In ebullient economic cycles, when capital and good cheer is plentiful, the ease in structuring and managing investment partnerships can be taken for granted. But in more uncertain times like now, when many deals are cash constrained, under-performing their original pro forma projections, and/or experiencing significant value erosion, the tensions rife in joint ventures quickly bubble to the surface and raise questions about how limited partners and general partners should be responding to protect their collective financial interests. A panel of experienced GPs and LPs shared their observations on the current state of joint venture partnerships at the IMN’s 2024 Winter Forum on Real Estate Opportunity & Private Fund Investing.
Matt Field, Co-CEO of Bay Area development firm TMG Partners helped frame the current environment to the audience. “I think this is a year where we’ve seen the contraction has been from our equity partners, where the illiquidity really hits every part of the capital stack. Debt funds have back leverage. All of a sudden that starts constraining things. We have equity partners who are making fund level decisions where they can’t call more capital. And so, we’re seeing really the backup in the capital stack start to affect the ability to make asset level decisions. The speed at which that happened…Obviously, it’s the fastest rate rise ever. I’ve been doing this since the mid -80s and it feels like it’s sort of a Frankenstein cycle. It’s a mix of a bunch of different cycles but it feels very much like the early 90s and the illiquidity which caused a completely different set of operating decisions if you’re having to make when capital is no longer available in the abundance that it was.”
Bow River Capital’s John Layton concurred with Field, explaining that the rapid rate hike had effectively brought the Denver-based investment management’s development pipeline to a grinding halt. “We hit pause on all development efforts. And so, I think the unexpected challenges, of course, has been just navigating this rapid change, you know, not just from a fundamental perspective of having to do what’s best for the real estate, but also having to manage with our partners to navigate this in a way that is kind of sharing in the pain together. And avoiding foot faults to make sure everyone remains motivated to do everything that they can to keep the real estate on track, on budget.”
The goal sounds simple but is easier said than done. While LPs increasingly find themselves being beckoned to contribute fresh capital to legacy transactions, they’ve been very hesitant to comply. Lynn King-Tolliver, founder of advisory firm Archere Investment Management explained how this is impacting GPs in real time. “I sit as an independent investment committee member for one of the world’s largest investment managers. They are looking at the choices they have to make and calling back defensive capital where they have commitments. That’s a really interesting position for a GP to be in because if we look at a lot of the terms in those agreements, they’re all to the benefit of the LP, assuming that the LP would be able to fund when the market conditions got tough. And so now, we have to say what are the options and what are the implications to a GP if the LP doesn’t fund? Who has the bank guarantees? I think those are some really interesting challenges that were not at all anticipated, because this is a very different set of challenges we’re seeing in the market when the bigger pocket has a very solid reason not to fund and not to make that capital available.”
Lynn-Tolliver also adeptly noted that sometimes JVs become more complicated when the strength of the underlying relationship between GP and LP is tenuous. “We have a whole group of professionals who are just coming into their mid-career cycle. So, if they started after the GFC, they saw the market steadily going up. When we talk about workouts and negotiating these agreements, this is the first time they are experiencing some of that disruption in the market. From the GP side, the relationship needs to go deeper than your frontline deal person, or the analyst you talk to. But do you have a relationship up the line inside the LP organization, so that you can, principle to principle have a conversation. Have you established that?”
Brandon Wang of Lincoln Property Company agreed with the panel, but also argued that partnership challenges could translate into new opportunities for firms like his, which has broad visibility and access to distressed sponsor groups. “The LP capital over the last 24 or 36 months has really dried up. I think what we’re pivoting in terms of strategy now. We’ve really been focused on distress and really attacking the economy, kind of from a servicing perspective. Through the GFC, we were operating roughly 50 million square feet, and I think we picked up roughly 10 million square feet of distressed servicing last year. And so, we’re hoping that that ultimately turns into a capitalist solution pipeline for us, where equity now, given the cost of capital, is looking for upside with protection. And so, we’re able to be the special capital asset solution, where we’re coming in at a reset basis, we’re providing go forward capital, we’re getting a priority return on that, and that’s putting proceeds above and beyond the principal balance.”
