Item 1. Business.
GENERAL
We are a
publicly traded holding company conducting substantially all of our operations through our principal operating subsidiary,
ZAIS Group, LLC (“ZAIS Group”), an investment advisory and asset management firm focused on specialized credit.
ZAIS Group is a wholly-owned consolidated subsidiary of ZAIS Group Parent, LLC (“ZGP”), which is our
majority-owned consolidated subsidiary. Our Class A common stock (“Class A Common Stock”) is traded on the NASDAQ Stock
Market under the ticker symbol “ZAIS”. We are headquartered in Red Bank, New Jersey and also maintain an
office in London. Prior to March 2015, we were a publicly traded special purpose acquisition corporation called
HF2 Financial Management Inc. (“HF2”). On March 17, 2015, we completed a business combination transaction with
ZGP (the “Business Combination”), whereby we acquired a 66.5% interest in ZGP and changed our
name to ZAIS Group Holdings, Inc. In the Business Combination, HF2 made a $78.2 million cash contribution to ZGP
and effected the transfer of all its outstanding shares of Class B common stock (“Class B Common Stock”) to
the members of ZGP (including Christian Zugel, the former managing member of ZGP and the founder and Chief Investment Officer
of ZAIS Group, and certain related parties, collectively, the “ZGP Founder Members”).
ZAIS Group was formed
in 1997 and is an investment adviser registered with the Securities and Exchange Commission (“SEC”) under the Investment
Advisers Act of 1940, as amended (the “1940 Act”), and with the Commodity Futures Trading Commission (“CFTC”)
as a Commodity Pool Operator (“CPO”) and Commodity Trading Advisor (“CTA”). ZAIS Group provides investment
advisory and asset management services to private funds, separately managed accounts, structured vehicles (collateralized debt
obligation vehicles and collateralized loan obligation vehicles, together referred to as “CLOs”) and, until October
31, 2016, ZAIS Financial Corp. (“ZFC REIT”), a publicly traded mortgage real estate investment trust (collectively,
the “ZAIS Managed Entities”). The ZAIS Managed Entities predominantly invest in a variety of specialized credit instruments
including corporate credit instruments such as collateralized debt obligations or loan obligations, securities backed by residential
mortgage loans, bank loans and various securities and instruments backed by these asset classes. ZAIS Group had approximately
$3.444 billion of assets under management (“AUM”) as of December 31, 2016. ZAIS Group also serves as the general partner
to certain ZAIS Managed Entities, which are generally organized as pass-through entities for U.S. federal income tax purposes.
ZAIS Group’s AUM is primarily comprised of (i) total assets for mark-to-market funds and separately managed accounts; (ii)
uncalled capital commitments, if any, for funds that are not in liquidation; and (iii) for issued structured vehicles, all assets
being managed calculated per the management fee basis methodology defined in the respective vehicles’ indenture, although
in certain circumstances some or all of the referenced management fees may be waived. AUM also includes assets in the warehouse
phase for new structured credit vehicles and is based on actual assets managed without reductions for leverage and most other
liabilities and includes all assets regardless of whether management fees are being earned.
ZAIS
Group’s approach to disciplined and opportunistic credit investing focuses on investing in cash flowing assets and
structures that offer an increased loss-adjusted yield or return relative to a more liquid, less complex instrument of
similar credit risk. ZAIS Group manages complexity with institutional depth of experience and expertise, combined with a
reliance on analytics. ZAIS Group employed 61 employees across its investment management, client relations, information
technology, law, compliance, risk management, finance and operations groups as of March 24, 2017. The ZAIS Group team
includes 24 investment professionals as of March 24, 2017 and is led by Christian Zugel, ZAIS Group’s founder, Chairman
and Chief Investment Officer. The Company continually reviews its business and fund activities with a view towards improving
our profitability. As a result of concluding that a planned expansion of our capabilities in the residential mortgage whole
loan market would no longer be a part of our future strategy, a reduction in expenses related to infrastructure staffing was
made by completing a reduction in force on March 8, 2016, which resulted in a decrease of 23 employees of ZAIS Group.
At
December 31, 2016, the Company had 60 employees compared with 95 employees at December 31, 2015. On October 31, 2016,
the Company’s management agreement with ZFC REIT was terminated upon completion of a merger between ZFC REIT and
Sutherland Asset Management Corp, which resulted in a decrease of $0.589 billion in ZAIS Group’s AUM during the fourth
quarter ended December 31, 2016. As a result of the termination of the ZFC REIT management agreement, management fees earned
by ZAIS Group are expected to decrease by approximately $2.8 million annually on a run-rate basis. The decrease in management
fees for the year ended December 31, 2016 was offset by the receipt of a termination payment from ZFC REIT in the amount of
$8.0 million that ZAIS REIT Management LLC (“ZAIS REIT Management”), a consolidated subsidiary of ZAIS Group,
received pursuant to a termination agreement between ZAIS REIT Management and ZFC REIT (the “Termination Agreement”).
On February 15, 2017,
the Board of Directors of the Company established a Special Committee of independent and disinterested directors to consider
any proposals by management or third parties for strategic transactions. The Company’s Board of Directors has been
undertaking a strategic review of the Company’s business in order to enhance shareholder value, and has engaged
a financial advisor for this purpose. Various alternatives have been and are being considered, including a possible sale
or combination or other similar transaction, or a going private transaction which would result in the termination of
the registration of our Class A Shares so as to cease periodic and other public company compliance and reporting. The Company
has received from and provided to potential counterparties certain due diligence information. In addition, the
Company’s management and financial advisor have held and expect to continue to hold preliminary discussions with
potential counterparties and participants. There is no assurance that any of the preliminary discussions which have taken
place or may in the future take place will result in any transaction or that any of the strategic alternatives under
consideration will be implemented. The Company does not intend to provide periodic public updates of these matters except as
required by law or regulation.
ZAIS Group has an established
track record of investing through multiple market cycles and believes that its performance across these cycles and the credit
spectrum in which it invests is largely attributable to several distinguishing elements of its platform:
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Disciplined
Investing:
ZAIS Group maintains a disciplined approach to credit
investing coupled with robust risk mitigation.
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Broad
Credit Expertise:
ZAIS Group’s proficiency at evaluating every
level of the capital structure, in both mortgage and corporate credit assets and related
derivative securities, enables ZAIS Group to assess relative value effectively and deploy
capital opportunistically in what ZAIS Group views as the most attractive investment
opportunities.
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Flexible
Approach:
ZAIS Group’s infrastructure and technical experience
allow ZAIS Group to manage various types of investment vehicles, including separate accounts,
commingled funds, permanent capital vehicles and structured credit products, depending
on the characteristics of the investment opportunity.
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Competitive Strengths
With ZAIS Group’s investment track record
and established platform, ZAIS believes it is well-positioned to capitalize on market opportunities due to the following attributes:
Significant Experience.
ZAIS Group has
been an active investor in specialized credit and other specialized credit products since 1997. Members of ZAIS Group’s
senior team, including those employees on ZAIS Group’s Investment Committee and Management Advisory Committee, have, on
average, more than 20 years of industry experience, covering investment management, fixed income trading, research, investment
banking and financial services. ZAIS believes that its extensive track record and broad experience in managing credit investments
through a variety of economic, credit and interest rate environments provides it with a competitive advantage over more recent
entrants.
Distinguished Investment Track Record Across Multiple Market
Cycles.
Since inception, ZAIS Group has designed investment portfolios to perform well across a range of macroeconomic
scenarios or capitalize on specific market opportunities. Our longest running commingled opportunistic structured credit fund,
ZAIS Opportunity Fund, has a track record spanning more than ten-years.
ZAIS Opportunity Fund Performance
(1)(2)
Year
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YTD
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ITD
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2003
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18.97
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%
(3)
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18.97
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%
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2004
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42.25
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%
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69.24
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%
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2005
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15.43
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%
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95.35
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%
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2006
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16.26
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%
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127.12
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%
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2007
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2.31
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%
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132.37
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%
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2008
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-73.57
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%
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-38.58
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%
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2009
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103.74
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%
(2)
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25.13
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%
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2010
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111.71
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%
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164.91
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%
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2011
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31.75
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%
(2)
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249.01
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%
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2012
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22.66
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%
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328.08
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%
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2013
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8.56
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%
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364.74
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%
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2014
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8.37
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%
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403.63
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%
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2015
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-9.35
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%
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356.55
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%
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2016
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18.99
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%
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443.27
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%
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2017
(4)
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3.71
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%
(4)
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463.40
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%
(4)
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(1) All returns reflect an investment in
ZAIS Opportunity Domestic Feeder Fund, LP (‘‘Domestic Feeder’’) Series A interests. All returns are
net of fees including incentive allocation, if any, and expenses; reflect a blended calculation of fee-paying interests for
the relevant time period; and reflect the reinvestments of dividends, interest and earnings. The year to date and inception
to date ("ITD") returns represent the cumulative effect of compounding the monthly returns for the relevant period.
All ITD returns and the YTD 2017 returns are unaudited. Some YTD returns reflected herein may vary from the results disclosed
in the respective year's audited annual report of the Domestic Feeder due to (i) the treatment of certain transactions under
generally accepted accounting principles which are discussed in further detail in notes 2 and 3 and (ii) the impact of timing
differences of capital contributions throughout the years 2004 to 2007. Returns would differ for an investment in Domestic
Feeder Series B and ZAIS Opportunity Fund, Ltd. (“Offshore Feeder”) Series A or Series B. An individual
investor's return may vary based on timing of capital transactions. Effective April 1, 2012, management fee rates were
reduced from 1.50% to 1.25% for Series A and from 1.00% to 0.75% for Series B. Effective January 1, 2013, incentive fee or
allocation rates were reduced from 25% to 20% for Series A and from 20% to 15% for Series B. Past performance is not
a guarantee, prediction or indicator of future returns and no representation is made that any investor will or is likely
to achieve results comparable to those shown or will make any profit or will be able to avoid incurring substantial
losses.
(2) The Domestic Feeder's returns YTD for
2009 and 2011 have been adjusted to include the impact of income resulting from certain withdrawal charges that were levied on
withdrawing investors and retained by the Domestic Feeder for the benefit of the remaining investors. Therefore, the YTD 2009 and
2011 returns reflected herein are higher than the returns reflected in the respective years’ annual report which was calculated
in accordance with accounting principles generally accepted in the United States (“GAAP”). As a result, the 2009 and
2011 ITD returns, as well as the consequential effect on subsequent ITD returns presented herein, have been adjusted to reflect
the position of the remaining investors.
(3) All investors’ subscriptions in the Offshore Feeder and contributions to the
Domestic Feeder during the period 8/28/03 to 10/31/03 (the “Ramp-Up Period”) were treated as if they were made on
8/28/03 based on an agreement among ZAIS Group and the investors. Allocations of net P&L during the Ramp-Up Period were allocated
to each investor based on each investor’s proportionate share of initial subscriptions or contributions during the Ramp-Up
Period. The YTD 2003 return reflected herein is higher than the GAAP return in the respective annual report which was based on
the P&L during the Ramp-Up Period being treated as part of the investors’ October initial capital contributions.
(4) Estimated YTD and ITD return through February 28, 2017.
Broad Credit Investment
Products Platform.
ZAIS Group is an active investor across a broad range of product sectors, including
securitized credit and related investments. ZAIS Group’s current investments include, but are not limited to,
non-agency and agency residential mortgage backed securities (“RMBS”), commercial real estate (“CRE”)
investments including commercial mortgage backed securities (“CMBS”), mezzanine loans and commercial properties,
corporate CLOs, individual corporate debt securities, leveraged loans, and structured corporate synthetics. Within these
products, ZAIS Group invests in senior, mezzanine and equity investments. ZAIS Group’s involvement in investing across
the specialized credit market provides ZAIS Group with context for assessing cross-sector relative value. The depth of ZAIS
Group’s credit insight can then be used to source what ZAIS Group believes are the most attractive investment
opportunities.
Diverse Client Base and Product
Mix.
Since its inception in 1997, ZAIS Group has built long-term relationships with an international
investor base, including public and private pension funds, endowments, foundations, insurance companies, family offices,
funds of funds, sovereign wealth funds and investment advisors. ZAIS Group manages assets using a range of strategies and
investment vehicles, including hedge funds, hybrid private equity funds, separately managed accounts, structured vehicles
such as CLOs and, until October 31, 2016, ZFC REIT. The chart set forth below provides a breakdown of our AUM by investor
type.
AUM by Investor Type as of December 31
(1)
:
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(1)
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ZAIS Group’s December 31, 2015 AUM uses values for certain structured vehicles that are prior to December 31, 2015 based on the most recent trustee report received as of December 31, 2015 for each respective vehicle.
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ZAIS Group’s December 31, 2016 AUM uses values for certain structured vehicles that are prior to December 31, 2016 based on the most recent trustee report received as of December 31, 2016 for each respective vehicle.
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Robust Proprietary Analytics Platform.
ZAIS
Group has developed a proprietary analytics platform which includes credit modeling, loan and securities valuation, loan data
management and servicing oversight capabilities. ZAIS Group supports corporate loan and consumer loan level analytics to generate
scenario analysis across the specialized credit markets. ZAIS Group maintains a private database of corporate CLO structures,
including covenants, waterfall rules, portfolios, and performance. For RMBS, ZAIS Group maintains an advanced loan-level collateral
performance database, feeding its mortgage credit models. ZAIS Group’s analytics allow it to compare investments under various
assumptions, such as different macroeconomic conditions, credit spread and market volatility observations, and default and recovery
rates. Utilizing a common analytics platform for both securities and loans enables ZAIS Group to make relative value allocations
across these sectors.
ZAIS’s Investment Vehicles
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ZAIS Group manages customized solutions in the
form of
separately managed accounts
and funds of one that are tailored to the investment objectives of investors. The
investors in these managed accounts may generally contribute additional capital or withdraw capital with little or no notice.
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CLOs
purchase debt or loans and finance
the purchases through the issuance of new debt and equity securities. Series of notes are issued with different risk-return
profiles based on their position in the capital structure and payment waterfalls. The “equity securities” in such
a structure typically take the first loss risk and are entitled to any excess returns from the vehicle. Should the credit
quality of the portfolio deteriorate, the equity securities will often be cut off from any distributions in order to protect
the more senior debt tranches and accelerate their amortization.
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ZAIS Group’s
hedge funds
generally
permit new and existing fund investors to contribute capital on a periodic basis (typically monthly) and to redeem their capital
on a periodic basis. These funds have an indefinite life as long as they have investors and ZAIS Group elects to continue
their existence.
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ZAIS Group’s
hybrid private equity
style funds
generally permit investors to make capital commitments when the fund is formed and these commitments are drawn
down as the fund makes investments. Capital is returned to fund investors on distribution dates after the investment period
has ended (averaging three years) and there is a set termination date for the respective funds. In general, fund investors
may not withdraw or redeem capital during the investment period and additional fund investors are not permitted to join the
fund after the fund’s final closing date.
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ZAIS’s Investment Strategies
Corporate Debt Strategies
ZAIS Group’s corporate credit expertise,
proprietary analytics platform and experienced credit analysts allow ZAIS Group to provide solutions and insight to optimize portfolios
backed by corporate debt. ZAIS Group believes, regardless of product form or credit ratings, that integrating a breadth of information
across corporate credit markets can generate investment ideas and risk management processes capable of generating above average
returns. ZAIS Group has consistently sought to offer its investors opportunities to capitalize on dislocated markets across the
corporate credit spectrum. As of December 31, 2016, ZAIS Group has approximately $2.072 billion deployed in corporate debt strategies.
Mortgage Strategies
ZAIS Group’s
mortgage investment platform combines a skilled team of experienced mortgage investors with analytical and risk management
systems focused on the residential and commercial mortgage sectors. ZAIS Group has organized its internal resources to
address opportunities across the mortgage markets as such opportunities evolve. Over time, ZAIS Group has successfully
positioned its platform to capitalize on market dislocations and the subsequent recovery of the mortgage securities and the
Government Sponsored Enterprises’ first and second loss tranche securities. ZAIS Group has built a fully integrated
investment platform focused on analyzing and managing securitized mortgage loan assets. ZAIS Group’s mortgage team is
actively engaged in asset selection. ZAIS Group believes these strategies are well suited to the current mortgage environment
to capitalize on market conditions. As of December 31, 2016, ZAIS Group has approximately $0.576 billion deployed in mortgage
strategies.
On October 31, 2016, the Company’s management
agreement with ZFC REIT was terminated upon completion of a merger between ZFC REIT and Sutherland Asset Management Corp which
resulted in a decrease of $0.589 billion to ZAIS Group’s AUM during the fourth quarter ended December 31, 2016. As a result,
management fees earned by ZAIS Group are expected to decrease by approximately $2.8 million annually on a run-rate basis. The
decrease in management fees for the year ended December 31, 2016 was offset by the receipt of the termination payment in the amount
of $8.0 million.
Multi-Strategy Vehicles
ZAIS Group also uses its credit expertise and
analytics platform to manage multi strategy funds that focus on various specialized credit investments. Some of these multi strategy
funds contain investments in mortgage and corporate debt strategies referred to above. As of December 31, 2016, ZAIS Group has
approximately $0.796 million deployed in multi-strategy funds.
The following charts show our AUM by strategy and form of investment
vehicle.
AUM by Strategy as of December 31
(1)
:
AUM by Vehicle Type as of December 31
(1)
:
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(1)
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ZAIS Group’s December 31, 2015 AUM uses values for certain structured vehicles that are prior to December 31, 2015 based on the most recent trustee report received as of December 31, 2015 for each respective vehicle.
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ZAIS Group’s December 31, 2016 AUM uses values for certain structured vehicles that are prior to December 31, 2016 based on the most recent trustee report received as of December 31, 2016 for each respective vehicle.
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Fee and Income Structure
The following table presents the range of management
and incentive fee rates on the ZAIS Managed Entities during the respective periods presented:
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Year Ended December 31,
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2016
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2015
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Management
Fee Income
(1)
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Funds and accounts
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0.50% - 1.25%
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0.50% - 1.25%
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CLOs
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0.15% - 0.50%
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0.15% - 0.50%
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ZFC REIT
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1.50%
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1.50%
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Incentive
Income
(1)(2)
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Funds and accounts
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10% - 20%
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10% - 20%
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CLOs
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20%
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10% - 20%
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(1)
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Certain management
and incentive fees have been and may in the future be waived and therefore the actual fee rates may be lower than those
reflected in
the
range.
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(2)
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Incentive
income earned for certain of the ZAIS Managed Entities is subject to a hurdle rate of
return as specified in each respective ZAIS Managed Entity’s operative agreement.
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For the management of its investment products
and other vehicles, ZAIS Group receives fees and other income as follows:
Management Fee Income
Management fee income is typically based on
a fixed annual percentage of net assets of the ZAIS Managed Entities and it is intended to compensate ZAIS for the time and effort
ZAIS Group expends in researching, and managing investments. These fees are generally collected on a monthly or quarterly basis.
Funds and accounts
: Management fees earned by ZAIS
Group for funds and accounts are generally based on net asset value prior to the accrual of incentive
fees/allocations or drawn capital during the investment period.
CLOs
: Management fees earned by ZAIS Group for
the CLOs it manages are generally based on the par value of the collateral and cash held in the CLOs.
ZFC REIT
: Through October
31, 2016, management fees earned by ZAIS Group from ZFC REIT, were based on ZFC REIT's stockholders' equity, as defined in
the amended and restated investment advisory agreement between ZAIS REIT Management and ZFC REIT. Twenty percent of
the management fee income received from ZFC REIT was paid to holders of Class B interests in ZAIS REIT Management. On October
31, 2016, the management agreement with ZFC REIT was terminated upon completion of the merger between ZFC REIT and
Sutherland Asset Management Corp which resulted in a decrease to ZAIS Group’s AUM of approximately $0.589 billion
during the fourth quarter ended December 31, 2016. In addition to the reduction in ZAIS Group’s AUM, management fees earned
by ZAIS Group will decrease by approximately $2.8 million annually on a run-rate basis as a result of the Termination
Agreement. The decrease in management fees earned from ZFC REIT for the year ended December 31, 2016 was offset by the
receipt of a termination payment in the amount of $8.0 million.
Incentive Income
In some cases, ZAIS Group receives incentive
income when certain pre-agreed financial hurdles have been met.
Funds and accounts
: For ZAIS Managed Entities
with hedge fund-style fee arrangements, incentive income earned by ZAIS Group is based on a percentage of the net realized and
unrealized profits attributable to each investor, subject to a hurdle (if any) set forth in each respective entity’s operative
agreement. Additionally, all of ZAIS Group’s funds and accounts with hedge fund-style fee arrangements are subject to a
perpetual loss carry forward or perpetual “high-water mark,” meaning that the funds and accounts will not pay incentive
fees/allocations to ZAIS Group with respect to positive investment performance generated for an investor in any year following
negative investment performance until that loss is recouped, at which point an investor’s capital balance surpasses the
high-water mark. For funds and accounts with private equity-style fee arrangements, incentive income earned by ZAIS Group is based
on a priority of payments under which investor capital must be returned and a preferred return, as specified in each fund’s
operative agreement, must be paid to the investor prior to any payments of incentive-based income to ZAIS Group.
