On March 23, 2009, the U.S. Department of Treasury (the “Treasury”), in conjunction with the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve, released details on the Public-Private Investment Program (“PPIP”), which is designed to provide private investors with the opportunity to coinvest with the U.S. federal government (the “USG”) to purchase “toxic assets” (i.e., legacy loans, which consist of residential and commercial real estate loans held directly on the balance sheets of banks, and legacy securities, which consist of commercial mortgage backed securities and residential mortgage backed securities originally issued prior to 2009) from participating financial institutions.
Of significant importance to private investors desiring to participate in the PPIP are the specific terms of the Public-Private Investment Funds (“PPIFs”) expected to be formed between private investors and the USG to purchase these assets, including with respect to issues such as corporate form, governance, capital structure, tax, exit/transfer rights and other related terms. Although the USG has provided some details on these terms, many significant questions remain unanswered.The precise terms of the PPIFs are likely to be fleshed out over the next few weeks during the public comment process.
This Client Alert provides a brief overview of the information released by the USG to date with respect to the terms of PPIFs as they relate to governance, capital structure, exit rights and other matters. In addition, this Client Alert identifies key questions and issues for which terms have not been provided and that private investors should be analyzing and considering before establishing a co-investment relationship with the USG.
Brief Overview of Co-Investment Terms for Public-Private Investment Funds
The PPIP consists of two separate programs: the legacy loans program and the legacy securities program. The following is a brief overview of the principal co-investment terms outlined to date by the USG for each program. For additional information and terms concerning each program, visit http://www.ustreas.gov/press/releases/tg65.htm.
Legacy Loans Program
- Governance –
- PPIFs are expected to be managed within parameters established by the FDIC and Treasury. The FDIC and Treasury will establish governance procedures and terms for management, a servicing agreement, financial and operating reporting requirements, exit timing and exit alternatives for each PPIF. No specific terms have been disclosed; however, to the extent practicable, it has been suggested that standard documentation will be used for this purpose.
- Private managers approved by the FDIC are expected to have control over asset management duties until final liquidation, subject to rigorous oversight from the FDIC.
- The FDIC is expected to provide oversight for the formation, funding and operation of a number of PPIFs that will purchase legacy loans, including approving asset pools from participating financial institutions, determining asset pool leverage ratios and conducting auctions. In addition, the FDIC is expected to play an ongoing role in reporting, oversight and accounting of PPIFs.
- PPIFs will be required to agree to waste, fraud and abuse protections as the same will be defined by the FDIC and Treasury. In addition, PPIFs will be expected to make representations, warranties and covenants regarding the conduct of their business and compliance with applicable laws.
- Capital Structure –
- The FDIC is expected to provide guarantees of non-recourse debt (up to a 6-to-1 debt-toequity ratio) issued by PPIFs to participating financial institutions in the PPIP or third party investors, which debt will be secured by the assets purchased by a PPIF. PPIFs will be required to maintain a debt service coverage account (the “Coverage Account”) to ensure that working capital is sufficient to meet anticipated debt servicing obligations, interest expense and operating expenses. It is expected that a portion of the cash proceeds from assets sales will be retained by PPIFs until proceeds from asset sales have resulted in the Coverage Account being fully funded.
- The Treasury is expected to make an equity co-investment in each PPIF alongside private investors of up to 50% of the total equity capital (subject to an undisclosed minimum investment amount if private investors desire to take less than 50% of equity capital from the Treasury).
- Warrants – As required by the Emergency Economic Stabilization Act, the Treasury will receive warrants to purchase additional equity capital in each PPIF. No specific terms of these warrants have been disclosed.
- FDIC Fees/Expenses – The FDIC is expected to receive a fee from PPIFs in exchange for its debt guarantee, as well as ongoing administrative fees. In addition, the FDIC is expected to be reimbursed by PPIFs for the FDIC’s expenses in connection with its oversight role.
Legacy Securities Program
- Governance –
- Fund managers approved by the USG are expected to control asset selection and pricing, asset liquidation, trading and disposition on behalf of PPIFs.
- As with the legacy loans program, PPIFs will be required to agree to waste, fraud and abuse protections as the same will be defined by the FDIC and Treasury.
