On March 23, Treasury released the details of the Public-Private Investment Program, the component of the Financial Stability Plan designed to address the “legacy” assets at the center of the global financial crisis. The program will comprise two separate initiatives, the Legacy Loans Program, through which FDIC-insured institutions will be allowed to sell an array of assets, initially including residential and commercial real estate loans held on their balance sheets (“legacy loans”), and the Legacy Securities Program, through which a broader, though as-yet undefined, range of sellers will be able to sell certain pre-2009 securities (“legacy securities”). In each case, the loans or securities would be sold to newly-formed funds capitalized with a combination of public and private equity and eligible for additional government loans or debt guarantees (such funds, the “Public-Private Investment Funds” or “PPIFs”).
We summarize these programs below and then discuss several open issues for interested investors to consider. We note that the details of these programs are still preliminary and the specific requirements and structure of these investments will be subject to further clarifications from the government.
Legacy Loans Program
FDIC to oversee formation of multiple funds. Under this program the FDIC will oversee the formation and operation of multiple PPIFs to purchase legacy loans from insured banks and thrifts.
Auction process to be utilized. Private investors will bid through an auction program run by the FDIC for the opportunity to form a PPIF to purchase a particular loan or loan pool. The loan pools will first be identified by eligible banks in consultation with their regulators. The FDIC will then conduct diligence, prepare marketing materials and engage a valuation firm and financial advisor to advise on what amount of the PPIF’s debt the FDIC will guarantee (not to exceed a debt to equity ratio of 6:1) and to conduct the auction.
Bid procedures. Prior to the submission of bids, private investors will be informed of the maximum leverage to be guaranteed by the FDIC and the terms of that debt (which is expected to be non-recourse and secured and to include debt service coverage escrows) and will be given access to due diligence information. Potential investors must be pre-qualified by the FDIC to participate. In the bid submissions, bidders will specify the total amount of equity to be contributed by private investors and Treasury, respectively. While it is expected that Treasury will fund up to 50% of the total equity contributions, a bidder can request in its bid that Treasury provide less than 50%. The auction rules will require a refundable deposit from each bidder equal to 5% of the “bid value.”
Criteria for successful bids; seller consideration. The FDIC will then select the highest bid for the legacy assets based on the cash equivalent price of the loan pool implied by the bid. The seller will be permitted to accept or reject the bid. The seller’s total consideration will comprise (i) the cash provided by the private investor’s and Treasury’s equity investment in the PPIF and (ii) either an FDIC-guaranteed note issued by the PPIF or the cash proceeds from the PPIF issuing such note to a third party.
Servicing; governance. The FDIC has indicated that the loans will be sold to the PPIF “servicing free,” meaning that the PPIF would decide when servicing responsibilities would transfer to the PPIF from the selling bank. The manager chosen by the private investors would manage the servicing of the asset pool and the timing of its disposition—subject to strict FDIC oversight.
Consideration for the government. In addition to returns on Treasury’s equity investments, the FDIC will receive annual guarantee fees, administrative fees and expense reimbursements. Treasury will also receive warrants in the PPIF consistent with those issued by other TARP recipients under the EESA.
Legacy Securities Program
Treasury to oversee formation of multiple funds. Under this program, to be administered by Treasury, PPIFs will be formed and funded to target investments in eligible legacy securities. Eligible legacy securities will initially include only U.S. residential mortgage backed securities (“RMBS”) and U.S. commercial mortgage backed securities (“CMBS”) issued prior to 2009 that (i) were originally rated AAA (or its equivalent) by two or more nationally recognized rating agencies without regard to ratings enhancement and (ii) are secured by the actual mortgage loans, leases or other assets and not by other securities (with certain limited exceptions). The eligible assets may be purchased only from financial institutions from which Treasury may purchase assets pursuant to EESA.