CLOs
: For CLOs, incentive income is earned based
on a percentage of all profits, subject to the return of contributed capital (and subordinate management fees, if any), and a
preferred return as specified in the respective CLO’s collateral management agreements.
ZFC REIT
: The advisory agreement between ZAIS REIT Management
and ZFC REIT did not provide for ZAIS Group to earn incentive income from ZFC REIT.
Capital Invested In and Through ZAIS Group’s Products
As further alignment of ZAIS Group’s
interests with those of its investors, ZAIS Group and certain eligible employees have invested capital in ZAIS Managed Entities.
Regulatory and Compliance Matters
ZAIS Group is subject to extensive regulation
by a number of regulators and self-regulatory organizations that have the authority to authorize, and in specific circumstances
to limit, restrict or prohibit, regulated entities from carrying out particular activities if they fail to comply with applicable
laws and regulations. A significant failure to comply could expose ZAIS Group to liability or reputational damage. Further, new
legislation, heightened regulatory oversight of fundraising activities, changes in rules of self-regulatory organizations or exchanges
or changes in the interpretation or enforcement of existing laws and regulations may directly affect ZAIS Group’s operations
and profitability.
Rigorous legal and compliance
analysis of ZAIS Group’s businesses and investments is ingrained in its culture. ZAIS Group strives to maintain a culture
of compliance through the use of carefully tailored policies and procedures, monitoring and oversight, a code of ethics, compliance
systems, communication of compliance guidance and employee education and training, including by making clear that doing business
in compliance with applicable law and regulations is the responsibility of each of ZAIS Group’s employees. ZAIS Group has
compliance professionals, led by a Chief Compliance Officer, who monitor ZAIS Group’s compliance with regulatory requirements
to which ZAIS Group is subject and manages ZAIS Group’s compliance policies and procedures. ZAIS Group’s compliance
policies and procedures address a wide variety of regulatory and compliance obligations that arise under the various bodies of
law that apply to ZAIS Group’s business. Senior management is involved in various aspects of ZAIS Group’s compliance
program.
United States
ZAIS Group is registered with the SEC as an
investment adviser pursuant to the Advisers Act. The Advisers Act, together with the SEC’s regulations and interpretations
thereunder, is a highly prescriptive regulatory statute. The SEC is authorized to institute proceedings and impose sanctions for
violations of the Advisers Act, ranging from fines and censures to termination of an adviser’s registration and, in the
case of willful violations, can refer a matter to the Unites States Department of Justice for criminal prosecution.
Under the Advisers Act, an investment adviser
(whether or not registered under the Advisers Act) owes fiduciary duties to its clients. These duties impose standards, requirements
and limitations on, among other things, trading for proprietary, personal and client accounts; allocations of investment opportunities
among clients; use of “soft dollars,” a practice that involves using client brokerage commissions to purchase research
or other services that help managers make investment decisions; execution of transactions; and recommendations to clients. On
behalf of its investment advisory clients, ZAIS Group makes decisions to buy and sell securities for each ZAIS Managed Entity,
selects broker dealers to execute trades and negotiates brokerage compensation.
The Advisers Act also imposes specific restrictions
on an investment adviser’s ability to engage in principal and cross transactions. ZAIS Group policy permits cross trades
so long as no client is disfavored. Generally, cross trades between clients will be permitted if: (1) third party bids are obtained
to assess appropriate market values, (2) ZAIS Group receives any necessary client permissions following disclosure of certain
material facts related to any such trade and (3) complete records are maintained. Any cross trades involving assets for which
third party bids are not available will only be executed after obtaining a reasonable, independent indicator of value and approval
from the ZAIS Group Conflicts/Cross Trade Committee. ZAIS Group does not receive any special compensation for cross trades. While
cross trades may create the appearance of a conflict of interest, ZAIS Group believes its cross trade procedures mitigate the
potential conflict and provide all parties to the transaction with a fair and equitable price.
As a registered investment adviser, ZAIS Group
is subject to additional requirements that cover, among other things, disclosure of information about its business to clients;
maintenance of written policies and procedures; maintenance of extensive books and records; restrictions on the types of fees
ZAIS Group may charge; custody of client assets; client privacy; advertising; and solicitation of clients. The SEC has legal authority
to inspect any investment adviser and typically inspects a registered adviser periodically to determine whether the adviser is
conducting its activities in compliance with (i) applicable laws and regulations, (ii) disclosures made to clients and (iii) adequate
systems, policies and procedures reasonably designed to prevent and detect violations.
Under the Advisers Act, ZAIS Group’s
investment management agreements may not be assigned without the client’s consent. The term “assignment” is
broadly defined and includes direct assignments as well as assignments that may be deemed to occur upon the transfer, directly
or indirectly, of a controlling interest in ZAIS Group.
Section 28(e) of the Exchange Act provides
a “safe harbor” to investment managers who use commission dollars generated by their advised accounts to obtain investment
research and brokerage services that provide lawful and appropriate assistance to the manager in the performance of investment
decision-making responsibilities. ZAIS Group, as a matter of policy, does not use “soft dollars” and so it has no
incentive to select or recommend a broker or dealer based on any interest in receiving research or related services. Rather, ZAIS
Group selects brokers based on its clients’ interest in receiving best execution.
With respect to certain investment vehicles,
ZAIS Group is also registered with the CFTC as a CPO or CTA. ZAIS Group is also a member of the National Futures Association (“NFA”),
the commodity and futures industry self-regulatory organization that inspects CPOs and CTAs for compliance with the CFTC’s
and its own rules and regulations. As with the Advisers Act, the CEA governs many aspects of ZAIS Group’s derivatives-related
business.
ZAIS Group is also a member of various Swap
Execution Facilities (“SEFs”), each of which is a self-regulatory organization with its own rulebook, and with inspection
and enforcement authority. The SEFs of which ZAIS Group is a member have contracted with the NFA to conduct compliance inspections
of their members.
United Kingdom
ZAIS Group (UK) Limited, a wholly owned subsidiary
of ZAIS Group is authorized and regulated by the Financial Conduct Authority in the United Kingdom. Its regulatory authorizations
fall within the framework established by the European Markets in Financial Instruments Directive (as implemented into English
law) and encompass, among other things, the ability to advise on investments, manage investments and arrange deals in investments
for non-retail clients. ZAIS Group (UK) Limited has exercised its right to provide these services to clients across the European
Economic Area (“EEA”) by passporting its regulatory authorizations into all other EEA member states.
ZAIS Group (UK) Limited does not hold client
money and, on the basis of its size and systemic importance, the Financial Conduct Authority has classified it as a “flexible
portfolio firm”.
Competition
ZAIS Group competes in all aspects of its business
with other investment management companies, including investment funds, hedge funds, private equity funds and traditional and
non-traditional financial services companies, including commercial banks and insurance companies. ZAIS Group faces competition
in the pursuit of outside investors for its funds. ZAIS Group also pursues investment opportunities for client accounts and for
ZAIS Group alongside many competitors.
ZAIS Group competes for outside investors based
on a variety of factors, including:
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investment
performance;
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investor
perception of investment managers’ drive, focus and alignment of interest;
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terms
of investment, including the level of fees and expenses charged for services;
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ZAIS
Group’s actual or perceived financial condition, liquidity and stability;
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ZAIS
Group’s investment professionals and its non-investment staff;
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the
quality and mix of services provided to, and the duration of relationships with, investors;
and
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ZAIS
Group’s business reputation.
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In order to grow its business, ZAIS Group must
be able to compete effectively for outside investors. ZAIS Group must also effectively execute its investment strategies on behalf
of its clients and itself. ZAIS Group’s ability to successfully implement its investment strategies is based on a variety
of factors, including:
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the
experience and insights of its management team;
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the
research and recommendations of its portfolio management team;
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its
efficient investment analysis and decision-making processes; and
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the
effective support of its analytics platform and trading personnel.
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Many of ZAIS Group’s
competitors are substantially larger and may possess greater financial and technical resources. Several of these competitors
have recently raised, or are expected to raise, significant amounts of capital and many of them have similar investment objectives
to ZAIS Group, which may create additional competition for investment opportunities. Some of these competitors may also have a
lower cost of capital and access to funding sources that are not available to ZAIS Group, which may create competitive disadvantages
for ZAIS Group with respect to investment opportunities. Some of these competitors may have higher risk tolerance, make different
risk assessments or have lower return thresholds, which could allow them to consider a wider variety of investments, bid more
aggressively for investments that ZAIS Group wants to make or accept legal or regulatory limitations or risks ZAIS Group would
be unable or unwilling to accept. Moreover, an increase in the allocation of capital to alternative investment strategies by institutional
and individual investors could lead to a reduction in the size and duration of pricing inefficiencies that many of ZAIS Group’s
investment funds seek to exploit. Alternatively, a decrease in the allocation of capital to alternative investments strategies
could intensify competition for that capital and lead to fee reductions and redemptions, as well as difficulty in raising new
capital.
Competition is also intense for the attraction
and retention of qualified employees. ZAIS Group’s ability to continue to compete effectively in its businesses depends
upon its ability to attract new employees and retain and motivate existing employees.
Employees
ZAIS believes
that one of the strengths and principal reasons for its success is the quality and dedication of its people. The
Company continually reviews its business and fund activities with a view towards improving our profitability. As a result
of concluding that a planned expansion in our capabilities in the residential whole loan market would no longer be a part of
our future strategy, a reduction in expenses related to infrastructure staffing was made by completing a reduction in force
on March 8, 2016 which resulted in a decrease of 23 employees of ZAIS Group. As of March 24, 2017, ZAIS Group employed
61 individuals, including 24 investment professionals, located in its Red Bank and London offices. At December 31, 2016, ZAIS
Group had 60 employees compared with 95 employees at December 31, 2015.
Executive Officers of the Company
The following sets forth
certain information with respect to our executive officers:
Christian
M. Zugel
, 56, founded ZAIS Group in 1997 and currently serves as the Chairman of our board of directors and as
Chief Investment Officer. Mr. Zugel also served as Chairman of the board of directors of ZFC REIT from July 2011 until
October 31, 2016 and Chief Investment Officer of ZFC REIT from March 2016 until October 31, 2016. Prior to founding ZAIS
Group, Mr. Zugel was a senior executive with J.P. Morgan Securities Inc., where he led J.P. Morgan’s entry into many
new trading initiatives. At J.P. Morgan, Mr. Zugel also served on the Asia Pacific management-wide and firm-wide market
risk committees. Mr. Zugel received a Masters in Economics from the University of Mannheim, Germany.
Michael F. Szymanski
,
50, currently serves as our Chief Executive Officer, President and Director and has served as the President of ZAIS Group since
2011. Mr. Szymanski also served as Chief Executive Officer, President and Director of ZFC REIT from July 2011 until October 31,
2016. Prior to joining ZAIS Group, Mr. Szymanski was Chief Executive Officer of XE Capital Management, LLC, an investment management
firm specializing in structured products, from 2003 to 2008. Prior to that, Mr. Szymanski was Chief Financial Officer of Zurich
Capital Markets (or ZCM), a subsidiary of Zurich Financial Group, from 2000 to 2002. At ZCM, Mr. Szymanski managed global finance,
accounting, tax, treasury, and risk management for a business specializing in structured products, including hedge fund linked
derivatives and principal investments. Prior to that, Mr. Szymanski was a Vice President in the Bank and Insurance Strategies
Group of Lehman Brothers from 1997 to 2000, providing capital markets structuring and advisory services to financial institutions
and corporations. Prior to that, Mr. Szymanski spent nine years at Ernst & Young LLP advising financial services clients,
leaving as a Senior Manager in the Capital Markets/M&A Advisory Group in New York. Mr. Szymanski served in E&Y’s
National Office-Financial Services Industries Group, providing internal consultation services to resolve clients’ accounting
and regulatory issues, specializing in financial instruments. Mr. Szymanski also served on the board of directors of the National
Stock Exchange from December 30, 2011 to February 19, 2015 and as Chairman of its audit committee from February 10, 2012 to February
19, 2015. Mr. Szymanski is a Certified Public Accountant and received a B.A. in Business Administration with a concentration in
Accountancy from the University of Notre Dame and an Executive M.B.A. with a concentration in Finance from New York University’s
Stern School of Business.
Howard E. Steinberg
,
72, currently serves as our General Counsel and also serves as General Counsel and a Managing Director at ZAIS Group. Before joining
ZAIS Group in February of 2011, Mr. Steinberg was a partner in the international law firm of McDermott Will & Emery LLP. Mr.
Steinberg received a B.A. from the University of Pennsylvania and a J.D. from the Georgetown University Law Center. Effective
April 1, 2017, Mr. Steinberg will resign as General Counsel and an employee of ZAIS Group and become Senior Legal Advisor to the
Company and ZAIS Group. He will be succeeded by Mark Russo, 38, currently Assistant General Counsel of the Company and ZAIS Group.
Mr. Russo joined the ZAIS Group Law Department in 2007. He received a B.S. from the Pennsylvania State University and a J.D. from
Saint John’s University School of Law.
Nisha Motani
,
45, currently serves as our Acting Chief Financial Officer (“CFO”) and Chief Accounting Officer. Ms. Motani
also serves as Acting Chief Financial Officer of ZAIS Group. Ms. Motani was also Chief Accounting Officer of ZFC REIT
from March 2013 until October 31, 2016. Ms. Motani brings over 20 years of financial and accounting experience to her
role. Prior to joining ZAIS in October 2003, Ms. Motani served as a Senior Manager in the Financial Services audit
practice of Deloitte & Touche where she specialized in Investment Management. Ms. Motani is a Certified Public
Accountant with a B.S. in Accounting from Rutgers School of Business.
Marc
D. Galligan
, 62, currently serves as our Chief Risk Officer and is a Managing Director at ZAIS Group where he has served
as the Chief Risk Officer since 2008 and is also Head of Middle Office. Mr. Galligan
has 39 years of experience in the credit markets. Before joining ZAIS Group in August of 2008, he was a Senior Managing
Director responsible for Credit Trading Risk Management at Bear Stearns, which included cash and credit derivative trading
risk, as well as Leverage Finance. Before Bear Stearns, Mr. Galligan spent 20 years in a variety of credit and investment
banking roles at The First National Bank of Boston and The Chase Manhattan Bank. Mr. Galligan received a B.S. in Finance from
Boston College and an M.B.A. from the Thunderbird School of Global Management.
Gregory Barrett,
50
,
currently serves as Head of Client Relations and Business Development globally and is responsible for working with the firm’s
Client Relations team, portfolio managers and CIO to lead and create distribution strategies for ZAIS. Mr. Barrett has 23 years of industry experience, including capital
formation, capital introduction, and entrepreneurial start-ups. Prior to joining ZAIS in February of 2016, Barrett was a Managing
Director and a senior member of Dyal Capital Partners, where he co-headed Dyal's Business Services platform. Previously, he was
a senior member of Barclays Capital Prime Services Group from 2008 to 2012. During his tenure at Barclays, he was Global Head
of the Capital Solutions Group and responsible for key account coverage oversight of the Capital Solutions Group. Mr. Barrett
holds an M.B.A. in Finance from Fordham University and a B.A. in English and Philosophy from Franklin and Marshall College.
Organization Structure
The following diagram illustrates
the Company’s corporate structure at December 31, 2016:
Available Information
The Company maintains
a website at www.zaisgroupholdings.com and makes available, free of charge, on its website (a) its annual report on Form 10-K,
quarterly reports on Form 10-Q and current reports on Form 8-K (including any amendments thereto), proxy statements and other
information (collectively, “Company Documents”) filed with, or furnished to, the SEC, as soon as reasonably practicable
after such documents are so filed or furnished, (b) Corporate Governance Guidelines, (c) Code of Ethics and (d) written charters
of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of the board of directors. Company
Documents filed with, or furnished to, the SEC are also available for review and copying by the public at the SEC’s Public
Reference Room at 100 F Street, NE., Washington, DC 20549 and at the SEC’s website at www.sec.gov. Information regarding
the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The Company provides copies of
its Corporate Governance Guidelines and Code of Conduct and Ethics, free of charge, to stockholders who request such documents.
Requests should be directed to ZAIS Investor Relations, ZAIS Group, LLC at Two Bridge Avenue, Suite 322, Red Bank, New Jersey
07701.
Item 1A. Risk Factors.
The Company’s
business and operations are subject to a number of risks and uncertainties, the occurrence of which could adversely affect its
business, financial condition, consolidated
results of operations and ability to make distributions to stockholders and
could cause the value of the Company’s capital stock to decline. Please refer to the section entitled “Forward-Looking
Statements.”
Risks Related to ZAIS Group’s Business
If ZAIS Group is unable to significantly
increase its AUM, or develop new sources of revenue, our revenues and operating income will continue to be negatively impacted,
and we will likely continue to incur operating losses.
ZAIS Group’s
AUM has declined significantly from its peak of $11.707 billion prior to the financial crisis in 2008 to $3.444 billion as of
December 31, 2016, largely attributable to the return of investor capital from certain private equity style ZAIS Managed
Entities, the termination of certain legacy CLOs managed by ZAIS Group, certain investor redemptions and the challenges of
raising significant new assets to replace those assets being returned to investors. While ZAIS Group had historically been
profitable until 2015, it incurred net losses in both 2016 and 2015 based on GAAP. ZAIS Group incurred a smaller net loss in
2016 as compared to 2015 due to increases in revenues and other income, including the receipt in 2016 of an $8.0 million
termination fee from ZFC REIT. Revenue and results of operations are primarily dependent on the management fee income and
incentive income ZAIS Group earns on the assets under its management. During 2016, the alternative asset management industry
has been under fee pressure, and ZAIS Group has not been able to maintain its historic fee levels. The CLO origination
business, which generally has a lower embedded management fee structure than the mortgage and corporate credit funds, has
grown and become a larger percentage of ZAIS Group’s AUM. The typical management fee rates for CLO vehicles generally
range between 0.30% and 0.50% and for the mortgage and corporate credit funds the fee rates generally range between 0.50% and
1.50%. As a result, the average fee rate earned by ZAIS Group on the ZAIS Managed Entities has declined. The average AUM
during 2015 and 2016 was approximately $4.220 billion and $3.877 billion, respectively. Additionally, ZAIS Managed Entities
representing total AUM as of December 31, 2016 of approximately $0.291 billion are winding down and are in liquidation. On
October 31, 2016, the management agreement with ZFC REIT was terminated upon completion of the merger between ZFC REIT and
Sutherland Asset Management Corp. which resulted in a decrease of $0.589 billion in ZAIS Group’s AUM during the fourth
quarter ended December 31, 2016. As a result of this transaction, management fees earned by ZAIS Group are expected to
decrease by approximately $2.8 million annually on a run-rate basis. The decrease in management fees for the year ended
December 31, 2016 was offset by the receipt of a termination payment in the amount of $8.0 million. For the year
ended December 31, 2016, we reported a GAAP net loss of $(3.8) million, compared with GAAP net loss of $(23.9) million for
the year ended December 31, 2015. For the year ended December 31, 2016, we reported revenue of $31.7 million, which includes
the non-recurring $8.0 million termination fee from ZFC REIT as compared with revenue of $23.2 million for the year
ended December 31, 2015. The current recurring revenue base does not cover the current run-rate of compensation, and general
and administrative expenses. The Company currently anticipates that its expenses in 2017 will exceed its revenues as they did
in 2015 and 2016. If ZAIS Group is unable to significantly increase its assets under management and thereby generate
additional revenue from management fee income and potentially, incentive income, or develop new sources of revenue, it is
likely that we will continue incurring operating losses. In that event, we may need to sell assets to raise cash and/or
curtail certain business activities, including foregoing additional investments in newly formed ZAIS Managed Entities. There
is no assurance that ZAIS Group will be able to increase its assets under management or develop new sources of revenue.
Difficult market and political conditions
may adversely affect ZAIS Group’s business, including by reducing the value or hampering the performance of the investments
made by the ZAIS Managed Entities, each of which could materially and adversely affect ZAIS Group’s business, results of
operations and financial condition.
ZAIS Group’s business
is materially affected by conditions in the global financial markets and economic and political conditions throughout the world,
such as interest rates, availability and cost of credit, inflation or deflation, economic uncertainty, changes in laws (including
laws relating to ZAIS Group’s taxation, taxation of investors in the ZAIS Managed Entities, the possibility of changes to
tax laws in either the United States or any non-U.S. jurisdiction and regulations on asset managers), trade barriers, commodity
prices, currency exchange rates and controls and national and international political circumstances (including wars, terrorist
acts and security operations). These factors are outside of ZAIS Group’s control and may affect the level and volatility
of asset prices and the liquidity and value of investments and ZAIS Group may not be able to or may choose not to manage its exposure
to these conditions. Increasing uncertainty following the U.S. election and Brexit, among other geopolitical events, could lead
to increased market volatility in 2017 and future years, and uncertainty and instability for investment management businesses.
