The joint venture (JV) model is a popular choice among investors for structuring their investments into hospitality and leisure (H&L) assets. Investors who have access to capital (e.g., institutional investors, private funds, sovereign wealth funds, or family offices and high-net-worth individuals) but who may struggle to source investment opportunities or operate H&L assets on their own will often partner with operators (e.g., branded hotel operators or white-label hotel and asset managers.) who have the resources and expertise (including in particular markets and/or geographies) to source investment opportunities, arrange debt finance, and manage hotel operations, but they may (i) lack the material capital required to access high-quality investment opportunities or fund any required capital expenditure or development on their own or (ii) not be interested in investing material capital directly into the H&L asset.

This article sets out the key considerations for both operators and investors when establishing programmatic JVs in the H&L sector. The aim is to equip both parties with a framework for thinking about the shape of the key JV terms. Note that, for the purposes of this article, we are considering only 95/5, 90/10, and 80/20 style JVs between investors and operators (investor/operator JVs).

1. Funding

a. How will the parties split the JV equity funding requirements between them?

Investors will generally expect operators to have some “skin in the game” in the form of the operator having a minority equity interest in the JV and thus being responsible for a proportion of the equity funding required for the investment program and/or any development project as well as the JV’s operating expenses. It would be typical for the operator’s equity interests in the JV to be treated as being on equal footing with the investor’s equity.

b. Should the parties’ respective equity commitments be capped?

Parties may agree to a fixed-equity commitment from the outset or otherwise commit only to fund amounts that they have agreed on from time to time (including by reference to an agreed business plan and/or budget). Where there is a fixed-equity commitment, it is also standard for it to be capable of being drawn only during a fixed-investment period. In such a case, the parties should consider if any funding requirements — e.g., funding to make follow-on investments, complete “in-progress” transactions, or fund JV operating expenses or emergencies — should be capable of being drawn against the parties’ respective undrawn equity commitments after the investment period. If the parties’ funding obligations are determined by reference to a business plan or similar, the parties should consider whether the approval of any updates to the business plan (or, at the very least, any updates that increase any such funding obligations) should be subject to the parties’ unanimous approval.

c. What are the consequences of a party failing to fund its share of any equity funding?

Generally, if a party fails to fund its share of any equity commitment drawdown, the other party should have a right (provided it funded its own contribution) to fund the shortfall by way of a priority loan (typically at an interest rate that is greater than the market rate), with the payment of interest and principal having priority over other distributions to the parties in the JV’s distribution waterfall. Another consequence could be a dilution (i.e., typically more than a 1:1 dilution) of the non-funder’s equity interest in the JV. Additionally, a funding failure may also be treated as an event of default and give the funder certain contractual rights and remedies (e.g., damages for breach of contract) or trigger expressly agreed-upon default provisions against the non-funder (covered below).

2. Governance

a. How are roles and responsibilities allocated among the parties?

The operator is typically responsible for day-to-day operational activities under a separate management agreement between it and the JV. Such activities will generally include preparing and regularly updating the business plan, sourcing investment opportunities, sourcing debt finance for any investments or developments, and interfacing with a franchisor or third-party hotel manager (as applicable). Control of the JV-level board will typically rest with the investor (as majority owner) with certain key decisions (reserved matters) requiring the joint approval of both parties (as protection for the operator as the minority equity partner in the JV).

b. What types of decisions should be reserved matters?

These will usually include sale/acquisition of the asset(s) (sometimes limited to a sale of the asset at an undervalue versus the latest fair market value or on non-arm’s-length terms); entry into, variation, or termination of any third-party franchise agreement or hotel management agreement; incurrence of any third-party debt financing; material capital expenditures relating to the H&L assets; altering the capital structure of the JV; and winding up or effecting any insolvency procedure in respect of the JV.

c. How to resolve any deadlocks on reserved matters?

Most deadlock resolution mechanisms will provide for referral of a deadlocked matter to each party’s senior executive(s) for resolution. If the senior executives are unable to resolve the deadlock, there are few possible options for escalation, including:

1. Maintaining the status quo (that is, the parties take no action in relation to the reserved matter).
2. Either party having the right to require the other party to either buy out the offering party’s interests in the JV or sell its interests in the JV to the offering party on the same price per unit.
3. The investor having the right to terminate the operator’s appointment and buy out its interests in the JV for a price equal to the then-fair market value of such interests.

3. Liquidity

a. Should transfers to third-party investors be permitted?

