Treasury's Public-Private Investment Program: Key Issues for Fund Managers

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NEWS & INSIGHTS
Publications
27 MAR 2009

Treasury’s Public-Private Investment Program: Key Issues for Fund Managers
ALTERNATIVE ASSET MANAGEMENT ALERT

by Drew Chapman, Bruce Wein and Jennifer Gallo

The United States Department of the Treasury has announced the details of the Public-Private Investment Program under which it will make targeted investments in multiple Public-Private Investment Funds (PPIFs) that will purchase troubled real-estate related assets. The program, announced on March 23, is designed to draw new private capital into the market for these assets, including both real estate loans held directly on the books of banks (Legacy Loans) and securities backed by loan portfolios (Legacy Securities), by providing government equity co-investment and debt financing. The Treasury has stated that a key principle of the chosen approach is to use private capital and private fund managers to help provide a market mechanism for valuing the troubled assets. The Treasury announcement leaves many specifics to be determined and has invited public comment regarding portions of the Public-Private Investment Program. Below is a summary of the program, including the Legacy Loans Program and the Legacy Securities Program, highlighting certain key issues relevant to fund and asset managers. Legacy Loans Program Summary of Legacy Loans Program: The Legacy Loans Program is intended to attract private capital to purchase eligible loan assets from participating banks through the provision of Federal Deposit Insurance Corporation (FDIC) debt guarantees and Treasury equity co-investment. The FDIC will provide oversight for the formation, funding and operation of PPIFs that will purchase eligible assets from participating banks. Eligible pools of loans, with committed financing, will be auctioned by the FDIC to private investors.

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Eligible Assets: Treasury’s announcement suggests that the program will initially focus on pools of real estate (both residential and commercial) related loans as determined under criteria established by the FDIC, but the program may be expanded to cover other assets. The Legacy Loans Program documents note that assets must meet certain “minimum requirements” in order to be eligible. No additional information regarding these requirements has been provided. Eligible Banks: Approved insured US banks and US savings associations will be eligible to sell assets. Banks or savings associations owned or controlled by a foreign bank or company are not eligible. Eligible Private Investors: While qualification criteria have not been published, private investors are expected to include an array of investors approved by the FDIC, such as financial institutions, individuals, mutual funds, publicly managed investment funds, pension funds, private equity funds and hedge funds. Although the language in the documents is somewhat unclear, it appears that private investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such private investors or sellers that are 10 percent or larger private investors in the PPIF. Management and Oversight: Private asset managers approved and subject to “strict” oversight by the FDIC will retain control of the assets. PPIFs will be subject to waste, fraud and abuse protections determined by the FDIC and Treasury. Auction Process: After eligible banks have identified the assets to be sold, the FDIC will value the asset pool in consultation with a third-party valuation firm and conduct an auction. Once a bid is selected by the FDIC, the bank will have the option of accepting or rejecting the bid within a pre-established timeframe. Potential private investors will be pre-qualified by the FDIC to participate in the auction. Bids must be accompanied by a refundable deposit of 5 percent of the bid value.

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Financing: The Treasury will contribute up to 50 percent of the equity capital with the balance of the equity coming from the winning bidder. The FDIC will guarantee debt financing up to a 6-to-1 debt-toequity ratio, collateralized by the assets of the PPIF. The amount of debt the FDIC is willing to guarantee will vary from pool to pool based on analyses performed by the FDIC with input from a third-party valuation firm. The FDIC loan is described as “non-recourse debt” in the program materials which suggests that the FDIC will have no recourse beyond in the assets of the PPIF. Profits/Losses: The Treasury and private investors will share profits and losses in proportion to equity invested. Warrants: As required by the Emergency Economic Stabilization Act (the EESA), the Treasury will receive warrants in connection with its investment in a PPIF. Legacy Securities Program The Legacy Securities Program consists of two related parts including: (i) expansion of the Term-Asset Backed Securities Loan Facility (TALF) program, under which non-recourse loans will be made available to investors to fund purchases of legacy securitization assets and (ii) partnership with private fund managers to support the market for legacy securities.

