Hedge Fund Returns
2009 No. 5 Public-Private Investment Program –
Hedge Fund Returns is published Potential Opportunities for Investors by Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY By John J. Dedyo ([email protected]) and Germaine N. Gurr 10153, +212-310-8000. ([email protected]) Weil Gotshal’s multidisciplinary hedge fund practice group spans On March 23, 2009, the United States Department of the Treasury (the “Treasury”) the United States, Europe and Asia. announced its rollout of the much anticipated Public-Private Investment Program We represent blue chip hedge fund managers around the globe as well (“P-PIP”), which is designed to raise new capital to purchase “legacy” or “toxic” as investors in hedge funds. residential and commercial mortgage loans and other assets backed by such We provide seamless service and loans currently held by banks and other financial institutions (“Legacy Assets”). unparalleled transactional advice Under P-PIP, the US government’s basic plan is to provide a combination of debt to hedge fund managers. Our hedge fund manager clients benefit financing and equity capital to private investors who will use these government from our substantial expertise funds, along with their own equity capital, to purchase Legacy Assets. As a result and reputation in fund formation, of the illiquidity of Legacy Assets, banks and other financial institutions have mergers & acquisitions, leveraged had a difficult, if not impossible, time raising new capital. Moreover, consumers finance, real estate and structured finance transactions as well as our have generally found it much more challenging to obtain financing from banks pre-eminent restructuring practice. or financial institutions at reasonable rates (if at all); this lack of financing has Our representation frequently only further exacerbated the credit crisis and the collapse of the credit markets. includes the following: The current plan is for P-PIP to provide up to $500 billion (with the potential of n establishing hedge funds, hybrid expanding to $1 trillion over time) in purchasing power to buy Legacy Assets. P-PIP funds, special situation funds intends to reinvigorate the credit markets through two main programs: the Legacy and distressed debt funds Loans Program and the Legacy Securities Program (which includes an expansion of and seeding new hedge fund managers the Term Asset-Backed Securities Loan Facility (“TALF”)). According to the Treasury, P-PIP should work as follows: n strategic transactions involving hedge fund managers, including the acquisition or sale of controlling and minority stakes in hedge fund managers n control and non-control acquisitions and dispositions and investments in senior and subordinated debt and structured products n leveraged lending transactions and debtor-in-possession financing n advice with respect to the management of CLOs and CDOs Legacy Loans Program n out of court and in court workouts and restructurings of debt Under the Legacy Loans Program, each qualified bank interested in participating in The members of our hedge fund the program will work with regulators to identify pool(s) of eligible Legacy Assets practice group are listed on the last that such bank wishes to sell (each an “Eligible Asset Pool”). The Federal Deposit page of this publication. Insurance Corporation (“FDIC”) will then accept or reject such Eligible Asset Pool
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based on critieria that has not yet been private investor that won the bid will the Eligible Asset Pool up for auction, provided by the Treasury or the FDIC. select an asset manager, approved by which materials include the proposed Once a pool has been accepted, the the FDIC, to manage the P-PIF with financing terms and leverage ratio for FDIC will work with an independent oversight by the FDIC. The Eligible the Eligible Asset Pool. valuation firm to determine the Asset Pool will be sold on a “servicing STEP 5: Interested private investors maximum amount of leverage to released” basis and the P‑PIF equity- make bids based on the above infor- accept for such Eligible Asset Pool. holders will make decisions with mation, with a high bid of $78 The FDIC anticipates that the debt to respect to the servicing of the assets as dollars. Ideally, the bank then decides equity ratio for each Public-Private provided in the governing documents to accept the bid. Investment Fund (each a “P-PIF”), for the P-PIF. To the extent such which will be formed to purchase the equityholders so elect, the selling bank STEP 6: The Treasury and the private Eligible Asset Pool(s), will not exceed may continue to service the trans- investor each receive a 50% equity 6 to 1. ferred assets. The equity ownership of stake in the