These and other conditions in the global financial markets and the global economy may result in adverse consequences for the ZAIS
Managed Entities and their respective investee companies and investments, which could restrict their investment activities and
impede their ability to effectively achieve investment objectives.
In the event of a market
downturn, each of ZAIS Group’s businesses could be affected in different ways. The ZAIS Managed Entities, ZGP, ZAIS Group
or its subsidiaries may face reduced opportunities to sell and realize value from their existing investments, and a lack of suitable
investments for the ZAIS Managed Entities, ZGP, ZAIS Group or its subsidiaries to make. In addition, adverse market or economic
conditions could have an adverse effect on the returns of the ZAIS Managed Entities and investments directly held by ZGP, ZAIS
Group or its subsidiaries, and, therefore, ZAIS Group’s earnings. A general market downturn, or a specific market dislocation,
may cause ZAIS Group’s revenue and results of operations to decline by causing:
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the
net asset value or the AUM of ZAIS Managed Entities to decrease, lowering management
fees;
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lower
investment returns, reducing incentive income; and
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investor
redemptions, resulting in lower fees.
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Furthermore, while difficult
market conditions may increase opportunities to make certain distressed asset investments, such conditions also increase the risk
of default with respect to investments held by the ZAIS Managed Entities, ZGP, ZAIS Group or its subsidiaries. The attractiveness
of the ZAIS Managed Entities relative to other investment products could decrease depending on economic conditions. The ZAIS Managed
Entities, ZGP, ZAIS Group or its subsidiaries may also be adversely affected by difficult market conditions if ZAIS Group fails
to predict the adverse effect of such conditions on particular investments, resulting in a significant reduction in the value
of those investments.
The investment management business is competitive.
The investment management
business is highly competitive, with competition based on a variety of factors, including investment performance, business relationships,
quality of service provided to investors, investor liquidity and willingness to invest, ZAIS Managed Entities’ terms (including
fees), brand recognition and business reputation. ZAIS Group competes for investors with other investment managers, public and
private funds, business development companies, small business investment companies and others. Numerous factors increase ZAIS
Group’s competitive risks, including:
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a
number of ZAIS Group’s competitors have greater financial, technical, marketing
and other resources and more personnel than ZAIS Group does;
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some
of the ZAIS Managed Entities may not perform as well as competitors’ funds or other
available investment products;
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a
number of ZAIS Group’s competitors have raised significant amounts of capital,
and some of them have similar investment objectives to ZAIS Group’s, which may
create additional competition for investment opportunities and may reduce the size and
duration of pricing inefficiencies that otherwise could be exploited;
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some
of ZAIS Group’s competitors may have a lower cost of capital and access to funding
resources that are not available to ZAIS Group, which may create competitive disadvantages
for the ZAIS Managed Entities;
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some
of ZAIS Group’s competitors may be subject to less regulation and, accordingly,
may have more flexibility to undertake and execute certain businesses or investments
than ZAIS Group does or bear less compliance expense than ZAIS Group does;
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some
of ZAIS Group’s competitors may have more flexibility than ZAIS Group has in raising
certain types of funds under the investment management contracts they have negotiated
with their investors;
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some
of ZAIS Group’s competitors may have better expertise or be regarded by investors
as having better expertise than ZAIS Group in a specific asset class or geographic region;
and
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other
industry participants may, from time to time, seek to recruit ZAIS Group’s investment
professionals and other employees away from ZAIS Group.
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This competitive pressure could adversely affect
ZAIS Group’s ability to make successful investments and limit ZAIS Group’s ability to obtain future funds for management,
either of which would adversely impact ZAIS Group’s business and our results of operations and financial condition.
ZAIS Group’s operating cash flow
may continue to be insufficient to fund its operating expenses which are currently funded by the proceeds of the Business Combination,
reducing the amount of capital available to invest and correspondingly decreasing the amount of revenue potentially generated
by the investments.
ZAIS Group primarily
uses cash flow from operations to pay compensation and benefits, general, administrative and other expenses and foreign
taxes. ZAIS Group’s cash flows are also used to fund various investments, including investments in entities in which
ZAIS Group serves as the investment manager, property and equipment and other capital items. If cash flow from operations
continues to be insufficient to fund operating expenses or such investments, ZAIS Group will continue to fund a portion of
its business requirements with the proceeds from the Business Combination. For the year ended December 31, 2016, the
Company’s stand-alone (excluding the activities of the Consolidated Funds, as defined below) net cash used in
operations was $8.1 million. The sources of operating cash flow were insufficient to cover operating expenses, and the excess
working capital needs were funded by the proceeds of the Business Combination. The Company currently anticipates that this
negative working capital trend will continue in 2017, and could limit our ability to expand our investments from the proceeds
of the Business Combination, thereby decreasing the revenue potentially generated by the capital invested from the Business
Combination.
ZAIS Group’s AUM has been subject
to volatility and certain ZAIS Managed Entities are being liquidated or may be disposed of in the near term.
Historically, ZAIS
Group’s AUM has fluctuated from time to time. ZAIS Group’s AUM has declined significantly from its peak of
$11.707 billion prior to the financial crisis in 2008 to $3.444 billion as of December 31, 2016, largely attributable to the
return of investor capital from certain private equity style ZAIS Managed Entities, the termination of certain legacy CLOs
managed by ZAIS Group, the termination of the Company’s management agreement with ZFC REIT, certain investor
redemptions and the challenges of raising significant new assets to replace those assets being returned to investors. These
challenges stem largely from structured credit products being disfavored by certain investors seeking to deploy structured
credit when dislocation occurs, rather than to earn cash flows from current positions in structured credit and take advantage
of dislocations when they arise. Additionally, European investors have exited because of capital considerations due to
regulatory requirements.
Further, ZAIS
Managed Entities representing total AUM as of December 31, 2016 of approximately $0.291 billion are winding down and are in
liquidation. These liquidations are expected to occur within the next 12 to 24 months. Clients invested in separately managed
accounts may generally withdraw their invested capital with little or no notice which could further reduce ZAIS Group’s
AUM. On October 31, 2016, the Company’s management agreement with ZFC REIT was terminated upon completion of the merger
between ZFC REIT and Sutherland Asset Management Corp. which resulted in a decrease of $0.589 billion of ZAIS Group’s
AUM during the fourth quarter ended December 31, 2016. As a result, management fees earned by ZAIS Group are expected to
decrease by approximately $2.8 million annually on a run-rate basis. The decrease in management fees for the year ended
December 31, 2016 was offset by the receipt of a termination payment in the amount of $8.0 million. If ZAIS Group is unable
to raise significant new assets to replace those that have and will be returned to investors, its AUM would be subject to
further decline resulting in a lower base of assets on which it charges management fees and may receive incentive income.
This, in turn, would continue to negatively impact ZAIS Group’s revenue and results of operations.
ZAIS Group derives a substantial portion
of its revenues from ZAIS Managed Entities managed pursuant to advisory agreements that may be terminated
.
The applicable investment
advisory agreement for each of the ZAIS Managed Entities may permit the investors in a ZAIS Managed Entity to remove ZAIS Group
as investment manager in certain circumstances. ZAIS Group’s separately managed accounts are governed by investment management
agreements that may be terminated by investors, generally upon little or no notice and with or without cause, as set forth in
the applicable agreement. Termination of these agreements would reduce ZAIS Group’s AUM and therefore negatively affect
ZAIS Group’s revenue, which could have a material adverse effect on our results of operations.
ZAIS Group may not be able to maintain
its current fee structure as a result of industry pressure from the ZAIS Managed Entities’ investors to reduce fees, which
could have an adverse effect on its profit margins and our results of operations.
ZAIS Group has experienced
declines in its fee structures for new mandates as a result of industry pressure from the ZAIS Managed Entities’ investors
to reduce fees. Although ZAIS Group’s investment management fees vary among and within asset classes, historically ZAIS
Group has competed primarily on the basis of its performance and not on the level of its investment management fees relative to
those of its competitors. In recent years, however, there has been a general trend toward lower fees in the investment management
industry as well as a general trend toward reducing management fees and incentive income to external managers, whether through
direct reductions, deferrals, rebates or fee sharing arrangements. ZAIS Group’s average management fees charged with respect
to certain asset types has declined as a result of this industry pressure towards lower fees. Although ZAIS Group has no obligation
to modify any of its fees with respect to the existing ZAIS Managed Entities, it may experience pressure to do so. No assurance
can be made that ZAIS Group will succeed in providing investment returns and service that will allow ZAIS Group to maintain its
current fee structure. Fee reductions on existing or future businesses could have an adverse effect on ZAIS Group’s profit
margins and our results of operations.
The historical returns attributable to
the ZAIS Managed Entities should not be considered as indicative of the future results of ZAIS Group or any ZAIS Managed Entity
or of any returns expected on an investment in Class A Common Stock of ZAIS.
An investment in Class
A Common Stock is not an investment in any of the ZAIS Managed Entities. The historical performance of the ZAIS Managed Entities
is relevant to ZAIS Group primarily insofar as it is indicative of fees ZAIS Group has earned in the past and may earn in the
future and ZAIS Group’s reputation and ability to raise new investments in ZAIS Managed Entities. The historical and potential
returns of the ZAIS Managed Entities are not, however, directly linked to returns on Class A Common Stock. Therefore, you should
not conclude that positive performance of ZAIS Managed Entities will result in positive returns on an investment in Class A Common Stock, nor should you conclude that ZAIS Managed Entities’ prior performance is indicative of the future results of the
ZAIS Managed Entities. Poor future performance of the ZAIS Managed Entities could cause a decline in ZAIS Group’s revenues
and could therefore have a negative effect on ZAIS Group’s operating results and returns on the Class A Common Stock.
Moreover, the historical
returns of the ZAIS Managed Entities should not be considered indicative of the future returns of those ZAIS Managed Entities
or from any future ZAIS Managed Entities, in part because:
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market
conditions during previous periods may have been significantly more favorable for generating
positive performance than the market conditions ZAIS Group may experience in the future;
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The
ZAIS Managed Entities’ returns have previously benefited from investment opportunities
and general market conditions that may not recur, and the ZAIS Managed Entities may not
be able to achieve the same returns or profitable investment opportunities or deploy
capital as quickly;
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some
of the ZAIS Managed Entities’ rates of returns are calculated on the basis of market
value of the ZAIS Managed Entities’ investments, including unrealized gains, which
may never be realized;
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in
recent years, there has been increased competition for investment opportunities which
may reduce the ZAIS Managed Entities’ returns in the future; and
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ZAIS
Group’s newly established ZAIS Managed Entities may generate lower returns during
the period that they take to deploy their capital.
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The future internal rate
of return for any current or future ZAIS Managed Entity may vary considerably from the historical internal rate of return generated
by any particular ZAIS Managed Entity, or for the ZAIS Managed Entities as a whole. Future returns will also be affected by the
risks described elsewhere in this Annual Report on Form 10-K, including risks of the industries and businesses in which a particular
ZAIS Managed Entity invests.
Poor performance of the ZAIS Managed Entities
would cause a decline in ZAIS Group’s revenue and results of operations, and would adversely affect ZAIS Group’s ability
to obtain investments in future ZAIS Managed Entities.
ZAIS Group’s revenue
is derived principally from two sources: (1) management fee income, based on the size of the ZAIS Managed Entities and (2) incentive
income, based on the performance of the ZAIS Managed Entities. A portion of ZAIS Group’s revenue and cash flow is variable,
primarily due to the fact that incentive income can vary from year to year. Incentive income from certain ZAIS Managed Entities
may, in some cases, be subject to (i) a hurdle and a perpetual loss carry forward, or “perpetual high-water mark,”
meaning that the funds and accounts will not pay incentive fees/allocations with respect to positive investment performance generated
for an investor in any year following negative investment performance until that loss is recouped, at which point an investor’s
capital balance surpasses the high-water mark or (ii) a priority of payments under which investor capital must be returned and
a preferred return must be paid to the investor prior to any payments of incentive-based income to ZAIS Group. For the year
ended December 31, 2016, incentive income was 29.5% of ZAIS Group’s total revenues, representing a 31.1% increase over the
year ended December 31, 2015. Total revenues for the year ended December 31, 2016 includes the $8.0 million termination fee received
by ZAIS Group from ZFC REIT. For the year ended December 31, 2015, incentive income was 30.7% of ZAIS
Group’s total revenues. In the event that any of the ZAIS Managed Entities perform poorly, ZAIS Group’s revenue and
results of operations will decline, and it will likely be more difficult for ZAIS Group to obtain new investments in ZAIS Managed
Entities. In addition, investors may withdraw their investments in the ZAIS Managed Entities (or, in the case of separately managed
accounts, terminate investment management agreements) as a result of poor performance of the ZAIS Managed Entities or otherwise.
ZAIS Group’s investors and potential investors continually assess the ZAIS Managed Entities’ performance and ZAIS
Group’s ability to obtain new investments for management.
Employee misconduct could harm ZAIS Group
by impairing ZAIS Group’s ability to attract and retain investors for the ZAIS Managed Entities and subjecting ZAIS Group
to significant legal liability, regulatory scrutiny and reputational harm.
ZAIS Group’s ability
to attract and retain investors and to pursue investment opportunities for the ZAIS Managed Entities depends heavily upon the
reputation of ZAIS Group and its professionals, especially ZAIS Group’s senior professionals. ZAIS Group is subject to a
number of obligations and standards arising from ZAIS Group’s investment management business. Violation of these obligations
and standards by any ZAIS Group employee could adversely affect investors in the ZAIS Managed Entities and ZAIS. The nature of
ZAIS Group’s business often require that it deal with confidential matters of great significance to companies in which the
ZAIS Managed Entities may invest. If ZAIS Group’s employees were to use or disclose confidential information improperly,
ZAIS Group could suffer serious harm to its reputation, financial position and current and future business relationships. It is
not always possible to detect or deter employee misconduct, and the extensive precautions ZAIS Group takes to detect and prevent
this activity may not be effective in all cases. If one or more of ZAIS Group’s employees were to engage in misconduct or
were to be accused of such misconduct, ZAIS Group’s businesses and reputation could be adversely affected and a loss of
investor confidence could result, which would adversely impact ZAIS Group’s ability to obtain new funds for management.
We may be subject to financial criminal
activity which could result in financial loss or damage to our reputation.
Instances of financial
criminal activity, personal trading violations and other abuses, including misappropriation of assets by internal or external
perpetrators, may arise despite our internal control policies and procedures. Instances of such criminal activity by financial
firms and their personnel, including those in the investment management industry, have led the U.S. government and regulators
to increase enforcement of existing rules relating to such activities, adopt new rules and regulations and enhance oversight of
the U.S. financial industry. Because ZAIS entities conduct business internationally, they are subject to the rules of other jurisdictions
that govern and control financial criminal activities, and may be exposed to financial criminal activities on an international
scale
.
Compliance with existing and new rules and regulations may have the effect of increasing expenses. Further, should
the personnel of any ZAIS entity be linked to financial criminal activity, either domestically or internationally, it would suffer
material damage to its reputation which could result in a corresponding loss of clients, client assets and revenue.
We are vulnerable to reputational
harm because we operate in an industry in which personal relationships, integrity and client confidence are of critical importance.
For example, if an employee were to engage in illegal or suspicious activities, we could be subject to legal or regulatory sanctions
and suffer serious reputational harm (as a consequence of the negative perception resulting from such activities), which could
impair client relationships and the ability to attract new clients.
Reputational harm could result in a loss
of AUM and revenues.
The integrity of ZAIS
Group’s brand is critical to its ability to attract and retain clients, business partners and employees and maintain relationships
with consultants. ZAIS Group operates within the highly regulated financial services industry and various potential scenarios
could result in harm to its reputation. They include internal operational failures, failure to follow investment or legal guidelines
in the management of accounts, intentional or unintentional misrepresentation of ZAIS Group’s products and services in offering
or advertising materials, public relations information, social media or other external communications, employee misconduct (including
prohibited postings on social media), legal or regulatory actions against ZAIS Group or investments in businesses or industries
that are controversial to certain special interest groups. The negative publicity associated with any of these factors could harm
ZAIS Group’s reputation and adversely impact relationships with existing and potential clients, third-party distributors,
consultants and other business partners and subject ZAIS Group to regulatory sanctions. Damage to ZAIS Group’s brands or
reputation would negatively impact its standing in the industry and result in loss of business in both the short term and the
long term.
A significant portion of ZAIS Group’s
AUM is or may be derived from a small number of clients, the loss of which could significantly reduce ZAIS Group’s management
fees and have a material adverse effect on our results of operations.
Certain of
ZAIS Group’s strategies derive a significant portion of their total AUM from assets of a single client or a small
number of clients. As of December 31, 2016, the ten largest investors, the two largest investors and the largest investor
accounted for approximately 43%, 29% and 17% of ZAIS Group’s AUM (including AUM of the CLO vehicles managed by ZAIS
Group), respectively. The same investors accounted for approximately 89%, 60% and 35% of ZAIS Group’s AUM (excluding
AUM relating to the CLO vehicles managed by ZAIS Group). If any of these clients withdraw all or a portion of their AUM, ZAIS
Group’s business would be significantly affected, which would negatively impact ZAIS Group’s management fees and
could have a material adverse effect on its results of operations and financial condition. Additionally, ZAIS Group’s
CLO management business accounts for approximately 51% of ZAIS Group’s AUM and a loss of key employees associated with
the CLO management business may impact ZAIS Group’s ability to expand or continue this business and could result in the
loss of a significant amount of ZAIS Group’s AUM.
ZAIS Group’s failure to comply with
investment guidelines set by its clients and limitations imposed by applicable law could result in damage awards against ZAIS
Group and a loss of ZAIS Group’s AUM, either of which could adversely affect its results of operations or financial condition.
Certain clients who retain
ZAIS Group to manage assets on their behalf specify guidelines regarding investment allocations and strategy that ZAIS Group is
required to follow in managing their portfolios. In addition, ZAIS Group is required to comply with the investment guidelines
and limitations set forth in the constituting and offering documents of the ZAIS Managed Entities. ZAIS Group’s failure
to comply with any of these guidelines and other limitations could result in losses to clients which, depending on the circumstances,
could result in ZAIS Group being obligated to make clients whole for such losses. If ZAIS Group believed that the circumstances
did not justify a reimbursement, or clients believed the reimbursement it offered was insufficient, they could seek to recover
damages from ZAIS Group, withdraw assets from the ZAIS Managed Entities or terminate their investment advisory agreement with
ZAIS Group. Any of these events could harm ZAIS Group’s reputation and adversely affect its business.
ZAIS is taxable as a corporation for U.S. tax purposes and a
change in projected long-term profitability could materially impact after-tax results of operations.
As of December
31, 2016, the Company recorded a Deferred Tax Asset (“DTA”) of approximately $7.0 million related to
Net Operating Loss (“NOL”) carryforwards and other future deductible amounts related to the Company’s
allocable share of the consolidated results of operations as well as NOL carryforwards and development stage start-up
expenses incurred during the period from its inception and prior to the closing of its Business Combination with ZGP. These
DTAs relate to NOL carryforwards and future deductible amounts that can be used to offset the Company’s taxable income
in future periods and reduce its income taxes payable in those future periods. Unless the Company is able to generate
sufficient taxable income to utilize its NOL carryforwards before their expiration, it is likely that some or all of these
NOL carryforwards could ultimately expire unused. The Company incurred a net book loss for the year ended December 31, 2016
and it is anticipated the expenses will again exceed revenues in 2017. Accordingly, management believes that it is not more
likely than not that its deferred tax asset will be realized and the Company has established a full valuation allowance
against the deferred tax asset as of December 31, 2016.
ZAIS Group’s expenses are subject
to fluctuations that could materially impact our results of operations.
ZAIS Group’s results
of operations depend, in part, on the level of ZAIS Group’s expenses, which can vary from period to period. The Company
currently anticipates that its expenses in 2017 will exceed its revenues, as they did in 2016 and 2015. If ZAIS Group is unable
to significantly increase its assets under management and thereby generate additional revenue from management fee income and potentially,
incentive income, or develop new sources of revenue, it is likely that it will continue incurring operating losses. In that event,
ZAIS Group may need to sell assets to raise cash and/or curtail certain business activities, including foregoing additional investments
in newly formed ZAIS Managed Entities or investment vehicles. ZAIS Group and its affiliates have a certain level of recurring
expenses in their day-to-day operations, and some of those expenses cannot be materially reduced. If ZAIS Group’s revenues
do not increase, even with decreases in variable expenses, ZAIS Group’s results of operations will continue to be negatively
impacted as is the case in the current year. Although management is evaluating certain alternatives which could alter the operating
loss trend, there is no specific plan at this point in time that has been identified to alter the operating loss trend in future
years. While ZAIS Group attempts to project expense levels in advance, there is no guarantee that unforeseen expenses will not
arise.
ZAIS and ZAIS Group may be subject to litigation
risks and may face liabilities and damage to ZAIS Group’s professional reputation as a result.
In recent years, the volume
of claims and amount of damages claimed in litigation and regulatory proceedings against investment managers have been increasing.