Five or more private fund managers to be selected. Treasury will select five or more private fund managers based on announced criteria, including: a demonstrated capacity to raise at least $500 million of private capital; experience and track record working “primarily” with eligible legacy securities; at least $10 billion of eligible legacy securities under management; operational capacity to manage in accordance with guidelines; and headquarters in the United States. Treasury indicated on April 6 that these selection criteria will be “viewed on a holistic basis” and that the failure to meet any criterion will not preclude a manager from being selected. Applications to be fund managers under the Legacy Securities Program were due on April 24 and, on April 29, Treasury announced that it had received more than 100 unique applications from traditional fixed income, real estate and alternative asset managers. Treasury selections for preliminary approval are expected by May 15. Fund managers will then have twelve weeks after being selected to raise a minimum of $500 million in equity capital for the program from private investors. Treasury anticipates opening the program to smaller fund managers (who may be subject to a lower capital raising requirement) in the future. In addition, Treasury noted that several of the applications contained creative proposals for partnering with small, veteran-, minority- and women-owned fund managers.
Capital structure. Treasury and a vehicle controlled by the applicable fund manager (the “Private Vehicle”) would be the sole direct investors in each of the PPIFs and Treasury would match equity contributions from the Private Vehicle. The private investors in the Private Vehicle would have to agree to at least a three-year lock up (though Treasury may require longer periods and could require the Private Vehicle be structured as a closed-end fund with no redemption rights). Treasury initially indicated that (i) debt financing would be available in the form of secured non-recourse loans from Treasury equal to 50% of the Private Vehicle equity capital, provided that the private investors do not have any voluntary withdrawal rights, (ii) the leverage could be increased up to 100% of equity capital if restrictions regarding leverage, withdrawal rights, priorities and other factors as yet undetermined by Treasury are imposed and (iii) these senior loans would be structurally subordinated to any TALF financing obtained by the PPIFs (as described below). According to its April 6 guidance, Treasury is now considering the following debt arrangements (it is not entirely clear whether Treasury will select one of these structures or will provide a menu to fund managers):
- No Treasury debt financing to the PPIF; PPIF leverage limited to leverage provided by TALF, any other Treasury program or debt financing raised from private sources;
- Leverage limited to senior secured Treasury debt financing (up to 100% of the PPIF’s total equity capital) to the PPIF. No additional leverage (either from TALF or private sources) would be permitted; and
- Unsecured Treasury debt financing (up to 50% of the PPIF’s total equity capital) to the PPIF and additional leverage through TALF, any other Treasury programs or debt financing raised from private sources, subject to total leverage requirements and covenants to be agreed upon.
In its April 21 quarterly report to Congress, the Office of the Special Inspector General of the Troubled Asset Relief Program (“SIGTARP”) expressed concern that the “leverage-onleverage” which results from allowing Legacy Securities PPIFs to participate in the TALF program would leave so little of investors’ capital at stake that it erodes their incentives to conduct proper due diligence on (and assign appropriate prices to) the assets they acquire. The SIGTARP thus recommended that Treasury either prohibit Legacy Securities PPIFs from participating in the TALF program or increase the haircuts available to them under the TALF program so as to leave them with the same leverage enjoyed by non-PPIF investors. The SIGTARP report noted that Treasury had acknowledged its concerns, but advocated seeking alternative ways to mitigate risks.
New TALF expansion. Simultaneous with the announcement of the Public-Private Investment Program, Treasury announced that the TALF funding would be made available for purchases of non-agency RMBS that were originally rated AAA as well as CMBS and consumer credit assetbacked securities (“ABS”) that are rated AAA. Permitted leverage ratios, haircuts, lending rates, minimum loan sizes and durations have yet to be determined.
Governance. The PPIFs would be managed by the private managers subject to reporting and an undefined level of oversight by Treasury.
Consideration for the government. In addition to returns on debt and equity investments, Treasury will receive warrants as required by EESA—the terms of which will be determined in part based on the amount of debt issued by the government.
There is very little detailed guidance on how these PPIFs would actually work. Highlighted below are select issues to be considered by those interested in participating in either PPIF program. As additional details emerge, we will continue to update you.
