Agree to Disagree: Contingent Terms in Recent Joint Venture Contracts

Negotiations to form or terminate a joint venture can stall – sometimes indefinitely – for many reasons.

Chief among them is disagreement on valuation – whether the relative value of the parties’ assets contributed into the venture at inception, or the current value of the venture’s projected performance at break-up.

Disagreements on valuation are, in essence, divergent assumptions about the future: how the parties’ contributions to the venture will perform, what the venture as a whole will accomplish, and how the external market (including prices, costs, and regulation) will evolve.

Contingent deal terms are one way bridge these differences. Under a contingent term, if certain events or outcomes occur (for example, growth milestones, performance targets, price levels, regulatory decisions), then a particular action is automatically triggered^[1]See, Managing the Future with Contingent Deal Terms, The JV Deal Exchange Issue 13, Water Street Partners.

The pharma and biotech industry is no stranger to contingent deal terms. Milestone payments and tiered royalties in pharma and biotech partnerships are almost always tied to R&D and commercialization targets. Upstream oil and gas and mining exploration partnerships also use contingent terms extensively. Companies in these sectors for instance, earn into ventures based on how much they spend.

But beyond these industries, contingent terms have been underutilized in joint ventures.

That was until last year. And then things changed.

With rising inflation and interest rates, and general uncertainty around the profitability and expected return of joint venture investments – especially in green energy – contingent deal terms are now suddenly a prominent feature of many venture agreements^[2]The use of earnouts – a contingent term used in M&As – has also been on the rise in M&A transactions over the past year as a hedge against uncertainty. See, Companies Turn to Earnouts to … Continue reading.

Contingent Deal Terms – Examples in Green Energy

Companies are using different types of contingent deal terms in their green energy joint ventures. At venture formation, companies are either tying part of their initial cash contribution to the performance of the assets or business contributed by their partner, or to development costs of the venture’s project. At termination, companies are either negotiating for a post-exit profit-sharing mechanism or payout, or a post-exit retention of obligations to meet cost overruns (Exhibit 1).

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A few of these deals are illustrated below:

• Initial cash contribution partly tied to future performance: Oil major Eni inserted a contingent component into its cash contribution to a renewable diesel joint venture with US-based petroleum refiner PBF Energy, called Saint Bernard Renewables. Eni paid a little over $400 million as compensation to PBF for its share of the capital expenditure already incurred by PBF in standing-up the biorefinery that PBF contributed to the venture. Eni will also pay around $400 million after the startup – at commercial scale – of the biorefinery’s pre-treatment unit that removes impurities from feedstock. Additionally, Eni will pay $20 million if the pre-treatment unit’s commercial start-up occurs by a set forecasted date. This amount progressively reduces – ultimately reducing to zero – for a delayed startup. Further, Eni will pay $30 million if the biorefinery’s renewable diesel unit – that converts the feedstock to renewable fuel – achieves a certain production capacity target, with an acceptable feedstock slate, and above a minimum yield. Here again, the amount is reduced – eventually to zero – for a lower than target capacity.
• Withholding of purchase consideration, with release linked to project development costs: The deal between Dominion Energy and infrastructure investor, Stonepeak, illustrates the withholding and subsequent release of part of the purchase consideration based on project development costs. Under this deal, Dominion sold a 50% non-controlling interest in a wind project off the East Coast of the US to Stonepeak. The deal is structured to limit Stonepeak’s exposure to project cost increases. Stonepeak paid Dominion approximately $3 billion for 50% of the construction costs incurred by Dominion through closing, less a withheld amount of $145 million. Dominion will receive this – or a part of this – $145 million withholding only if final construction costs of the project are within a set range. This is how the payout works: If the final construction costs are around $10 billion or less, Dominion will receive most of the withholding. The amount Dominion will receive is reduced for higher levels of construction costs, down to zero if final construction costs exceed around $11 billion – the level at which Dominion will not receive any of the withheld amount.
• Future (post-exit) profit-sharing mechanism as part of exit consideration: Shell is withdrawing from its Korean floating offshore wind farm joint venture, MunmuBaram, with a post-exit profit-sharing mechanism. Shell’s partner in the venture, Hexicon, will make an initial down payment of $5 million. In addition, Shell will benefit from a profit-sharing arrangement of up to $50 million over a three-year period. If Hexicon sells is shares in the future, the profit-sharing mechanism will be further altered depending on the timing and net proceeds of the sale.
• Post-exit retention of cost-sharing obligations for capital expenditure overruns: Eversource Energy is exiting from its South Fork Wind and Revolution Wind joint ventures with Ørsted in the US by selling its 50% ownership stake in these ventures to Global Infrastructure Partners (GIP). But Eversource is retaining, post-exit, cost-sharing obligations for the construction of the ventures’ wind farm projects. These cost-sharing obligations provide that Eversource will share equally with GIP in GIP’s funding obligations for up to approximately $240 million of incremental capital expenditure overruns incurred (above a base construction forecast), after which, GIP’s obligations for any additional capital expenditure overruns will be borne solely by Eversource.

