Sometimes a joint venture arrangement between a developer and an equity investor will involve both a development management arrangement and a bespoke joint venture agreement of some sort. We deal with both aspects.
In Part I, we deal with Development Management Agreements. In Part II we deal with Joint ventures and waterfall arrangements.
Part I: Development Management Agreements
Most development management agreements, “DMAs” provide that the development management fees are paid quarterly from the date of the DMA until the end of the project, usually practical completion. The only way the employer under a DMA can stop paying these fees is if the DMA is terminated or suspended.
DMAs normally provide that the employer can terminate the DMA if the developer is in breach of its material obligations, or if it is grossly negligent, wilfully disobedient or fraudulent. In some cases there is an ability to terminate if the project is delayed beyond fixed deadlines or the project costs exceed certain agreed limits.
If there is substantial delay to the development caused by the contractor having to down tools, or due to supply chain issues caused by Covid-19, then one must consider any force majeure provisions. A developer would be arguing that any delay is outside its control. Force majeure is not a legally defined term, so each provision must be reviewed on its merits and the facts.
Assuming that the DMA does have a force majeure clause, it is likely that the agreement will contain provisions entitling the employer to suspend the project if delays occur which cannot be rectified quickly. Normally such a suspension clause will effectively freeze the DMA and entitle the Owner to stop paying any fees until the project recommences.
Some DMAs then go on to provide that if the suspension period exceeds a certain time (normally a minimum of 3 months) then the employer or sometimes, both parties, can terminate the DMA.
DMA checklist for Covid-19-related delays
- Check if employer can terminate or penalise, if any timing deadlines or costs limits are missed and if so, try to extend these timing deadlines or link extensions to any Covid-19- based delays.
- Check the suspension provisions in the DMA and ascertain whether an employer can terminate.
- Try to negotiate reduced fees rather than total suspension, during any Covid-19 period of disruption.
- Try to negotiate an extension of any suspension period (particularly if less than 6 months).
- Try to include the suspension of any employer’s right to terminate arising from Covid-19 period of disruption.
- Check the extent of the services to be provided by the developer under the DMA. It may be that some services can be carried out and others impossible. One needs also to analyse the fees and how they relate to each of the services. There may be an argument for a pro-rata payment.
- Check Key Person provisions in the DMA. In the current climate it may be prudent to provide for substitute Key Persons should a Key Person fall ill with Covid-19
Part II Joint Venture Agreements and Waterfalls
Where a developer and an investor (which is the employer under any DMA) are both putting cash into a property development, the provisions detailing how the parties are to distribute their returns and profits (known as the “waterfall”) are normally set out in the joint venture shareholders’ agreement or partnership agreement.
This agreement may also contain development management-type provisions and the comments in Part I of this article will apply to those obligations.
In a Covid-19 delay situation, the risk is that not only might the investor argue that any fees due to the developer are capable of being suspended but that the developer’s shareholding or its entitlement to profits might be compromised by any delay.
Shareholders’ and partnership agreements and especially those sections covering fees and profit share are generally more bespoke than boilerplate DMAs . The devil, as ever, will be in the detail of the drafting.
In the majority of joint ventures between developers and investors, there is a substantial disparity between the equity participation of the respective parties.
The ultimate split of profits is normally determined by the level of equity each party is putting in and the extent to which the investor/employer is reducing its risk.
The most common way for risk to be reduced is for the investor to require that a fixed amount of interest be attached to its equity investment, on a rolled-up basis (this is known as a coupon) and that this rolled-up coupon is paid out to the investor in addition to its equity (normally on a pari- passu basis with the developer) before any other profits are distributed.
The next layer of risk reduction might be for the investor to insist on being paid out all profits until it achieves a what is known as an IRR i.e. a certain internal rate of return (“IRR”) on its equity (normally inclusive of the aforesaid coupon) and thereafter the balance of the profits are distributed.
Where the investor does not reduce its risk by these types of arrangements, it will generally look to achieve a much higher overall profit share from day one.
Most waterfalls are variations of the following formula, whereby the proceeds of all sales (and income) are to be distributed as follows:
- repayment of all project costs;
- repayment of all third party debt, interest and borrowing costs;
- repayment of all equity from investor and developer (usually on a pari-passu basis);
- Payment of any rolled-up coupon owed to the investor and the developer (usually on a pari -passu basis);
- balance of the proceeds to then be allocated either on a fixed basis (i.e. 50/50 or 60/40 etc.) or on a “ratcheted” basis depending on the achievement of further IRR hurdles for the investor (or for the project). By way of example, an investor may require to be paid all profits up to say a 10% IRR hurdle, then profits are split say 50%/50% up to 20% IRR and then profits are split say 70%/30% in favour of the developer thereafter.
Action for Developer, assuming significantly lower equity input than investor.
- Coupon Freeze : try to negotiate a coupon freeze or a coupon reduction during the Covid-19 delay period;
- IRR freeze: try to negotiate an IRR freeze or reduction during the Covid -19 delay period
- Carve-out: try to negotiate a “carve-out” exception to any IRR hurdles which are artificially affected by the Covid -19 delay period.
Using the waterfall example above, it may be that the waterfall provides that the developer only starts to be entitled to any profit share after the Investor’s (or project) IRR achieves say 10%. The calculation of IRR is, of course, dependant on time. The earlier the project concludes and all receipts are in, the higher the IRR will be and vice versa.
Consequently a 3 month delay in the project, which may be caused by Covid-19 delay could
- cause the IRR to either not reach 10% (in which case the developer would get no profit share at all); or
- cause the IRR not to reach the next IRR hurdle and hence deprive the developer of an enhanced profit share.
Developers should check their waterfall clauses carefully and run projections based on at least a three month delay, to ascertain whether the current Covid-19 crisis could have a potentially damaging effect on their potential profit share, all other things being equal.
In these circumstances, it is crucial that this obvious unfair outcome be brought to the Investor’s attention and a solution negotiated if possible.
This update is for general purpose and guidance only and does not constitute legal advice. Specific legal advice should be taken before acting on any of the topics covered. No part of this update may be used, reproduced, stored or transmitted in any form, or by any means without the prior permission of Brecher LLP.