newly-formed P-PIF that is the P-PIF will be spilt equally (unless created to purchase the Eligible Asset Private investors interested in otherwise agreed) between the Treasury Pool in exchange for their equity capital purchasing any of the Eligible Asset and the private investor, and the contributions of $6.50 each (based on Pools available under the Legacy Loans Treasury and such investor will share the five-to-one leverage ratio). Program may participate in auctions profits and losses in the P-PIF on a pro for the sale of such Eligible Asset STEP 7: The P-PIF issues the remaining rata basis. The selling bank will receive Pools; the auctions will be managed $65 as debt to the bank, which debt is a portion of the purchase price in cash, by the FDIC. Prior to the auction, the guaranteed by the FDIC and collater- to the extent of the equity investment FDIC will conduct due diligence on alized by the Eligible Asset Pool. of the private investor and the the Eligible Asset Pool(s), and provide Treasury, and will receive the balance STEP 8: The private investor then private investors with marketing thereof in the form of FDIC-guaranteed selects an asset manager, approved by materials that will contain information debt issued by the P-PIF. The FDIC’s the FDIC, to manage the P-PIF with about the Eligible Asset Pool(s), as well guarantee will be collateralized by the oversight by the FDIC. as the amount of leverage available Eligible Asset Pool. The selling bank for such Eligible Asset Pool(s). Private may sell the FDIC-guaranteed debt into Although many of the details of the investors will use this information to the market if it elects. The following is Legacy Loans Program have yet to be prepare and submit a bid, which will an example of how the Legacy Loans provided, some of the advantages contain, among other things, the total Program is intended to work: to hedge funds and other financial amount of equity capital such private investors of investing in a P-PIF investor is willing to invest to purchase STEP 1: A participating bank and its may include: the Eligible Asset Pool. The Treasury regulators decide on a pool of Legacy n Limited economic downside risk: has agreed to match a private investor’s Assets with a face value of $100 to Unless the US government decides to equity commitment such that a private submit for auction under P-PIP. change the rules currently antici- investor and the Treasury would STEP 2: The FDIC approves the pool pated, a private investor could invest each invest 50% of the total equity of Legacy Assets submitted by the as little as 7.15% of the total initial investment for such Eligible Asset bank, as an Eligible Asset Pool that value of a P-PIF, with the Treasury Pool(s) (although a private investor may be auctioned by the FDIC committing another 7.15%, and the may elect in its bid to receive less than under P-PIP. P-PIF issuing non-recourse debt that 50% of the total equity commitment is guaranteed by the FDIC and from the Treasury). The FDIC has STEP 3: The FDIC then conducts due collateralized by the Eligible Asset agreed, in return for a fee, to guarantee diligence on the Eligible Asset Pool, Pool for the remaining 85.7%. The the debt that will be issued by the and, with the help of a valuation firm, maximum downside risk for the P-PIF. The highest bidder will win the determines that it would be willing private investor in this scenario is the auction, and the selling bank will then to leverage the Eligible Asset Pool at a loss of its 7.15% equity investment be given an opportunity to reject or five-to-one debt-to-equity ratio. with an upside of 50% of the total accept the highest bid. STEP 4: The FDIC then provides value of the P-PIF after the sale or If the highest bid is accepted by the interested pre-qualified private collection of all of its assets minus bank, a P-PIF will be created. The investors with marketing materials for (i) the payment of the P-PIF’s debt
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obligations, (ii) FDIC fees, and Some of the disadvantages to hedge not been provided. The FDIC has (iii) servicing fees and other funds and other financial investors of indicated that there will be restric- expenses; subject to any changes in investing in a P-PIF may include: tions on a P-PIF’s management the capital structure of the P-PIF as a discretion and exercise of remedies. n Additional regulatory oversight: The result of the warrants held by the For example, the FDIC has said that Treasury has specified that P-PIFs Treasury (as discussed below). it expects that residential mortgage will be subject to rigorous oversight loans purchased by a P-PIF would be n Low cost, non-recourse debt financing: by the FDIC, but it has not yet subject to the