It is common to find financial investors forming joint ventures with business operators. The financial investor provides the capital, and the operator provides the industry expertise to manage the joint venture. Since the financial investor relies on the operator to run the business, one key consideration for the financial investor is incentivisation. What is the most efficient way to motivate the operator to maximise the profitability and performance of the joint venture?
Incentivisation is particularly problematic for the financial investors of a new breed of joint ventures: the single-project asset finance joint venture company (the “SPAF JV Company”). Part of the difficulty lies in the unique features of the financial investor, being its:
• non-exclusive relationship with its joint venture partner (ie both parties can engage in competing businesses alone or with other parties);
• majority stake in the joint venture coupled with long investment horizon;
• preference for passive management; and
• lack of industry expertise.
This article examines the effectiveness of common incentive mechanisms in the context of SPAF JV Companies and, in doing so, provides insights into incentivisation which also inform other types of joint ventures.
Unique Features of SPAF JV Companies
The SPAF JV Company is a relatively recent creature that evolved from the traditional financial leasing model for asset finance. Under the traditional model, a financial leasing company finances an operator’s acquisition of certain operational assets (such as vessels and aircrafts) by acquiring such assets itself and then leasing them to the operator. The operator has operational control over the assets, and bears the profit and loss from its operation of the assets. The financial leasing company relies on the rental income from the operator to recoup its acquisition cost and to gain a return.
As financial leasing companies come under increasing pressure for higher returns, many PRC financial leasing companies are turning to the model of SPAF JV Companies. Under this new model, the financial leasing company (ie the “financial investor”) forms a joint venture company with an asset operator or its affiliate (ie the “operations investor”). Both investors pool their funds together to acquire operational assets through the SPAF JV Company. These assets are managed by the operations investor for the SPAF JV Company. The SPAF JV Company is “project-specific” in the sense that it is set up to own and operate only the assets acquired through the joint venture and there is an assumption that these assets will be solely managed by the operations investor for the company.
In principle, this structure increases the returns for the financial investor by reducing its acquisition cost and allowing it to participate in the operational profits. However, since stable rental income under the traditional model is replaced by less predictable returns, the new model also increases the risks for the financial investor. Therefore, it is imperative that the financial investor has control over the business and is able to monitor and/or incentivise the operations investor.
Although financial investors typically have considerable control over the company through its majority stake, financial investors usually distance themselves from active management because active management increases their costs and thereby affects their returns. This is particularly true for financial investors who have a portfolio of SPAF JV Companies. Further, financial investors who are commercial banks simply may not have the expertise and personnel to manage the operations efficiently.
The financial investor’s need to minimise management costs and its lack of expertise have an important implication for the governance structure. Instead of mechanisms that focus on monitoring the operations investor, financial investors prefer mechanisms that incentivise the operations investor to maximise the performance of the joint venture.
Incentivisation through Shareholding
Many financial investors will tell you that, one of the main reasons for them to use a corporate vehicle for the joint venture is to incentivise the operations investor by giving it skin in the game. By virtue of its shareholding in the company, the operations investor will reap the rewards of a successful business and suffer the consequences if it is poorly managed. Whilst shareholding serves as a simple and effective incentive measure in most cases, there is one important factor in SPAF JV Companies which may weaken this incentive.
Most joint venture agreements contain non-compete provisions that restrict the shareholders from competing with the joint venture company. Similar non-compete provisions are, however, absent in the joint venture agreements of most SPAF JV Companies. This is not an oversight. The absence of non-compete restrictions stems from the fact that the parties still view the joint venture primarily as a financing vehicle. The parties intend the joint venture assets to be managed together with other assets owned or operated by the operations investor, because this would result in more efficient management and use of the assets. Take the shipping industry for example. The vessels acquired by the SPAF JV Company will usually form part of the existing fleet which is managed by the operations investor outside the SPAF JV Company, so that the combined fleet would have a greater market power, and benefit from economies of scale and volume discounts. Seen in this light, the “competing” business of the operations investor is in fact one of the bases of the joint venture.
