Distressed Real Estate and Investment Management Alert March 2009 Authors: Anthony R.G. Nolan anthony.nolan@klgates.com +1.212.536.4843 Daniel F. C. Crowley dan.crowley@klgates.com +1.202.778.9447 Gordon F. Peery gordon.peery@klgates.com +1.617.261.3269 David H. Jones david.jones@klgates.com +1.704.331.7481 Anthony J. Barwick tony.barwick@klgates.com +1.919.743.7340 K&L Gates comprises approximately 1,900 lawyers in 32 offices located in North America, Europe, and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations, and public sector entities. For more information, please visit www.klgates.com. Public-Private Investment Partnerships to Tackle Legacy Toxic Assets On Monday, March 23, 2009, the U.S. Department of Treasury ( Treasury ) announced the expansion of the Troubled Assets Relief Program ( TARP ) to facilitate removal of distressed real estate-related assets from the balance sheets of financial institutions. The announcement described the framework for two publicprivate investment programs (collectively, PPIP ) under which the United States will make equity co-investments in, and provide leverage to, investment vehicles that will be established to acquire from financial institutions existing whole loans, commercial mortgage-backed securities ( CMBS ) and private-label residential mortgage-backed securities ( RMBS ). For background information on programs related to TARP and the Economic Stabilization Act of 2008 ( EESA ), please see the K&L Gates Global Financial Markets Newsstand. The latest announcement by the Treasury sets broad guidelines for how the PPIP will operate to provide an opportunity for private investors to participate in the purchase of real estate loans as well as CMBS and RMBS assets. As described below, the PPIP will combine additional capital from federal sources with capital from private investors and will add federally provided or guaranteed debt to provide financing for the PPIP vehicles purchases. Among the details that Treasury made available, an applicant that wishes to be a Fund Manager under the Legacy Securities Program (discussed in detail below) must apply no later than April 10, 2009, with preliminary approval from Treasury expected on or prior to May 1, 2009. Also due on April 10, 2009 are comments to the Federal Deposit Insurance Corporation ( FDIC ), which solicited public comments on the Legacy Loans Program (also described below in greater detail). Background When the TARP program was first announced in the fall of 2008, it was envisioned as a program that would use Treasury funds to purchase illiquid mortgage-related securities from banks. Critics pointed out several flaws in the plan. First, the original TARP plan did not provide a clear mechanism for determining the prices at which toxic assets would be sold. If the Treasury were to overpay for assets, the U.S. taxpayers would bear the risk of nonperformance. On the other hand, if the Treasury were to pay a price that reflected market valuations of such assets, the purchases would not contribute enough capital to recapitalize the banking system. In addition, many financial institutions were concerned that Treasury purchases at distressed prices would create observable inputs that would lead other institutions to mark down similar assets to a benchmark based on the price for which the Treasury acquired assets, further depleting their capital. Consequently, in November 2008 the Treasury changed direction by instituting a program of capital infusions known as the Capital Purchase Program and by instituting the Term Asset-Backed Securities Loan Facility ( TALF ) program, which was designed to resuscitate the securitization markets as a source of liquidity not only for financial institutions but
for consumers and small businesses whose borrowing needs had traditionally been beyond the capacity of the traditional banking system. The first TALF funding occurred on March 25, 2009, with K&L Gates representing a sponsor in one of the first TALF-eligible securitizations. With TALF now underway, the announcement of the PPIP marks Treasury s return to the effort to remove toxic assets from banks balance sheets. However, the basis of this effort is quite different from that which was originally conceived. With the PPIP providing for private investors to invest sideby-side with the Treasury and also providing an auction process with respect to real estate loans, the PPIP creates a market clearing price for at least some of these assets. To the extent that performance losses exceed expectations, the taxpayers risk will be mitigated because private equity investors will share those losses pro rata with the Treasury s equity position and because most Treasury funding will be in the form of debt that bears losses after the equity. To the extent that the market price is too low to provide significant capital for a viable selling institution, the Treasury s previously announced plan to stress-test banks will provide additional government-funded equity as needed. A Summary of How It Works: Two Programs for Two Asset Classes A cornerstone of the PPIP program is the formation of joint ventures between government and private capital providers. These public-private joint venture entities are designed to help provide a market mechanism for valuing distressed assets and acquiring those assets from their current owners through attractive leveraged acquisition financing of those assets. The Legacy Loans Program: Under the Legacy Loans Program, the FDIC and the Treasury will provide oversight for the formation, funding and operation of public-private investment funds ( PPIFs ) that will purchase distressed loans on a pool-by-pool basis from insured federal- and statechartered banks and thrifts that are not under foreign ownership or control and that elect to sell assets to a PPIF ( Participant Banks ). Potential private investors in a PPIF will need to be pre-qualified by the FDIC in order to participate in the Legacy Loans Program. The PPIFs will purchase distressed loan assets