The Public-Private Investment Program - Genuine Opportunity or More For the Same "Old Boy" Network? Too Early to Say
Corporate & Finance Alert
April 7, 2009
Last week, the U.S. Treasury announced the much-anticipated details of the Public Private Investment Program (“PPIP”). The program, which is part of the Obama Administration’s broader “Financial Stability Plan,” focuses on the purchase of what were described as “troubled assets” under the Troubled Assets Relief Program (“TARP”), part of the Emergency Economic Stabilization Act of 2008 (“EESA”) enacted last October. The existing announcements provide only a general framework with the major elements, and importantly, the detail of the programs to be fleshed out in the coming weeks by Treasury and the FDIC.
Although the TARP was originally proposed as a purchase program for troubled loans and mortgage-backed securities, the Bush Administration, somewhat controversially, applied the first portion of the TARP proceeds toward direct capital infusions into banking institutions – a decision that forever changed the face of banking in America.
The objectives of the new PPIP appear to be much closer to the original objectives of the TARP – namely, to restart the nation’s credit markets by moving at least some of the legacy troubled assets off the balance sheets of financial institutions so those financial institutions can (it is hoped!) expand and resume their lending activities.
The initial stock market reaction to the PPIP was largely favorable, and a number of major assets managers such as PIMCO, KKR, BlackRock and banks, such as Goldman Sachs and Morgan Stanley, have expressed an interest in participating in the programs despite the pessimism of some commentators in the financial press and elsewhere, both home and abroad. A number of key uncertainties remain, however, most notably the concern over pricing. There is no certainty that buyers and sellers will, in fact, be able to find a clearing price for these troubled assets. Another potential question mark hangs over whether private investors will stay away because of a fear that the government might retroactively change the terms of the public-private partnership, impose conditions on unrelated activities, chastise them for as yet unidentified issues because of their participation or impose “windfall profits” taxes on them if their investments are “too successful”, etc. In recent days, commentators have honed-in on suggestions that the large banks who created the problem are now looking at ways in which to profit from the initiative.
So what did Obama and Treasury Secretary Geithner come up with that has caused such excitement? Will it really provide opportunities for investors of all shapes and sizes or is it simply more taxpayer money to bail out the banks? We believe that there will be financial market opportunities although the lack of current detail regarding the implementation and parameters of the separate programs makes it difficult to speculate about these opportunities. While we eagerly await further details it is nonetheless useful to understand the basics of what is proposed.
The PPIP consists of two core programs – the legacy loans program (“Loan Program”) and the legacy securities program (“Securities Program”). Under both programs, assets will be purchased by funds capitalized by equity contributed by Treasury and private investors and leveraged by potentially attractive direct government or FDIC-guaranteed debt financing. Both are built around the same basic concepts of pricing established by private investors and credit support provided by the government. The Loan Program is designed to create a market for troubled loans still on the balance sheets of US banks (and thrifts). The Securities Program is designed to remedy the illiquidity in the secondary markets for certain mortgage-backed securities – initially residential mortgage backed securities (known as “RMBS”) and commercial mortgage backed securities (known as “CMBS”). Although the programs initially target only real estate-related assets, the Treasury has indicated that it may evolve, based on market demand, to include other asset classes.
Overview – Loans Program
The government plans to spend approximately half of its TARP resources to attract private capital to purchase commercial and residential loans, generally in pools, from participating FDIC-insured banks through the provision of FDIC guarantees of debt issued by a 50% Treasury co-investment. The Treasury expects a broad spectrum of investors to participate in this program, including individual investors, pension funds, insurance companies, mutual funds, publicly managed investment funds and financial institutions. The mechanics of this participation, however, are still unclear.
Basically, under the Loans Program, banks will identify loans they plan to sell. The FDIC will analyze the loans and determine the level of debt to be issued by the purchasing entity that the FDIC will guarantee; however the leverage ratio will not be permitted to exceed a 6-to-1 debt-to-equity ratio. The FDIC will then conduct an auction for the loans; private investors will bid for the loans and the bank will then decide whether to accept an offer. The winning bidder will then form a Public-Private Investment Fund (“PPIF”), to which it will contribute 50% of the required equity in excess of the guaranteed debt with the Treasury contributing the remaining 50% of equity. Private investors will be prequalified by the FDIC to participate in the auctions. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee. Once the PPIF purchases the assets, the private fund managers will control and manage the assets until final liquidation, subject to FDIC oversight.
Also, private investors may not participate in any PPIF that purchases assets from sellers that are affiliates of the private investor or represent 10% or more of the aggregate private capital in the PPIF. The extent to which banks who have benefited from bail-out funds can participate as investors rather than sellers remains unclear and has already attracted controversy, with critics charging that the government’s public-private partnership – which provide generous loans to investors – are intended to help banks sell, rather than acquire, troubled securities and loans.