US Government Loan The FDIC has not specified the stated what such oversight will Modification Program. terms on which the P-PIF will issue entail. Moreover, the Treasury has debt, other than stating that such indicated that, in order to protect n Fees to the FDIC: The FDIC will be terms will be determined on a taxpayers, P-PIFs will be required paid a fee for guaranteeing the pool-by-pool basis based, in part, to agree to waste, fraud and abuse P-PIF’s debt. It also will receive a fee on the risk profile of the Eligible protections, none of which have for its ongoing oversight of each Asset Pool. However, the Treasury been clearly defined. In addition, P-PIF, and it will be reimbursed has announced that the debt will P-PIFs must also agree to provide for any expenses related to such be non-recourse, guaranteed by the access, as needed, to information oversight. Neither the Treasury nor FDIC (for a fee) and collateralized required by various US government the FDIC has indicated the amount by the Eligible Asset Pool. This debt regulatory bodies. Until the of these fees or how they will be structure may provide a private Treasury provides more detail on paid. Such fees must be taken into investor with an opportunity to the regulatory obligations to be consideration in order for a private purchase such Eligible Asset Pool placed on private investors, it will investor to determine its anticipated with limited risk (other than its loss be difficult to determine the burden return on investment. of committed equity). such obligations will impose. n 5% bidder deposit: Bids will not be n Private bidders set the price: Under n Risk of rules changing: Private considered at auction unless accom- the Legacy Loans Program, private investors participating in P-PIP may panied by a refundable cash deposit investors will set the price of the be at risk of having the rules of the for 5% of the bid value. In the event Eligible Asset Pools sold in the programs change along the way in the bid is rejected or unsuccessful, auction process. response to Congressional or public the deposit will be refunded in full disapproval of P-PIP once it is already to the bidder. However, a bidder n No detail on fee restrictions: The in place and active. Any changes that wins the auction may be at Treasury has not provided any detail may affect a private investor’s antici- risk of losing its deposit if it does clarifying whether a fund sponsor pated return on investment. not complete the transaction; the will be able to charge a management Treasury has not provided any infor- and/or incentive fee to any of its n Treasury will receive warrants in the P- mation on this to date. Moreover, limited partners who invest in a PIF: The Treasury has indicated that, the Treasury has not clarified dedicated fund to invest in P-PIFs. consistent with requirements under whether the deposit is composed the EESA, it will receive warrants in of 5% of the total value of the n Passive private investors not subject the P-PIF. The terms and amount Eligible Asset Pool, of the total equity to executive compensation restric- of such warrants have not been component of a P-PIF, or of the tions under EESA: The Treasury has specified, but presumably could private investor’s equity component. stated that passive private investors reduce, or create uncertainty in, the will not be subject to the executive n No participation in affiliated trans- potential return to private investors. compensation restrictions under actions: Private investors may Section 111(b) of the Emergency n Restrictions on asset management: The not participate in any P-PIF that Economic Stabilization Act of 2008 FDIC and the Treasury have stated purchases assets from banks that (“EESA”). However, the Treasury that they will establish governance are affiliates of such investor or has not specified who will qualify procedures on the management, that represent 10% or more of the as a passive investor, or whether servicing, reporting and exit timing aggregate private capital in the P-PIF. asset managers of P-PIFs and/or and alternatives for each P-PIF; The guidelines provided to date do their employees will be subject to however, the specific details of such not disclose the considerations for executive compensation restrictions. contemplated procedures have determination of affiliate status,
