Mustafa Hussain

Halos and wings, but no angels

Mustafa Hussain details the incongruities between aspirations and practice in joint ventures.

What keeps private clients up at night? The answers may include relationships, risk, returns and other concerns. But prime among these nightmares is the fear of falling foul of that proverbial ‘rags to riches and back again’ tri-generational cautionary tale.

Such fear pushes some private clients to diversify investments and pool their risk with like-minded others. After all, being a club member empowers you to make more friends, split costs and access more attractive opportunities.

The preoccupation is to avoid the family ending up in those metaphorical rags. However, in steering towards the comfort of a sartorial status quo, negotiating the right terms with business partners is also key. In the absence of befitting legal precision addressing the expectations of private clients in entering such joint ventures, clients may find themselves acting on a wing and a prayer.

Two phenomena illustrate the incongruity between aspirations and practice:

The halo effect

This phenomenon accounts for how clients are positively influenced by their previous observations, impressions and judgements. This affirmative bias sees them assuring themselves that past performance evidences future success.

By way of illustration, consider a successful European theatrical production that desires to tour globally. The theatre company requires capital and a local sponsor to open the door to the Middle East. A senior Gulf-based mercantile patriarch with a successful track record in industrial sectors agrees to invest, in consideration of exclusive rights in the region. A joint venture can be used as a vehicle for this private client to channel the corporate finance and enter into agreements with the company.

Through the lens of the halo effect, the creative directors anticipate a silent partner, who will meet drawdown requests on time and in full and who will support the resolution oflocal ‘roadblocks’. The halo effect also sees the investor count on returns (commensurate with those of Europe), the kudos of associating with the show/its stellar circle (supporting a sense of’arrival’ on the international scene) and achieving diversification.

In the absence of the aforementioned contractual precision, the halos can be quickly eclipsed. The second phenomenon aids us in understanding why.

The butterfly effect

The butterfly effect refers to metaphorical theories best explained by an example. The tiniest flutter of a butterfly’s wings leads to a gust of air that builds to wind that swells to a storm that intensifies to a hurricane that wreaks havoc. Interconnectivity sees a negligible transpiration producing an incommensurable ultimate force.

In our example, the patriarchal investor may assume that, since he has strong relations with the theatrical directors, this will transmute into the executives in his private office and those running the company collaborating efficiently and getting along. That may not be the case.

As a family patriarch, he puts family first. In practice, this could, and frequently does, result in the company receiving requests to employ family members wishing to ‘dip their toes’ into the showbiz pool. Such requests might be divorced from the suitability or eligibility of the candidate for fulfilling that role.

Patriarchs are almost as used to hearing ‘yes’ as showbiz divas are. Seemingly abstract requests for performers to adjust flesh-revealing costumes (to meet the modesty requirements oflocal culture) or adjust storylines that portray the Gulf region in a negative light (not to mention the eradication of content offensive to religious morality) may seem reasonable to the host, but bring perplexing and creatively, as well as practically, insurmountable challenges to the company.

In reality, outlandish requests for ‘my daughter to have the Harry Potter actor at her birthday party’ or ‘tickets to the premiere for 700 of my friends’ may be resolvable. However, fundamental amendments to the tried and tested business model, which assures the profitable results that lead to the halo in the first place, can be deeply problematic. 

The nature of the strong personalities on all sides can see cultural sensitivity slip in favour of entrenched positions. One side of the venture wants to maintain end-integrity. The other side cannot be associated with a project that causes loss of face or local offence. Ironically, local controversy could jeopardise the core sources of the private client’s income, thereby defeating the objective of diversification.

The halos, so prevalent at the outset, fade when a request builds, butterfly-effect style, to a chaotic end esult that can be destructive of profits and relationships.

How can practitioners help?

Do not skip due diligence, even if handshakes occurred in a social setting. Also, have as detailed a term sheet as circumstances allow. If something is not right, walking away early trumps limping away later.

If the investor is in a jurisdiction that has foreign remittance controls, or if they have a large variance in their liquidity, provide for fulfilment of drawdown requests to be late or appropriately rescheduled, rather than switching straight to default.

Do not permit the principal’s passion to distract the appointment of non-executives, and ensure they have information access. Avoid shadow directorships, which are a real risk with principals who insist on turning up to board meetings, notwithstanding no formal appointment.

Reserved matters schedules are beneficial for setting out the specifics that each party requires, thereby avoiding those tricky requests from which chaos can ensue.

If a private client commits to making introductions, referrals or pushing business towards the venture, do not permit this to go undocumented. Failing to specify a volume or at least a best endeavours qualification to bind the principal may result in disgruntlement if such introductions do not materialise and there is no redress for the omissions.

Privacy can be a big issue for private clients: the mandatory disclosure of owner/investor names and amounts should be carved out of confidentiality clauses, sensitively discussed and agreed between the parties. Private clients sometimes prefer to re-organise their group holdings and settle their investments into trust, so including the right to do this, or carving it out of non-assignment clauses, without consent is pragmatic. 

Reporting lines should be clearly set out. The principal will want the ability to receive information themselves, care of their private office and perhaps even to share this with their general counsel. If invested via a trust structure, the trustee will also need access to data regardless of the principal having received it directly already. Similarly, consider all the concerned parties when specifying who may give instructions on behalf of the principal or trust to the joint venture and its executives.

In some cultures, loss of face can be far more serious for a private client than loss of profit. It may be helpful to include so called ‘anti-embarrassment’ clauses in the document. These enable recalculation of price or adjustment in scenarios where there are multiple investors coming in at different prices or terms.

Though an exploration of the detail of these provisions is beyond the scope of this article, other helpful terms to include may encompass:

  • first rights of refusal;
  • sequel rights;
  • ‘golden’ shares (giving greater control); and
  • providing for appropriate dilution (or anti-dilution) if an individual private client is late or skips an investment round.

Termination rights for slightly wider than usual reasons, such as ‘cultural differences’, may also help provide a basis for the parties to wind up the arrangements between them without overshadowing continuing social relationships.

In drafting exit provisions, it can be unhelpful to provide for a specific timetable, such as the five-year horizon often used by funds. Private clients, especially those driven by passion, sometimes like to buy and hold. They can be truly committed to meaningful business relationships with their partners and value loyalty and longevity, rather than short-term flips.

If the joint venture agreements are carefully prepared in a manner that embraces the idiosyncrasies of the parties (and anticipates outlandish requests), there is no reason why the halo effect may not persist long into the life of the investment and collaboration between the parties. Of course, there remains the rather important matters of performance and profitability. These may well cause the chaos of the butterfly effect to ensue. But the draftsperson’s role is to try to minimise the scope for disagreements and disputes, and these tools, tailored to private clients, may just help in crossing off one more worry from the list of things that interrupt a client’s nightly sleep.

Mustafa Hussain, ‘Halos and wings, but no angels’, STEP Journal (Vol28 Iss6), pp.48-49

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