Expansion of TALF to Include Eligible Assets

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Summary of Program: Through the expansion of TALF, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible Assets: Eligible assets are expected to include certain non-agency residential mortgagebacked securities (RMBS) that were originally rated AAA, and outstanding and commercial mortgage backed securities (CMBS) and asset backed securities (ABS) that are rated AAA. Eligible Private Investors: Subject to certain eligibility requirements, private investors, even those who do not partner with Treasury under the Public-Private Investment Program, will be able to access the TALF to purchase legacy securities. Additional: Haircuts will be determined at a later date and will reflect the risk associated with the assets provided as collateral. Lending rates, minimum loan sizes and loan durations have not yet been determined. Legacy Securities PPIFs Summary of Program: Legacy Security PPIFs are investment funds that will be managed by qualifying private fund managers to purchase legacy securities from qualifying financial institutions on behalf of the Treasury and private investors. The investment objective/strategy of the PPIFs is to generate attractive returns through opportunistic investments by following a long-term buy and hold strategy, although the Treasury will consider other articulated strategies (including limited trading). Structure: The only investors in the PPIF will be the Treasury and a vehicle through which private investors will invest in a PFIF (a Private Vehicle). Eligible Assets: Eligible assets will initially be RMBS and CMBS originated prior to 2009 with a AAA rating at origination that are secured directly by the actual mortgage loans, leases or other assets and not by securities (other than certain swap positions, as determined by the Treasury). Loans and other assets underlying any eligible asset must be situated predominantly in the United States. Eligible Sellers: Qualifying “financial institutions” as defined in the EESA. ERISA Investors: Private Vehicles are expected to be structured to permit ERISA investors. As a result, ERISA investors will be able to own up to 25 percent of a Private Vehicle or, if its fund manager is willing to comply with applicable restrictions, an even greater amount. Management: Treasury will select approximately five (although this number could increase) private asset managers to act as fund managers to the PPIFs. The fund manager will have full discretion in investment decisions, although the PPIFs will predominately follow a long-term buy and hold strategy. Approved fund managers will have a limited period of time from preliminary approval to raise at least $500 million in private capital and demonstrate committed capital before receiving final approval from Treasury. Fund managers will be required to submit a fundraising plan to include retail investors, if possible. Fund managers will be subject to waste, fraud and abuse protections determined by the FDIC and Treasury. Pre-Qualification Criteria for Fund Managers: Fund managers will be pre-qualified based on criteria

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that are expected to include a demonstrated ability to raise at least the aforementioned $500 million of private capital; demonstrated experience investing in eligible assets, including through performance track records; a minimum of $10 billion (market value) of eligible assets under management; and demonstrated operational capacity to manage the PPIFs in a manner consistent with Treasury’s investment objective while protecting taxpayers. Fund managers must be headquartered in the US. Small, women-, minority- and veteran-owned asset managers may partner with other private asset managers to meet the above qualification criteria. Application: Treasury has posted a detailed description of information required to be submitted with the application, including information regarding ownership and corporate structure, expertise, current assets under management, fundraising history, past performance and investor references. The application deadline is April 10, 2009. Treasury expects to inform an applicant of its preliminary approval on or before May 1, 2009. The application can be found here. Financing: Treasury and private investors will invest equity capital on a 1-to-1 basis. Treasury will provide non-recourse debt of up to 50 percent of a PPIF’s total equity capital (i.e., private and Treasury), provided that Treasury debt financing will not be available to any fund manager for a PPIF in which private investors have voluntary withdrawal rights. Treasury will consider requests for senior debt of up to 100 percent of a PPIF’s total equity capital, subject to certain restrictions. The senior debt will have the same duration as the underlying PPIF and will be repaid on a pro-rata basis as principal repayments or disposition proceeds are realized by the PPIF. These senior loans will be structurally subordinated to any financing extended by the Federal Reserve to these PPIFs via the TALF. PPIFs may also finance the purchase of eligible assets through TALF, any other Treasury program or debt raised from private sources; provided that Treasury equity capital and Private Vehicle capital must be leveraged proportionately from such private debt funding sources. Fees: Fund managers may charge fees on private investors in their discretion. Treasury will consider fees proposed to be charged when evaluating applications for the Legacy Securities Program. Treasury will accept proposals for fixed management fees to apply as a percentage of Treasury equity capital. Any fees paid to a fund manager or its affiliates other than the Treasury fees (as described above) and incentive or management fees charged to private investors should accrue to the benefit of the Treasury and private investors on a pari passu basis based on equity capital commitments. Profits/Losses: Treasury and private investors will generally share profits and losses on a pro rata basis in accordance with equity capital investments, except in the case of Treasury warrants. Withdrawal Rights: Private investors may be given voluntary withdrawal rights at the level of the Private Vehicle, provided that no investor may voluntarily withdraw prior to three years from the first investment by the Private Vehicle. Treasury debt financing is partially contingent upon private investors not having withdrawal rights. Warrants: As required by the EESA, the Treasury will receive warrants in connection with its investment in a PPIF. Restrictions: Fund managers may not purchase eligible assets from affiliates, other fund managers or any private investor that has committed at least 10 percent of the aggregate private capital raised by the fund manager for the investment in the PPIF. Additionally, private investors may not be informed of potential acquisitions of specific eligible assets prior to acquisition.