from Participant Banks with either cash or a combination of cash and FDIC-guaranteed debt issued by the PPIP. The debt issued by the PPIF will be nonrecourse. The FDIC guarantee of the debt will be collateralized by the purchased assets, also on a non-recourse basis. Leverage limits will be determined on a pool-by-pool basis in the FDIC s discretion as part of the auction process for each pool of Legacy Loans, with debt-to-equity ratios up to 6-to-1 for each PPIF. Neither the FDIC nor the Treasury has provided further information on any other key terms applicable to the FDIC-guaranteed debt or on the exact requirements for qualification by participants in the program. Pricing mechanics and key financing terms for purchasers of Legacy Loans (e.g., applicable LIBOR margins, guarantee fees, administrative fees, minimum loan size, loan-to-value discounts, etc.) will be determined in connection with the auction process for Legacy Loans. To start the auction process, a Participant Bank will identify a pool of loans it would like to sell. The FDIC will oversee initial due diligence and preparation of required marketing materials and will conduct each auction process with the assistance of a third party valuation firm. Prior to the auction date, the FDIC will conduct a separate analysis to determine the amount of acquisition debt for the applicable pool that it is willing to guarantee. Final eligibility of assets for purchase will be determined by the relevant Participant Bank, its primary regulator, the FDIC and Treasury. Bids from the qualified private bidders will be based on the amount of equity each bidder is willing to invest in acquiring the pool being auctioned, with the winner being the bidder who proposes to fund the largest amount of equity. The Treasury will agree to invest equity side-byside with the private equity to create the public component of the winning PPIF, although the public component will in all cases represent no more than 50% of the total equity in a PPIF. A Participant Bank may elect either to accept or to reject the bid once the auction is complete. March 2009 2
Participant Banks of all sizes will be eligible to sell their assets. Once the assets have been acquired by the PPIF from one or more Participant Banks, the private partner will have the responsibility for asset management. The Participant Bank may continue to service the Legacy Loans, unless otherwise agreed and subject to the control and direction of the PPIF. The PPIF will be subject to additional governance procedures, management, financial and operational reporting requirements as may be established by the FDIC and Treasury. The FDIC has invited public comment on the Legacy Loans Program. Given the lack of detail, comments from parties with experience in this market may have a material impact on how this program evolves. As noted above, the comment period for market participants to respond to the FDIC concerning the existing outlines of the Legacy Loans Program expires on April 10, 2009. Instructions for making comments can be found at http://www.fdic.gov/llp/progdesc.html. For further discussion of how the Legacy Loans Program is expected to operate, including a range of potential issues yet to be addressed, please see the K&L Gates Mortgage Banking and Consumer Credit Alert - Legacy Loans Program: The Government Offers Bridge Over Troubled Assets, which is being issued contemporaneously with this Alert. Legacy Securities Program: Under the Legacy Securities Program, private asset managers ( Fund Managers ) will be authorized to raise private capital to invest in joint investment funds ( Legacy Securities Funds ) with Treasury on a dollar-fordollar basis, with profits and losses shared on a pro rata basis. The Fund Manager will control and manage the Legacy Securities Fund and will have responsibility and control over the acquisition, disposition and liquidation of the assets in the Fund. The private investors will contribute capital through an investment vehicle also controlled by the Fund Manager (a Private Vehicle ). Fund Managers must be headquartered in the United States and will be pre-qualified based upon criteria that are anticipated to include the following: (1) demonstrated capacity to raise at least $500 million of private capital; (2) demonstrated experience investing in CMBS and RMBS; (3) a minimum of $10 billion (market value) of securitized assets under management; and (4) demonstrated operational capacity to manage Funds in achieving attractive long-term opportunistic investment returns following a predominantly long-term buy-and-hold strategy. The deadline for applications for loans from Treasury under this program is April 10, 2009, and preliminary application approval from Treasury is expected on or prior to May 1, 2009. Applicants will have a limited time after approval to raise at least $500 million. The Treasury expects to approve approximately five (5) Fund Managers, but this number may be increased depending on the quality of applications received. Eligibility to invest in a Legacy Securities Fund is designed to be open to a broad array of investors. The Treasury is particularly encouraging participation by individual retail investors, pension plans, insurance companies and other long-term investors. Legacy Securities Funds may borrow from the Federal Reserve Bank of New York ( New York Fed ) under the TALF program. The Legacy Securities Program expands the TALF program by relaxing two important eligibility criteria for CMBS and RMBS. While TALF-eligible securities generally must have been issued after January 1, 2009 and must be rated AAA at the time of the TALF financing, CMBS and private-label RMBS issued before 2009 will be eligible for TALF. There seems to be a discrepancy, however, in the Treasury s statements on the rating requirements for CMBS to be eligible for TALF financing. RMBS are eligible for both purchase by a Legacy Securities Fund and TALF financing as long as they were originally rated AAA. However, the March 23, 2009 Treasury announcement seems to provide that while CMBS that were originally rated AAA may be purchased by a Legacy Securities Fund, that CMBS must be currently rated AAA in order to be eligible for TALF financing. In other words, it is not clear whether CMBS that were rated AAA at the time of issuance but have since been downgraded will be eligible for purchase under the Legacy Securities Program but not eligible for TALF financing. Additionally, it remains to be seen whether the New York Fed will relax the origination March 2009 3
