On this Ropes & Gray podcast, real estate partner Sally Davis and asset management partner Eric Requenez discuss some of the key similarities and differences between terms in real estate joint ventures and terms in real estate funds, including considerations for investors and practitioners in the space who are looking to invest through either of these structures or any of the various "hybrid" models found somewhere in between.
Sally Davis: Thank you for tuning in today to this Ropes & Gray podcast. My name is Sally Davis. I am a partner in the real estate investments and transactions group here at Ropes & Gray based in New York. We have a global real estate practice consisting of approximately 100 lawyers who focus on a wide variety of real estate and related matters, including joint ventures (JVs), acquisitions, financings, repurchase facilities, real estate M&A, and more. My practice focuses primarily on equity-side investing in real estate but generally runs the gamut across joint ventures, acquisitions, dispositions, financings, and across geographies and asset types. Today, I am joined by my partner Eric Requenez, who is a member of the asset management group here at Ropes. Eric, hello. Why don't you tell everyone a little bit about yourself?
Eric Requenez: Thank you, Sally. As Sally mentioned, I am a partner in the asset management group, also based in our New York office. Our group includes more than 300 lawyers focused on advising a global client base of asset management firms, including fund sponsors, investors, and investment advisors. My practice focuses primarily on private funds—and, in that, real estate funds—representing fund sponsors, distributors, and investors in connection with the formation, structuring, and capitalization of U.S. and non-U.S. private investment funds.
Sally Davis: Thanks, Eric. Let's get started. As practitioners in the real estate space, Eric and I advise clients with a common goal of creating a vehicle through which one or more capital providers may invest in real estate (or real-estate-related assets) in which a sponsor is authorized and obligated to acquire, manage, operate, and ultimately dispose of assets thereby creating value for both the sponsor and investors. But achieving that common goal can be structured in different ways: on my side of the practice, many of our clients opt to structure their real estate investments through joint venture partnerships typically comprised of one capital provider (the capital partner) and one sponsor (the JV manager), whereas Eric's side of the practice focuses on larger, commingled funds (both closed-ended and opened-ended) in which several capital providers invest.
Eric Requenez: This brings us to our topic today, "Commercial Real Estate Joint Ventures and Funds: What's the Difference?" As Sally noted, while JVs and funds share a common goal and offer investors and sponsors a similar opportunity to invest in real estate assets, whether through a partnership-type vehicle or otherwise, the terms and conditions governing each structure can look quite different. The operating agreement for a JV and the operating agreement for a limited partnership agreement for a fund will contain similar concepts (such as capitalization, decision-making, economics, indemnification, removal rights, and the like), but each structure really handles these concepts fundamentally differently. So, for investors and legal practitioners who often invest and work within just one of these structures, undertaking a transaction involving the other may be challenging—in part, due to lack of familiarity with the typical norms and customs of that practice.
Sally Davis: Yes, that's exactly right, Eric. I think of it like traveling to a different country where you don't speak the language. But, in the ever-evolving world of commercial real estate investing and the increased popularity of hybrid deals such as club deals, programmatic joint ventures, and JVs with fund conversion components, we have found that it's becoming more and more valuable to understand the key similarities and differences between the approaches.
Eric Requenez: Thanks, Sally. With that, why don't we start at the very beginning with the term of a joint venture versus the term of a fund? A closed-end fund will have a specified term (generally, in the range of 7–10 years with the potential for extension) and, upon expiration of the term, the fund's assets will be liquidated. An open-ended fund, on the other side, as its name would suggest, has a perpetual term.
Sally Davis: Similarly for JVs, the term can be open-ended or may be limited to a certain period of time, for example, 10 years from the date the first asset is acquired, and, upon expiration of the term, the JV's assets will also be liquidated. JVs generally don't permit the JV manager to automatically extend the JV's term; rather, extension generally will require the consent of the JV capital partner.
Eric Requenez: That's interesting, Sally, and I think this is one of the spaces where funds really differ from JVs. Because, on the fund side, the GP often is authorized to unilaterally extend the fund term for closed-end funds for a specified period. In some cases, however, in order to extend the fund term, the GP may be required to obtain the approval of a Limited Partner (LP) Advisory Committee or the like or a majority-in-interest of the LPs.
Sally Davis: So, then, once the entity is formed, the next most important question is undoubtedly going to be: How will it be capitalized? With respect to a JV, the JV manager's percentage interests in the JV varies quite a bit from deal to deal and could be anywhere from 1% to 50%. I would say the deals we see most commonly tend to have the JV manager investing somewhere in the 1%–10% range. As I understand from discussions with you, Eric, JV investors generally expect the JV manager to invest more capital in a JV than fund investors require of the GP in a fund. Is that right?