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Issues for Fund Managers In addition to the summary above, the following issues may be of particular interest to fund managers: Structure: We anticipate that PPIFs and private vehicles will be structured to be exempt from the registration requirements of the Investment Company Act of 1940, primarily relying on Section 3(c)(7) of that Act, although in certain cases a fund manager may wish to access retail investors through the use of a registered, closed-end fund that may be listed on a stock exchange (although this would place some restrictions on, among other things, the amount of leverage the fund can utilize). Tax: It is likely that the vehicles established in connection with the Legacy Loans Program and Legacy Securities Program (other than closed-end registered funds as described above) will be structured as partnerships or limited liability companies which are not subject to US federal income tax. Under certain circumstances, US tax-exempt and non-US investors may seek to invest through a foreign feeder fund treated as a corporation for US income tax purposes and organized in a low-tax jurisdiction to minimize adverse US tax issues (such as a US tax-exempt investor incurring “unrelated business taxable income”). Another relevant issue is whether, particularly in the case of Legacy Loans PPIFs, foreign feeder funds will be treated as engaged in a US trade or business and therefore be subject to U.S. tax. If a Legacy Loan PPIF acquires a direct interest in the real estate securing the mortgage (i.e., by way of a foreclosure or a deed in lieu), a corporate feeder fund will be subject to US tax on any net gain from disposition of the real estate. Unless this adverse result is eliminated via sophisticated planning, the overall net after tax returns to those who invested through the foreign corporate feeder fund would be substantially reduced. In any event, the structure to be employed should take into account the repayment terms of the government loans to insure that the private investors will not have a tax liability attributable to the vehicle greater than the associated cash flow. The tax impact to the private investors of the fees and interest on the loans will need to be addressed. Management: Asset managers in the Legacy Loans Program will be subject to “strict” FDIC oversight. However, neither the parameters for oversight nor the criteria for the selection of the asset manager have been disclosed. Under the Legacy Securities Program, the documents provide for a predominantly “long-term buy and hold” strategy. In both instances, investors and/or fund managers may want to seek clarification as to the parameters of these roles and restrictions. Executive Compensation: Program materials indicate that "passive" private investors in the Legacy Loans Program and Legacy Securities Program will not be subject to executive compensation restrictions. However, "passive" is not defined, and it is unclear whether executive compensation restrictions would apply to fund managers or the general partner of a PPIF. Furthermore, the program materials do not indicate whether the "waste, fraud and abuse protections" applicable to the PPIFs and fund managers to protect taxpayers will be interpreted to restrict executive compensation.

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TALF Expansion: Many of the important details of the expansion of TALF are unresolved, including haircuts, lending rates, minimum loan sizes and loan durations, as well as whether TALF covers all securities eligible to be sold under the Legacy Securities Program. Further clarification is needed on these points. Warrants: The details and terms of the warrants to be issued in connection with the Legacy Loans Program and Legacy Securities Program have not been provided. Until the terms of the warrants have been disclosed, the amount of upside to private investors in the Public-Private Investment Program cannot be determined. Funding: Under the Legacy Securities Program, Treasury retains a right to cease its unfunded commitments of equity and debt to a Legacy Securities PFIF in its sole discretion. It is unclear whether private investors or fund managers will have any recourse against the Treasury if it does not meet its funding obligations. Reporting Requirements: Under the Legacy Loans Program, PPIFs must agree to provide access to information to representatives of TARP and the Government Accountability Office. Under the Legacy Securities Program, fund managers must provide access to books and records of the Legacy Securities Funds they manage and monthly reports to Treasury regarding purchase, disposal, valuation and profits/losses on eligible assets included in the PPIF. Confidentiality: Fund managers considering participation in the Legacy Securities Program should note the application's confidentiality requirements and the language that provides the Treasury with the unlimited right to use, for any governmental purpose, any information submitted in or with the application. Retroactive Changes: A primary concern is whether the Treasury, FDIC or the US Congress will make retroactive changes to the provisions of the Public-Private Investment Program once the programs have become effective. This issue is of particular concern with respect to executive compensation.

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