Joint ventures and fund arrangements are two frequently used structures that coexist on opposite sides of the commercial real estate investment world. They share a common goal of providing a vehicle through which to invest in real estate assets and to enable a sponsor to acquire, manage, and ultimately dispose of assets on the investors’ behalf — but they take different approaches to achieve that goal. While a JV agreement and a fund agreement will both contain similar concepts (for example, capitalization, decision-making, economics, indemnification, and removal rights), each structure handles these concepts fundamentally differently. For investors and legal practitioners who often invest and work within just one of these structures, undertaking a transaction in the other may be challenging, in part due to a lack of familiarity with the native norms and customs. Think of traveling to a different country where you don’t speak the language.
But in the ever-evolving world of commercial real estate investment, these two structures continue to overlap in new ways, such as club deals, funds of one, programmatic JVs, and JVs with fund conversion features. With these hybrid deals, some investors and legal practitioners face difficulty in translating from JV to fund (and vice versa). Below, we focus on a few key provisions found in both structures and discuss the different approaches to each.
Capitalization: A JV investor will often have discretion over some of or all the capital contribution amount (for example, the JV investor will commit to purchase an initial asset, and then any additional capital contributions following the acquisition of the asset would be subject to approval). Fund investors, on the other hand, will typically agree to a capital commitment upfront, from which capital can be called by the sponsor for any/all purposes during the investment period. For example, there is no uncommitted or discretionary funding concept as in the JV. If a JV investor fails to fund a capital contribution, it may be subject to dilution and/or enable the other funding investor or sponsor to make a loan in the amount of the non-funding investor’s owed contribution. In the fund context, remedies a fund sponsor may exercise for failure to fund will often be much more draconian, including withholding of distributions, elimination of voting rights, and/or a forced sale or forfeiture of the non-funding investor’s position in the fund.
Acquiring Assets and Decision-Making: In the JV context, an investor will likely have approval rights over new investments, including any significant add-ons. For funds, so long as a new asset meets agreed-upon investment criteria and strategy (which often are broadly defined), a fund investor will typically not have approval rights and the sponsor will be freely entitled to call from committed capital to fund such investment. Similarly, a JV investor will typically have approval rights over other major decisions relating to investments, although the number and scope of those decisions will vary across JVs, as opposed to a fund – where it’s not typical for investors to have approval rights over major decisions.
Indemnification: A JV sponsor will be entitled to indemnification from the JV subject to a fair number of carve-outs for a broad range of so-called “bad acts” for which there is no exculpation or indemnity, such as gross negligence, willful misconduct, and breach of the agreement. Also, a JV sponsor will typically be required to come out of pocket and carry its own insurance to fund its defense costs, which are subject to reimbursement if a court ultimately finds in its favor.
A fund sponsor will similarly be entitled to indemnification from the fund, but such indemnification will often be subject to a narrower range of “bad act carve-outs.” Additionally, the occurrence of such a bad act may need to be proven in court before it can be said to have occurred. It’s also common in the fund context for the fund to bear the cost of insurance and for a sponsor’s defense costs to be advanced by the fund, at least until some level of adjudication has been obtained on the question of whether exclusion from indemnification applies.
Removal: Typically, a JV investor will have the right to remove the JV sponsor from governance upon the occurrence of the cause, with a fairly broad definition that may include not only customary bad acts but other conduct, including failures to fund capital or to perform in accordance with a performance standard or material breach of the JV agreement. Fund investors, collectively, will similarly be able to remove the fund sponsor for cause, but the definition of “cause” is likely to be limited to a narrower set of bad acts (e.g., fraud, willful misconduct, criminal conduct, gross negligence) and often only if causing a material adverse effect on the fund’s operations and investments. Additionally, a key difference between JV and fund removal rights is that cause will generally need to be proven in the fund context — litigated to a final non-appealable judgment, for example — before any removal takes effect, whereas sometimes just a JV investor’s claim that a bad act has occurred will be sufficient to trigger a removal of the JV sponsor.
Though not the only reason, one important reason for these different JV and fund approaches relates to the way the parties involved view the investment in their broader business strategy. For a JV — with a limited number of investors and usually a limited investment target — the baseline assumption may be that each investor expects to be an active participant in the investment activity and retain some level of control over the success of the venture and, therefore, expects that each investor will bear its own costs. In a fund — with numerous investors and a broader investment mandate — the parties may view their primary decision as choosing a manager who will then take on the responsibility for all business decisions of what is expected to become an active, operating business where the investors do not have time, interest, ability, or there are too many to participate in management. Given the fund investors’ more limited role, it seems to follow that all costs and liabilities associated with a fund will generally be paid by the investors and out of investments, and the fund sponsor can make decisions and act for the fund on the investors’ behalf and expect broader rights and protections in doing so. Rationale aside, savvy investments in either of these structures or hybrid arrangements require investors and legal practitioners to be conversant in the approaches each structure takes with respect to these and other key provisions to be positioned to negotiate acceptable terms for all parties involved.