Generally, transfers to third-party investors are restricted other than in the following scenarios:

1. The investor is typically permitted to transfer all (or sometimes any part of) its interests to any third party with the ability to drag the operator into any such sale on the same or substantially the same terms as the investor receives from such third party (such that the investor can sell 100% of the JV to a third party, if it elects to do so). Even if the investor elects not to exercise its drag right, the operator will generally have the ability to tag along on any such sale on the same or substantially the same terms as the investor receives from such third party; this is built in as minority protection for the operator against the risk of being in a JV with a new third party with whom it may not want to co-invest.
2. In some cases, if the investor wishes to sell its interests, the operator may also have a “right of first offer” over the interests to give it a chance to buy out the investor before the investor is able to sell its interests to a third party. The operator may also have the ability to bring in new third-party equity capital so that the operator may replace the departing investor with a person of its choosing. The investor will usually have an equivalent right opposite the operator.
3. If the operator is terminated as manager of the JV in a nondefault scenario, the investor will typically have the right to buy out the operator’s interests at fair market value. The operator will also typically have the ability to sell its interests to the investor at the then-fair market value. This allows for a termination of the arrangements between the investor and operator (i.e., the management appointment and operator’s equity co-investment) at the same time (if the investor or the operator wish to do so).
4. Both parties will typically have the ability to transfer their respective interests to their respective affiliates without needing the other party’s consent.

b. Should there be a lock-up period during which each party is restricted from transferring its interests in the JV to a third party without the other party’s approval?

Parties may include a lock-up period during which both parties are fully restricted from transferring their respective interests without the other party’s consent (other than in the case of a transfer to an affiliate). The benefit of a lock-up period is that it underscores the parties’ commitment to the JV, which ensures stability and creates better alignment.

4. Default and Remedies

a. What are the typical events of default?

These will include fraud or other criminal acts, a material unremedied breach of the JV agreement, insolvency, and/or an unsanctioned change of control of any of the parties. In the case of the operator, this will also include a cross-default under the management agreement and/or any key persons ceasing to be involved in the operator’s business.

b. What are the consequences of a party committing a default?

As a baseline, a defaulting party would be liable to the other party for actual damages under law. However, that may not be particularly useful because the other party will likely be a special purpose vehicle without any other assets, so other contractual remedies may include the right to acquire the defaulting party’s interest at a discount to its fair market value; disenfranchisement — i.e., a suspension of the defaulting party’s governance rights (including the reserved matters regime); offsetting any losses against distributions otherwise payable to the defaulting party; and/or, in the case of the operator, the forfeiture of any promote/performance fee.

5. Promote/Performance Fee

a. How will any promote/performance fee be structured?

It is commonplace for operators to receive an enhanced share of the JV profits once the investor receives a minimum return. The share of profit and minimum return is a matter for the parties to agree on commercially, but the parties should also consider whether the promote/performance fee will be paid on a “deal-by-deal” basis (i.e., a percentage of the profits of each investment on a stand-alone basis based on the cash flows relating to such investment) or a “whole-of-fund” basis (i.e., a percentage of the JV profits based on the cumulative cash flows of all the JV’s investments). If the promote is being paid on a whole-of-fund basis, is it being paid “as it earns” (i.e., as soon as the investor’s investment has been repaid and the minimum return is achieved, notwithstanding that there may be unrealized investments in the JV) or “back-ended” at the end of the life of the JV once all unrealized investments have been sold and the resulting proceeds have been distributed to the parties.

b. What are the protections for promote overpayment?

In the case of a whole-of-fund model, in which promote accrues and is paid prior to the realization of all investments, it is common to have either a promote clawback mechanism (whereby the operator undertakes to repay any promote overpayment) or an escrow mechanism (whereby a portion of any accrued promote is held in an escrow account until all unrealized investments have been sold and the resulting proceeds have been distributed to the parties).

6. Exclusivity and Other Restrictions

a. Should the investor have exclusive access to the operator’s pipeline of investment opportunities?

It is increasingly typical for investors to seek exclusive access to an operator’s pipeline of investment opportunities in exchange for their equity commitment. This right will typically:

1. Be limited to H&L assets that satisfy pre-agreed investment criteria (instead of a general right of first refusal over any investment opportunities that the operator has access to).
2. Terminate if the investor rejects a specified number of such investment opportunities presented to it.
3. Exclude existing H&L assets that the operator owns, manages, or otherwise has any interest in.

If the investor rejects any such opportunity, the operator is usually free to pursue it (whether on its own or with others). Some established operators may also seek reverse exclusivity rights from investors prohibiting the investors from entering into JVs with (or appointing other operators to execute) a similar strategy to their JV.

b. What other restrictions should the parties consider?

In addition to confidentiality restrictions that would apply to both parties, investors may also seek to restrict the operator from acquiring, managing, or having any interest in any H&L assets that compete with the JV’s H&L investments (including any rejected opportunities presented to the investor under any exclusivity arrangement — see above). There is a risk of overly broad restrictions being legally unenforceable, so the parties should ensure that these are carefully drafted to be limited as to duration, geographical scope, and type of H&L investment and only to the extent necessary for the protection of the economic activity of the JV.

Parties entering into investor/operator JVs should take great care at the beginning of the transaction to carefully outline and agree the terms of their partnership to ensure the seamless running of the investment/project during the life of the JV.

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