One on One: Getting to Yes: Developers and Investors at the Negotiating Table
The following was distributed as part of the Real Estate Private Equity Fund - First Quarter, 2014 newsletter.
When looking at commercial real estate transactions from 30,000 feet, it's easy to forget that each investment in each project is the result of a complex dance between investor and developer – and that for each deal that actually closes, there are many more that fall by the wayside.
In order to get a better idea of the issues that arise when equity partners and operating partners are crafting an agreement, the CohnReznick Real Estate Private Equity Fund Quarterly Review sat down with Ronald A. Kaplan, Northeast Leader of the Firm’s Commercial Real Estate Practice and veteran advisor to a broad array of complex deals.
Even though every deal is different, are there certain things that you see coming up again and again at the negotiating table?
Definitely. Operating partners and equity partners are both focused on creating value, but their perspectives are different, and that creates tension. An obvious example is in the term of the joint venture. A lot of operating partners basically just never sell—their relationship with the project runs that deep. There's a reason that many of the great real estate firms are second- and third-generation enterprises. Most equity partners, on the other hand, are going to want a concrete exit strategy after three to five years. They are completely focused on balancing liquidity with maximizing return for their investors.
Another issue is control rights—who gets to decide things like when to refinance and under what terms, or anything else that might go beyond day-to-day management issues. Operating partners are wary of giving equity partners too much of a say here. Changing economic or industry conditions can call for decisive action, and operating partners don't want to be forced into making strategic decisions by committee. In their view, their expertise in handling big-picture issues is central to what they are bringing to the table.
What about the money? How do the two sides differ when it comes to who gets what?
Return to the partners plays out both above and below the line. Above the line, in some cases both sides typically want to collect asset management fees. Below the line, it's a question of the distribution waterfall. Initially, both sides get whatever return on investment was originally agreed upon, and then a return of capital. But in subsequent distributions, there is room for negotiation. For example, if you start off with a 90/10 split, matching the split in the project equity, once a certain internal rate of return has been reached, a promote will commence where that split can shift to 80/20 or higher as returns increase. Figuring out how to structure those shifts can be a key point of discussion (and contention).
Obviously, your perspective is as an accountant and advisor. What are the key accounting issues that come up during these negotiations?
Well, the first question is whose accountant gets used. And that same question plays itself out with regards to choosing lawyers and other professional services providers. Each side wants their own people; but that also provides natural room for compromise.
But even if the operating partner get to pick the accountants, the equity partner will have non-negotiable requirements regarding financial reporting that the operating partner, depending on their experience and their own practices, may find difficult to fulfill. For example, it's common for equity partners to require monthly reporting, but it’s rare for operating partners to generate financial information that frequently. A lot of operating partners end up outsourcing some of their internal accounting processes to give them the extra capability they need.
You've been involved with hundreds of deals between investors and developers. What advice would you give to minimize the chances of things falling apart at the table?
Operating partners need to accept that overall, the balance of power is in the equity partners' favor—they've got the money, and they are going to set the requirements attached to the capital. At the same time there is room for negotiation. So operating partners need to really pick their two or three most important issues and stick with those. Most developers place the highest priority on control provisions—they know that is the provision that will affect them the most on a day-to-day basis, so that is the area they will focus on.
For more information, please contact Ron Kaplan, Partner, at 646-834-4179.
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