There’s been a notable uptick in private equity managers and certain large institutional investors partnering to form joint venture vehicles in which they co-own and co-operate invested assets. In many ways, the nontraditional funding approach can be advantageous for both parties—institutional investors gain the benefit of PE firms’ functional expertise and can take a more active role in managing the investment, and managers can build stronger relationships with these partner-investors and jointly shoulder the capital expenditure required to finance a large investment.
Nonetheless, PE joint ventures with investors can have challenges, primarily related to contrasting objectives or timelines. Although no one wants to plan the divorce on the way to the wedding, no joint venture will last in perpetuity, and the best time to step back, reflect on and plan the venture’s ending is in the beginning. Joint ventures can end for a variety of reasons, some innocuous—like the investment running its course—and others acrimonious—like breach or fraud. Accordingly, the parties should anticipate and negotiate terms for the partnership’s dissolution at the same time they settle other key terms, such as the economics and control rights, and include the agreed-upon exit mechanisms within the venture’s governing documents.
This article, the third in a three-part series on joint ventures, discusses exit strategy negotiations and common exit provisions that allow either party to initiate termination of the joint venture. The first article in this series discussed the reasons behind the growth of joint ventures and the benefits to both managers and investors; different types of joint ventures; and best practices for managers to avoid potential conflicts when entering into a joint venture. The second article described legal structures typically employed in joint ventures, regulatory obligations and common terms negotiated.
Reasons for Exiting a Joint Venture
Joint ventures can end for numerous reasons, most of them unexceptional, such as that an investment has run its course or the venture has attained a pre-specified amount of assets under management. According to Gould & Ratner partner Fred Tannenbaum, “The end point for a joint venture could be after a certain number of years or a certain number of investments or at a particular AUM threshold. I’ve seen the exit done in each of those ways, and it always comes down to the particular terms of the deal, the particular investment interests of the manager, and the investor and the assets themselves.”
Paul McCoy, a partner at Morgan Lewis & Bockius, noted that a joint venture’s time horizon can also factor into the timing of and rationale underlying an exit. “There is often a mismatch in the return time horizons of these joint ventures, and that needs to be considered when negotiating the deal. Many institutional investors are long-term hold players; as long as the asset is generating sufficient positive returns, then there is no reason to get rid of it. Fund managers, on the other hand, are investing other people’s money, and those other people often have finite timeframes for their investments to generate returns and exit the investment. That mismatch is often considered when negotiating the exit rights up-front when entering a joint venture, as the parties may have different feelings about exiting the position when the time comes.”
Certain “bad acts” can also trigger the termination of a joint venture. Edward Dartley, a partner at K&L Gates explained, “You could see termination rights because of SEC actions, but it really depends on the nature of the action. Terminations will usually come about in egregious cases and instances of fraud. Generally, investors want certainty that the rug will not be pulled out from under them if there is a breach of the agreement, and they want the comfort to know that if things go wrong they can get out of the deal.”
Negotiating the Exit
Sources who spoke with the Private Equity Legal & Compliance Digest concurred that it is essential for managers and investors to negotiate up front, and include in the joint venture agreement, the parameters of the joint venture’s eventual exit, because neither party can predict whether and how their relative bargaining positions will shift over time and whether and how the dynamic of the partnership will change. Exit rights and provisions should also be included in the joint venture agreement to provide greater certainty and so that both parties have contemplated and agreed upon, in advance, the steps that should be taken if one partner to the venture no longer believes it can fulfill its objectives, wants to monetize its stake or liquidate the assets, or if the investment has just run its course.
“You have to consider how the arrangement will end,” Tannenbaum advised. “These joint ventures never last in perpetuity, so you have to think about the logical end point.”
Robert Bodansky, a partner at Seyfarth Shaw, noted that joint venture agreements can cover a variety of exit scenarios, depending on the asset class and investment timelines. “There could be buy/sell provisions and, if no one wants to buy, there could be a forced sale. Some of these vehicles have a fixed duration, but it depends on the asset class and the investors’ horizon. These investors are often long-term investors, so they can be patient with investments. At the same time, they’re also opportunistic. If there is a good reason to sell early, they won’t hesitate to do so.”
JV agreements can even contemplate the details of an exit that occurs prior to the partners’ full investment of capital, said Paul Hastings partner Siobhan Burke. “You typically agree upfront how much capital will be deployed. The agreements can be amended to increase the capital commitment, but often once you get to the full investment of the capital there won’t be an expansion. There are generally mechanisms built into the contract to let one party or the other, or both parties, get out of the deal before there is even full investment.”