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although the FDIC has indicated Legacy Loans Program: Potential Structure Chart that it anticipates that the deter- mination will be along the lines of the Bank Holding Company Act’s GP Multiple LPs Taxpayer “common control” test. n Undisclosed prequalification require- ments: Potential private investors will be pre-qualified by the FDIC to Private Investor Treasury Funds participate in an auction to purchase Fund Eligible Asset Pools. However, the FDIC has not stated the qualifica- 50% 50% tions that investors must satisfy, other than to say that private Bank Debt (FDIC P-PIF guaranteed and investors who participate in the (Eligible Asset secured by Eligible Pool) Legacy Loans Program are expected Asset Pool) to include individual investors, pension plans, insurance companies and other long-term investors. that were originally rated AAA and operational capacity to manage the n Participant bank can reject highest bid: (ii) the expansion of the TALF to Legacy Securities Funds in a manner While the highest bidder wins the include certain non-agency residential consistent with the Treasury’s stated auction, the selling bank can refuse mortgage-backed securities that were objectives; and (v) headquarters in to sell the Eligible Asset Pool(s) at originally rated AAA and commercial the US. Such asset managers must the highest bid and reject the bid. mortgage-backed securities and asset- submit the application to the Treasury backed securities that are rated AAA. no later than 5 p.m. (EST) on Friday, Private investors, including hedge April 24, 2009, to be pre-qualified to funds and private equity funds, Legacy Securities P-PIF raise capital to invest alongside the might take advantage of the Legacy One part of the Legacy Securities Treasury in a Legacy Securities Fund. Loans Program by setting up distinct Program will provide a combination The Treasury currently contemplates funds to raise capital to invest in and of debt financing and equity capital informing applicants of its preliminary purchase these Legacy Assets. Unless to dedicated funds (“Legacy Securities approval on or prior to May 15, 2009. the Treasury otherwise indicates in Funds”) purchasing qualified mortgage- additional disclosures, an investor backed securities issued prior to 2009 Once pre-qualified by the Treasury, should be allowed to charge fees (“Legacy Securities”) from regulated asset managers will have a limited to its limited partners under such US financial institutions described in period of time (which has yet to be fund, including, without limitation, Section 101(a)(1) of EESA. The Treasury specified) to raise at least $500 million management and incentive fees. will participate as an equity investor of private capital to purchase Legacy However, it is unclear whether private matching private investors in the Securities designated by the asset investors will be allowed to charge Legacy Securities Funds. manager in its application, and to fees to the P-PIFs (although managers The Treasury will initially approve up demonstrate committed capital prior of Legacy Securities Funds, as defined to five asset managers (and perhaps to receiving matching final approval below, may charge fees as indicated by more) to manage the Legacy Securities from the Treasury. Under the Legacy the Treasury and discussed below). Funds. Interested asset managers must Securities Program, approved asset R:\8901-9000\8964 HFR_2009_NO.5\ART\PIF CHART_#195523.DOC complete an application provided by managers will receive funds from the Legacy Securities Program the Treasury, which demonstrates, Treasury in an amount equal to the The Legacy Securities Program consists among other things, (i) a track record private capital raised by such asset of two parts: (i) the establishment of of purchasing Legacy Securities; manager. Any capital received by an Legacy Securities P-PIFs to invest in (ii) a capacity to raise at least $500 asset manager from the Treasury will certain commercial mortgage-backed million of private capital; (iii) a be invested one-for-one on a fully securities and residential mortgage- minimum of $10 billion of Legacy side-by-side basis with private investor backed securities issued prior to 2009 Securities under management; (iv) an funds for a term no greater than ten
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years, unless otherwise extended financing to the Legacy Securities terms on which it will provide debt with the Treasury’s consent. Asset Fund for an amount equal to 50% of financing to Legacy Securities Funds managers may charge management its total equity commitment. (or TALF loans for the purchase of and incentive fees, as proposed in their Legacy Securities). However, the STEP 3: Asset manager is able to raise respective applications to the Treasury. Treasury has announced that the $500 of private capital for the Legacy debt will be non-recourse. A Legacy Securities Fund also will Securities Fund. The Treasury matches have the ability, if its fund structure the $500 with its own $500 equity n Highly-rated securities: Private meets certain guidelines, to subscribe