Managing joint venture investment assets involves some additional complications not found in asset management for traditional mortgage debt.
The difference lies in two key areas — in the nature of calculating and tracking preferred returns and in the fact that the equity investment sits in the first loss position.
Let’s look individually at these issues and highlight some of the solutions.
Preferred Return Calculations
Unlike loan interest, which is easily tracked using industry agreed-upon methodologies and multiple commercially available loan servicing systems, preferred equity and the waterfall structures in joint venture operating agreements can come in an infinite number of structures.
While many waterfall structures contain similarities, each is individually negotiated. If the sponsor and the limited equity partner are not on the same page on how the calculations work, there can be enormous discrepancies in the cash split calculated by each party.
Here are just a few ways in which miscommunication can lead to discrepancies:
- Not specifying the accrual period of the preferred return (monthly, quarterly, annual)
- Using the basic Excel function for internal rate of return versus the more complex XIRR function that accounts for irregular cash flows
- Not establishing when the cash is considered to be invested — is it at the commencement of the deal or when the cash is actually contributed?
- Not clearly defining the details of “promote” distributions to the sponsor.
To achieve agreement with the sponsor from the outset and on an ongoing basis, there are a few basic remedies.
First, address potential conflicts in the operating agreement. The joint venture operating agreement should provide detail on the potential pitfalls just listed and include an example of exactly how the preferred return is calculated and how the waterfall works.
Next, on a monthly or quarterly basis, the asset manager should provide statements detailing the accrued preferred return for each partner in the deal. Note that most commercial loan servicing systems cannot fully track the complexities of preferred returns and waterfalls and often produce inaccurate “payoff statements.” Most sponsors will use Excel to monitor the deal, and it works best if the joint venture partner and everyone involved uses the same spreadsheet format from the outset.
Obviously, senior debt carries principal risk, but in order for the asset to be impaired, all equity must be wiped out. Further, there is typically no obligation for a senior lender to provide additional funds to the project in the event of a property-level issue. Managing the need for additional equity contributions requires a more hands-on approach than you might otherwise see with a typical loan structure.
The goal of active asset management is to head off trouble before it begins. These are the kinds of measures that can aide in identifying potential problems and mitigate risk:
- Business plan tracking
- Monthly sponsor calls
- More frequent site visits
- Monthly asset management reports that track past, present and future monthly action items and highlight “red flag” issues
- Quarterly valuations
Valuing a joint venture position is more complex than valuing a loan, since any fluctuation in the underlying property value and the timing of collateral sale will dramatically affect the recovery amount.
For example, a $50 million loan is worth roughly that same amount to the lender whether the underlying collateral is worth $75 million or $100 million. But for an equity investment, a considerable amount of data is needed to determine value, including the amount and terms of the existing debt, the amount and timing of remaining capital contributions, the hurdles to reach the preferred return, and the specifics of the project’s promote/waterfall structure. Maintaining dynamic models that account for these variables will allow for a quick calculation of cash flow distributions.
In summary, joint venture equity investments require active asset management from pre-closing through disposition to ensure partnership alignment and loss mitigation. CBRE offers a full-service third-party underwriting and asset management platform specializing in complicated transactions. For more information on our services, visit us at www.cbre.us/assetmanagement or www.cbre.us/underwritingadvisory.