Key open questions regarding the PPIF programs include:
- Asset Eligibility. It is not yet clear which asset classes will be eligible to be sold into the Legacy Loans Program. Initially it seems most likely that the program will focus on commercial real estate loans and non-agency residential mortgages. Will that be expanded to cover REO and commercial and industrial loans? How will loan pools be packaged? Also, the FDIC has not clarified the meaning of “legacy” – what will be the cutoff for eligible loan origination dates? Will there be a holding period applied for either program or could a qualified seller purchase loans or securities (e.g., out of a CDO or from a non-qualified seller) and immediately sell it to a PPIF? Will the Legacy Loan Program allow for a PPIF to bid on multiple pools of legacy loans? Will the programs be expanded to include purchases of distressed assets held by non-financial institutions impacted by the financial crisis, including pension and mutual funds? Will the categories of eligible assets be broadened to include other asset classes?
- Asset Pricing. Will these PPIFs actually be able to bid prices high enough to interest the banks that have thus far been unwilling to sell these legacy assets at private market prices? Will regulators force a write-down of those assets (perhaps in conjunction with the Financial Stability Plan’s mandatory “stress testing”) or otherwise use influence to compel the banks to participate? For example, press reports have indicated that following the stress tests several financial institutions may increase their tangible common equity by converting the Senior Preferred Stock issued to Treasury pursuant to the Capital Purchase Program into Convertible Preferred Stock under the Capital Assistance Program, effectively making the government the largest—and, in some cases, the majority—shareholder in such institutions. Although the Convertible Preferred Shares do not have voting rights until they are converted into common shares, will Treasury use its influence as an equity holder to force the banks to sell loans or securities to PPIFs?
- Political and Rule Change Risks. Will private investors and fund managers have an appetite to participate in programs the rules of which could continue to change and develop as the political landscape shifts? Will they be interested in subjecting themselves to risks of potential future regulation as beneficiaries of the PPIF program “subsidies”? And will private fund managers be willing to subject themselves to enhanced public disclosures? In this regard note that the Legacy Securities Program application provides that “Treasury shall have an unlimited right to use, for any governmental purpose, any information submitted in connection with the application.”
- Executive Compensation Restrictions. The March 23 Frequently Asked Questions for both the Legacy Securities Program and Legacy Loans Program indicated that executive compensation restrictions would not apply to “passive” private investors in PPIFs. The FAQs provided little guidance on what was meant by “passive” and left unclear whether the executive compensation restrictions would apply to fund managers or their employees and affiliates. On April 21, Treasury issued an updated FAQ for the Legacy Securities Program, stating that the executive compensation restrictions would not apply to asset managers of or private investors in Legacy Securities Program PPIFs provided that such asset managers and their employees are not employees of, or controlling investors in, the PPIFs and that other investors are purely passive. This conflicted with an April 9 letter by Treasury, quoted in SIGTARP’s April 21 Quarterly Report to Congress, which said that the executive compensation restrictions would apply to asset managers if they were “co-owners” of the PPIFs. We are awaiting further guidance on these points, including whether the concepts in the April 21 Legacy Securities Program FAQs will apply to the Legacy Loans Program.
- Manager Qualifications. What qualifications for private fund managers will be applicable? No specific criteria have been announced with respect to the private fund managers under the Legacy Loans Program. With respect to the Legacy Securities Program, it is not clear whether the requirement for a track record “primarily” in eligible assets will exclude more diversified managers and narrow the field to more specialized players. Likewise, the application’s requirements to provide detailed oversight standards may favor registered advisers.
- Investor Qualifications. What qualifications for private investor participation will be required? Will sovereign wealth funds or other quasi-governmental entities be allowed to participate? Will the restrictions contained in the stimulus bill on hiring H-1B Visa workers apply to investors participating in the PPIF program? No specific criteria for investors have been announced for either program (other than the deposit requirement for the Legacy Loans Program). With respect to the Legacy Loans Program, private investors must be approved by the FDIC and cooperation between private investors will be prohibited once the auction process begins (to maintain fairness). Also, with respect to the 5% deposit requirement, it is not clear whether an alternative will be available for creditworthy funds who are not structurally set up to make deposits for bidding.