ZAIS Group makes investment decisions on behalf of investors in the ZAIS Managed Entities that could result in substantial losses.
This may subject ZAIS Group to legal liabilities or actions alleging, among other things, negligence, intentional misconduct,
breach of fiduciary duty or breach of contract. Further, ZAIS Group may be subject to third-party litigation arising from allegations
that ZAIS Group improperly exercised control or influence over investments. In addition, ZAIS, ZAIS Group and, the ZAIS Managed
Entities, and each of their respective officers and employees are each exposed to the risks of litigation related to investment
activities, including litigation from investors and shareholders. Additionally, ZAIS Group is exposed to risks of litigation or
investigation by investors or regulators alleging that ZAIS Group or a ZAIS Managed Entity engaged in transactions that presented
conflicts of interest that were not properly addressed.
Legal liability or the
commencement of legal actions against ZAIS or ZAIS Group could have a material adverse effect on ZAIS Group’s reputation,
business, financial condition and/or results of operations. ZAIS Group depends to a large extent on its business relationships
and reputation for integrity and high-caliber professional services to attract and retain investors and to pursue investment opportunities
for the ZAIS Managed Entities. As a result, allegations of improper conduct by ZAIS or ZAIS Group by either private litigants
or regulators, whether the ultimate outcome is favorable or unfavorable to ZAIS or ZAIS Group, as well as negative publicity and
press speculation about us, ZAIS Group’s investment activities or the investment industry in general, whether or not valid,
may harm ZAIS Group’s reputation, which may be damaging to its businesses and negatively impact our results of operations.
The cost of insuring ZAIS Group’s
business is significant and may increase.
ZAIS Group’s and
our insurance costs are significant and can fluctuate substantially from year to year. In addition, certain insurance coverage
may not be available or may only be available at prohibitive costs. As insurance coverage is renewed, it may be subject to additional
costs caused by premium increases, higher deductibles, co-insurance liability, changes in the size of ZAIS Group’s business
or nature of ZAIS Group’s operations, litigation or acquisitions or dispositions. ZAIS Group may also obtain additional
form, and increased level, of coverage which may involve materially increased costs.
In addition, we may obtain
additional liability insurance for our directors and officers. There have been historical periods in which directors' and officers'
liability insurance and errors and omissions insurance have been available only with limited coverage amounts, less favorable
terms or at prohibitive cost, and these conditions could recur.
Risks Related to the ZAIS Managed Entities
Dependence on leverage by certain of the
ZAIS Managed Entities subjects them to potential volatility and contractions in the debt financing markets and could adversely
affect ZAIS Group’s ability to achieve attractive rates of return on those investments.
Certain of the ZAIS Managed
Entities use leverage, and ZAIS Group’s ability to achieve attractive rates of return on investments in those ZAIS Managed
Entities depends on ZAIS Group’s (or, in the case of a separately managed account, the client’s) ability to access
sufficient sources of indebtedness at attractive rates. The ZAIS Managed Entities may choose to use leverage as part of their
respective investment programs. As of December 31, 2016, ZAIS Group served as investment manager to two ZAIS Managed Entities
utilizing various degrees of leverage. These two ZAIS Managed Entities had combined AUM of $1.011 billion. The weighted average
leverage ratio of these ZAIS Managed Entities is approximately 14.65% (based on net asset value), with one of the ZAIS Managed
Entities accounting for a majority of the leverage employed. The use of leverage poses a significant degree of risk and enhances
the possibility of a significant loss to investors. A ZAIS Managed Entity may borrow money from time to time to make investments
or may enter into derivative transactions that have embedded leverage. The interest expense and other costs incurred in connection
with such borrowing or embedded leverage may not be recovered by returns on such investments and may be lost, and the timing and
magnitude of such losses may be accelerated or exacerbated, in the event of a decline in the market value of such investments.
Gains realized with borrowed funds may cause the ZAIS Managed Entity’s net asset value to increase at a faster rate than
would be the case without borrowings. Losses realized with borrowed funds may also cause the net asset value of the related ZAIS
Managed Entity to decrease at a faster rate than would be the case without borrowings. Any of the foregoing circumstances could
have a material adverse effect on ZAIS Group’s business and our results of operations and financial condition.
The use of leverage also
gives rise to counterparty risk. In connection with repo financings and certain swap transactions, some ZAIS Managed Entities
are required to post an initial margin and subsequent variation margin calls. If the counterparty should become insolvent, initial
and variation margin posted by a ZAIS Managed Entity could be lost due to the failure of the counterparty.
If the ZAIS Managed Entities
or the issuers or companies in which the ZAIS Managed Entities invest raise capital in the structured credit, leveraged loan or
high yield bond markets, the results of their operations may suffer if such markets experience dislocations, contractions or volatility.
Any such events could adversely impact the availability of credit to businesses generally and could lead to an overall weakening
of the U.S. and global economies. Any economic downturn could adversely affect the financial resources of the ZAIS Managed Entities
and their investments (in particular those investments that depend on credit from third parties or that otherwise participate
in the credit markets) and their ability to make principal and interest payments on, or refinance, outstanding debt when due.
Moreover, these events could affect the terms of available debt financing with, for example, higher rates, higher equity requirements
or more restrictive covenants.
The absence of available
sources of sufficient debt financing for extended periods of time or an increase in either the general levels of interest rates
or in the risk spread demanded by sources of indebtedness would make it more expensive to finance those investments. Certain investments
may also be financed through borrowings on ZAIS Managed Entities’ debt facilities, which may or may not be available for
a refinancing at the end of their respective terms. In addition, the interest payments on the indebtedness used to finance the
ZAIS Managed Entities’ investments are generally deductible expenses for applicable income tax purposes, but may be subject
to limitations with respect to timing or amount under applicable tax law and policy. Any change in such tax law or policy to eliminate
or substantially limit the availability of these income tax deductions may reduce the after-tax rates of return on the affected
investments for certain investors, which may have an adverse impact on ZAIS Group’s businesses and our financial results.
If the markets make it
difficult or impossible to refinance debt that is maturing in the near term, some of ZAIS Group’s investee companies may
be unable to repay such debt at maturity and may be forced to sell assets, undergo a recapitalization or seek bankruptcy protection.
Any of the foregoing circumstances could have a material adverse effect on ZAIS Group’s business and our results of operations
and financial condition.
Some of the ZAIS Managed Entities may invest
in companies that are highly leveraged, which may increase the risk of loss associated with those investments.
Some of the ZAIS Managed
Entities may invest in companies whose capital structures involve significant leverage. For example, in many non-distressed leveraged
loan investments, indebtedness may be as much as 75% or more of an investee company’s total debt and equity capitalization,
including debt that may be incurred in connection with the ZAIS Managed Entities’ investment, whether incurred at or above
the investment-level entity. In distressed situations, indebtedness may exceed 100% or more of an investee company’s capitalization.
Additionally, while the ZAIS Managed Entities generally purchase senior positions in the aforementioned companies, the debt positions
acquired by the ZAIS Managed Entities may be the most junior in what could be a complex capital structure, and thus subject ZAIS
Group to the greatest risk of loss.
Investments in highly
leveraged entities are also inherently more sensitive to declines in revenues, increases in expenses and interest rates and adverse
economic, market and industry developments.
Furthermore, incurring
a significant amount of indebtedness by an entity could, among other things:
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subject
the entity to a number of restrictive covenants, terms and conditions, any violation
of which could be viewed by creditors as an event of default and could materially impact
a ZAIS Managed Entity’s ability to realize value from the investment;
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allow
even moderate reductions in operating cash flow to render the entity unable to service
its indebtedness, leading to a bankruptcy or other reorganization of the entity and a
loss of part or all of the ZAIS Managed Entities’ investment in it;
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give
rise to an obligation to make mandatory prepayments of debt using excess cash flow, which
might limit the entity’s ability to respond to changing industry conditions if
additional cash is needed for the response, to make unplanned but necessary capital expenditures
or to take advantage of growth opportunities;
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limit
the entity’s ability to adjust to changing market conditions, thereby placing it
at a competitive disadvantage compared to its competitors that have relatively less debt;
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limit
the entity’s ability to engage in strategic acquisitions that might be necessary
to generate attractive returns or further growth; and
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limit
the entity’s ability to obtain additional financing or increase the cost of obtaining
such financing, including for capital expenditures, working capital or other general
corporate purposes.
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A substantial portion of the investments
owned by the ZAIS Managed Entities are recorded at fair value as determined in good faith by ZAIS Group and, as a result, there
may be uncertainty regarding the value of the investments of the ZAIS Managed Entities.
The debt and equity instruments
in which the ZAIS Managed Entities invest for which market quotations are not readily available are valued at fair value as determined
in good faith by ZAIS Group or such other party as may be responsible for the valuation of the relevant ZAIS Managed Entity. Most,
if not all, of ZAIS Managed Entities’ investments (other than cash and cash equivalents) are classified as Level 3 under
Accounting Standards Codification Topic 820 — Fair Value Measurements and Disclosures. This means that the valuation
of assets owned by the ZAIS Managed Entities is based on unobservable inputs and assumptions about how market participants would
price the asset or liability in question. Inputs into the determination of fair value of the ZAIS Managed Entities’ investments
require significant management judgment or estimation. Even if observable market data is available, such information may be the
result of consensus pricing information, stale information or broker quotes, which include a disclaimer that the broker would
not be held to such a price in an actual transaction. The non-binding nature of consensus pricing or quotes accompanied by disclaimers
materially reduces the reliability of such information and the pricing indications received may not accurately reflect the price
at which a third party is willing to enter into a transaction.
The types of factors that
ZAIS Group may take into account in determining the fair value of ZAIS Managed Entities’ investments generally include prices
received from third party valuation agents, broker quotes (if available), market rates of interest, general economic conditions,
economic conditions in particular industries, the condition of financial markets, the financial condition of issuers, recent trading
activity, and other relevant factors. Because such valuations are inherently uncertain, may take into account prices that fluctuate
substantially over short periods of time and may be based on estimates, ZAIS Group’s determinations of fair value may differ
materially from the values that would have been used if a ready market for these debt and equity instruments existed.
Because there is significant
uncertainty in the valuation of, or in the stability of the value of illiquid investments, the fair values of such investments
as reflected in a ZAIS Managed Entity’s net asset value do not necessarily reflect the prices that would actually be obtained
by ZAIS Group on behalf of the ZAIS Managed Entity when such investments are sold. ZAIS Managed Entities’ net asset value
could be adversely affected if determinations regarding the fair value of such ZAIS Managed Entity’s investments were materially
higher than the values that such ZAIS Managed Entity ultimately realizes upon the disposal of such loans and securities. Realizations
at values significantly lower than the values at which investments have been reflected in the ZAIS Managed Entity net asset values
would result in losses for the applicable ZAIS Managed Entity, a decline in asset management fees and the loss of potential incentive
income. Also, a situation where asset values turn out to be materially different than values reflected in a ZAIS Managed Entity’s
net asset value could cause investors to lose confidence in ZAIS Group which could, in turn, result in redemptions from the ZAIS
Managed Entities or difficulties in raising additional funds for ZAIS Group to manage.
The ZAIS Managed Entities may face risks
relating to undiversified investments.
While diversification
within the asset classes in which the ZAIS Managed Entities invest is generally an objective of the ZAIS Managed Entities, there
can be no assurance as to the degree of diversification, if any, that will be achieved in any ZAIS Managed Entity. Difficult market
conditions or slowdowns affecting a particular asset class, geographic region or other category of investment could have a significant
adverse impact on a ZAIS Managed Entity if its investments are concentrated in that area, which would result in lower investment
returns. Such lack of diversification could expose a ZAIS Managed Entity to losses disproportionate to economic conditions or
market declines in general if there are disproportionately greater adverse movements in the particular investments. If a ZAIS
Managed Entity holds investments concentrated in a particular issuer, security, asset class or geographic region, such ZAIS Managed
Entity may be more susceptible than a more widely diversified investment portfolio to the negative consequences of a single corporate,
economic, political or regulatory event. Accordingly, a lack of diversification on the part of a ZAIS Managed Entity could adversely
affect its performance and, as a result, ZAIS Group’s business and our results of operations and financial condition. Additionally,
since ZAIS Group invests directly in certain ZAIS Managed Entities, ZAIS Group is subject to the same diversification risks as
the ZAIS Managed Entities disclosed herein.
Investments
made by the ZAIS Managed Entities may be volatile and may have limited liquidity.
Many of the ZAIS Managed
Entities invest in relatively high-risk, illiquid assets that often have significantly leveraged capital structures, and ZAIS
Group may fail to realize any profits from these investments for a considerable period of time, lose some or the entire principal
amount it invests in these investments or may not be able to liquidate these investments at a desired price.
The ZAIS Managed Entities
may make investments or hold trading positions in markets that are volatile and may be illiquid. Timely divestiture or sale of
trading positions can be impaired by decreased trading volume, increased price volatility, concentrated trading positions, limitations
on the ability to transfer positions in highly specialized or structured transactions, limits imposed by exchanges or other regulatory
organizations, market disruptions and changes in industry and government regulations. When a ZAIS Managed Entity holds a security
or position, it is vulnerable to price and value fluctuations and may experience losses if the value of the position decreases
and it is unable to sell, hedge or transfer the position in a timely manner. Any losses suffered by the ZAIS Managed Entity may
have a negative impact on ZAIS Group’s results of operations.
In particular, with respect
to futures contracts, it may be difficult to execute a trade at a specific price when there is a relatively small volume of buy
and sell orders in a market. Limits imposed by futures exchanges or other regulatory organizations, such as accountability levels,
position limits and price fluctuation limits, may contribute to a lack of liquidity with respect to certain investments. In addition,
over-the-counter contracts and cleared swaps may be illiquid because they are contracts between two parties and generally may
not be transferred by one party to a third party without the counterparty’s consent. Conversely, a counterparty may give
its consent, but a ZAIS Managed Entity still may not be able to transfer an over-the-counter contract to a third party due to
concerns regarding the counterparty’s credit risk. In addition, the ZAIS Managed Entities’ assets are subject to the
risk of failure of any of the exchanges or other trading platforms on which their positions trade or of central clearinghouses
or counterparties. Most U.S. exchanges limit fluctuations in certain prices during a single day by imposing “daily price
fluctuation limits” or “daily limits,” the existence of which may reduce liquidity or effectively curtail trading
in particular markets.
Therefore, it may be impossible
or costly for the ZAIS Managed Entities to liquidate positions rapidly, particularly if the relevant market is moving against
a position or in the event of trading halts or daily price movement limits on the market or otherwise. Alternatively, it may not
be possible in certain circumstances for a position to be purchased or sold promptly, particularly if there is insufficient trading
activity in the relevant market or otherwise. Additionally, since ZAIS Group invests directly in certain ZAIS Managed Entities,
ZAIS Group is subject to the same volatility and liquidity risks as the ZAIS Managed Entities disclosed herein.
Investments by the ZAIS Managed Entities
may rank junior to investments made by others.
The securities in which
the ZAIS Managed Entities invest may be subordinate to other securities of the third party issuers. By their terms, the senior
securities of these issuers may provide that their holders are entitled to receive payments of interest or principal on or before
the dates on which payments are to be made to the more subordinate securities held by the ZAIS Managed Entities. Also, in the
event of a default or other credit event including, but not limited to, liquidation, dissolution, reorganization or bankruptcy,
holders of securities ranking senior to those held by the ZAIS Managed Entities may typically be entitled to receive payment in
full before distributions are made to the ZAIS Managed Entities. After repaying senior security holders, the issuer of the securities
held by the ZAIS Managed Entities may not have any remaining assets to use for repaying amounts owed to the securities held by
the ZAIS Managed Entities. To the extent that any assets remain, holders of securities that rank equally with those securities
held by the ZAIS Managed Entities would be entitled to share on an equal and ratable basis in distributions that are made out
of those assets. Also, during periods of financial distress or following insolvency, the ability of the ZAIS Managed Entities
to influence an issuer’s affairs and to take actions to protect their investments may be substantially less than that of
the senior security holders. Additionally, since ZAIS Group invests directly in certain ZAIS Managed Entities, ZAIS Group is subject
to the same risks as the ZAIS Managed Entities disclosed herein.
Third-party investors in certain of the
ZAIS Managed Entities may not satisfy their contractual obligation to fund capital calls when requested, which could adversely
affect a ZAIS Managed Entity’s operations and performance.
Certain of the ZAIS Managed
Entities require investors to make capital commitments that ZAIS Group is entitled to call from those investors at any time during
prescribed periods. At December 31, 2016 one ZAIS Managed Entity, which is consolidated in our December 31, 2016 financial statements
and included in Item 8 herein, has uncalled capital commitments of approximately $59.8 million, which includes $30.5 million of
uncalled capital applicable to ZAIS Group. In February 2017, ZAIS Group made a $5.0 million commitment to a ZAIS Managed Entity
which focuses on investing in non-ZAIS managed CLOs, none of which has been called as of March 24, 2017.
ZAIS Group, as investment
manager to these ZAIS Managed Entities, controls the capital call process, including when and if to call additional capital. ZAIS
Group has historically depended on investors fulfilling and honoring their commitments when it calls capital from them in connection
with making investments and otherwise paying obligations when due. Any investor that does not fund a capital call may be subject
to several possible penalties. However, the impact of any such penalty is often directly correlated to the amount of capital previously
invested by the investor in the ZAIS Managed Entity and if an investor has invested little or no capital, for instance early in
the life of the ZAIS Managed Entity, then certain penalties may not be as meaningful. Investors may also negotiate for lesser
or reduced penalties at the outset of the ZAIS Managed Entity, thereby limiting ZAIS Group’s ability to enforce the funding
of a capital call. Third-party investors in certain ZAIS Managed Entities often use distributions from prior investments to meet
future capital calls. In cases where valuations of existing investments fall and the pace of distributions slows, investors may
be unable to make new commitments to ZAIS Managed Entities or to meet existing commitments to the ZAIS Managed Entities. The failure
of investors to honor a significant amount of capital calls for certain ZAIS Managed Entities could have a material adverse effect
on the operation and performance of those ZAIS Managed Entities and, in turn, ZAIS Group’s business.
The ZAIS Managed Entities may be forced to dispose of investments
at a disadvantageous time.
The ZAIS Managed Entities
may make investments that they cannot advantageously dispose of prior to the date the applicable ZAIS Managed Entity is dissolved
or that they may be forced to dispose of at an inopportune time to meet an investor redemption request. Although ZAIS Group generally
expects that investments will be disposed of prior to dissolution or be suitable for in-kind distribution at dissolution of a
ZAIS Managed Entity, such ZAIS Managed Entity may have to sell, distribute or otherwise dispose of investments at a disadvantageous
time as a result of its dissolution. This would result in a lower than expected return on the investments and, perhaps, on the
ZAIS Managed Entity itself.
Hedging strategies may adversely affect
the returns on the ZAIS Managed Entities’ investments.
ZAIS Group uses various
forward contracts, options, swaps (including total return swaps), caps, collars, floors, foreign currency forward contracts, currency
swap agreements, currency option contracts or other instruments to manage the ZAIS Managed Entities’ exposure to market
risks. The success of any hedging or other derivative transactions generally depends on the degree of correlation between price
movements of a derivative instrument and the position being hedged, the creditworthiness of the counterparty, the costs of the
hedging transaction and other factors. Because the ZAIS Managed Entities may enter into transactions to hedge their exposure to
market risks, while the transaction may reduce the risks of losses with respect to adverse movements in such market factors, the
transaction may also limit the opportunity for gain if the value of the hedged positions increases. There can be no assurance
that any hedging transaction will successfully hedge the risks associated with hedged positions or that it will not result in
poorer overall investment performance than if it had not been executed.
While such hedging arrangements
may reduce certain risks, such arrangements themselves may entail certain other risks. These arrangements may require the posting
of cash or other collateral at a time when a ZAIS Managed Entity has insufficient cash or illiquid assets such that the posting
of the cash is either impossible or requires the sale of assets at prices that do not reflect their underlying value. Moreover,
these hedging arrangements may generate significant transaction costs, including potential tax costs and legal fees, which may
reduce the anticipated returns on an investment. Finally, the CFTC has indicated that it may soon issue a proposal for certain
foreign exchange products to be subject to mandatory clearing, which could increase the costs of entering into currency hedges.
ZAIS Group’s failure to appropriately
address conflicts of interest could damage ZAIS Group’s reputation and adversely affect ZAIS Group’s businesses.
ZAIS Group continues to
confront potential conflicts of interest relating to its investment activities on behalf of itself and the ZAIS Managed Entities.
ZAIS Group serves as the investment adviser to a number of ZAIS Managed Entities, and may, in the future establish new ZAIS Managed
Entities that will compete with one another and with ZAIS Group. Certain ZAIS Managed Entities have overlapping investment objectives
and strategies, including different fee structures, and potential conflicts may arise with respect to ZAIS Group’s decisions
regarding how to allocate investment opportunities and shared expenses among those ZAIS Managed Entities. For example, a decision
to receive material non-public information about a company or loan borrower while pursuing an investment opportunity for a particular
ZAIS Managed Entity gives rise to a potential conflict of interest if it results in ZAIS Group’s having to restrict the
ability of other ZAIS Managed Entities to take any action with respect to such company.
