Large institutional investors with designated in-house teams tasked with evaluating investment opportunities and overseeing allocations have begun partnering with private equity managers to form joint ventures—vehicles into which they can channel their deep resources and experience to take on an even more active role in deploying significant assets. Joint ventures can be beneficial for both large institutional investors and private equity managers because the permanent agreement to purchase, manage and sell assets can result in faster execution timelines and reduced investment costs.
As with any business relationship, private equity managers must scrupulously attend to the joint venture relationship, and perhaps the key to its long-term success is the agreement governing it. A well-crafted joint venture agreement clearly describes the nature of the parties’ partnership and the joint venture’s parameters, and delineates each party’s obligations and rights with respect to the venture. At the same time, an effective joint venture agreement is flexible enough to allow for changes in the market, the assets to be acquired, business plans or other factors that could arise.
This article, the second in a three-part series on joint ventures, provides an overview of the legal structures commonly employed in joint venture agreements, reviews applicable regulatory obligations and assesses frequently negotiated and important terms that can help facilitate a smooth relationship in furtherance of the partnership’s investment goals. Part One of this series explored the reasons underlying the increase in private equity managers’ and institutional investors’ use of joint ventures to partner on investments in certain assets and the benefits of the vehicles to both; types of joint ventures; and best practices for managers to avoid conflicts of interest between a joint venture and other funds managed. The third article will examine exit provisions.
Joint Venture Legal Structures
Choosing an appropriate legal structure for a joint venture vehicle involves a variety of considerations and depends on a number of variables. Dorothy Mehta, a partner at Cadwalader, Wickersham & Taft, explained, “The structure depends on the agreed-upon terms as well as the strategy and the type of participants. For U.S. investors, a partnership structure—either a limited partnership or a limited liability company—might provide the most flexibility and tax optimization. It really varies depending on where the team is located and what is being invested in.”
The limited partnership legal structure, however, may not be appropriate for all joint ventures. According to Siobhan Burke, a partner at Paul Hastings, “The joint venture could be a contract, or it could be an LLC. These are typically not limited partnerships, as most private equity funds are, because the investor has a more active role.”
Akin Gump Strauss Hauer & Feld partner Blayne Grady explained further, “Joint ventures are typically owned exclusively by large, sophisticated investors that satisfy certain statutory ‘qualified purchaser’ thresholds. The joint ventures are usually contract deals or can also be an LLC. Limited partnerships can be tricky because the investor has more control, either with respect to investments or business operations, so investors have to give some consideration to limited liability. You don’t have these issues with an LLC or contractual arrangement.”
Paul McCoy, a partner at Morgan Lewis & Bockius, said he typically sees joint ventures structured as LLCs “at least in the U.S., and in jurisdictions that have something comparable.”
“The classic structure is definitely a vehicle that would accommodate and house the business,” noted John Caccia, a partner at Skadden, Arps, Slate, Meagher & Flom. “Managers don’t want to expose any existing businesses, so they want to have a separate vehicle for this partnership.”
Caccia continued, “Many of these partnerships will start as a memorandum of understanding where both parties agree to certain things, but once the agreements get a little more specific in terms of the costs, revenue sharing and decision-making, the parties will be advised to form a vehicle to formalize the arrangement.”
Although an LLC can be a relatively flexible structure for a joint venture, Edward Dartley, a partner at K&L Gates, noted, “Sometimes these deals are done through contract, especially if there is no tax reason to be an owner—for instance, if the investor wants the carried interest as opposed to ordinary income. Most often, I see arrangements being done in the form of a contract at the management company level with the management fee. Institutional investors may choose to be an owner of the general partner or fund so they can participate in the carried interest and get the favorable tax treatment, but when it comes to the management company and the management fees, those are going to be taxed as ordinary income anyway, so you don’t have the same need to be an owner. If the institutional investor wants to stay off the radar screen with respect to SEC filings, one way to do that is to have a contractual revenue share at the management company.”
When structuring joint ventures as limited partnerships, investors need to carefully negotiate approval rights, advised Seyfarth Shaw partner Robert Bodansky. “If it’s done as a limited partnership, you want to maximize the transparency and the approval rights for the investor. At the same time, you need to be careful not to provide so many approval rights that the investor is considered to be a general partner and has the liabilities that go with being a general partner.”
Registration and Disclosure Obligations Stemming From Joint Ventures
The legal structure chosen for the joint venture vehicle may impact the manager’s, investor’s and, potentially, the joint venture vehicle’s regulatory obligations, including registration with the Securities and Exchange Commission and Form ADV disclosure requirements.
“With respect to registration,” said Burke, “The sponsor is often a registered investment adviser. The entity itself is probably not registered. Depending on the ownership structure and how much of a stake the investor owns, it also likely would not need to be registered.”
Anastasia Rockas, a partner at Skadden, Arps, Slate, Meagher & Flom, explained that a separate advisory entity not tied to the existing registered investment adviser’s registration is usually associated with the joint venture and could require that the joint venture register. “Registration will depend on factors such as assets under management, the location of the manager, the investors and how decisions are being made. It’s a function of the different facts and circumstances.”
Dartley explained further, “Typically with private funds, the fund itself is not regulated, but the manager is. In a joint venture, the JV company would not be regulated, unless it is also serving as the management company. Registration comes in with respect to the management company and the general partner of the fund. If a management company is going to manage over $150 million, it is going to need to be registered with the SEC. Below that $150 million threshold, the management company would be an exempt reporting advisor.”
