Private Investment Opportunities in Troubled Assets
Corporate & Finance Alert
October 21, 2008
On October 14, 2008, the Secretary of the Treasury, the Chairman of the FDIC and the Chairman of the Federal Reserve Board jointly announced a plan to inject $250 billion of capital available under the Troubled Asset Relief Program (“TARP”) into qualified financial institutions, including US bank holding companies designated by banking regulators as systemically important. While this may come as a relief to banking institutions, it is the Treasury’s plans for the remaining $450 billion available under TARP, that could open a door to economic opportunities for private real estate funds and other private investors.
It is likely that remaining TARP funds will be allocated to the purchase of troubled mortgages and other real estate assets owned as a result of foreclosures. As opposed to selling these distressed assets and toxic debt directly, in accordance with the mandate to the Treasury under the Emergency Economic Stabilization Act of 2008 (the “Act”) to “encourage the private sector to participate in purchases of troubled assets,” the Treasury is contemplating the contribution of these assets to joint ventures owned partly by investors and partly by the government, a move that has the potential to greatly increase the ultimate return on purchased troubled assets.
Unfortunately, the Act provides little to no guidance on how to encourage private sector participation or the structure of any public/private joint ventures. Accordingly, although not a perfect model due to structural differences, experts are looking towards the structure of the Resolution Trust Corporation (“RTC”), which emerged during the last real estate collapse, to garner insight on what to expect under TARP.
The RTC made use of equity partnerships wherein the RTC would contribute assets (generally commercial non-performing or sub-performing mortgage loans) to a newly created limited partnership in exchange for a limited partnership interest in the venture and a promissory note. A private investor would then purchase its interest in the partnership at the “derived investment value” (based on a formula devised by the RTC). As a result of RTC-provided seller financing, the private investor would pay less for its equity interest in the limited partnership than if the transaction was structured as all equity. The private investor would run the day-to-day management as the general partner of the venture and would provide investment management services for the partnership. Accordingly, the RTC sought partners with experience in managing and liquidating distressed real estate assets, as well as a sufficient source of capital.
It should be noted that investors hoping to capitalize on the purchase of distressed assets under TARP through a public/private partnership may face some bureaucratic and administrative challenges.
First, it is not yet clear whether these equity partnership will be subject to the Federal Acquisition Regulation (“FAR”). FAR governs the acquisition process through which the United States government purchases most goods and services. Complying with FAR is a complex and burdensome process which has been criticized for the high cost of compliance. Additionally, FAR imposes a host of diversity, minority and socioeconomic requirements. If the Treasury determines that the utilization of equity partnerships with private investors fall within the scope of the FAR procurement rules, the requirements could prove unduly onerous for investors who do not presently provide federal goods and services.
Second, the Treasury is required under the Act to issue guidelines to address potential conflicts of interests that may arise in connection with the Act, including, among other things, the purchase and management of assets. Although the guidelines have not yet been implemented, the conflict of interest requirements of FAR and those implemented in connection with the RTC are complex and difficult to comply with, often resulting in the acquisition of unwitting conflicts together with a portfolio of assets.
Finally, any private investor looking to manage a portfolio of assets will likely get swept up in the oversight and reporting requirements of TARP, which provides for (i) a Financial Stability Oversight Board which will meet on a monthly basis and report on suspected fraud or misrepresentation to the Special Inspector General for TARP; (ii) a Congressional Oversight Panel, which will report monthly to Congress on the effectiveness of the Act on, among other things, financial markets, foreclosure mitigation and market transparency; (iii) a Special Inspector General for TARP who will be charged with auditing and investigation the purchase, management and sale of assets; (iv) the Government Accountability Office which is charged with conducting audits of many aspects of TARP; and (v) the Treasury, which has numerous reporting obligations under the Act including monthly reports to Congress and the Oversight Panel.
In summary, there are a number of potential opportunities for real estate investors who have the means and resources to acquire and manage real estate assets. The Treasury is working around the clock to put into place the framework for the purchase of troubled assets as contemplated by the Act, but for now, the mechanisms, costs and burdens of participation have yet to be fully determined. We will be monitoring the situation as it progresses and will issue further alerts as more information becomes available.