The Treasury released sample transaction illustrates the PPIP process for legacy loans:
Step 1: A bank with a pool of residential mortgages with $100 face value that it is seeking to divest approaches the FDIC.
Step 2: The FDIC determines that for this pool the agency is willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool is then auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – for example, $84 – is the winner and forms a PPIF to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC provides guarantees for $72 of PPIF debt, leaving $12 of equity (and allowing the FDIC to meet its 6-to-1 debt to equity ratio). In this case, some or all of the $72 of FDIC-guaranteed debt may be issued directly to the seller as part of the purchase price.
Step 5: The Treasury then provides 50% of the equity funding required on a side-by-side basis with the investor. In this case, the Treasury invests approximately $6, with the private investor contributing $6.
Step 6: The private investor then manages the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.
Overview – Securities Program
The Securities Program consists of two somewhat related elements. It is designed to draw private capital into the markets for legacy securities by providing debt financing from the Federal Reserve under the existing Term Asset-Backed Securities Loan Facility (“TALF”) and through matching private capital raised for dedicated funds targeting legacy securities.
Firstly, through the expansion of the TALF (which began operations on March 17, 2009 and participation has been disappointing with only around 2.5% of the $200 billion set aside being utilized in the first week of operation), non-recourse loans will be made available to investors who hold legacy securitization assets. In addition to the current eligible assets under the TALF (for example, asset backed securities relating to auto loans, student loans and credit card loans), eligible assets are expected to expand to include certain non-agency RMBS that were originally rated AAA, and outstanding CMBS and other asset-backed securities that are rated AAA. Borrowers will need to meet certain eligibility criteria and will be permitted to borrow an amount equal to the value of the legacy securities (which are pledged as collateral) minus a haircut. Importantly, eligibility and haircuts are yet to be determined. Similarly, lending rates, minimum loan sizes, and loan durations have not yet been determined. Gibbons is currently assisting a number of clients with accessing TALF funds and anticipate interest to rise as the categories of eligible assets widens.
Legacy Securities PPIFs
Under the second part of the Securities Program, the Treasury will make co-investment and debt available by partnering with private capital providers to participate in legacy securities PPIFs that will invest in legacy mortgage and asset backed-securities that originated prior to 2009 with a rating of AAA at origination. Under this program, several large private asset managers (initially expected to be five) will be selected jointly as a Fund Manager to raise the private capital to invest in these joint investment programs with the Treasury.
Under this program, private investment managers will have the opportunity to apply for qualification as a PPIF fund manager. Applicants will be pre-qualified based upon criteria that include a demonstrable historical track record in the targeted asset classes, a minimum amount ($10 billion) of assets under management in the targeted asset classes, and detailed structural proposals for the proposed legacy securities PPIF. The Treasury expects to approve approximately five PPIF fund managers and may consider adding more depending on the quality of applications received. Applications must be submitted by April 10th, 2009 and Treasury anticipates responding by May 1st, 2009. Small asset manager that are veteran-, minority- and women-owned are encouraged to partner with larger fund managers in order to meet the criteria. Approved PPIF fund managers will have a period of time to raise private capital to target the designated asset classes and will receive matching equity capital from the Treasury. PPIF fund managers will be required to submit a fundraising plan to include retail investors, if possible.
Private investors will participate in the PPIF through an investment vehicle “controlled” by a fund manager. The governance structure is yet to be revealed but private investors may be given voluntary withdrawal rights subject to certain limitations to be agreed with the Treasury. Also, these private investment vehicles are likely to be structured so that ERISA investors will be eligible to participate as indirect investors in the PPIFs.
The Treasury will invest equity capital on a fully side-by-side basis with the private investors in each PPIF. Furthermore, PPIF fund managers will have the ability, to the extent their PPIF structures meet certain guidelines, to have the PPIF issue to the Treasury non-recourse senior debt in the amount of up to 50% of a PPIF’s total equity capital, and the Treasury will consider requests by the PPIFs to issue non-recourse senior debt in the amount of up to 100% of a PPIF’s total equity capital subject to further restrictions on asset level leverage, redemption rights, disposition priorities, and other factors the Treasury deems relevant. This senior debt will have the same duration as the underlying fund and will be repaid on a pro-rata basis as principal repayments or disposition proceeds are realized by the PPIF. Gains and losses on equity capital will be shared equally between Treasury and private investors.
The Treasury released sample transaction illustrates the PPIP process for legacy securities:
Step 1: The Treasury will launch the application process for managers interested in the legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with the Treasury.
Step 3: The Treasury agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and fund-level leverage for the proposed PPIF.
Step 4: The fund manager commences the sales process for the PPIF and is able to raise $100 of private capital for the PPIF. The Treasury provides $100 equity co-investment on a side-by-side basis with private capital and provides a $100 loan to the PPIF. The Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the PPIF.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy.
Step 7: The PPIF, if the fund manager so determines, would also be eligible to take advantage of any expansion of the TALF program for legacy securities when such expansion occurs.