commitment, and provides the Legacy investors may purchase qualified for senior secured non-recourse loans Securities Fund with $500 of senior commercial and residential from the Treasury in an amount up debt financing, which will be secured mortgage-backed securities that to 50% of the total equity capital by the Legacy Securities purchased by were originally rated AAA or of such Legacy Securities Fund (and the Legacy Securities Fund. equivalent (or, in the case of TALF, the Treasury will consider requests qualified asset-backed securities STEP 4: Asset manager now has $1,500 for senior debt of up to 100% of that are currently rated AAA) and to invest in Legacy Securities and can such Legacy Securities Fund’s total that are directly secured by the charge management and incentive fees equity subject to certain restric- actual mortgage loans, leases or as approved in its application. tions, including restrictions on asset other assets. level leverage, withdrawal rights, Expansion of TALF and disposition priorities) (“Treasury n Control of the process: Asset managers The second part of the Legacy Debt Financing”). Any Treasury Debt (and private investors under TALF) Securities Program will expand TALF to Financing provided to purchase Legacy will be able to control the process of include loans to purchase certain non- Securities for a Legacy Securities asset selection and pricing, as well as agency residential mortgage-backed Fund will be secured by the Legacy asset liquidation, trading and dispo- securities that were originally rated Securities of the borrower. A Legacy sition. This provides asset managers AAA and outstanding commercial Securities Fund may, however, finance with great flexibility to determine mortgage-backed securities and asset- the purchase of Legacy Securities when, what and how they will backed securities that are rated AAA. through qualified TALF loans or invest in and divest the Legacy Eligible borrowers will have to meet through debt financing from private Securities (although the Treasury sources as long as the equity capital of the criteria set out under TALF in order anticipates that Legacy Securities the Treasury and the private investors to qualify for these TALF loans. The Funds predominantly will follow a is leveraged proportionately from such minimum capital investment that long-term buy and hold strategy and private debt financing sources. Any an eligible borrower will be required that trading will be limited). TALF loans used to finance purchases to make to receive such TALF loans n Passive private investors (and eligible by a Legacy Securities Fund will be (which will be based on the risk profile borrowers of TALF loans for Legacy senior to any Treasury Debt Financing of the underlying assets), as well as Securities) are not subject to executive for such Legacy Securities Fund. An the lending rates, minimum loan sizes compensation restrictions under EESA: example of a Legacy Securities Fund and loan durations under TALF for The Treasury has stated that passive may look as follows: this newly expanded class of Legacy private investors will not be subject Securities, have yet to be determined to the executive compensation STEP 1: Asset manager interested in by the Treasury. However, the Federal restrictions under Section 111(b) of Legacy Securities Program submits Reserve says it is working to ensure the EESA. However, the Treasury has application for pre-qualification that the duration of these TALF loans not specified who will qualify as a (application must, among other take into account the duration of the things, provide details of the asset passive investor, or whether asset underlying assets securing them. manager’s fund raising plan). managers and/or their employees Some of the advantages to hedge will be subject to executive compen- STEP 2: Asset manager is pre- funds and other financial investors sation restrictions. qualified by Treasury and begins of investing in the Legacy Securities raising capital for Legacy Securities Some of the disadvantages to hedge Program may include: Fund, which private capital raised funds and other financial investors will be matched by the Treasury. The n Low cost, non-recourse debt financing: of investing in the Legacy Securities Treasury also agrees to provide debt The Treasury has not specified the Program may include:
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n Limited pool of asset managers. The Legacy Securities Fund: Potential Structure Chart Treasury will select only five asset managers of Legacy Securities Funds GP Multiple LPs Taxpayer (unless it otherwise indicates). Based on the qualifications required by the Treasury to be an asset manager, this may be limited to certain large asset management companies.