There are also additional
conflicts of interest that ZAIS Group encounters in managing the ZAIS Managed Entities. ZAIS Group may or may not cause a ZAIS
Managed Entity to purchase different classes of securities that may have interests that conflict with the interests owned by another
ZAIS Managed Entity. ZAIS Group or the ZAIS Managed Entities may hold similar positions or the same security, yet ZAIS Group may
liquidate its position as circumstances warrant, potentially affecting the liquidity or value of the securities held by the other
ZAIS Managed Entities. ZAIS Managed Entities may take conflicting positions with that of other ZAIS Managed Entities. For example,
a ZAIS Managed Entity may take a long position while another ZAIS Managed Entity may take a short position in the same security.
Additional conflicts may arise in circumstances where the ZAIS Managed Entities purchase from or sell assets to ZAIS or other
ZAIS Managed Entities. Further, ZAIS Group or certain ZAIS Managed Entities may liquidate investments at different times than
other ZAIS Managed Entities due to, among other things, differences in investment strategies or fund durations.
In addition to the various
conflicts set forth above, conflicts of interest may exist in the valuation of ZAIS Managed Entities’ investments and related
to decisions about the allocation of specific investment opportunities among the ZAIS Managed Entities and the allocation of fees
and costs among the ZAIS Managed Entities. Though ZAIS Group believes it has appropriate means to resolve these conflicts, ZAIS
Group’s judgment on any particular issue could be challenged. If ZAIS Group fails to appropriately address any such conflicts,
it could negatively impact ZAIS Group’s reputation and its ability to raise funds, may trigger redemptions by existing clients,
may result in potential litigation against us or may result in a regulatory investigation related to our practices used to address
such conflicts of interest.
Certain of the ZAIS Managed Entities invest
in RMBS that are subject to particular risks.
As of December 31, 2016,
ZAIS Group served as investment manager to seven ZAIS Managed Entities investing a portion of their assets in RMBS with an aggregate
fair market value of approximately $430.3 million.
Holders of RMBS generally
bear risks inherent in structured products. In particular, the rate of defaults and losses are affected by a number of factors,
including general economic conditions, the unemployment rate, the level of interest rates, the availability of mortgage credit,
local conditions in the geographic area where the related mortgaged property is located, the terms of the loan, the borrower’s
equity in the mortgaged property and the financial circumstances of the borrower. Further, a region’s economic condition
and housing market may be directly, or indirectly, adversely affected by natural disasters or civil disturbances such as earthquakes,
hurricanes, fires, floods, eruptions or riots. The above factors may have a larger effect depending on the composition and concentration
of the residential mortgage loans. For example, subprime, non-conforming mortgage loans, balloon mortgage loans, interest only
mortgage loans, adjustable-rate mortgage loans, and negatively amortizing mortgage loans may be subject to greater risks than
traditional fixed rate mortgage loans.
Foreclosure.
Residential
mortgage foreclosure rates increased significantly in connection with the crisis in the credit markets that began in 2007 – 2008.
This trend negatively impacted the financial and capital markets generally and the mortgage-lending and mortgage-investment industry
segments more specifically. If a residential mortgage loan is in default, foreclosure of such residential mortgage loan may be
a lengthy and difficult process, and may involve significant expenses. Furthermore, the market for defaulted residential mortgage
loans or foreclosed properties may be very limited. In the event that a ZAIS Managed Entity invests in RMBS collateralized by
residential mortgage loans that are subsequently foreclosed on, such ZAIS Managed Entity would likely lose some or all of its
investment, which could have a material adverse effect on the its performance and profitability.
Underwriting.
Defaults on residential mortgage loans underlying the RMBS may result from substandard underwriting and
purchasing guidelines or the failure of the loan originator to comply with good or adequate origination guidelines. The
applicable originator’s underwriting standards and any applicable purchasing guidelines may not identify or
appropriately assess the risk that the interest and principal payments due on a mortgage loan will be repaid when due, or at
all, or whether the market value of the related mortgaged property is sufficient to otherwise provide for recovery of such
amounts. In addition, with respect to any exceptions made to the applicable originator’s underwriting standards in
originating a mortgage loan, those exceptions may be subjective and may increase the risk that principal and interest amounts
may not be received or recovered and compensating factors, if any, which may be the premise for making an exception to the
underwriting standards may not, in fact, compensate for any additional risk. No assurance can be given that any of the
mortgage loans underlying an RMBS owned by a ZAIS Managed Entity comply with an originator’s underwriting guidelines or
that any mortgage loans have compensating factors in the event that those mortgage loans do not comply with the related
originator’s underwriting guidelines. RMBS owned by the ZAIS Managed Entities may contain mortgage loans that may have
been originated with less stringent underwriting guidelines than mortgage loans being originated in the current
environment.
Prepayment.
The
rate of prepayments of newly originated residential mortgage loans is sensitive to prevailing interest rates. Generally, if prevailing
interest rates decline, mortgage prepayments may increase if refinancing is available at lower interest rates. If prevailing interest
rates rise, prepayments on the mortgage loans may decrease. However, an expansion of credit could result in an increase in refinancing
activity even in a rising interest rate environment if credit standards are relaxed and underwriting guidelines expanded. Prepayments
also may occur as a result of solicitations of the borrowers by mortgage loan lenders. In addition, the timing of prepayments
of principal may also be affected by liquidations of or insurance payments on the mortgage loan, or repurchases by the related
originator for breaches of representations and warranties or defective documentation. An increase in prepayments has a negative
effect on the value of mortgage loans purchased at a premium due to the loss of future interest payments.
Legal/Regulatory.
Ownership of residential mortgage loans also includes the potential of certain legal risks of ownership, including
assignee liabilities. The Truth in Lending Act provides that subsequent purchasers of residential mortgage loans originated in
violation of certain requirements specified in the Truth in Lending Act may have liability for such violations. The Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) also prohibits lenders from originating
residential mortgage loans unless the lender determines that the borrower has a reasonable ability to repay the loan. This requirement
has been codified in the “ability-to-repay” rules (collectively, the “ATR Rules”) under the Truth in Lending
Act (“Regulation Z”). The ATR Rules, among other things, require that originators follow certain procedures and obtain
certain documents in order to make a reasonable, good faith determination of a borrower’s ability to repay a residential
mortgage loan. In addition, the U.S. Consumer Financial Protection Bureau has issued regulations, which became effective January
2014, specifying the standards for a “qualified mortgage” that would have the benefit of a safe harbor from liability
under the ATR Rules if certain requirements are satisfied, or a rebuttable presumption of safety from such liability if only certain
of these requirements are satisfied. Interest-only loans, hybrid mortgage loans and balloon loans, as well as loans with a debt-to-income
ratio exceeding 43% in general do not constitute qualified mortgages. Possible liabilities that could be required to be paid by
an assignee of a mortgage loan include actual damages suffered by the borrower, litigation costs (which could exceed the principal
amount of a mortgage loan), statutory damages and special statutory damages. A borrower may also assert a violation of the ATR
Rules as a defense in a foreclosure action. Various state and local legislatures may adopt similar or more onerous provisions
in the future. In addition, the qualified mortgage rule may adversely affect the market generally for mortgage-backed securities,
if investors are not willing to invest in pools of mortgage loans that do not satisfy the qualified mortgage requirement. Violations
of these federal and state regulations may result in losses related to the related RMBS and may result in corresponding losses
to the ZAIS Managed Entities holding such RMBS.
Third
Party Service Providers.
Mortgage loans are subject to risks of loss related to the third party service providers
such as loan servicers, including from violations of consumer protection laws, servicing protocols and servicing errors, including
errors in the recordation of mortgage loans, or other factors that may cause foreclosure delays. Loan modifications by servicers
may impact the value of mortgage loans.
Certain of the ZAIS Managed Entities invest
in commercial mortgage and related assets that are subject to particular risks.
Certain of the ZAIS Managed
Entities invest in a variety of assets backed by commercial mortgages including collateralized mortgage backed securities (“CMBS”),
commercial real estate mortgages and mezzanine loans and direct commercial property ownership. As of December 31, 2016, ZAIS Group
served as an investment manager to four ZAIS Managed Entities investing a portion of their assets in CMBS, commercial real estate
mortgages, mezzanine loans and direct commercial property ownership with an aggregate fair market value of approximately $47.0
million.
The values of the commercial
mortgage loans and the assets backed by commercial mortgages are influenced by the rate of delinquencies and defaults experienced
on the commercial mortgage loans and by the severity of loss incurred as result of such defaults. The factors influencing delinquencies,
defaults and loss severity include: (i) economic and real estate market conditions by industry sectors (e.g., multifamily, retail,
office, etc.); (ii) the terms and structure of the mortgage loans; and (iii) any specific limits to legal and financial recourse
upon a default under the terms of the mortgage loan.
Exercise of foreclosure
and other remedies may involve lengthy delays and additional legal and other related expenses on top of potentially declining
property values. In certain circumstances, the creditors may also become liable upon taking title to an asset for environmental
or structural damage existing at the property.
Commercial mortgage loans
have a risk of loss through delinquency and foreclosure. The ability of a borrower to repay a loan secured by income-producing
property typically is dependent primarily upon the successful operation and operating income of such property (i.e., the ability
of tenants to make lease payments, the ability of a property to attract and retain tenants, and the ability of the owner to maintain
the property, minimize operating expenses and comply with applicable zoning and other laws) rather than upon the existence of
independent income or assets of the borrower. Many commercial mortgage loans provide recourse only to specific assets, such as
the property, and not against the borrower's other assets or personal guarantees.
Commercial mortgage loans
generally do not fully amortize, which can necessitate a sale of the property or refinancing of the remaining “balloon”
amount at or prior to maturity of the mortgage loan. Accordingly, investors in commercial mortgage loans and CMBS bear the risk
that the borrower will be unable to refinance or otherwise repay the mortgage at maturity, thereby increasing the likelihood of
a default on the borrower's obligation.
The repayment of a commercial
mortgage loan is typically dependent upon the ability of the related mortgaged property to produce cash flow through the collection
of rents. Even the liquidation value of a commercial property is determined, in substantial part, by the amount of the mortgaged
property’s cash flow (or its potential to generate cash flow). However, net operating income and cash flow are often based
on assumptions regarding tenant behavior and market conditions. Net operating income and cash flow can be volatile over time and
may be insufficient to cover debt service on the mortgage loan at any given time. Lenders typically look to the debt service coverage
ratio (that is, the ratio of net cash flow to debt service) of a mortgage loan secured by income-producing property as an important
measure of the risk of default of that mortgage loan.
The net operating income,
cash flow and property value of a commercial mortgage property may be adversely affected by a large number of factors specific
to the property, such as:
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the
age, design and construction quality of the mortgage property;
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perceptions regarding
the safety, convenience and attractiveness of the mortgaged property;
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the characteristics
of the neighborhood where the mortgaged property is located;
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the proximity and
attractiveness of competing properties;
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the adequacy of
the mortgaged property’s management and maintenance;
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increases in interest
rates, real estate taxes and other operating expenses at the mortgaged property and in relation to competing properties;
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an increase in the
capital expenditures needed to maintain the mortgaged property or make improvements;
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the dependence upon
a single tenant, or a concentration of tenants, at the mortgaged property in a particular business or industry;
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a decline in the
financial condition of a major tenant at the mortgaged property;
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an increase in vacancy
rates for the applicable property type in the relevant geographic area;
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a decline in rental
rates as leases are renewed or entered into with new tenants;
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national, regional
or local economic conditions (including plant closings, military base closings, industry slowdowns and unemployment rates);
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local real estate
conditions (such as an oversupply of competing properties, space, multifamily housing, manufactured housing or hotel capacity);
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natural disasters
or civil disturbances such as earthquakes, hurricanes, fires, floods, eruptions or riots;
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the length of tenant
leases (including that in certain cases, all or substantially all of the tenants, or one or more sole, anchor or other tenants,
at a particular mortgaged property have leases that expire or permit the tenant(s) to terminate its or their lease(s) during
the term of the related mortgage loan) and other lease terms, including co-tenancy provisions;
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the creditworthiness
of tenants;
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in the case of rental
properties, the rate at which vacant space or space under expiring leases is re-let; and
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the mortgaged property’s
“operating leverage” (i.e., the percentage of total property expenses in relation to revenue, the ratio of fixed
operating expenses to those that vary with revenues, and the level of capital expenditures required to maintain the property
and to retain or replace tenants).
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A decline in the real
estate market or in the financial condition of a major tenant tends to have a more immediate effect on the net operating income
of mortgaged properties with short-term revenue sources, such as short-term or month-to-month leases or leases with termination
options, and may lead to higher rates of delinquency or defaults under the related mortgage loans.
In addition, underwritten
or adjusted cash flows, by their nature, are speculative and are based upon certain assumptions and projections, including with
respect to matters such as tenancy and rental income. Any variance of these assumptions or projections, in whole or in part, could
cause the underwritten or adjusted cash flows to vary substantially from the actual cash flows of a mortgaged property.
Certain of the ZAIS Managed Entities invest
in structured finance securities that are subject to particular risks.
Certain of the ZAIS Managed
Entities invest in structured finance securities, including CLOs, credit default swaps, interest only and inverse interest only
securities, synthetic risk transfer securities, securities backed by manufactured housing loans and other asset backed securities
that are subject to particular risks, including:
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Insolvency considerations
with respect to issuers of securitized products;
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Control rights and
the intentions of the parties holding such control rights;
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Uninvested cash
balances may limit returns, thereby possibly limiting amounts available for distribution to the security holders;
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The performance
of structured finance securities are heavily dependent on the decisions of the manager of the securities;
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Action by a rating
agency may affect the performance of a structured finance security;
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Optional or mandatory
redemptions by holders of senior or mezzanine tranches of securities may affect the performance and life of the securities;
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Limited information
is available with respect to the collateral of these structured finance securities;
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Certain structured
finance securities may contain covenant lite loans which carry additional risks;
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The restructuring
of the government sponsored entities could impact the performance of securities guaranteed by such agencies; and
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Structured finance
securities often contain conflicts of interests between their manager and the owners of certain classes of the issuer’s
securities.
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Certain of the ZAIS Managed Entities invest
in leveraged loans that are subject to particular risks.
Certain of the ZAIS
Managed Entities invest in leveraged loans, either directly, or through securities backed by leveraged loans, including CLOs.
Additionally, ZAIS Group invests in ZAIS Managed Entities that invest in the equity tranches of CLOs which provides exposure
to leveraged loans. Further, the recently adopted European and United States risk retention requirements, require ZAIS Group
to invest in a percentage of the debt or equity tranches of the CLOs (and therefore leveraged loans) it manages.
Currently, ZAIS Group has met this requirement through its investment in a majority owned affiliate of ZAIS Group that
invests in the debt and equity tranches of certain CLOs for which ZAIS Group serves as the collateral manager. Leveraged
loans may be risky and investors in these types of investments could lose some or all of their principal.
Leveraged loans may experience
volatility in the price that is paid on such leveraged loans. Such prices vary based on a variety of factors, including, but not
limited to, the level of supply and demand in the leveraged loan market, general economic conditions, levels of relative liquidity
for leveraged loans, the actual and perceived level of credit risk in the leveraged loan market, regulatory changes, changes in
credit ratings and the methodology used by credit rating agencies in assigning credit ratings, and such other factors that may
affect pricing in the leveraged loan market. Since leveraged loans may generally be prepaid at any time without penalty, the obligors
of such leveraged loans would be expected to prepay or refinance such leveraged loans if alternative financing were available
at a lower cost. For example, if the credit ratings of an obligor were upgraded, the obligor were recapitalized or if credit spreads
were declining for leveraged loans, such obligor would likely seek to refinance at a lower credit spread. The rates at which leveraged
loans may prepay or refinance and the level of credit spreads for leveraged loans in the future are subject to numerous factors
and are difficult to predict. Declining credit spreads in the leveraged loan market and increasing rates of prepayments and refinancings
are likely to result in a reduction of portfolio yield and interest collections on leveraged loans owned by the ZAIS Managed Entities.
Leveraged loans have historically
experienced greater default rates than investment grade securities and loans. A non-investment grade loan or debt obligation or
an interest in a non-investment grade loan is generally considered speculative in nature and may default for a variety of reasons,
including:
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Some of the borrowers
have relatively short or no operating histories. These companies are and will be subject to all of the business risks and
uncertainties associated with any new business enterprise, including the risk that these companies may not reach their investment
objective and the value of a ZAIS Managed Entity’s investment in them may decline substantially.
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The borrower companies
may be unable to meet their obligations under the securities held by the ZAIS Managed Entities, which may be accompanied by
a deterioration in the value of the securities holding these leverage loans or of any collateral with respect to any securities
and a reduction in the likelihood of the ZAIS Managed Entities realizing on any guarantees they may have obtained in connection
with their investment.
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Because many of
the obligors on leveraged loans are privately held companies, public information is generally not available about these companies.
The ZAIS Managed Entities depend partially on obtaining adequate information to evaluate these companies in making investment
decisions from biased parties including the lead underwriter(s) and the borrowers, themselves.
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Many of these borrowers
have substantial financial leverage which may make it difficult for them to access the capital markets to meet future capital
needs. The high leverage also makes operating results less predictable and may affect their competitiveness, which could affect
their ability to repay their loans.
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Most of the ZAIS
Managed Entities’ leveraged borrowers borrow money at floating spreads tied to LIBOR. When LIBOR rises, their total
interest costs increase and their interest coverage ratios drop which can cause liquidity issues which may lead to a payment
default.
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A portfolio company's
failure to satisfy financial or operating covenants imposed by the ZAIS Managed Entities or other lenders could lead to defaults
and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under
other agreements and jeopardize a portfolio company's ability to meet its obligations under the debt securities that the ZAIS
Managed Entities hold. The ZAIS Managed Entities may incur expenses to the extent necessary to seek recovery upon default
or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company.
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Upon any loan becoming
a defaulted asset, such defaulted asset may become subject to either substantial workout negotiations or restructuring, which
may entail, among other things, a substantial reduction in the interest rate, a substantial write-down of principal, and a substantial
change in the terms, conditions and covenants with respect to such defaulted asset. In addition, such negotiations or restructuring
may be quite extensive and protracted over time, and therefore may result in substantial uncertainty with respect to the ultimate
recovery on such defaulted asset. The liquidity for defaulted assets may be limited, and to the extent that defaulted assets are
sold, it is highly unlikely that the proceeds from such sale will be equal to the amount of unpaid principal and interest thereon.
Loans and interests in
loans have significant liquidity and market value risks since they are not generally traded in organized exchange markets but
are traded by banks and other institutional investors engaged in loan syndications. Because loans are privately syndicated and
loan agreements are privately negotiated and customized, loans are not purchased or sold as easily as publicly traded securities.
A portion of these investments may be subject to legal and other restrictions on resale, transfer, pledge or other disposition
or may otherwise be less liquid than publicly traded securities. In addition, historically the trading volume in the loan market
has been small relative to the high-yield debt securities market. Depending upon market conditions, there may be a very limited
market for leveraged loans. Non-investment grade loans are often issued in connection with leveraged acquisitions in which the
issuers incur a substantially higher amount of indebtedness than the level at which they had previously operated. The lower rating
of non-investment grade loans reflects a greater possibility that adverse changes in the financial condition of the obligor or
general economic conditions (including, for example, a substantial period of rising interest rates or declining earnings or disruptions
in the financial markets) or both may impair the ability of the obligor to make payments of principal and interest.
Certain of the ZAIS Managed Entities invest
in credit default swaps and other synthetic securities that are subject to particular risks.
ZAIS Managed Entities
may also enter into derivative transactions that have the effect of creating a “synthetic security” – that is,
the artificial creation of an asset using combinations of other assets, at least some of which derive their value from one or
more reference obligations – or invest in an entity whose assets consist of one or more “pre-packaged” synthetic
securities. The use of synthetic securities presents risks in addition to those resulting from direct purchases of the reference
obligations. Synthetic securities can frequently be created at a much lower net cost than would be incurred by purchasing (or
selling short) the reference asset (or assets) but produce returns or losses that mirror the returns or losses of the reference
asset (or assets), which has a leveraging effect that can produce high gains, but also high losses, in relation to the amount
invested. While one or more components of a synthetic security may be exchange traded or cleared (such as futures contracts, or
options on futures contracts, traded on a commodities exchange or cleared swaps), in many cases a synthetic security is created
using over-the-counter transactions. When a synthetic security is created using over-the-counter transactions, the person creating
the synthetic security (the “owner”) usually has one or more contractual relationships (typically in the form of swaps)
only with counterparties with respect to the components of the synthetic security, and not with the obligor on the reference obligation.
The owner generally has no right directly to enforce compliance by the reference obligor with the terms of the reference obligation
or any rights of set-off against the reference obligor, nor does the owner generally have any voting or other consensual rights
of ownership with respect to the reference obligation. ZAIS Managed Entities that establish synthetic security positions, or invest
in entities that have established synthetic security positions, do not directly benefit from any collateral supporting the reference
obligation and do not have the benefit of the remedies that would normally be available to a holder of a reference obligation.