- Fund Structuring. The Treasury expects that the Private Vehicles will be structured to allow for pension plan investors, but it is not clear whether this means that the Private Vehicles may simply cap pension plan participation to less than 25% (as is commonly done by private funds wishing to remain exempt from ERISA) or whether the Treasury intends for each Private Fund to run as if it held pension plan assets, subjecting it to a much higher standard of care. There are numerous other structuring considerations for the PPIFs depending on how much true “retail” participation is desired (or mandated) for the equity or debt securities. Issues surrounding the Investment Company Act of 1940 (the “40 Act”) have led to suggestions that the S.E.C. provide no-action assurance so that registered investment companies subject to the 40 Act’s leverage limitations will be allowed to participate. There are also various tax considerations including the applicability of rules related to “taxable mortgage pools” and issues related to the U.S. taxation of foreign investors in assets with these characteristics.
- Asset Purchasing Process. Under the Legacy Loans Program, the FDIC has called for and received hundreds of public comments regarding the specific process to be utilized to maximize participation in the program by buyers and sellers. Open questions include whether sellers should be able to set reserves, whether the reserves should be blind or disclosed, whether there will be a single round or multiple rounds of bidding and whether there will be opportunities for bilateral negotiations or preemptive bids.
- Investor Lock-Up. What is the lock-up period for private investors? The Legacy Loans Program is completely silent on this issue or on life term of the funds. While the Legacy Securities Program suggests that voluntary withdrawal may be allowed after the first three years, a condition for participating in the debt financing is that there are no voluntary withdrawal rights. The Legacy Securities Program also suggests a maximum of 10 years for the life of the funds (subject to extension with the Treasury’s consent). Until these points are clarified, it is not clear whether the program will attract some hybrid or relatively illiquid hedge fund investors in addition to traditional private equity investors.
- • Financing Commitments. What will be the strength of equity commitments from private investors and the government? Note that under the Legacy Securities Program, the Treasury will expressly reserve the right to “cease funding of committed but undrawn Treasury equity capital and debt financing in its sole discretion.” This optionality could seriously hamper private fundraising and begs the question of how firm the private investor commitments must be and what special remedies would be needed if the Treasury exercised this option. Also, with respect to the 5% deposits required under the Legacy Loans Program is “bid value” the equity components or the full amount of debt and equity capitalization?
- Debt. Will the debt be issued to the asset sellers or third parties? How will the debt be priced and will the maturities and amortization schedules match the underlying assets? How will the prepayment and make whole provisions operate in the event of an early asset sale? Will the guarantee fees be risk-based? Will private investors be allowed to arrange the debt terms or will it be “stapled” by the government? Will investors be provided appropriate protections against seller insolvency (e.g., will “true sale” opinions be expected)? Will the debt be offered publicly? If so, will the SEC provide no-action relief with respect to registration requirements under the 40 Act and under the Securities Act of 1933, as amended?
- Governance/Oversight. How much management power and oversight over the PPIFs will be retained by the government? While the announcement indicates that private sector managers will control and manage the legacy assets, the legacy loan PPIFs will be subject to “strict FDIC oversight” and we should expect similar government oversight to be applied to the legacy securities PPIFs. All of the PPIFs will be subject to waste, fraud and abuse protections, each to be defined. It is not clear what additional protections are contemplated beyond those already provided in the antifraud provisions of the Investment Advisers Act to which all fund managers (whether or not registered) are subject. In addition the PPIFs will be subject to enhanced reporting requirements and access to books and records must be provided to various government agencies. Each PPIF will be restricted from purchasing legacy assets from affiliates of the fund managers or 10% or larger private investors in such PPIF and, under the Legacy Securities Program, a PPIF will also be restricted from purchasing assets from any of the other four (or more) fund managers in the program or any of their affiliates. It is unclear what additional affiliate restrictions will apply or if they will be more restrictive than the cross trade and principal transaction provisions of the Investment Advisers Act applicable to all fund managers.
