As we head towards the last part of 2020 in the midst of a recession and some of the most challenging business conditions many have ever faced, it is worthwhile considering the aftermath of the 2008 global financial crisis. Then, in the real estate funds space, there was a shift away from pooled investments through funds and an uptick in real estate joint ventures, as investors sought to take greater control over their investments.
It is certainly possible demand for joint venture opportunities in the real estate sector will increase in the next twelve months. Investors in real estate considering indirect investments of this type should take note of the following five important points when finalising joint venture terms.
1. Decision making – directors resolutions vs. shareholder resolutions
If the joint venture company (the JV Co) is an English company, whilst day-to-day decisions are generally made by the board of directors, consideration should be given as to which matters should be reserved for approval by shareholders. A minority shareholder, who only has minority representation on the board, is likely to want a number of key matters to be reserved for approval of both shareholders to give it a right of veto over very key decisions relating to the JV Co. Shareholders can vote in their own self-interest whereas directors of a company must act in the way that they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.
Often, parties agree a list of board decisions where at least one director appointed by the majority shareholder and one director appointed by the minority shareholder must vote in favour of the resolution for it to be passed. This would usually have the effect of reducing the list of reserved matters in relation to which the board must seek the approval of both shareholders.
There can be some exceptions to the situations where a unanimous shareholder resolution is needed for a reserved matter, for example where the reserved matter is permitted in a business plan that has already been approved or where it relates to an obligation under an agreement that has already been approved.
The shareholders' agreement should provide that the approval protocol for matters requiring the approval of the both parties also applies in relation to any subsidiaries of the JV Co.
A typical method of funding by investors to the JV Co is through the provision of shareholder loans, with the JV Co issuing loan notes, in an agreed form, to the shareholders against the loans made. The shareholders' agreement will usually provide that loans be repaid to the parties pro rata to their respective percentage contributions so as to reflect the integrity of the joint venture agreement. This also reduces the possibility of the JV Co, when repaying the loans, preferring a creditor and potentially being in breach of the Insolvency Act 1986 if it were to become insolvent in the following two years.
The joint venture documentation should specify the consequences of a failure by a party to fund the JV Co when a valid drawdown request has been served. The non–defaulting party should have the option to provide default funding which would accrue interest at a rate higher than that which would apply to normal shareholder loans. There may also be the option to convert such a default loan into shares, in effect diluting the equity interest of the defaulting party.
Either the JV Co shareholders' agreement or the articles of association of the JV Co will contain provisions relating to the transfer of shares in the JV Co, including pre-emption rights on transfer, permitted transfers of all of a party's shares to a company in its group, drag-along and tag-along provisions and compulsory transfer. Generally, partial transfers of shareholdings are to be avoided.
The parties may wish to consider a lock-in period, within which all transfers are prohibited. Typically, this may be linked to a period after practical completion in a real estate development joint venture.The parties may also consider prohibiting transfers to competitors of shareholders remaining invested in the JV Co.
The transfer provisions should ensure that an equivalent proportion of loans made by shareholders are transferred at the same time as the transfer shares in the JV Co.
4. Business plan
For a minority shareholder in a JV Co, having the approval of the business plan and annual updates to it as a reserved matter i.e. needing unanimous shareholder approval, will be key. The business plan will set out the strategy and spending plan for the following period. While the majority shareholder would prefer this to be a decision of the board, who take the day-to-day decisions of the JV Co, this is usually an argument that is won by the minority investor.
Where this is the case, the JV Co shareholders' agreement will need to include provisions that will apply if the parties cannot agree an updated business plan. For example, that the last approved business plan continues, except for line items that are agreed, and that adjustments are made for inflation and for compliance with legal, regulatory and committed contractual obligations.
Restrictive covenants are often included in joint venture agreements. They usually involve a series of restrictions on the parties to protect the JV Co's business. Typically, these are to the effect that a party will not, at any time when it is a shareholder, and for a specified period, say a year, after it ceases to be a shareholder, carry on any other business that competes with the business of the JV Co or entice away its customers, employees or key suppliers.
An advantage of joint venture structures is the ability for the parties to be flexible in the terms by which they will be bound. Investors will also have far greater scope to negotiate these than they would do in fund investments. However, it is important that those terms properly reflect the commercial position agreed between the parties. There is no one-size-fits-all for joint venture agreements and each term, and in particular those highlighted above, should be carefully crafted to the specific situation.