- Capital Structure –
- The Treasury is expected to provide a one-for-one match of every dollar of private capital raised from private investors by an approved fund manager for a PPIF formed and established to purchase legacy securities. However, the Treasury stated that it maintains the right to terminate committed but undrawn funds at its sole discretion.
- To the extent a PPIF formed to purchase legacy securities meets certain guidelines, the Treasury is expected to make senior debt available to each such PPIF in the amount of 50% of the PPIFs total equity capital. In addition, the Treasury will consider requests for senior debt in the amount of up to an additional 50%of total equity capital of the PPIF, subject to further undefined 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 PPIFs; however, this debt will be structurally subordinate to any financing extended by the Federal Reserve to a PPIF via the Term Asset-Backed Securities Loan Facility, or TALF.
- Warrants – As with the legacy loans program, the Treasury will receive warrants to purchase additional equity capital in each PPIF. No specific terms of these warrants have been disclosed; however, the terms will be determined in part based on the amount of debt financing taken by a PPIF.
- Exit Strategies – Private investors may be given voluntary withdrawal rights subject to negotiated limitations including a three year lock-up; however, there are no voluntary withdrawal rights in respect of participation in the debt financing.
Issues to Consider Before Co-Investing in a PPIF
Although the terms outlined above provide some insight as to the contours of the co-investment relationship between the USG and private investors in PPIFs, many material terms remain unexplored. It is expected that many of these terms will be outlined in more detail following the public comment process. However, it is possible that some or many of the questions set forth below will not be answered or that, if answered, the terms outlined by the USG will not be subject to negotiation. In any event, the following are some issues that private investors should consider in connection with determining whether to co-invest through a PPIF.
- Form of Co-Venture – No guidance has been provided on the entity form that will be used for PPIFs; however, the presumption is that they will be organized as flow-throughs, similar to most investment funds. Understanding the form of PPIFs is critical to private investors in gaining additional perspective on whether to participate in the PPIP, and will help shape decisions on significant issues such as governance, tax, accounting, regulatory matters and exit strategies.
- Governance – Limited insight has been provided on how PPIFs will be governed. However, based on the information provided, the FDIC is expected to have an active role in governance issues and, as indicated, expects to have rigorous oversight over the affairs of each PPIF. In connection with making a determination whether to co-invest in the PPIFs, private investors should understand how much flexibility privately appointed management will have in governance matters. Some issues to be considered include:
- Governing body – Specifically in the context of the legacy loans program, what will be the form of a PPIFs governing body (i.e., will there be a board)? If there is a governing body, what will be its composition (i.e., equal representation between the USG and private investors)? Will the composition of the governing body be tied to the amount of capital invested?What control will the governing body have over day-to-day operations?What procedures will be in place to remove and replace representatives on the governing body?
- Management – Specifically in the context of the legacy loans program, who will be responsible for managing the day-to-day business and affairs of a PPIF? What qualifications will private managers need to satisfy to be approved by the USG? Under what circumstances will management and, with respect to PPIFs formed to purchase legacy securities, the fund manager, be subject to removal and replacement and who will have the authority to make this determination?What limitations on day-to-day operations will be imposed on management?
- Approval Rights –What actions will require the prior approval of the USG (i.e., will approval rights be limited only to “fundamental” decisions, such as insolvency-related actions, dispositions of a material portion of assets and other similar items)?
- Deadlocks – If the governing body of a PPIF has equal representation between the USG and private investors, or if the USG has approval rights over certain material actions, what procedures will be in place to resolve deadlocks? Will disputes be resolved through meditation, arbitration or another form of dispute resolution procedure? Will the disputing parties have buy-sell rights? If so, how will these rights be implemented and what impact, if any, will the non-recourse debt have on this process?
- Fiduciary Duties; Indemnification; Exculpation – Will the governing body of a PPIF have limited fiduciary duties? Will the governing body and management receive standard indemnification, advancement of expenses and exculpation provisions? Moreover, the nonrecourse provisions of the FDIC guaranteed debt should be drafted carefully so that private investors are not subject to attack, including for tort-based claims.
- Corporate Opportunities – Will private investors/management be required to offer similar business opportunities to a PPIF or will they be free to engage in other business ventures involving similar assets outside of the PPIF?