- Management and Incentive Fees. Will the private fund managers be entitled to a management fee on committed capital and a carry on profits? The Legacy Loans Program is silent on the ability of the fund managers to receive any management or incentive fees. The Legacy Securities Program expressly permits a fixed management fee based on invested (not committed) capital by the Treasury; does not address incentive fees with respect to Treasury profits; and suggests that management and incentive fees with respect to the private capital will be allowed in the manager’s discretion (but subject to Treasury review in the application process). It is unclear whether this government review in the auction or application processes will have any impact on the fee structures adopted in this market.
- Transaction Fees. Will the fund managers be entitled to participate in transaction fees? The summary of terms for the Legacy Securities Program indicates only that the government and the private investors share those fees on a pari passu basis. It is unclear if the fund managers will be able to participate in these fees based on the typical 80/20 fee sharing arrangements that are standard for private equity funds.
- Government Fees/Expenses. Unlike the Legacy Loans Program, there is no express fee and expense reimbursement provision in the Treasury’s Legacy Securities Program.
- Asset Dispositions/Investments. When and how will the PPIFs be able to hedge and/or sell the acquired assets? What restrictions will apply to future investments by the PPIFs?
- Warrants. How will the warrants work in the fund structures and how will this dilution affect a private sponsor’s ability to raise capital? Until further details including the debt terms and pricing are announced, as well as the expected pricing of legacy assets, it will be difficult to assess whether private investors will determine that the added dilution from the warrants is a reasonable trade-off in their rate of return calculations.
- Available Public Capital. How much government equity capital will be made available to each of these two programs? The announcement indicates that $100 billion in TARP funds would be utilized for both programs. Of this, $25 billion has been allocated to the TALF program to support purchases by Legacy Securities Program PPIFs. It is not clear how the remaining $75 billion will be split between the two programs.
- Timing of Fundraising Relative to Asset Purchases. What is the expected timing of the private fundraising relative to legacy asset purchases? Under the Legacy Securities Program, the selected fund managers will have twelve weeks to raise private capital and, only if the target private amount is raised, would the manager be entitled to request the government equity and debt funding. Once the fund is formed and the funds committed, the fund would begin to make investments in the eligible legacy securities. The Legacy Loans Program, on the other hand, provides investors an opportunity to make targeted investments in specific pools of loans identified upfront in the auction process, subject to the 5% deposit requirement. It remains unclear how much lead time private managers wishing to participate in the Legacy Loans Program will have to conduct diligence and fundraise prior to initial bid submission. While not addressed, presumably the 5% deposit is forfeited if the manager is unable to raise the private equity in a winning bid accepted by a bank. Additionally, because one or both programs may contemplate hedge fund structures, it is not clear how the fundraising requirement would apply to hedge funds. For example, would a hedge fund be eligible for Treasury equity as soon as it raises a certain amount or would it need to maintain a certain amount of capital (or net asset value) in the fund on an ongoing basis (even after the expiration of the lock-up period and despite redemptions made from the fund)?
- Timing of Program Relative to CAP. How will the PPIFs purchasing of distressed assets be timed relative to other parts of the Financial Stability Plan, especially investments under the Capital Assistance Program (CAP)? Reports indicate that following the publication of the stress test results on May 7, several large banks will have six months to boost their capital—either through private capital raising or by converting the government’s Senior Preferred Stock into Convertible Preferred. Because selling legacy assets to PPIFs may have the effect of reducing a bank’s capital, the capital requirements mandated by the CAP may create a disincentive for banks to shed their legacy assets. It is unclear how the government intends to limit this disincentive, or whether the capital targets under the CAP reflect (or require) a certain level of participation in the PPIP.
- Diligence/Rating Agency Reform. How will due diligence and rating agency reform be timed relative to the PPIFs purchases?
- Timing Relative to Loan Modifications. How will the timing of the Housing Affordability and Stability Plan operate in relation to the PPIF’s purchasing and will potential loan modifications be factored into private sector pricing of the troubled assets?