In addition, in the event of the insolvency of a counterparty to one or more of the components of the synthetic security, the
owner of the synthetic security may be treated as a general creditor of the counterparty, and generally has no claim of title
with respect to the reference obligation. Consequently, ZAIS Managed Entities that utilize synthetic securities would be subject
to the credit risk of the counterparty as well as that of the reference obligor. As a result, concentrations of synthetic security
positions with any one counterparty may subject ZAIS Managed Entities to additional risk with respect to defaults by such a counterparty
as well as by the reference obligor.
Through their use of synthetic
securities, ZAIS Managed Entities are exposed to the risks related to the reference obligations of such synthetic securities.
The market value of a reference obligation generally fluctuates with, among other things, changes in prevailing interest rates,
general economic conditions, the condition of certain financial markets, international political events, developments or trends
in any particular industry, the financial condition of the reference obligor (and the obligors of the securitized assets underlying
a reference obligation that is collateral security) and the terms of the reference obligation. Adverse changes in the financial
condition of reference obligors (and, if the reference obligor is an ABS issuer, of the obligors of the securitized assets underlying
an ABS), general economic conditions or both may result in a decline in the market value of a reference obligation. In addition,
future periods of uncertainty in the United States economy and the economies of other countries in which reference obligors (and
the obligors of the securitized assets underlying an asset backed security) are domiciled and the possibility of increased volatility
and default rates may also adversely affect the price and liquidity of reference obligations.
Many reference obligations
have no, or only a limited, trading market. Trading in fixed income securities in general, including ABS and related derivatives,
often takes place primarily in over-the-counter markets consisting of groups of dealer firms that are typically major securities
firms. Because the market for certain ABS and related derivatives is a dealer market, rather than an auction market, no single
obtainable price for a given instrument prevails at any given time. Not all dealers maintain markets in these securities at all
times. The illiquidity of reference obligations can restrict the ability of ZAIS Group or the ZAIS Managed Entities to take advantage
of market opportunities. Illiquid reference obligations may trade at a discount from comparable, more liquid investments. In addition,
reference obligations may include privately placed securities that may or may not be freely transferable under the laws of the
applicable jurisdiction or due to contractual restrictions on resale, and even if such privately placed securities are transferable,
the value of such reference obligations could be less than what may be considered the fair value of such securities.
ZAIS Group depends on its senior management
team, senior investment professionals and other key personnel, and its ability to retain them and attract additional qualified
personnel is critical to its success and growth prospects.
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ZAIS Group depends
on the diligence, skill, judgment, business contacts and personal reputations of its senior management team, including Christian
Zugel, its Chief Investment Officer, Michael Szymanski, its President and Chief Executive Officer, Nisha Motani, its Chief
Accounting Officer and Acting Chief Financial Officer, various senior investment professionals and other key personnel. ZAIS
Group’s future success depends upon its ability to retain its senior professionals and other key personnel and its ability
to recruit additional qualified personnel. These individuals possess substantial experience and expertise in investing, are
responsible for locating and executing investments on behalf of the ZAIS Managed Entities, have significant relationships
with the institutions that are the sources of many of the investment opportunities for the ZAIS Managed Entities and, in certain
cases, have strong relationships with the investors in the ZAIS Managed Entities. Therefore, if any of ZAIS Group’s
senior investment professionals or other key personnel join competitors or form competing companies, it could result in the
loss of significant investment opportunities and certain existing investors.
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The departure for
any reason of any of ZAIS Group’s senior professionals could have a material adverse effect on its ability to achieve
its investment objectives, cause certain of its investors to withdraw capital they have invested or committed to the ZAIS
Managed Entities, elect not to commit additional capital to the ZAIS Managed Entities or otherwise have a material adverse
effect on ZAIS Group’s business and its prospects. The departure of some or all of those individuals, including ZAIS
Group’s Chief Investment Officer, Christian Zugel, could also trigger certain “key man” provisions in the
documentation governing certain ZAIS Managed Entities, which would permit the investors in those entities to withdraw their
capital.
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The market for qualified
investment professionals is extremely competitive and ZAIS Group may not succeed in recruiting personnel or it may fail to
effectively replace current personnel who depart with qualified or effective successors. ZAIS Group’s efforts to retain
and attract its professionals may also result in significant additional expenses, which could adversely affect ZAIS Group’s
profitability.
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Many of the members
of ZAIS Group’s senior management team and ZAIS Group’s senior investment professionals have entered into non-competition
agreements with ZAIS Group. There is no guarantee that these individuals will not resign, join ZAIS Group’s competitors
or form a competing company, or that the non-competition provisions in these agreements would be upheld by a court. If any
of these events were to occur, ZAIS Group’s business would be materially adversely affected.
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In addition to reduced levels of incentive compensation for most employees in recent years, any future decreases in levels
of incentive
compensation
paid to
employees due to
the
Company’s
financial results could have a material adverse effect on ZAIS Group’s ability to retain or recruit personnel,
including senior managers, investment professionals, key personnel and other employees, which could reduce its
profitability and growth.
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Risk Factors Related to Future Growth
If ZAIS Group is unable to execute development
opportunities, it may not be able to implement its growth strategy successfully.
ZAIS Group’s growth
strategy includes the expansion of certain of ZAIS Group’s existing businesses, as well as the development and implementation
of new business opportunities. It also encompasses funding of risk retention vehicles to comply with new risk retention rules
for CLO issuers. The success of these growth initiatives depends on, among other things: (a) the availability of suitable opportunities,
(b) the level of competition from other companies that may have greater financial resources, (c) ZAIS Group’s ability to
value potential development accurately and negotiate acceptable terms for those opportunities, (d) ZAIS Group’s ability
to obtain requisite approvals and licenses from the relevant governmental authorities and to comply with applicable laws and regulations
without incurring undue costs and delays, (e) ZAIS Group’s ability to identify and enter into mutually beneficial relationships
with service providers and counterparties and (f) ZAIS Group’s ability to properly manage conflicts of interest. If ZAIS
Group is not successful in implementing its growth strategy, its business, results of operations and the market price for our
Class A Common Stock may be adversely affected.
The
Company continually reviews its business and fund activities with a view towards improving our profitability. As a result
of concluding that a planned expansion in our capabilities in the residential whole loan market would no longer be a part of
our future strategy, a reduction in expenses related to infrastructure staffing was made by completing a reduction in force
on March 8, 2016 which resulted in a decrease of 23 employees of ZAIS Group. This reduction is expected to result in
an annualized run rate savings of approximately $3.5 million in base compensation and benefits. Total severance charges in
the amount of approximately $1.0 million were incurred during the year ended December 31, 2016. On October 31, 2016,
the Company’s management agreement with ZFC REIT was terminated upon completion of the merger between ZFC REIT
and Sutherland Asset Management Corp which resulted in a decrease of $0.589 billion to ZAIS Group’s AUM during the
fourth quarter ended December 31, 2016. In addition, management fees earned by ZAIS Group are expected to decrease by
approximately $2.8 million annually on a run-rate basis. The decrease in management fees for the year ended December 31, 2016
was offset by the receipt of a termination payment in the amount of $8.0 million. On February 15, 2017, the Board of
Directors of the Company established a Special Committee of independent and disinterested directors to consider any proposals
by management or third parties for strategic transactions. The Company’s Board of Directors has been undertaking a
strategic review of the Company’s business in order to enhance shareholder value, and has engaged a financial advisor
for this purpose. Various alternatives have been and are being considered, including a possible sale or combination or other
similar transaction, or a going private transaction which would result in the termination of the registration of our Class A
Shares so as to cease periodic and other public company compliance and reporting. The Company has received from and provided
to potential counterparties certain due diligence information. In addition, the Company’s management and
financial advisor have held and expect to continue to hold preliminary discussions with potential counterparties and
participants. There is no assurance that any of the preliminary discussions which have taken place or may in the future take
place will result in any transaction or that any of the strategic alternatives under consideration will be implemented. The
Company does not intend to provide periodic public updates of these matters except as required by law or regulation.
ZAIS Group may enter into new businesses,
make future strategic investments or acquisitions, enter into joint ventures and invest its own capital, each of which may result
in additional risks and uncertainties in ZAIS Group’s business.
ZAIS Group seeks to grow
its business by increasing AUM in existing businesses, creating new investment products and, potentially, adding new product lines.
ZAIS Group may pursue growth through strategic investments, including opportunities that may arise for ZAIS Group to acquire other
alternative or traditional asset managers. To the extent ZAIS Group makes strategic investments or acquisitions, enters into joint
ventures, enters into a new line of business or invests its own capital, ZAIS Group will face numerous risks and uncertainties,
including risks associated with (i) committing resources, (ii) the possibility that ZAIS Group has insufficient expertise to engage
in such activities profitably or without incurring inappropriate amounts of risk, (iii) combining or integrating operational and
management systems and controls and (iv) risk of loss associated with investing its capital. To the extent that ZAIS Group invests
its own capital, it will be subject to many of the risks described herein relating to the ZAIS Managed Entities. ZAIS Group’s
investments may not be diversified, thereby increasing the risk of loss associated with certain of the investments ZAIS Group
makes. Entry into certain lines of business may subject ZAIS Group to new laws and regulations with which it is not familiar,
or from which ZAIS Group is currently exempt, and may lead to increased litigation and regulatory risk. If a new business generates
insufficient revenues or if ZAIS Group is unable to efficiently manage its expanded operations, our results of operations will
be adversely affected. In the case of joint ventures, we will be subject to additional risks and uncertainties in that ZAIS Group
may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that
are not under our control.
ZAIS Group may use third-party distribution
sources to market certain ZAIS Managed Entities and strategies, including ZAIS Group’s CLO management business.
ZAIS Group’s ability
to grow its AUM is partially dependent on third-party intermediaries, including investment banks, solicitation agents and broker-dealers.
No assurance can be made that these intermediaries will be accessible to ZAIS Group on commercially reasonable terms, or at all.
In addition, pension fund consultants and other investment management consultants may review and evaluate ZAIS Group and its institutional
products from time to time. Poor reviews or evaluations of either a particular product, or of ZAIS Group, may result in institutional
client withdrawals or may impair ZAIS Group’s ability to attract new assets through these consultants.
ZAIS Group’s business depends in
large part on its ability to raise capital from investors in the ZAIS Managed Entities. If ZAIS Group is unable to raise such
capital, it would be unable to collect management fees, which would materially and adversely affect ZAIS Group’s business
and our results of operations and financial condition.
ZAIS has
experienced challenges in raising significant new capital since the financial crisis in 2008 and more recently in the
environment of lower interest rates and challenging regulation. Structured credit products have been disfavored by many
investors, and European investors have generally reduced investments in certain securitized investment vehicles due to
increased regulatory requirements. ZAIS Group’s ability to raise capital from investors depends on a number of factors,
including many that are outside of its control. Investors may downsize their investment allocations to rebalance a
disproportionate weighting of their overall investment portfolio among asset classes. In the event of poor performance of the
ZAIS Managed Entities, it could be more difficult for ZAIS Group to raise new capital. ZAIS Group’s investors and
potential investors continually assess the performance of the ZAIS Managed Entities independently, relative to market
benchmarks and relative to ZAIS Group’s competitors. ZAIS Group’s ability to raise capital for existing and
future ZAIS Managed Entities, including new CLO securitizations, depends in part, on the performance of the ZAIS Managed
Entities. If economic and market conditions deteriorate, ZAIS Group may be unable to raise sufficient amounts of capital to
support the investment activities of future ZAIS Managed Entities. If ZAIS Group is unable to successfully raise capital,
ZAIS Group’s business and our results of operations and financial condition would be adversely affected.
ZAIS Group’s existing businesses
combined with any new business initiatives may place significant demands on ZAIS Group’s administrative, operational and
financial resources.
ZAIS Group’s
current business places significant demands on its legal, compliance, accounting and operational infrastructure. The number
of employees in these disciplines has declined from 50 at December 31, 2015 to 31 at March 24, 2017, which could present
significant challenges in supporting the operational needs of ZAIS Group going forward. Any new business initiatives that
ZAIS Group effectuates would likely increase the demands placed on ZAIS Group and will result in increased expenses. In
addition, ZAIS Group is required to continuously develop its systems and infrastructure in response to the increasing
sophistication of the investment management market and legal, accounting, regulatory and tax developments. Any future ZAIS
Group initiatives will depend in part on, ZAIS Group’s ability to maintain an operating platform and management system
sufficient to support such new initiatives and will require ZAIS Group to incur significant additional expenses and to commit
additional senior management and operational resources. As a result, ZAIS Group faces significant challenges, including:
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maintaining
adequate financial, regulatory (legal, tax and compliance) and business controls;
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implementing
new or updated information and financial systems and procedures;
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training,
managing and appropriately sizing ZAIS Group’s work force and other components
of ZAIS Group’s businesses on a timely and cost-effective basis;
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mitigating
the diversion of management’s attention from ZAIS Group’s core businesses;
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reducing
the disruption of ZAIS Group’s ongoing business;
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entering
into markets or lines of business in which ZAIS Group may have limited or no experience;
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maintaining
the required investment of capital and other resources; and
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complying
with additional regulatory requirements.
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Entry into certain lines
of business may subject ZAIS Group to new laws and regulations with which it is not familiar, or from which it is currently exempt,
and may lead to increased litigation and regulatory enforcement risk. If a new business does not generate sufficient revenues
or if ZAIS Group is unable to efficiently manage ZAIS Group’s expanded operations, ZAIS Group’s results of operations
will be adversely affected. ZAIS Group’s strategic initiatives may include joint ventures, in which case it will be subject
to additional risks and uncertainties in that it may be dependent upon, and subject to liability, losses or reputational damage
relating to systems, controls and personnel that are not under ZAIS Group’s control. We cannot identify all the risks we
may face and the potential adverse consequences on ZAIS Group and any investment that may result from any attempted expansion.
Certain of ZAIS Group’s initiatives
may be effectuated through seed investments in ZAIS Managed Entities and finding additional investors in such ZAIS Managed Entities
may be difficult.
Certain of ZAIS Group’s initiatives may be effectuated through
seed investments in ZAIS Managed Entities. ZAIS Group has already made two such investments, an investment in a ZAIS Managed Entity
focused on investing in equity tranches of CLOs for which ZAIS Group serves as the investment manager and an equity investment
in the first-loss equity tranche of a ZAIS Managed Entity focused on investing in high-yield bonds. Additionally, subsequent to
December 31, 2016, ZAIS Group has made a $5.0 million commitment to a ZAIS Managed Entity which focuses on investing in non-ZAIS managed CLOs, none of which has
been called as of March 24, 2017.
As a seed investor, ZAIS
Group may bear a disproportionate share of startup expenses related to the formation of a ZAIS Managed Entity. It may be difficult
for ZAIS Group to attract additional investors to these newly formed ZAIS Managed Entities and it may never be successful in finding
additional investors to invest in such ZAIS Managed Entities. In such cases, the amount of investable capital would be constrained
to the amount of capital invested in the ZAIS Managed Entity by ZAIS Group and the ZAIS Managed Entity may not be able to achieve
the diversification or level of investments optimal to achieve the desired investment portfolio. Additionally, ZAIS Group may
invest funds in a strategy in which it has little or no track record as an investment manager.
The market for securitization products
may not grow or expand, which could result in limitations on ZAIS Group’s ability to effectuate certain of ZAIS Group’s
strategies.
The market for securitization
products may not grow or expand, which could limit ZAIS Group’s ability to effectuate certain of its strategies, including
its CLO related strategies. Certain of ZAIS Group’s initiatives rely on ZAIS Group’s ability to establish and market
interests in ZAIS Managed Entities that purchase and securitize assets. If the market for securitization does not increase, ZAIS
Group’s ability to effectuate certain of its initiatives dependent on securitization may not be achievable.
ZAIS Group may in the future engage in
certain market making activities that would require ZAIS Group or one of its subsidiaries to become a registered swap dealer or
security-based swap dealer, which would result in significantly increased compliance and operational burdens.
ZAIS Group may decide
to engage in certain market making activities that would require ZAIS Group or one of its subsidiaries to become a registered
swap dealer or security-based swap dealer, which would result in a significantly increased compliance and operational burden.
The Commodity Exchange Act (“CEA”), the Exchange Act and related regulations impose, or will impose, significant compliance
requirements on swap dealers and security-based swap dealers in a number of areas, including capital and margin, reporting and
recordkeeping, daily trading records, business conduct standards, documentation standards, monitoring of trading, risk management
procedures, disclosure of information, ability to obtain information, conflicts of interest and segregation of collateral. Firms
that wish to register as a swap dealer or a security-based swap dealer must have adequate documentation to support their compliance
with these requirements, which could result in significant additional compliance and operational burdens on ZAIS Group. Any failure
to comply with these rules, if applicable, could subject ZAIS Group to regulatory action or result in reputational harm and could
affect the value of Class A Common Stock.
An increase in interest rates may have
an impact on ZAIS Group’s ability to pursue certain of ZAIS Group’s growth initiatives.
Rising interest rates
generally reduce the demand for mortgage loans due to the higher cost of borrowing and increase the expected duration and weighted
average of life of existing RMBS, CMBS and the underlying mortgage loans. A reduction in the volume of mortgage loans originated
may affect the volume of assets available to purchase as part of certain ZAIS Group’s strategies related to residential
and commercial mortgage related assets. Rising interest rates may also cause assets that were issued prior to an interest rate
increase to provide yields that are below prevailing market interest rates. If rising interest rates cause ZAIS Group to be unable
to acquire a sufficient volume of these mortgage related assets with a yield that is above ZAIS Group’s borrowing costs,
ZAIS Group’s ability to satisfy certain of its initiatives and to generate income may be materially and adversely affected.
The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily,
short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative
to longer-term interest rates (a flattening of the yield curve), ZAIS Group’s borrowing costs may increase more rapidly
than the interest income earned on ZAIS Group’s assets. Because ZAIS Group expects its investments, on average, generally
will bear interest based on longer-term rates rather than its borrowings, a flattening of the yield curve would tend to decrease
ZAIS Group’s net income and the market value of its net assets. To the extent that ZAIS Group has purchased assets with
long durations using short term borrowings, it may need to liquidate such assets at unfavorable prices if long-term funding or
other sources of funds are unavailable. Additionally, to the extent cash flows from investments that return scheduled and unscheduled
principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which
would likely decrease ZAIS Group’s net income. It is also possible that short-term interest rates may exceed longer-term
interest rates (a yield curve inversion), in which event ZAIS Group’s borrowing costs may exceed ZAIS Group’s interest
income and it could incur operating losses.
The current interest rate environment negatively
impacts ZAIS Group’s business and may continue to do so.
The United States financial
markets have been experiencing a period of historically low interest rates which make it more difficult for the ZAIS Managed Entities
to earn returns that investors may find attractive. Lower returns make it more difficult for ZAIS Group to attract new investors
or increase investments from existing investors in the ZAIS Managed Entities, resulting in reduced assets under management on
which ZAIS Group earns management fees and a reduced potential to earn incentive fees. Additionally, lower returns are less
attractive to investors, resulting in the increased potential for investor redemptions.
In addition, certain of
the ZAIS Managed Entities have acquired assets that would traditionally be securitized into structured finance securities.
In this low interest rate environment, the senior securities issued by certain of these securitization transactions have become
unattractive to traditional buyers of these senior securities. The lack of market participants for certain of these securities
may have additional negative impact on the ZAIS Managed Entities, and in turn, ZAIS Group’s profitability.
Risks Related to ZAIS Group’s
Regulatory Environment
Extensive regulation affects ZAIS Group’s
activities, increases the cost of doing business and creates the potential for significant liabilities and penalties that could
adversely affect ZAIS Group’s business and results of operations.
ZAIS Group’s business
is subject to extensive regulation, including periodic examination, by governmental agencies and self-regulatory organizations
in the jurisdictions in which it operates. The SEC oversees ZAIS Group’s activities as a registered investment adviser under
the Investment Advisers Act of 1940 (“Advisers Act”). The National Futures Association (the “NFA”) and
the CFTC oversee ZAIS Group’s activities as a CPO and a CTA. In addition, ZAIS Group regularly relies on exemptions from
various requirements of the Securities Act, the Exchange Act, the 1940 Act, the CEA and ERISA. These exemptions are sometimes
highly complex and may in certain circumstances depend on compliance by third parties whom ZAIS Group does not control. If for
any reason these exemptions were to be revoked or challenged or otherwise become unavailable to ZAIS Group, ZAIS Group could become
subject to regulatory enforcement action or third-party claims, which could have a material adverse effect on ZAIS Group’s
business.