- Impact of Debt – What restrictions/limitations will the debt have on the operation of the business of a PPIF?
- Reporting Requirements – What information will private investors need to disclose to the USG in connection with anticipated reporting requirements? Will private equity funds and other similar funds be required to disclose the identity of their investors and, if so, will this information be kept confidential?
- Affiliated Transactions – With respect to the legacy loans program, certain private investors will not be permitted to participate in a PPIF that purchases assets from sellers, including where the sellers of such assets are affiliates of such private investors. With respect to the legacy securities program, assets may only be purchased from sellers that are not affiliates of the fund manager, any other fund manager or their respective affiliates or any private investor that has committed 10% or more of the aggregate private capital raised by the fund manager. How will the governing documents implement this restriction? Will this restriction be measured at the time of the initial purchase of assets or will it be an ongoing commitment?
- Capital Structure –
- Terms of Debt Financing – What will be the specific terms of the debt financing received by PPIFs (e.g., interest, affirmative/negative covenants, prepayment penalties, mandatory repayments, events of default, etc.)?
- Equity Capital – With respect to the legacy securities program, the information provided suggests that capital provided by the Treasury will be on a committed basis and subject to termination/withdrawal in the sole discretion of the Treasury. This raises questions concerning the capital requirements of PPIFs in general. Will funds from private investors also be on a committed basis? If funds will be provided on a committed basis, how will capital calls be made and will there be any conditions to funding? Will there be penalties for failing to contribute committed funds? In the context of the legacy loans program, outside of asset sales, where will PPIFs obtain funds to maintain appropriate levels in the Coverage Account? How much will need to be in the Coverage Account before it is considered fully funded?Will the USG and private investors be expected to commit additional funds beyond their initial capital to fund operations?
- Warrants – What will be the terms of the warrants? What dilutive impact will the warrants have on private investors?Will the exercise of the warrants have any impact on governance or other related issues?
- Distributions – How often will distributions be made to equity owners?Will management be entitled to a promote or other incentive fee for maximizing returns?
- Transfers/Exit Strategies – With respect to the legacy securities program, private investors may be given voluntary withdrawal rights subject to negotiated limitations including a three year lock-up (however, there are no voluntary withdrawal rights in respect of participation in the debt financing). This raises questions about transfer/exit strategies in general for both programs, particularly the legacy loans program, for which no details on transfers/exit strategies have been provided.
- Transfers in General – Will private investors and the USG be subject to limitations on their ability to transfer equity in PPIFs (e.g., will transfers of equity be subject to a lock-up period)? Will the USG be restricted from transferring the warrants?Will private investors be permitted to transfer equity to affiliates and other permitted transferees (e.g., other private investors or for estate planning purposes)? What limitations, if any, will be imposed on the Treasury in connection with the transfer of its equity?Will transfers be subject to a right of first refusal or right of first offer by other equity owners?
- Co-Sale Rights – Will equity owners have co-sale rights on transfers by other equity owners? If so, will the co-sale rights be subject to a minimum threshold of equity being transferred?
- Drag-Along Rights –Will all equity holders be subject to drag-along rights? If so, what will be the terms on which equity holders can be dragged? Will the USG have the ability to force a sale?
- Put/Call Rights – Will equity holders have the ability to exit PPIFs through put/call rights after a certain period of time or based on the occurrence of certain events? If so, what will be the parameters around the put/call rights (i.e., price, timing, etc.)?
- Tax Considerations –
- Classification – Will the PPIFs be organized and classified as corporations or as partnerships (i.e., flow-through entities) for income tax purposes? As indicated earlier, the presumption is that PPIFs will be organized as flow-throughs, similar to most investment funds.
- Debt Financing – Will the non-recourse debt be respected as debt, or will it be treated as equity, for tax purposes?
- Warrants – How will the warrants be treated for tax purposes?
- Trade or Business – Will PPIFs be treated as engaged in the active conduct of a trade or business in the United States for income tax purposes? This determination will be relevant for non-U.S. investors in PPIFs that are flow-through entities, and, if the PPIFs have direct non- U.S. investors, could affect the PPIFs' withholding obligations.
- Tax Reporting –Who will control the tax reporting of the PPIFs?Will tax positions taken by the PPIFs be subject to audit?