General Exit Rights
Cadwalader, Wickersham & Taft partner Dorothy Mehta explained that joint ventures typically include general rights to terminate the venture. “There might be termination rights for cause—some bad event occurred. Term Rights may not necessarily be triggered by a bad event, like fraud, however, but it could simply be that the joint venture has (or hasn’t) hit certain milestones, and the parties are separating, or if there are regulatory issues that come up that are beyond the control of either party, they might have a significant impact on the joint venture.”
“The manager may be able to terminate the arrangement if more than a certain number of deals have been rejected by the investor in a given time period,” Blayne Grady, a partner at Akin Gump Strauss Hauer & Feld, added. “Similarly, an investor might have termination rights if there isn’t sufficient deal flow over a certain period of time.”
More specific exit provisions negotiated and included within a joint venture agreement can include buy/sell provisions, removal of the manager, rights of first refusal, drag-along and tag-along rights, put rights and veto rights. Typically, the vehicle’s shareholder agreement, partnership agreement or limited liability company agreement outlines the appropriate exit mechanism(s).
Buy or sell rights detail the circumstances under which one or both parties can initiate sales or buyouts. Buy/sell provisions may stipulate, for instance, that the partner triggering the buy/sell agreement name a price, at which point the other partner must decide whether to sell its interest at that price or buy out the first partner at the same price. There may also be provisions that allow for a sale or buyout at a predetermined price or at a fair market value determined by an agreed-upon independent appraiser.
According to Grady, “One or both parties may have a right to trigger a buy or sell option in which one party will buy the other out of their interest in the joint venture. The party that initiates the buy/sell process will send an offer to the other party to buy the other party’s interests or sell their own interest to the other party.”
“There are often buy/sell provisions that outline [the price at which] one party is willing to buy and to sell, and the other party states their limits,” McCoy added. “It’s a good tool to keep things fair.”
Removing the Manager
Exit provisions can also specify the conditions and process for removing a manager with or without cause.
Bodansky said that removal provisions are fairly sensitive and often heavily negotiated. “Removal is typically for cause, although you do see removals without cause. If it’s a for cause removal, the GP will often receive a haircut or some other penalty for the wrongful conduct. If it’s a removal without cause, you need to find a way to take care of the sponsor, often by buying out its interest.”
Manager removal provisions are often narrowly drafted as well, Burke pointed out. “You may terminate the vehicle, or you could cease new investments and new capital commitments. These provisions will also outline the financial consequences for removing the manager or ending the agreement early.”
Rights of First Offer or First Refusal
Rights of first offer or first refusal are a fairly common exit provision joint venture parties negotiate. “One or both parties may have the right to first make an offer to buy the other party’s interest in the joint venture,” Grady explained. “Similarly, one or both parties may have a right to match any third-party offer to buy the other party’s interest in the joint venture.”
With the right of first offer, the solicited party can seek a third-party buyer. If the third party offers a price equal to or less than the soliciting partner’s offer, the interest must be sold to the soliciting partner at the original asking price. With the right of first refusal, one or both parties may have a right to subsequently match any third-party offer to buy the other party’s interest in the joint venture.
Drag-Along and Tag-Along Rights
Drag-along and tag-along rights are also common exit terms in joint venture agreements. The drag-along right allows one partner to cause a transfer of all of the interests to be sold, including those of the other partner or partners, without the consent of the other partner(s). With drag-along rights, the selling party can only do so if the co-venturer is included in the deal and gets the same price.
Pursuant to tag-along rights, if one party intends to sell, the second party can force the first party to include it in the sale and obtain the same benefits and price.
“You may see one or both joint venture partners have the right to ‘drag’ the other member into a sale of the interests in the joint venture, where the partner being dragged into the sale would be required to sell its interest in the joint venture on the same terms that the other partner who initiated the sale is selling its interests,” explained Dartley. “With a tag-along, the party with the right to ‘tag’ gets the benefit of the sale of interests in the asset at the price that the other party received. This prevents the other party from having a new partner that it doesn’t want to enter into a joint venture with.”
Some exit provisions include put rights, Dartley said, that allow the partner exercising the put to require the other party to buy the putting party’s interest in the joint venture. The sale price of the “putting” party’s interest is often based on a fair market value determined by a third-party appraiser.
While some joint ventures anticipate and set the terms for buying or selling interests in the JV, some prohibit sales and include veto rights allowing the parties to reject any proposed sales, or sometimes even additional investments beyond those originally contemplated in the JV agreement.
According to Tannenbaum, “There may be veto rights, so managers cannot just sell assets at will, but must get investor consent to do so. While the manager generally has the right to manage the investments in accordance with the strategy of the venture and its investment mandate, the investor will sometimes retain some right to veto certain types of investments, although these rights are highly negotiable.”
Some exit provisions include various restrictive covenants limiting the joint venturers’ investment activities after the joint venture ends. Mehta explained, “In addition to exit provisions, 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.”