Eric Requenez: Yes, that's generally right, Sally. The typical amount for a GP commitment in a closed-end fund generally ranges from 1%–5% of the fund's aggregate commitments, although it's usually on the lower to middle end of that. In an open-end fund, on the other hand, GP commitments are all over the map, but, generally, they're somewhere either stated as a specific dollar amount rather than a percentage, and, sometimes, new open-end funds may have a higher GP commitment amounts for the early years of the fund's life and, then, it will tail off as the fund has been established and operating for a few years.
I think that takes us maybe now to investor capital. Fund investors typically make upfront capital commitments that the GP draws down from during the fund's investment period. Drawdowns can be used for a variety of purposes in the fund context, including to acquire assets, pay management fees and other fund expenses, and other things like indemnification costs. Open-end funds will generally require investors to fund their commitments in full at closing but sometimes will also permit for drawdowns of capital over a specified period of time.
What do we do in the JV context, Sally?
Sally Davis: In a JV, it's a little different. Typically, the JV members will commit up front to fund only an initial capital contribution (for example, to purchase an initial asset), but any subsequent capital contributions following acquisition of that initial asset will generally be subject to capital partner approval, save for certain instances where funding additional capital contributions may be obligatory (for example, to fund emergency expenditures or fund amounts that were previously approved in a budget).
Eric Requenez: Thanks. Let's turn to the investment decision-making process now. In the fund context, Sally, once the investors have made their capital commitments, the GP generally will have discretion to investments without the consent of LPs—so long as the investments satisfy some pre-approved investment criteria that's set forth in the fund's LPA or operating agreement. Deviations from the stated investment restrictions, if there's any, could require consent of an LP Advisory Committee or a majority-in-interest.
Sally Davis: Yes, acquiring new assets in the JV context tends to be a bit more restrictive. A JV capital partner likely will have approval rights over making investments as well as exiting from investments and any leverage or borrowing terms. In fact, the JV capital partner will typically have approval rights over a number of what we call "major decisions," the scope of which will vary across JVs but typically will include acquisitions, sales, construction projects and plans, budgets, tax decisions, and other material contracts and similar material type of matters. Is that not the case in the fund context?
Eric Requenez: Again, this is one of the places where the fund context really deviates from the JV context, as it's rare for fund investors to have approval rights over those types of decisions. Instead, fund investors will likely only have approval rights over a very limited set of more "fundamental" types of decisions relating to the operation of the fund itself—but not the underlying investments—so, think of things like a material amendment to the fund agreements, merging into the fund, or potential extensions beyond the stated extension periods.
The varying scope of approval rights that a JV capital partner will have as compared to an investor in a commingled fund highlights an important theme that gets to the heart of why we see these differences between JVs and funds. For a JV with a limited number of investors and usually a limited investment target, the baseline assumption may be that the investor expects to be a more active participant in the investment and retain some level of control over the success of the venture. On the fund side, with generally a broader investor base and larger investment mandate, particularly for blind pools, the parties may view their primary decision as choosing a manager who's then going to take on the responsibility for the majority if not all of the business decisions.
Sally Davis: Thanks, Eric. I think that's a really good point, and it's important to keep in mind when considering the objectives of each party during negotiations. I think it's also key in helping to explain one of the other differences that we see between JVs and funds, namely, in the way that indemnification is handled for a JV manager versus a GP of a fund. In the JV context, a JV manager will be entitled to indemnification from the joint venture, subject to carve-outs for certain what we would typically consider to be "bad acts." So, those "bad acts" are negotiated but often include things like gross negligence, willful misconduct, fraud and material breach of the agreement. It is not common though for those "bad acts" to need to be proven in court for the carve-outs to apply, and, I understand in the fund context, it's handled somewhat differently.
Eric Requenez: Yes, that's right—we take a slightly different approach, generally, in the fund context, both in the open-end and close-end construct. Typically, a GP will be entitled to indemnification from the fund, and the GP's actions need to be fairly egregious not to have the benefit of exculpation or indemnification. Unlike the JV context, oftentimes, the "bad acts" of the GP need to be proven in court before any carve-outs will apply, including, sometimes, until there's a final adjudication that is not subject to further appeal, which, as you can imagine, could take a very long time. In addition, in the fund context, defense costs related to an indemnification claim generally will be advanced until there's reached some level of adjudication on the matter.