Grady pointed out, though, that otherwise exempt, smaller managers should consider whether the manager’s activities related to the joint venture will trigger registration requirements. “One of the regulatory issues that the manager needs to consider, particularly if it is not already registered with the SEC as an investment adviser, is whether the arrangement with the investor rises to the level of actively managing capital for purposes of having assets under management and triggering the registration threshold. If you’re a registered investment adviser already, it’s probably not going to change the way you do business. But if you’re not registered, then these arrangements could push the manager to registration earlier than it otherwise would have.”
The joint venture’s legal structure could also trigger regulatory disclosure requirements, said Grady. “If the JV is a vehicle, it could constitute a private fund or account that needs to be disclosed on the Form ADV or Form PF. Typically, the joint ventures are structured so the entity itself is not regulated for purposes of the Investment Company Act.”
Dartley explained how the JV is legally structured and how the way interests are divided could precipitate disclosure requirements. “If the management company is registered with the SEC, the indirect owners of that management company—if they own more than a certain percentage—would need to be disclosed on the Form ADV. Some institutional investors may have an aversion to being listed on the SEC filing and being subject to an SEC examination, so they will keep their interest in the joint venture company below 25%. Some institutional investors want to make sure the joint ventures are structured in such a way that they would not have such control that individuals working for the institutional investor would be considered ‘access persons’ for purposes of an investment manager’s compliance program and SEC compliance.”
McCoy said that artful managers may be able to avoid altogether any requirements to disclose the joint venture in the Form ADV. “You may not need to disclose this in your Form ADV, because you may be able to argue that there are no clients in the joint venture. If the joint venture is evenly balanced and there is no investment advice—i.e., no party is receiving advice regarding investing in a security—then an argument could be made that the Advisers Act does not apply. Often these deals involve the manager to a greater extent than the other party(s), at least a little bit, and so the Advisers Act would still apply to the extent the other party(s), or the joint venture entity itself, are receiving investment advice from the manager.”
State disclosure requirements may also apply to the joint venture. “I think one of the biggest risks is understanding that the nature of your partner can have implications throughout the agreement,” observed McCoy. “For example, if your joint venture partner is a California state pension, under California law there are public disclosure laws, so you will have to understand how those apply in the context of your joint venture. The answer is likely to be different depending on the specific terms of your joint venture and how involved the pension is.”
“Regardless of how the deal is structured, there is going to be some touch of regulatory obligation, whether it’s disclosure, recordkeeping or SEC audit exposure,” Mehta concluded.
Market Terms for Joint Ventures
There isn’t necessarily a traditional market for terms since joint venture agreements are often bespoke, but negotiating certain terms in advance can help facilitate a smooth relationship in furtherance of the partnership’s investment goals. Rockas noted that joint venture agreements often include “a lot of negotiations around control issues and economic issues, and there are often indemnification provisions to outline who is responsible for any issues that arise.”
Scope of the Joint Venture
Joint venture agreements must include provisions that define the nature of the JV’s business. These provisions typically restrict the types of assets, companies or geographic locations in which the JV may invest. They also outline specific investment parameters, such as how much each party will contribute to the joint venture and what asset(s) the JV partners intend to purchase.
“There will be provisions allowing the investor to have input in the selection of investments to be made by the venture, often through an opt-in or an opt-out provision,” Bodansky explained. “The sponsor will put together an investment package based on its due diligence and present it to the investor to see if the investor wants to participate in the deal.”
The JV agreement should also clearly define the capital contributions to be made by each of the parties in order to acquire the asset. These capital commitment obligations vary depending on the structure of the JV and are highly negotiable. Experts The Private Equity LCD spoke with said they’ve seen agreements in which the investor must contribute 90% of its share of the money needed to make the investment at the outset with additional capital required at a later date; alternatively, they’ve also seen agreements in which only 50% of the capital agreed to be committed is contributed at the outset.
Joint venture agreements should include control rights that contemplate which party is responsible for the day-to-day operations of the joint venture and has ultimate management authority over the assets. Control rights provisions also outline if and when consent is needed from all parties involved in the JV.
According to Mehta, control rights are a “heavily negotiated point,” and parties need to agree on who controls the investments and “who has what say. For example, who determines the investments? Who determines the key personnel?”
Dartley added, “Often you will see control rights so the manager cannot significantly change the structure of the vehicle without [the investor’s] consent. They can’t amend some of the major agreements or investment terms without [the investor’s] consent.”
Dartley said that the frequency of reporting generally is included in JV agreements as well. “There may be monthly reporting or quarterly reporting. Of course, there is always the ability to pick up the phone and ask questions. That’s one of the benefits for the investors—access to the GP and a close relationship that you don’t often see in a commingled fund or even in a typical co-investment vehicle. Joint venture vehicles are typically non-discretionary. This gives the investor more opportunity to customize and fine-tune the investment profile, which is something these larger pension investors are looking for.”
JV agreements sometimes contain confidentiality provisions that require all parties to keep the terms and existence of the venture confidential. Additionally, Mehta noted, “There may be non-competes related to investment opportunities—one party cannot take advantage of investing in a company, project or strategy that was the target of the joint venture.”
Finally, McCoy pointed out, “Joint ventures often include provisions to address deadlocks, such as buy-sell arrangements. The manager and investor also want to outline the decision rights during the life of the investment. You may also see covenants around the period of time the asset is owned.”
Deadlock provisions often address methods for resolving any impasses or stalemates, and specify negotiation procedures, mediation requirements—including how mediators will be chosen—or arbitration. Because deadlocks can lead to dissolution of the joint venture, buy-sell provisions through which either partner may initiate the buy-sell process—by offering either to buy the other partner’s equity or sell its equity to the other partner—also are often included in joint venture agreements.