fixed Exit Fee
- IRR Waterfall
Below is a graphic that shows the possible participants in both the Full Stack and the Normal Stack.
Within the JV partnership structures, there are a few possibilities for how returns are paid out. The first category is concerned with the interest rate or preferred returns. There are two basic methods of calculating preferred returns. The first is Current Pay. With Current Pay, the project needs to have cash flow from the beginning. Usually, there would be a quarterly payout to the participants. The second is Accrual Pay. With Accrual Pay, the return is not paid current. Instead a balance is built up and paid back before return of capital.
The JV sponsor often has a different payout structure. The promote is profit, extra fees, or kickers that the sponsor receives for good performance. This is a negotiated point between the sponsor and the institutional equity. The promote is where the sponsor makes the most money! There are a variety of promote structures and the structure is determined as part of the project contract.
When you look for a JV partner for your project, you will likely come across many different equity investment sources. These sources will include high net worth individuals, family offices, and broker dealers. Another source will be the institutional investors. These are organizations that pool together large sums of money and invest those sums in real property. During these transactions, you will likely be introduced to a variety of players!
In this course, we focused on three main JV equity partners. Who are these partners and what roles do they play in the deals?