date restriction to permit eligible CMBS and RMBS to be backed by significant concentrations of mortgage loans that were originated prior to October 1, 2007. The Legacy Securities Program also goes beyond the previously announced TALF program in that the Treasury will provide matching equity capital on a dollar-for-dollar basis to be used for the purchase of these asset types. Each Fund Manager will have the option to obtain secured non-recourse loans from the Treasury ( Treasury Debt Financing ) in an aggregate amount equal to between 50% to 100% of the Legacy Securities Fund s total equity capital, so long as the private investors in the fund do not have voluntary withdrawal rights. Any Treasury funding at a level over 50% leverage of total equity capital would subject the Legacy Securities Fund to further restrictions on asset level leverage, disposition priorities and other factors that Treasury may deem relevant. In addition to fund level leverage that may be provided by the Treasury Debt Financing, the Fund Managers may borrow from the New York Fed under the TALF to finance the purchase of these assets, subject to TALF haircuts that could be financed by Treasury Debt Financing as described above. Any Treasury Debt Financing to a PPIP that borrowed under the TALF program would be structurally subordinated to any TALF loans made by the New York Fed to that PPIP. The terms and conditions of any TALF asset acquisition financing will be determined at a later date after discussions with market participants. Importantly, Treasury may cancel any loan or equity commitment not previously funded at any time in the Treasury s discretion. Funds may also be financed through private sources, provided that Treasury capital and Private Vehicle capital must be leveraged proportionately from such private debt financing sources. The Treasury will be given warrants as required by the EESA to protect the interests of taxpayers. The terms and amount of such warrants will be determined based on the amount of Treasury Debt Financing taken. Because PPIP will depend on private investor participation, it may be some time before it is clear whether this approach will work to stabilize and revitalize the credit markets for commercial and private real estate assets. Unfortunately, Treasury s March 23, 2009 announcement did not provide many details regarding key terms that private investors will need to know prior to entering into a formal agreement for the purchase of legacy assets under either program. For example, the Treasury, in its announcement, made it clear that the executive compensation restrictions of the EESA would not apply to passive investors, the implication being that the restriction may apply to Fund Managers under the Legacy Securities Program and to the persons responsible for managing PPIFs participating in the Legacy Loans Program (possibly including Participant Banks). How these restrictions are interpreted in this context is yet to be known. Likewise, no details regarding the Treasury s rights as a warrant holder have been revealed. There are also questions regarding the mechanics of the auction, transferability of equity interests, and the extent to which investors may be subject to oversight or disclosure obligations. We will continue to monitor these details as they are announced and evolve for the benefit of our clients. The financing that the U.S. government will make available has the potential to significantly magnify, via leverage, private investor returns. Questions which remain unanswered include the extent of these enhanced returns, whether they will be enough to stimulate private demand for the distressed assets, and whether financial institutions will be willing to part with these distressed assets at the prices determined by the private market. There are doubts especially as to the willingness of financial institutions to sell Legacy Loans that are not currently marked to market and therefore not necessarily subject to embedded liquidity discounts. In addition, sponsors of private equity funds that may be established to make equity investments in PPIFs or joint venture feeders will have to consider a wide range of legal issues, including under the Investment Company Act and the Internal Revenue Code. In particular, offshore funds or those with foreign investors that invest in a PPIF under the Legacy Loans Program would have to consider structuring investments in order to minimize negative tax attributes associated with having income that is effectively connected to the conduct March 2009 4
of a trade or business in the United States. Another open question for potential sellers, investors and managers is the extent to which participation in either program could subject them to enhanced legislative or regulatory scrutiny or changing terms as the programs evolve. For PPIPs to stimulate bank lending and avoid the stagnation in the financial sector that Japan recently experienced over the course of a decade after a similar financial crisis, private investors will have to work closely with the Treasury, the FDIC and the New York Fed to establish a viable partnership and make many compromises to meet each of their needs under this program. If you have questions with respect to any of the foregoing, please contact the authors of this Alert. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Singapore (K&L Gates LLP Singapore Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. 2009 K&L Gates LLP. All Rights Reserved. March 2009 5