Sally Davis: That's interesting. I would say it's fairly atypical for defense costs to be advanced in connection with an indemnification claim unless and until the manager's proven not guilty.
Eric Requenez: Right, and I think all of this goes back to the broader theme that a GP is granted more discretion in handling the fund and managing its assets and therefore, in return, it often requires more protections from claims both from third parties and the fund investors.
Sally Davis: Let's move on now to removal rights. In a joint venture, the JV capital partner will typically have the right to remove the JV manager for "cause." The definition of "cause" likely will be fairly negotiated but will often include the traditional "bad acts" that we talked about earlier and may be more expansive as well to include other types of problematic conduct, for example, failing to fund a capital contribution and/or the bankruptcy of the manager. In some cases, an accusation of "cause" alone may be sufficient to remove the JV manager, although managers will often push for some form of expedited arbitration or even court resolution (likely just an initial court ruling) to prove "cause" before the JV manager can actually be removed.
Eric Requenez: That's interesting, because on the fund side, "cause" will almost always be limited to the more traditional set of "bad acts" and generally needs to be proven in court (again, possibly with a non-appealable judgment) before "cause" removal will be available to LPs.
Sally Davis: Although, don't you also see fund LPs having the right to remove without "cause?"
Eric Requenez: Yes, sometimes we see that, though it's not always the case. For some closed-end funds, LPs may be able to remove the GP without "cause" but that will require a larger supermajority vote of the LPs in most situations—for example, 75% to 80%—which, in practice, may be difficult to achieve and undoubtedly only arises if things have truly gone haywire (but not necessarily rising to the level of a "bad act," per se). Open-end funds, though, generally do not permit removal without "cause" because investors have the ability to redeem, so the idea there is that investors could just exit rather than removing the GP.
What about JVs—what do we do there?
Sally Davis: I would say a JV typically will not contain a right to remove the manager without "cause"—instead, a capital partner is likely to have one or more exit rights, which it would be able to exercise if it were ready and wanting to get out of the relationship. In JVs, it is typical, I would say, for a capital partner to have the right—perhaps after some negotiated lockout period—to trigger a buy/sell (for example, where it can sell its interests in the JV to its partner or to buyout its partner from the joint venture) or a forced sale of the underlying assets. The type and form of those rights will come in different flavors, and the manager may have certain rights of its own, for example, a right of first offer to buy, before the capital partner can proceed to sell the assets to a third party. But the general concept is that the capital partner will often have some unilateral mechanism to extricate itself from the investment and the joint venture after some period of time.
Eric Requenez: Interesting. This is another point where things are very different on the fund side, as it is rare for investors to have those types of exit rights. In closed-end funds, it's often the case that a supermajority-in-interest of investors can cause the termination of the fund, but in practice, it's rarely exercised. And, then, in the open-end fund context, it's extremely rare for investors to do this because they can simply exit the fund through the ordinary redemption process. In a closed-end fund, the only say an LP will otherwise have in determining the ongoing life of the investment is, generally, in the context of an expiration of the term and the LPs not approving the extension—in which case, the GP's going to be required to liquidate the fund's assets.
Sally Davis: So, I think, as you can see, while joint ventures and funds both create economic arrangements through which sponsors and investors can invest alongside each other in real estate assets, the terms governing those arrangements can look quite different. Particularly, since we are seeing more and more hybrid deals these days that draw from aspects of both the JV world and the fund world, we have found it helpful in our own practices to give thought to how the two worlds intersect and diverge, and we hope that this discussion today has been helpful to you as well.
Eric Requenez: That's right. We hope that by highlighting some of the key differences between the typical terms contained in real estate fund agreements versus real estate joint venture agreements, the next time you find yourself negotiating a real estate JV or a fund (or something in between), you will be better positioned to understand your counterparty's perspective and draw from market norms. It's also why it's important to identify early on whether your counterparty is viewing your arrangement as a JV or a fund as well as whether their counsel is more of a real estate transactional lawyer or a real estate funds lawyer as that may influence their approach to the transaction.
If anyone has any questions on this or any related topic discussed today, please don't hesitate to reach out to Sally, me, or your typical Ropes & Gray contact. Also, for more information on these or other topics of interest in the asset management or real estate areas, please visit our website at www.ropesgray.com. If you enjoyed today's discussion, please subscribe and listen to this series on Apple, Google, or Spotify. Thank you again for listening.
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