The SEC has indicated
that investment advisers who pay personnel transaction-based compensation for soliciting investments in the funds they advise,
or who employ personnel solely responsible for marketing interests in the funds they advise, may be required to register as a
broker-dealer or to arrange for those personnel to be registered representatives of a separate broker-dealer. ZAIS Group does
not believe it or its personnel are required to so register. Additionally, the Financial Industry Regulatory Authority (“FINRA”)
has adopted a new “Capital Acquisition Broker” category of firms set to become effective on April 14, 2017. If ZAIS
Group were found to be subject to these rules, ZAIS Group would be subject to potentially substantial additional compliance obligations,
which would further tax its compliance resources and may result in the need to hire additional personnel. No assurance can be
made that new regulations, or new interpretations of existing regulations, will not result in ZAIS Group being required to register
as a broker-dealer or its personnel to become registered representatives.
Since 2010, states and
other regulatory authorities have begun to require certain investment managers to register as lobbyists in connection with the
solicitation of investments by public entities. ZAIS Group has registered as such in certain jurisdictions where required. Other
states or municipalities may consider similar legislation or adopt regulations or procedures with similar effect. These registration
requirements impose significant compliance obligations on registered lobbyists and their employers, which may include annual registration
fees, periodic disclosure reports and internal recordkeeping, and may also prohibit the payment of contingent fees.
Each of the regulatory
bodies with jurisdiction over ZAIS Group has regulatory powers dealing with many aspects of financial services, including the
authority to grant, and in specific circumstances to cancel, permissions to carry on or be compensated for particular activities.
A failure to comply with the obligations imposed by the federal securities laws, including the SEC’s rules under the Advisers
Act and the CFTC’s and NFA’s rules under the CEA relating to recordkeeping, privacy, advertising and operating requirements,
disclosure obligations and prohibitions on fraudulent activities, could result in investigations, sanctions and reputational damage.
ZAIS Group is involved regularly in trading activities that implicate both U.S. securities and commodities law regimes, including
laws governing trading on inside information, market manipulation and technical trading requirements that relate to fundamental
market regulation policies. Violation of these laws could result in severe restrictions on ZAIS Group’s activities and damage
to ZAIS Group’s reputation.
Furthermore, the ZAIS
Managed Entities generally rely on exemptions from investment company status under the Investment Company Act of 1940 (the “Investment
Company Act”), and ZAIS Group is responsible for seeing to it that the ZAIS Managed Entities comply with the conditions
that apply to those exemptions, both at inception and on an ongoing basis. If the conditions that govern such an exemption were
violated and no other exemption was available to a ZAIS Managed Entity, it generally could not carry on its business unless it
registered as an investment company under the Investment Company Act, which would subject that ZAIS Managed Entity to complex
governance and operational requirements, restrictions and prohibitions that could make it undesirable or infeasible for that ZAIS
Managed Entity to continue in business. In addition, such a failure by a ZAIS Managed Entity to qualify for an investment company
status exemption could be attributed to ZAIS Group.
ZAIS Group’s failure
to comply with applicable laws or regulations could result in fines, censure, suspensions of personnel or other sanctions, including
revocation of the registration of ZAIS Group’s and its relevant subsidiaries as investment advisers, CTAs or CPOs. The regulations
to which ZAIS Group’s businesses are subject are designed primarily to protect investors in the ZAIS Managed Entities and
to ensure the integrity of the financial markets. They are not designed to protect our stockholders. Even if a sanction imposed
against ZAIS Group, one of ZAIS Group’s subsidiaries or its personnel by a regulator is for a small monetary amount, the
adverse publicity related to the sanction could harm ZAIS Group’s reputation, which in turn could have a material adverse
effect on ZAIS Group’s businesses in a number of ways, including making it harder for ZAIS Group to obtain investments in
the ZAIS Managed Entities and discouraging prospective clients and investors from doing business with ZAIS Group. See
“—ZAIS
Group is highly dependent on its information and communication systems; systems failures and other operational disruptions, including
cyber-attacks, could significantly affect ZAIS Group’s business, which may, in turn, negatively affect ZAIS Group’s
operating results.”
Failure to comply with “pay to play”
regulations implemented by the SEC and certain states, and changes to the “pay to play” regulatory regimes, could
adversely affect ZAIS Group’s businesses.
In recent years, the SEC
and several states have initiated investigations alleging that certain private equity firms and asset management firms or agents
acting on their behalf have paid money to current or former government officials or their associates in exchange for improperly
soliciting contracts with state pension funds. In June 2010, the SEC approved Rule 206(4)-5 under the Advisers Act regarding “pay
to play” practices by investment advisers involving campaign contributions and other payments to state or local candidates
or government officials (including state or local government officials who run for federal office) able to exert influence on
potential government entity clients. Among other restrictions, the rule prohibits investment advisers from providing advisory
services for compensation to a government entity for a period of up to two years, subject to very limited exceptions, after the
investment adviser, its senior executives or its personnel involved in soliciting investments from government entities make contributions
(except in de minimis amounts) to certain elected candidates and officials in a position to influence the hiring of an investment
adviser by such government entity. An adviser is required to implement compliance policies designed, among other matters, to track
contributions by certain of the adviser’s employees and engagements of third parties that solicit government entities and
to keep certain records to enable the SEC to determine compliance with the rule. In addition, there have been similar rules on
a state level regarding “pay to play” practices by investment advisers.
As public pension plans
are investors in some of the ZAIS Managed Entities, these rules could result in significant economic sanctions on ZAIS Group’s
businesses if ZAIS Group or any of the other persons covered by the rules make any such contribution or payment, whether or not
material or with an intent to secure an investment from a public pension plan, or may, for instance, provide a basis for the redemption
of affected public pension fund investors. In addition, investigations relating to the foregoing activities may require the attention
of senior management and may result in fines if ZAIS Group is deemed to have violated any regulations, thereby imposing additional
expenses on us. Any failure on ZAIS Group’s part to comply with these rules could cause ZAIS Group to lose compensation
for its advisory services and/or expose it to significant penalties and reputational damage.
New or changed laws or regulations governing
ZAIS Group or the ZAIS Managed Entities’ operations and changes in the interpretation thereof could adversely affect ZAIS
Group’s business.
The laws and regulations
governing the operations of the ZAIS Managed Entities, as well as their interpretation, may change from time to time, and new
laws and regulations may be enacted. Accordingly, any change in these laws or regulations and changes in their interpretation,
or newly enacted laws or regulations and any failure by the ZAIS Managed Entities to comply with these laws or regulations, could
require changes to certain of ZAIS Group’s business practices, negatively impact ZAIS Group’s operations, AUM or financial
condition, impose additional costs on ZAIS Group or otherwise adversely affect ZAIS Group’s business. The following includes
certain significant regulatory risks facing ZAIS Group’s business:
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Changes
in capital requirements may increase the cost of ZAIS Group’s financing
. If
regulatory capital requirements — whether under the Dodd-Frank Act, Basel
III, or other regulatory action — were to be imposed on the ZAIS Managed
Entities, they may be required to limit, or increase the cost of, financing they provide
to others. Among other things, this could potentially require the ZAIS Managed
Entities to sell assets at an inopportune time or price, which could negatively impact
ZAIS Group’s operations, AUM or financial condition.
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The
imposition of additional legal or regulatory requirements could make compliance more
difficult and expensive, affect the manner in which ZAIS Group conducts its businesses
and adversely affect ZAIS Group’s profitability
. The Dodd-Frank
Act, among other things, imposes significant new regulations on nearly every aspect of
the U.S. financial services industry, including new registration, recordkeeping and reporting
requirements on private fund investment advisers. Importantly, while several key
aspects of the Dodd-Frank Act have been defined through final rules, their extent and
impact are not yet fully known and may not be known for some time. Several aspects
of the Dodd-Frank Act remain outstanding and will be implemented by various regulatory
bodies over the next several years. The imposition of any additional legal or regulatory
requirements could make compliance more difficult and expensive, affect the manner in
which ZAIS Group conducts its businesses and adversely affect the performance of the
ZAIS Managed Entities or ZAIS Group’s profitability.
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The
implementation of the “Volcker Rule” could have adverse implications on ZAIS
Group’s ability to raise funds from certain entities
. In December
2013, the Federal Reserve and other federal regulatory agencies adopted a final rule
implementing a section of the Dodd-Frank Act that has become known as the “Volcker
Rule.” Subject to certain exceptions for offshore activities by non-U.S.
banks and bank holding companies, the Volcker Rule generally prohibits insured banks
or thrifts, any bank holding company or savings and loan holding company, any non-U.S.
bank with a U.S. branch, agency or commercial lending company and any subsidiaries and
affiliates of such entities, regardless of geographic location, from investing in or
sponsoring “covered funds,” which generally include private equity funds
or hedge funds and certain other collective investment vehicles and certain other proprietary
activities. In addition, the Volcker Rule and its implementing regulations generally
prohibit “proprietary trading” in many securities by banking organizations,
subject to a market-making and certain other exceptions. Although the Volcker
Rule regulations are lengthy and detailed and clarified many issues concerning the Volcker
Rule’s scope and related exemptions, the interpretation and implementation of a
variety of aspects of those regulations are still uncertain and may not be known for
some time. The Volcker Rule clearly and substantially curtails investments
by banking organizations in many kinds of private funds, and many commentators have suggested
that notwithstanding the Volcker Rule’s market-making exception, an inability by
major banking organizations (including major investment banks that are not commercial
banks but are subsidiaries of bank holding companies) to engage in proprietary trading
will adversely affect the depth and liquidity of the debt security markets. These
developments could result in adverse impacts and uncertainties in the financial markets
as well as ZAIS Group’s business. Although, in view of the nature
of its investors and clients, ZAIS Group does not currently anticipate that the Volcker
Rule will adversely affect the ZAIS Managed Entities or ZAIS Group’s fundraising
to any significant extent, there could be adverse effects on ZAIS Group’s ability
in the future to raise funds from the types of entities mentioned above as a result of
this prohibition, and the proprietary trading restrictions may adversely affect trading
in markets in which ZAIS Managed Entities invest.
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Increased
regulation on banks’ leveraged lending activities could negatively affect the terms
and availability of credit to the ZAIS Managed Entities.
In March 2013,
the Office of the Comptroller of the Currency, the Department of the Treasury, the Board
of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation
published revised guidance regarding expectations for banks’ leveraged lending
activities. This guidance, in addition to the final U.S. risk retention rules that
took effect in December 2016, could further restrict credit availability, as well as
potentially restrict certain of ZAIS Group’s investing activities that rely on
banks’ lending activities. This could negatively affect the terms and availability
of credit to the ZAIS Managed Entities. See
“— ZAIS Group’s
use of leverage to finance ZAIS Group’s businesses exposes ZAIS Group to substantial
risks, which are exacerbated by the ZAIS Managed Entities’ use of leverage to finance
investments”
and
“— Dependence on leverage by certain of
the ZAIS Managed Entities subjects them to potential volatility and contractions in the
debt financing markets and could adversely affect ZAIS Group’s ability to achieve
attractive rates of return on those investments.”
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New
restrictions on compensation could limit ZAIS Group’s ability to recruit and retain
investment professionals
.
The
Dodd-Frank Act authorizes federal regulatory agencies to review and, in certain cases,
prohibit compensation arrangements at financial institutions that give employees incentives
to engage in conduct deemed to encourage inappropriate risk-taking by covered financial
institutions. Such restrictions could limit ZAIS Group’s ability to recruit and
retain investment professionals and senior management executives.
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Changes in partnership tax audit rules
effective in 2018 will impose new obligations and potential liabilities on ZGP, ZAIS Group and the ZAIS Managed Entities and may
make compliance more difficult and expensive.
On November 2, 2015,
President Obama signed the Bipartisan Budget Act of 2015 (the “Act”) into law, instituting for tax years commencing
after 2017 significant changes to the rules governing federal tax audits of entities such as ZGP and the ZAIS Managed Entities
that are treated as partnerships for U.S. federal income tax purposes. The new rules impose an entity-level liability for taxes
on partnerships (and concomitantly, in the case of a general or limited partnership (such as certain of the ZAIS Managed Entities),
the general partner) in respect of Internal Revenue Service (“IRS”) audit adjustments, absent election of an alternative
regime described below under which the tax liability is imposed at the partner level. The new rules constitute a significant change
from existing law and will require clarification through guidance from the U.S. Treasury Department (the “Treasury”).
Certain proposed regulations were issued on January 18, 2017 but subsequently withdrawn in accordance with a White House directive.
Certain small partnerships
are eligible to elect out of the provisions altogether for a given taxable year, with the result that any adjustments to such
a partnership’s items can be made only at the partner level. This election may be made only by partnerships with 100 or
fewer partners, each of which is an individual, a C corporation, an S corporation or an estate of a deceased partner. Accordingly,
for example, any partnership having another partnership as a partner is not eligible to elect out of the new audit regime.
Under the new rules, in
general, any audit adjustment to items of partnership income, gain, loss, deduction or credit, and any partner’s distributive
share thereof, are determined at the partnership level. Subject to election of the alternative regime discussed below, the
associated "imputed underpayment” — the tax deficiency arising from a partnership-level adjustment with respect
to a partnership tax year (a "reviewed year") — is calculated using the maximum statutory income tax rate and
is assessed against and collected from the partnership in the year that such audit or any judicial review is completed (the "adjustment
year"). In addition, the partnership is directly liable for any related penalties and interest, calculated as if the partnership
had been originally liable for the tax in the audited year.
Under an alternative regime,
if the partnership makes a timely election with respect to an imputed underpayment and furnishes to each partner of the partnership
for the reviewed year, and to the Treasury, a statement of the partner’s share of any adjustment to income, gain, loss,
deduction or credit, the rules requiring partnership level assessment will not apply with respect to the underpayment and each
affected partner will be required to take the adjustment into account on the partner’s individual tax return, and pay an
increased tax, for the taxable year in which the partner receives the adjusted information return. Under this alternative, the
reviewed year partners (rather than the partnership) are liable for any related penalties and interest, with deficiency interest
calculated at an increased rate and running from the reviewed year.
The Act also institutes
significant changes to procedural aspects of partnership audits. Among other things, the “tax matters partner” role
under prior law is replaced with an expanded “partnership representative” role. The partnership representative, which
will not be required to be a partner, will have sole authority to act on behalf of the partnership in an audit proceeding, and
will bind both the partnership and the partners by its actions in the audit.
As noted, the Act’s
new partnership audit regime applies to tax returns filed for partnership taxable years beginning after December 31, 2017.
The delayed effective date affords time to consider the potential effects of the new rules on affected ZAIS entities, their partnership
arrangements and operative agreements and to evaluate options for addressing them. While the Act provides that a partnership may
elect for the amendments to the partnership audit rules made by the Act to apply to any return of the partnership filed for partnership
taxable years beginning after the date of enactment of the Act and before 2018, it is not currently contemplated that any ZAIS
entity will make such an election.
New rules may make mortgage securitization
more difficult to achieve.
In September 2014, the
SEC adopted rules substantially revising Regulation AB requirements regarding the offering process, disclosure and reporting for
publicly-issued asset-backed securities (the “Enhanced Disclosure Rules”). Among other things, publicly-issued asset-backed
securities transactions effected after the effective date of the Enhanced Disclosure Rules require enhanced loan-level disclosure
containing information that was not previously required, as well as substantial additional loan-level information, and requirements
for a review of underlying assets by an independent asset representations reviewer if certain trigger events occur. In addition,
the SEC has not yet acted on certain rules initially proposed in April 2010 and re-proposed in July 2011 that would make the Enhanced
Disclosure Rules applicable to private offerings issued in reliance on Rule 144A or Rule 506 of Regulation D at the request of
the investor. Furthermore, as a matter of market-place practice many Rule 144A offerings routinely comply with the rules applicable
to public offerings.
Due to the expense of
complying with Regulation AB, RMBS and CMBS sponsors may be less inclined to issue RMBS and CMBS in the future, thereby reducing
investment opportunities for ZAIS Group.
New rules proposed by the Basel Committee
may decrease market liquidity among banks and increase the volatility of certain securities owned by ZAIS Group and the ZAIS Managed
Entities.
In May 2012, the Basel
Committee on Banking Supervision (the “Basel Committee”) introduced a new capital framework, the Fundamental Review
of the Trading Book (“FRTB”), which set out a number of specific measures designed to modify trading book capital
requirements. The final FRTB standards were adopted by the Basel Committee in January 2016, and regulators in various jurisdictions
are expected to adopt modified standards based on the FRTB standards. If such standards are adopted, new rules would likely decrease
market liquidity among banks and increase the volatility of certain securities owned by ZAIS Group and the ZAIS Managed Entities.
Risk retention requirements in Europe and
the United States may make securitization of assets less profitable.
Articles 404-410 (inclusive)
of the Capital Requirements Regulation 575/2013 apply to credit institutions established in a member state of the European Economic
Area ("EEA") and investment firms (such articles, together with any applicable guidance, technical standards or related
documents published by the European Banking Authority and any related delegated regulations of the European Commission, the "CRR
Retention Requirements"). Among other things, the CRR Retention Requirements restrict credit institutions and investment
firms from investing in securitizations, including collateralized loan obligation transactions, unless (i) the originator, sponsor
or original lender in respect of the relevant securitization has explicitly disclosed that it will retain, on an ongoing basis,
a net economic interest of not less than 5% in respect of certain specified credit risk tranches or securitized exposures and
(ii) such investor is able to demonstrate that it has undertaken certain due diligence in respect of various matters including
but not limited to its investment position, the underlying assets and (in the case of certain types of investors) the relevant
sponsor or originator. Similar requirements are or are expected to be imposed on European insurance companies, UCITS funds
and investment funds managed by EEA alternative investment fund managers (such requirements, collectively with the CRR Retention
Requirements, the "EU Retention and Due Diligence Requirements"). Failure to comply with the EU Retention and
Due Diligence Requirements may result in various penalties including, in the case of those investors subject to regulatory capital
requirements, the imposition of a punitive capital charge on the asset-backed securities acquired by the relevant investor.
It is not clear how
the foregoing regulations will be implemented in each Member State of the European Union. No assurance can be given
that the implementation throughout the European Union of the EU Retention and Due Diligence Requirements and related
legislation and regulations will not affect the requirements that will influence relevant investors’ willingness or
ability to invest in securitized assets.
Similar but not identical requirements to those set out in Articles 404 through 410 of the EU CRR have been finalized for
alternative investment fund managers which are required to become authorized under the European Union’s Alternative Investment
Fund Managers Directive (Directive 2011/61/EU) (the “AIFMD”). The AIFMD has been implemented in the Member States
of the European Union pursuant to Section 5 of Regulation (EU) No 231/2013 (the “AIFM Regulation”); Articles 50 through
56 of the AIFM Regulation contain the risk retention and diligence requirements applicable to regulated alternative investment
fund managers assuming exposure to securitization positions on behalf of one or more alternative investment funds they manage.
Similar requirements are expected to be implemented for other types of European Union-regulated investors or investment managers
(for example, insurance and reinsurance undertakings) in the future. Compliance with the increased regulatory burden imposed by
the AIFMD may increase the operating expenses of ZAIS Group and the ZAIS Managed Entities. In general, ZAIS Managed Entities
must comply with legal requirements, including requirements imposed by the AIFMD, securities laws, and company laws in various
jurisdictions where ZAIS Managed Entities are domiciled or offered. Should any of these laws change or exemptions under these
regulations cease to be available or desirable over the duration of the ZAIS Managed Entities, the legal requirements to which
the ZAIS Managed Entities may be subject could differ substantially from current requirements.
On October 21 and 22,
2014, six United States federal agencies (including the Federal Deposit Insurance Corporation, the Office of the Comptroller of
the Currency, the Board of Governors of the Federal Reserve System, the SEC, the Department of Housing and Urban Development,
and the Federal Housing Finance Agency) adopted the US Risk Retention Regulations, which became effective in December 2016. Except
with respect to asset-backed securities transactions that satisfy certain exemptions, the US Risk Retention Regulations generally
require securitizers of asset-backed securities to retain not less than 5% of the credit risk of the assets collateralizing such
asset-backed securities. For purposes of these regulations, ZAIS Group will most likely be the “securitizer”
for most CLOs it manages. It is not possible to fully predict the impact of the US Risk Retention Regulations on the structured
credit market, but it is possible that these new regulations may lead to reduced liquidity, a smaller market for new issuances
and a general decrease in expected revenue and profit for entities (like ZAIS Group) acting as securitizer or investing in RMBS,
CMBS, CLOs or other structured credit investments.
As a result of the rules
discussed above, ZAIS Group is required to retain at least 5% of the credit risk of any securitization transaction that ZAIS Group
sponsors in a Member State of the European Union or the United States, as applicabl
e,
and,
when risk retention is required, will be prohibited for contractual and/or regulatory reasons from disposing of any such ‘risk
retention’ investment for a defined period during the life of the related securitization, even when it has an opportunity
to do so.
A number of ZAIS Managed Entities trade
instruments that require ZAIS Group to be registered with the CFTC as a CTA and a CPO.