Pitfalls and Enhancements

Contingent deal terms might seem like an ideal solution to circumvent gridlock in the heat of negotiations.

But drafted incorrectly these terms may just push disagreements to the future.

Retailer Marks & Spencer’s dispute with its partner Ocado is a cautionary tale in avoiding triggering conditions that are ambiguous. Under the deal, Marks & Spencer signed a £750 million ($949 million) deal in 2019 to own half of Ocado Group’s retail business. The retailer agreed to pay Ocado an initial £562 million ($710 million) upfront and make another payment of around £190 million ($240 million) if the venture met certain performance targets. Marks & Spencer believes that the final payment is binary – that is, it must pay the sum in full if the targets are met, or not at all. And since the venture missed the set targets, it is justified in withholding the payout. On the other hand, Ocado believes that the contract allowed for the targets to be adjusted – and that certain decisions jointly made by the partners over the past few years met the requirement for adjustment. Ocado is now threatening to sue Marks & Spencer to receive the payment in full.

In addition to avoiding language that can be interpreted differently, another obvious pitfall that dealmakers need to avoid is trigger conditions that can be gamed by one party for its advantage. For instance, if a payout to one party is linked to the performance of an asset, but its counterparty’s actions or inactions are critical to the optimal performance of the asset, then the contingent term should be avoided altogether – or used cautiously with a mitigating provision against the counterparty’s actions or inactions in bad faith.

Pitfalls aside, there are some enhancements that can be considered in drafting contingent terms.

One of which is the ability to settle the contingent payout earlier than it is due – when for instance, market conditions are expected to change unpredictably and a party does not want to hold on to a potentially unpredictable liability or alternatively, is willing to settle earlier. Miner Newmont’s exit from PT Newmont Nusa Tenggara (PTNNT), operator of the Batu Hijau copper and gold mine in Indonesia had such an enhancement. Newmont received a total consideration of $1.3 billion for its 48.5% economic interest in PTNNT. This amount comprised gross cash proceeds of $920 million and contingent payments of $403 million tied to, among other factors, higher copper prices in the future. This “metal upside amount” was payable to Newmont in any quarter – over a particular production phase of the venture – in which the London Metal Exchange quarterly average copper price exceeded a set amount. But the contract also provided for the parties to arrive at a settlement amount – and terminate the contingent payment – at any time after the first anniversary of the agreement by appointing two independent financial institutions to determine the current value of the “metal upside amount”.

Another possible enhancement is providing for a dispute resolution process – including binding arbitration – to settle any future disagreements, especially on whether, and the extent to which, the trigger condition has been fulfilled and a payout is required.

With the surge and swell of economic and regulatory uncertainty showing no sign of abating, is a contingent term right for your next joint venture?