In this final part of our programmatic (or platform) real estate joint venture (JV) mini-series, we complete our analysis of the key topics in programmatic JVs, focusing on economics, liquidity and default. If you missed it, in part two we delved into the details of exclusivity and investment discretion provisions. Going back to part one, we gave a crash course on programmatic JVs and explained why we believe they could prove important to this next phase of the economic cycle.
Economics
The key consideration for programmatic JVs compared with traditional JVs from an economics perspective, lies in the structure of the distributions waterfall. At one end of the spectrum is the "deal-by-deal" model, whereby each asset is treated as its own siloed investment. In this model, the returns generated from a specific asset are used to repay each partner the full amount of capital they invested in that specific asset, followed by a specified return. The operating partner is then paid its promote, calculated in respect of that individual asset.
At the other end of the spectrum is the "crossed" model, where a single waterfall operates across all assets throughout the JV's lifespan. In this model, the operating partner's promote is only paid once the partners have received back their full invested capital and specified return across the entire portfolio.
There are common middle-ground approaches between the "deal-by-deal" and "crossed" models, such as the "pooling" and "realised-deal" models. In the "pooling" model, assets are allocated into pools, and the waterfall and promote are crossed only for the assets within each specific pool. Care must be taken by the capital partner to ensure that the parameters for each pool represent a diverse range of assets within the entire platform, avoiding dominance by a single asset in any given pool. In the "realised-deal" model, the promote is calculated and paid each time an investment is sold, based on the performance of that specific deal and all prior realised deals.
Capital partners typically advocate for the "crossed" model, as they perceive their investment to be in the relationship and platform as a whole. They argue that returns should be evaluated collectively, allowing underperforming assets to be balanced against those which are better performing. On the other hand, operating partners often favour the "deal-by-deal" model. They aim to secure a full promote on successful investments, irrespective of the performance of other platform investments. Operating partners contend that this approach aligns with the outcome they would attain by individually pursuing investment opportunities in the market.
If a "crossed" or a "pooled" model is adopted, the operating partner may push for an interim promote pay-out given the prospect of waiting until the whole or a significant proportion of the platform's assets are sold before it receives any promote. Whilst the capital partner will always prefer that promote is paid based on actual realised value towards the end of the venture, it may accept that an interim pay-out is necessary to ensure that the promote properly incentivises the operating partner to drive returns.
Interim promote is typically calculated by assuming a full realization of the relevant assets at market value, offsetting costs or liabilities, and distributing the proceeds through the waterfall. The capital partner will, however, insist on implementing guardrails, including third-party independent valuations, only paying out a specified proportion of the calculated amount (i.e. to leave some 'skin in the game'), and a clawback mechanism where the operating partner must repay any amounts which subsequently prove to be overpaid based on actual realised values. Capital partners also typically seek security for the clawback obligation, such as a parent company guarantee or escrowing a portion of the interim promote amounts.
Another important consideration for capital partners in relation to payment of interim promote is how the relevant payment will be financed, given that it is based on a notional realisation of asset values rather than actual cashflows and liquidity events. The operating partner may propose that the capital partner funds the payment by contributing fresh capital to the joint venture. However, this may be unappealing to the capital partner, especially if they are yet to receive any real returns. For stabilised income producing assets, a potential compromise could involve diverting regular distributions to the operating partner, either in full or in part, until the interim promote amount is fully paid over time.
Default
An important consideration in programmatic joint ventures is how a default by the operating partner in one asset should impact other assets or the entire JV. This topic can elicit strong emotions for operating partners, as a cause event default can have significant consequences for their economics, including the loss of their promote, termination of management agreements leading to loss of fee income, and the potential for the capital partner to acquire their JV interest at a discounted price.
Operating partners may view it as punitive to lose their entire platform economics due to a default related to one specific asset. On the other hand, it is vital to capital partners that they protect their interests by having the ability to remove the operating partner from the entire venture where the relationship is irreparably damaged or reputational concerns arise. A common middle ground is often found through a tiered or cascade default regime. Under this approach, operating partner cause events that significantly impact the relationship, such as "bad acts" (e.g., fraud, gross negligence, wilful misconduct, or criminal acts), trigger default consequences for the entire joint venture. Conversely, for less serious default events confined to individual assets, such as failure to meet a performance hurdle or certain material breaches, the capital partner may have the right to remove the operating partner as the manager for that specific asset, while the other assets remain unaffected.
Without cause removal rights, which give the capital partner the ability to remove the operating partner from the joint venture at its discretion, are becoming less common across all types of real estate JVs. In our experience, these rights are even less prevalent in programmatic JVs, which is not entirely surprising, given that programmatic JVs are based on the parties committing to a long-term partnership together.
Liquidity
Liquidity and exit rights in programmatic JVs often differ from those in traditional real estate JVs. This is primarily driven by the differing dynamics of programmatic JVs as long term partnerships and the substantial value that can be built over time through the development of the platform. Some of these key differences we are observing in the market include:
- Longer initial lock-in periods, allowing operating partners sufficient time to aggregate assets and grow the platform before capital partners can exercise liquidity rights.
- Operating partners are reluctant to be locked in for the life of the venture without liquidity rights or a say in the timing of the capital partner's ultimate exit, unless they are incentivised with regular interim promote payments to provide interim liquidity.
- Capital partners insist on a comprehensive range of liquidity rights. This includes the ability to force a structured sale of the entire platform in order to realise any standalone platform value separate to the underlying real estate values (e.g., through an IPO) as well as the flexibility to sell assets individually, or in mini portfolios, where that would achieve the best market price.
- Traditional buy-sell provisions are less common, as the significant value of platform JV assets often exceeds the realistic acquisition capability of most operating partners. This can create a situation where the capital partner can manipulate the buy-sell price, knowing that the operating partner's only viable option is to sell. A potential workaround is to give the party receiving the buy-sell notice the option to either buy the portfolio or force a sale on the open market, with the offer price acting as a floor. However, in the cases of some larger platforms nearing the end of their lives, buy-sell provisions can even be unworkable for capital partners.
A final word...
For many investors and operators alike, understanding and leveraging programmatic JV structures will be vital in capitalising on the opportunities which will be presented by this next phase of the economic cycle. We hope that this three part mini-series has equipped you with a better understanding of programmatic JVs and their unique aspects, ultimately enabling you to navigate negotiations more effectively. In case needed, here are links to parts one and two of the series:
- Part one: Programmatic Real Estate Joint Ventures: a Vital Tool for PERE Investors in the Next Phase of the Economic Cycle
- Part two: Exploring Key Topics for PERE investors in Real Estate Programmatic JVs – Exclusivity and Investment Discretion
As always, we would welcome a discussion on what you are seeing in the market and to hear any alternative views.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.