Despite Wang’s optimism, it was clear at least up to this point, most capital has still been very cautious. Jim O’Brien of investment bank Baird put it bluntly. “On the advisory side, 2023 was a very, very difficult year. I mean, I’ve been doing this for 23 years and it’s probably been one of the more difficult years we have had. We were busy, but not busy making money.” But he did have one silver lining to add. The challenging dynamics of the market had forced a level of creativity in deal structuring that was largely lacking when interest rates and values were less of a concern. When describing 2023 transactions that did close, he stated, “In each case, there was a need to be creative and do something structurally that was unique.” Case in point, he described a programmatic JV venture with a typical 90-10 LP/GP split, where the LP received warrants that could translate into as much as a 20% interest in the GP operating company. “It really allowed that LP investor to juice their returns and create, as John (Layton) mentioned, this alignment of interest, where they weren’t just at the asset level, but they were also aligned at the operating company level.”
O’Brien’s example brought to light a critical roadblock complicating JVs today. The deal-level returns currently available to LPs are seldom high enough on a stand-alone basis for them to justify investing fresh capital. Field expanded on the point. “Equity returns have to be substantially wider than they were historically. You can’t have value add multifamily returns at 13-14% and credit ends at 14%. You’re not going to take any equity risk. So, we’re seeing situations where the equity returns just really aren’t working, which means you really need to re-structure where that equity is coming in at in the capitalist stack.”
Fortunately, Field also observed that lenders were beginning to show more flexibility in re-restructuring debt, which would eventually facilitate an influx of fresh JV capital. “We’re finding a lot more flexibility around this discussion,” he said. “I would say this is really, really current. Two and a half or three months ago that was not happening. Debt really thought it was safer than it was. There was a lot of sense that the interest rate rises were transitory and therefore cap rates were up for the short term, but not for long term. I think today most people are viewing the Treasury nudging in the 4% range long-term, whichever side of the trade you want to be on, whether you think it’s in the mid 3% (range) or mid 4% (range), the spread you need means cap rates have to be much wider.”
One creative way equity investors are attempting to hit their return targets, is by pursuing hybrid preferred equity positions that offer both a fixed interest component and upside. O’Brien explained. “With the market today, also seeing situations where you might have somebody make proposals for a 18% coupon on a preferred (equity investment), then another one may be 12% with a participation involved. So, we are seeing more of a 20% participation or 10% participation on preferred equity structures, to be able to hit coupon amounts that are that are being proposed to these investments. There is this level of creativity in terms of thinking about what the scale is, high coupon, no participation, or low coupon participation. Three or four years ago that wasn’t the case.”
When probed about what LPs look for in a potential GP partner, Layton explained that reputation is key. We underwrite our sponsors more than the first deal that they show us. It’s probably 90% sponsor and 10% deal on the first one. One of the biggest things we will do is reference checks and that can be previous partners. Another local way if you’re not in that market or don’t know much about the sponsor is lenders. I can’t tell you how many deals we’ve passed on because we’ve called major lenders in the area, and they said they would not bank that sponsor. That’s just an immediate pass.” He also focuses on the strength of a GP’s balance sheet and how much capital the members of the GP are personally contributing, to ensure strong alignment.
One of the biggest mistakes a GP can make when choosing a LP partner, Field argued, is being too short-sighted. Having a firm understanding of their orientation and ability to digest and work through problems is not a luxury but a necessity. “We’re definitely thinking about a relationship as opposed to a deal,” he said. “You go through a lot of pain and suffering to go through a JV agreement, and they’re sort of set up like prenuptial agreements. What’s going to happen when things go wrong? If you ever do pull out that agreement, things are toast. The relationship is burned. So, we’re really looking for people that are smart real estate investment focused as opposed to just financial capital, because real estate deals tend not to go exactly as they pro-forma. Folks with track record, where we can go reference check people. We are worried about people changing seats in some of these places because what happens is you make a deal, someone leaves, and the next person picking up that deal doesn’t have any ownership.”
He went on to illustrate the type of flexibility and reasonableness that creates mutually beneficial outcomes. “We had a partner in a deal where we had a waterfall, and it became pretty obvious we were getting mis-aligned. Our partner was going to be incentivized to take a lower, rent, higher credit deal and go for safety and cover themselves. We were going to be more inclined to take more risk on credit and take more structure. We sat down, observing this happening, and eliminated the waterfall and went to a hard split It fundamentally changed how the deal was working. It was a high 70s IRR deal. We left some money on the table. And they gave up some safety. We did multiple deals after it because of it. It really was about both of us being willing to acknowledge what was going on, being honest and transparent, and give up something. You never what’s going to happen. But you do know it will be different than what you thought it was at some point. And you’re going to need to figure out how to stay aligned.”