From an incentivisation perspective, however, the operations investor’s other business lessens its dedication to the joint venture. Since the SPAF JV Company is only one of its sources of income, the operations investor is likely to favour the business that gives it the largest share of the profits (all other things being equal). Without non-compete restrictions, the more lucrative business could, for example, be taken up by the operations investor’s self-owned fleet so that it enjoys the entire profit.
Since shareholding, by itself, may not provide sufficient incentivisation, the financial investor needs to add further incentives to motivate the operations investor.
The pressure on financial investors to secure at least a certain rate of return has led them to consider incentivising the operations investor through a profit guarantee mechanism. In essence, the operations investor guarantees the performance of the business so that the financial investor attains a certain level of returns from its investment in the joint venture. Profit is guaranteed in the sense that, if the performance target is not met, the operations investor may be liable for the shortfall or have its shareholding diluted.
Profit guarantee mechanisms are likely to encourage short-termism and create perverse incentives that could be detrimental to a company’s long-term prospects. For example, extensive cost-cutting maximises the short-term profits but creates potential safety hazards and may stunt future growth. The pressure on the operations investor to either perform or be penalised increases governance risks such as accounting malpractice. This in turn increases the financial investor's monitoring cost.
The mere fact that profit guarantees are common in the private equity context does not mean that they are appropriate for SPAF JV Companies. Private equity investors are relatively insulated against the long term effects of short-termism because they typically exit after three to five years. Financial investors of SPAF JV Companies, however, tend to stay for the medium to long-term. Hence, they are more likely to bear the negative long-term effects induced by profit guarantees.
Short-term Performance-linked Incentives
This is not to say that short-term incentives should never be used in SPAF JV Companies. They may prove useful for incentivising the operations investor over a short, but critical, period of the company’s development. For example, when the joint venture is breaking into new markets, the parties may put in place incentive mechanisms to encourage the operations investor to devote more effort during this crucial phase.
At times, it may be necessary to create short-term incentives on an ad-hoc basis in response to market conditions. In these circumstances, one option would be to introduce them into annual/short-term management contracts between the SPAF JV Company and the operations investor when these contracts come up for renewal. This kind of management contracts can be regarded as related party transactions for the SPAF JV Company and raise problems of their own. The issue of related party transactions will be discussed in a separate article.
Long-term Performance-linked Incentives
Short-term incentive mechanisms usually benchmark the company’s annual performance against the target net income, EBITDA or other metrics agreed in advance between the parties. This may not be feasible for long-term incentive mechanisms given the sheer difficulty of agreeing on the annual benchmark figures over a long period of time. Fortunately, there are other ways to structure long-term incentives.
One option would be to establish a dual-class share capital structure. As a long-term incentive measure, the share capital of the SPAF JV Company could be structured so that the holder of one class of shares has priority over the holder of the other class of shares when it comes to payment of dividends and distribution of company assets.
In its simplest form, the financial investor holds one class of shares (say, Class A Shares) and the operations investor holds another class of shares (say, Class B Shares). Distributions are first made to the holder of Class A Shares (ie the financial investor) until it receives an amount equal to its annual target return.
After that, distributions are made to the holder of Class B Shares (ie the operations investor) until it receives a certain amount. To strengthen the incentive, any surplus could be distributed to the operations investor only (instead of pro rata to all shareholders).
The order of payment and the right to receive the surplus amount increase the incentive for the operations investor to maximise profits so that it would receive a (higher) return. Further, since the share capital structure is likely to remain in place throughout the life of the company, it encourages the operations investor to consider both the short-term performance and the long-term development of the company.
Having said that, parties need to balance the benefits of a dual-class share capital structure with the cost and complexity of setting up and administering such a structure.
Every incentivisation structure has its strength and weakness. Therefore, instead of relying on one single incentive, financial investors should consider combining different incentive mechanisms to achieve maximum effect.
The author is very grateful to Ms. Hannah Ha, partner of Mayer Brown, for her careful review of this article.