n Private Investor Treasury’s ability to pull funding: The Asset Manager Treasury Funds Fund Treasury will retain the right to cease funding of committed but undrawn Treasury equity capital and debt 50% Contract 50% financing for a Legacy Securities Fund in its sole discretion. Treasury Debt Legacy Securities Financing or TALF Fund n Treasury will receive warrants in the Loans Legacy Securities Fund: The Treasury has indicated that, consistent with requirements under EESA, applying to be an asset manager (or by US government, be able to charge it will receive warrants in each investing in a fund of a selected asset a management and incentive fee. A Legacy Securities Fund. The terms manager that invests in such Legacy structure of such a fund might look and amount of such warrants has Securities) or by setting up a separate not been specified (although the as below. fund to raise capital to invest in a Treasury has said this will be based Legacy Securities Fund. Such a structure The information provided to date on in part on the amount of Treasury might look as above. P-PIP from the Treasury is preliminary. debt financing taken by the fund). The Treasury currently expects to Such warrants presumably could A private investor also may choose inform asset managers that submit reduce, or create uncertainty in, the to invest in the expanded TALF loan timely applications to participate in potential return to private investors program by setting up a separate in a Legacy Securities Fund. fund that invests in TALF-eligible the Legacy Securities Program of their Legacy Securities or other TALF- preliminary qualification on or prior to n Reporting through third party: The prices qualified securities. The fund created May 15, 2009. However, the timeframe of Legacy Securities must be tracked by the private investor should, for the Legacy Loans Program has not using third party sources and annual unless otherwise announced by the yet been provided by the Treasury. audited valuations by a nationally recognized accounting firm. n Withdrawal restrictions: Legacy Expanded TALF Loans: Potential Structure Chart Securities Funds will not be eligible to receive Treasury Debt Financing GP Multiple LPs if private investors are offered R:\8901-9000\8964 HFR_2009_NO.5\ART\REVISED VISIO BOXES_#195496.DOC voluntary withdrawal rights from the Legacy Security Fund. This restriction may limit the market- ability of the Legacy Securities Fund. TALF Focused Federal Reserve Private Investor Bank of New York Private investors may take advantage Fund TALF Loans of the Legacy Securities Program by
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R:\8901-9000\8964 HFR_2009_NO.5\ART\HFR CHART_#195501.DOC Hedge Fund Returns
Update: Participating in TALF – Pros and Cons for Investors
By Kristen L. Buppert ([email protected])
Since the publication of Hedge Fund Returns No.3 regarding the Pros and Cons for Investors participating in the Term Asset- Backed Securities Loan Facility (“TALF”), the Federal Reserve Bank of New York (“FRBNY”) completed the first and second round of subscription requests under TALF on March 19, 2009 and April 7, 2009. The statistics from two rounds provide additional insight for potential investors into how the TALF operates.
For the first two rounds of subscriptions, FRBNY reported that the amount of TALF loans requested for the initial period was $4.7 billion and $1.7 billon for the second period. During both periods, all subscription requests were in the auto or credit card sectors.
Between the first and second round of subscriptions, FRBNY also announced four additional categories of eligible collateral: mortgage servicing advances, loans or leases relating to business equipment, leases of vehicle fleets (including recreational vehicles, commercial and government, which were not included in the previous round), and receivables backed by floorplan loans. Despite these additional categories, subscriptions in the second period were made in the same two categories as the first round. The required percentage of equity that an eligible borrower must contribute for these new categories is as follows:
ABS Expected Life (years)
Sector Subsector 0-1 >1-2 >2-3 >3-4 >4-5 >5-6 >6-7 Motorcycle/ Auto other recreational vehicles 7% 8% 9% 10% 11% Auto Commercial and government fleets 9% 10% 11% 12% 13%
Equipment Loans and leases 5% 6% 7% 8% 9%
Floorplan Auto 12% 13% 14% 15% 16%
Floorplan Non-auto 11% 12% 13% 14% 15%
Servicing advances Residential mortgages 12% 13% 14% 15% 16%
As with the initial round of subscriptions, eligible borrowers will continue to have the option of choosing either fixed or floating interest rate payments for these new categories of collateral, as detailed below, which remains subject to adjustment by the Federal Reserve.
Sector Subsector Fixed Floating
Equipment 3-year LIBOR swap rate + 100 bps 1-month LIBOR + 100 bps
Floorplan 3-year LIBOR swap rate + 100 bps 1-month LIBOR + 100 bps
Servicing advances Residential mortgages 3-year LIBOR swap rate + 100 bps 1-month LIBOR + 100 bps
FRBNY has also clarified that if a primary dealer intends to transfer its interests in the TALF collateral, including to a special purpose vehicle formed by the primary dealer, the primary dealer must submit a plan one week prior to such transfer to FRBNY.
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Are DIP Loans Worth the Investment? BOSTON Participating in TALF – Pros and Cons for Investors BUDAPEST Credit Derivatives Determinations Committees: A Way Forward in a Developing Marketplace DALLAS Survival of the Fittest
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