Certain ZAIS Managed Entities
trade instruments that require ZAIS Group to be registered with the CFTC as a Commodity Trading Adviser (“CTA”) and
a Commodity Pool Operator (“CPO”). Registration as a CTA and CPO requires that ZAIS Group comply with a number of
complex regulations and conduct ZAIS Group’s business in compliance with certain restrictions placed on the activities of
ZAIS Managed Entities. Additionally, as a CTA and CPO, ZAIS Group is subject to examination by the NFA. The compliance infrastructure
necessary to conduct ZAIS Group’s business in accordance with these regulations is both costly and time consuming. If the
NFA were to find that ZAIS Group is not conducting its business in accordance with these rules and regulations, it may be required
to cease certain types of activities on behalf of the ZAIS Managed Entities. ZAIS Group’s inability to conduct certain types
of trades could impede the performance of those ZAIS Managed Entities, may result in reputational harm to ZAIS Group and could
have an impact on its profitability.
In order to trade certain derivatives products,
ZAIS Group must maintain its membership on an SEF and be subject to the SEF’s rules and regulations. Failure to maintain
such membership, or failure to comply with the SEF’s rules, could adversely impact ZAIS Group’s business and results
of operations.
The Dodd-Frank Act requires
that certain types of cleared derivatives trades be executed on a SEF. SEFs are self-regulatory organizations for purposes of
the CEA, and SEF members must agree to comply with the rules and regulations of the SEF, including rules regarding trading practices,
disclosure obligations, financial reporting requirements and books and records requirements. Each SEF charges transaction fees,
and some SEFs require that their members indemnify the SEF against certain losses or costs that may be incurred as a result of
the transactions executed on the SEF.
ZAIS Group currently maintains
membership on various SEFs and is subject to the rules of each such SEF. Any failure to comply with these rules may subject ZAIS
Group to regulatory action, may result in reputational harm and may affect the value of Class A Common Stock. In addition, no
assurance can be made that ZAIS Group will be able to maintain its membership on any SEF in the future, which would prevent ZAIS
Group from trading those types of swaps that are required by regulation to be executed on a SEF. Any inability of ZAIS Group to
participate fully in the derivatives market may result in ZAIS Group being unable to execute on a trading strategy, which could
adversely impact its business and results of operations.
We are subject to regulatory investigations,
which could harm ZAIS Group’s reputation and cause the ZAIS Managed Entities to lose existing investors or accounts or fail
to attract new investors or accounts.
Like most financial services
firms, from time to time ZAIS Group is subject to formal regulatory inquiries. ZAIS Group discloses information regarding
such inquiries if disclosure is required pursuant to financial reporting or securities disclosure standards.
The failure by ZAIS Group
to comply with applicable laws or regulations could result in fines, suspensions of individual employees or other sanctions. Even
if an investigation or proceeding did not result in a fine or sanction or the fine or sanction imposed against ZAIS Group or ZAIS
Group’s employees by a regulator were small in monetary amount, adverse publicity relating to an investigation, proceeding
or imposition of these fines or sanctions could harm ZAIS Group’s reputation and cause the ZAIS Managed Entities to lose
existing investors or accounts or fail to attract new investors or accounts.
ZAIS Group is subject to the U.K. Bribery
Act, the U.S. Foreign Corrupt Practices Act and other anti-corruption laws, as well as export control laws, customs laws, sanctions
laws and other laws governing ZAIS Group’s operations. If it fails to comply with these laws, it could be subject to civil
or criminal penalties, other remedial measures, and legal expenses, which could adversely affect ZAIS Group’s business,
results of operations and financial condition.
ZAIS Group’s operations
are subject to anti-corruption laws, including the U.K. Bribery Act 2010 (the “Bribery Act”), the U.S. Foreign Corrupt
Practices Act (the “FCPA”) and other anti-corruption laws that apply in countries where ZAIS Group does business.
The Bribery Act, FCPA and these other laws generally prohibit ZAIS Group and ZAIS Group’s employees and intermediaries from
bribing, being bribed or giving other prohibited payments or items or actions of value to government officials or other persons
to obtain or retain business or gain some other business advantage. ZAIS Group’s commercial partners operate in a number
of jurisdictions that may pose a risk of potential Bribery Act or FCPA violations, and ZAIS Group participates in collaborations
and relationships with third parties whose actions could potentially subject ZAIS Group to liability under the Bribery Act, FCPA
or local anti-corruption laws. In addition, ZAIS Group cannot predict the nature, scope or effect of future regulatory requirements
to which ZAIS Group’s internal operations might be subject or the manner in which existing laws might be administered or
interpreted.
ZAIS Group is also subject
to other laws and regulations governing its international operations, including regulations administered by the governments of
the United Kingdom and the United States, and authorities in the European Union, including applicable export control regulations,
economic sanctions on countries or persons, customs requirements and currency exchange regulations, or “Trade Control Laws.”
There is no assurance
that ZAIS Group will be completely effective in ensuring its compliance with all applicable anti-corruption laws, including the
Bribery Act, the FCPA or other legal requirements and Trade Control Laws. If ZAIS Group is not in compliance with the Bribery
Act, the FCPA and other anti-corruption laws or Trade Control Laws, it may be subject to criminal and civil penalties, disgorgement
and other sanctions and remedial measures, and legal expenses, which could have an adverse impact on ZAIS Group’s business,
financial condition, results of operations and liquidity. Likewise, any investigation of any potential violations of the Bribery
Act, the FCPA, other anti-corruption laws or Trade Control Laws by U.K., U.S. or other authorities could also have an adverse
impact on ZAIS Group’s reputation, ZAIS Group’s business, results of operations and financial condition.
Risks Relating to the Operation of ZAIS
Group’s Business
ZAIS Group is subject to risks in using
custodians, counterparties, administrators, prime brokers, clearing and other agents.
ZAIS Group, in its capacity
as an investment adviser, and some of the ZAIS Managed Entities depend on the services of custodians, counterparties, administrators,
prime brokers and other agents to carry out certain financing, investment and derivatives transactions. The terms of these contracts
are often customized and complex. In particular, some of the ZAIS Managed Entities use arrangements with a relatively limited
number of counterparties, which has the effect of concentrating the transaction volume (and related counterparty default risk)
of such ZAIS Managed Entities with these counterparties.
The ZAIS Managed Entities
are subject to the risk that the counterparty to one or more of these contracts defaults, either voluntarily or involuntarily,
on its performance under the contract. Any such default may occur suddenly and without notice to ZAIS Group. Moreover, if a counterparty
defaults, ZAIS Group may be unable to take action to cover its exposure, either because it lacks contractual recourse or because
market conditions make it difficult to take effective action. This inability could occur in times of market stress, which is when
defaults are most likely to occur.
In addition, it may not
be possible for ZAIS Group to accurately predict the impact of market stress or counterparty financial condition, and as a result,
ZAIS Group may not be in a position to take sufficient action to reduce the ZAIS Managed Entities’ risks effectively. Default
risk may arise from events or circumstances that are difficult to detect, foresee or evaluate. In addition, concerns about, or
a default by, one large participant could lead to significant liquidity problems for other participants, which may in turn expose
ZAIS Group to significant losses.
The ZAIS Managed Entities
often have large positions with a single counterparty. For example, some of the ZAIS Managed Entities have credit lines. If the
lender under one or more of those credit lines were to become insolvent, ZAIS Group may have difficulty replacing the credit line
and one or more of the ZAIS Managed Entities may face liquidity problems.
In the event of a counterparty
default, particularly a default by a major financial institution or a default by a counterparty to a significant number of ZAIS
Managed Entities’ contracts, one or more of the ZAIS Managed Entities may have outstanding trades that they cannot settle
or are delayed in settling. As a result, these ZAIS Managed Entities could incur material losses and the resulting market impact
of a major counterparty default could harm ZAIS Group’s businesses, results of operation and financial condition.
In the event of the insolvency
of a prime broker, custodian, counterparty or any other party that is holding assets of ZAIS or the ZAIS Managed Entities as collateral,
ZAIS or the ZAIS Managed Entities might not be able to recover equivalent assets in full as they may rank among the prime broker’s,
custodian’s or counterparty’s unsecured creditors in relation to the assets held as collateral. In addition, ZAIS
Group has elected not to require swap dealers and major swap participants that are ZAIS Managed Entity counterparties to segregate
any initial margin posted by the ZAIS Managed Entities in respect of any uncleared swaps entered into on or after November 3,
2014 in accordance with CFTC Rule 23.701. Because the cash is not segregated from such counterparty’s own cash and may not
be segregated from the prime broker’s, custodian’s or other counterparty’s own cash, ZAIS or the ZAIS Managed
Entities may therefore rank as unsecured creditors in relation thereto and ZAIS or the ZAIS Managed Entities, as applicable, will
bear the risk of such losses. If ZAIS Managed Entities’ derivatives transactions are cleared through a derivatives clearing
organization, the CFTC has issued final rules regulating the segregation and protection of collateral posted by customers of cleared
swaps.
ZAIS Group is highly dependent on its information
and communication systems; systems failures and other operational disruptions, including cyber-attacks, could significantly affect
ZAIS Group’s business, which may, in turn, negatively affect ZAIS Group’s operating results.
ZAIS Group’s business
is highly dependent on its communications and information systems which may interface with or depend on systems operated by third
parties, including market counterparties and other service providers. Any failure or interruption of these systems could cause
delays or other problems in ZAIS Group’s activities, which could have a material adverse effect on ZAIS Group’s operating
results and negatively affect the value of Class A Common Stock and ZAIS Group’s ability to make distributions to ZGP.
Additionally, ZAIS Group
relies heavily on financial, accounting and other data processing systems and operational risks arising from mistakes made in
the confirmation or settlement of transactions, from transactions not being properly booked, evaluated or accounted for or other
similar disruption in ZAIS Group’s operations may cause ZAIS Group to suffer financial loss, the disruption of ZAIS Group’s
business, liability to third parties, regulatory intervention or reputational damage.
ZAIS Group also faces
various security threats, including cyber security attacks to ZAIS Group’s information technology infrastructure and attempts
to gain access to ZAIS Group’s proprietary information (including information of ZAIS Group’s clients, investors and
employees), destroy data or disable, degrade or sabotage ZAIS Group’s systems. These security threats could originate from
a wide variety of sources, including unknown third parties. As with all financial institutions, we may be exposed to new and emerging
cyber threats against which we are not immediately or adequately protected. ZAIS Group is not aware of any cyber-attacks on its
systems which prevented the Company from conducting its day to day operations in the normal course of business. Although ZAIS
Group uses various procedures and controls to monitor and mitigate these threats, there can be no assurance that these procedures
and controls are sufficient to prevent disruptions to ZAIS Group’s systems. If any of these systems do not operate properly
or are disabled for any reason or if there is any unauthorized disclosure of data, such as personal client, investor, borrower
and employee information, whether as a result of tampering, a breach of ZAIS Group’s network security systems, a cyber-incident
or attack or otherwise, ZAIS Group could suffer financial loss, a disruption of ZAIS Group’s businesses, liability, regulatory
intervention or reputational damage.
Although ZAIS Group has
back-up systems and cyber security and consumer protection measures in place, ZAIS Group’s back-up procedures, cyber defenses
and capabilities in the event of a failure, interruption, or breach of security may not be adequate. Insurance and other safeguards
on which ZAIS Group relies may not be available or may only partially reimburse ZAIS Group for its losses related to operational
failures or cyber-attacks. In addition, ZAIS Group may choose to reimburse a client in the event of a trading error or under other
circumstances, even if it is not legally required to do so, and any such reimbursements could adversely affect ZAIS Group’s
results of operations.
Developing and maintaining
ZAIS Group’s operational systems and infrastructure and protecting ZAIS Group’s systems from cyber security attacks
and threats may become increasingly challenging and costly, which could constrain ZAIS Group’s ability to expand ZAIS Group’s
businesses. Any upgrades or expansions to ZAIS Group’s operations or technology may require significant expenditures and
may increase the probability that ZAIS Group will suffer system interruptions and failures. ZAIS Group also depends substantially
on its Red Bank office where a majority of ZAIS Group’s employees, administration and technology resources are located,
for the continued operation of ZAIS Group’s business. Any significant disruption to that office could have a material adverse
effect on ZAIS Group.
If ZAIS Group’s risk management systems
for ZAIS Group’s asset management business are ineffective, ZAIS Group may be exposed to material unanticipated losses.
ZAIS Group’s risk
management techniques and strategies may not fully mitigate the risk exposure of the ZAIS Managed Entities or ZAIS Group’s
investments in all economic or market environments, or against all types of risk, including risks that ZAIS Group might fail to
identify or anticipate. Some of ZAIS Group’s strategies for managing risk are based upon its use of historical market behavior
statistics. ZAIS Group applies statistical and other tools to these observations to measure and analyze the risks to which the
ZAIS Managed Entities are exposed. Any failures in ZAIS Group’s risk management techniques and strategies to accurately
quantify such risk exposure could limit ZAIS Group’s ability to manage risks in the ZAIS Managed Entities or to seek adequate
risk-adjusted returns. In addition, any risk management failures could cause a ZAIS Group’s investments or one of its ZAIS
Managed Entity’s losses to be significantly greater than the historical measures predict. Further, modeling does not take
all risks into account. ZAIS Group’s approach to managing those risks could prove insufficient, exposing ZAIS Group and
the ZAIS Managed Entities to material unanticipated losses.
The due diligence process ZAIS Group undertakes
in connection with investments may not reveal all facts that may be relevant in connection with an investment.
Before making certain
investments, ZAIS Group conducts due diligence that it deems reasonable and appropriate based on the facts and circumstances applicable
to those investments. When conducting due diligence, ZAIS Group may be required to evaluate important and complex business, financial,
tax, accounting, environmental and legal issues. Outside consultants, legal advisors, service providers, accountants and investment
banks may be involved in the due diligence process in varying degrees depending on the type of investment. Nevertheless, when
conducting due diligence and making an assessment regarding an investment, ZAIS Group relies on the resources available to it,
including information provided by the target of the investment and, in some circumstances, third-party investigations. The due
diligence investigation that ZAIS Group conducts with respect to any investment opportunity may not reveal or highlight all relevant
facts that may be necessary or helpful in evaluating such investment opportunity. Moreover, such an investigation will not necessarily
result in the investment being successful.
ZAIS Group uses analytical models and data
in connection with the valuation of ZAIS Group’s investments and the investments of the ZAIS Managed Entities, and any incorrect,
misleading or incomplete information used in connection therewith would subject ZAIS Group to potential risks.
Given the complexity of
ZAIS Group’s investment strategies, ZAIS Group relies heavily on analytical models and information supplied by third parties.
Models and data are used to value potential target assets and also in connection with hedging ZAIS Group’s positions and
those of the ZAIS Managed Entities. In the event models and data prove to be incorrect, misleading or incomplete, any decisions
made in reliance thereon could expose ZAIS Group to potential risks. For example, by relying on incorrect models and data, especially
valuation models, ZAIS Group may be induced to buy assets at prices that are too high, to sell certain other assets at prices
that are too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove
to be unsuccessful and result in additional costs.
ZAIS Group relies on intellectual property
to conduct its business and any disruption to this intellectual property could impede ZAIS Group’s ability to carry out
its initiatives.
ZAIS Group’s business
is dependent on the use of intellectual property, including intellectual property licensed from third parties and certain protected
intellectual property that it has developed. Many of ZAIS Group’s investments are based on its analytical models and the
systems that generate these models. There are a number of risks associated with ZAIS Group’s intellectual property including
the risk that:
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•
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the third
party licensing certain intellectual property to ZAIS Group is no longer willing to license
such intellectual property to ZAIS Group, or is unwilling to license the intellectual
property to ZAIS Group at a price that it is willing to pay;
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•
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the intellectual
property that ZAIS Group has developed is stolen or sabotaged;
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•
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the intellectual
property that ZAIS Group has developed becomes obsolete and ZAIS Group is unable to develop
new intellectual property to replace the outdated systems, models or software; and
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ZAIS Group
is unable to retain or attract competent employees who are able to maintain and further
develop such intellectual property.
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Risk Factors Relating to Our Organizational
Structure
Mr. Zugel controls a majority of the combined
voting power of our common stock in his capacity as sole trustee of a voting trust that holds the Company’s Class B Common
Stock.
We have two classes
of common stock: Class A Common Stock and Class B Common Stock. At the closing of the Business Combination 20,000,000 shares
of Class B Common Stock were transferred to the ZGP Founder Members and immediately deposited into a newly created
irrevocable trust (the “ZGH Class B Voting Trust”), of which Christian Zugel is the initial sole trustee. Shares
of Class B Common Stock are entitled to ten votes per share and vote with the holders of Class A Common Stock, as a single
class, on all matters presented to holders of our Common Stock for a vote. The ZGH Class B Voting Trust is entitled to vote
the shares of Class B Common Stock in its own discretion and represents approximately 93.5% of the combined voting power of
our Common Stock at December 31, 2016. In the future, even if all 180,000,000 authorized shares of Class A Common Stock are
issued and outstanding, and assuming the 20,000,000 shares of Class B Common Stock remain outstanding, the holders of Class
B Common Stock would hold approximately 52.6% of the combined voting power of our Common Stock. The number of shares of Class
B Common Stock may be reduced in the future if the ZGP Founder Members’ ownership of our capital stock (which includes
securities exercisable for or convertible into our capital stock) under certain circumstances decreases below 20%.
For so long as the outstanding
shares of Class B Common Stock represent at least a majority of the combined voting power of our common stock, the holders of
Class B Common Stock are able to elect all of the members of our board of directors and thereby control our management and affairs,
including determinations with respect to acquisitions, dispositions, borrowings, issuances of securities, and the declaration
and payment of dividends. In addition, the holders of Class B Common Stock are generally able to determine the outcome of all
matters requiring approval of our stockholders, and are able to cause or prevent a change of control of the Company or a change
in the composition of our board of directors, and could preclude any unsolicited acquisition of the Company even though it may
be in the best interests of the holders of Class A Common Stock. In particular, this concentration of voting power could deprive
holders of Class A Common Stock of the opportunity to receive a premium for their shares of Class A Common Stock as part of a
sale of the Company, and could ultimately adversely affect the market price of the Class A Common Stock.
Mr. Zugel and the ZGP Founder Members have
voting control and other significant influence over us, and their interests may differ from those of our public stockholders.
As sole trustee of the
ZGH Class B Voting Trust, Mr. Zugel has control over approximately 93.5% of the voting power of the outstanding common stock of
the Company, subject to reduction if the ownership by the ZGP Founder Members of the Company and/or ZGP decreases below 20% under
certain circumstances. The ZGP Founder Members also have consent rights under the Second Amended and Restated Limited Liability
Company Agreement, as amended, among us, ZGP and the ZGP Founder Members (the “ZGP LLC Agreement”) with respect to
certain actions of ZGP.
Mr. Zugel, together with
Mr. Zugel’s spouse and family trusts and his former spouse, own approximately 33.5% of the outstanding Class A units of
ZGP (“Class A Units”). Because such interests are held directly in ZGP, and not in the Company, Mr. Zugel, as an owner
of Class A Units, may have conflicting interests with holders of shares of our Class A Common Stock. For example, if ZGP makes
distributions to the Company, the ZGP Founder Members and other members are also entitled to receive such distributions pro rata
in accordance with their respective ownership in ZGP and their preferences as to the timing and amount of any such distributions
may differ from those of our public stockholders. Mr. Zugel, together with his spouse and family trusts and his former spouse
may also have different tax positions from us that could influence Mr. Zugel’s decisions regarding whether and when to dispose
of ZGP’s assets, especially in light of the Tax Receivable Agreement that we entered into in connection with the Business
Combination, as amended (“Tax Receivable Agreement”), whether and when to incur new or refinance existing indebtedness,
and whether and when the Company should terminate the Tax Receivable Agreement and accelerate its obligations thereunder. In addition,
the structuring of future transactions may take into consideration Mr. Zugel’s and/or Mr Zugel’s family members’
and trusts’ tax or other considerations even where no similar benefit would accrue to us or our shareholders.
ZAIS’s only significant asset is
its ownership of approximately 66.5% of ZGP. We have no operations of our own and no independent ability to generate revenue,
and may not have sufficient funds to pay taxes, pay interest, pay dividends on the Class A Common Stock, if any, or make payments
under the Tax Receivable Agreement.
Because all
of ZAIS’s activity is conducted through its operating subsidiary, ZAIS Group, we have no direct operations and
no significant assets other than the ownership of approximately 66.5% of ZGP at December 31, 2016. With no operations of our
own and no independent ability to generate revenue, we accordingly are dependent upon distributions from ZGP to pay our
taxes, pay interest to creditors, pay dividends to our stockholders and make payments under the Tax Receivable Agreement.
We are required to pay taxes on our allocable share of the taxable income of ZGP without regard to whether ZGP distributes
any cash or other property to us. Although the ZGP LLC Agreement requires ZGP to make distributions to the holders of the
Class A Units and any vested ZGP Class B Units (the “Class B Units” and together with the Class A Units, the
“Units”) (including us) pro rata equal to the income tax on the cumulative positive taxable income of ZGP as
determined based on an assumed tax rate and certain other factors, ZGP must have sufficient available cash in order to make
these distributions. Further, although we intend to cause ZGP to make sufficient distributions to allow us to make payments
under the Tax Receivable Agreement, pay interest to our creditors and pay dividends, if any, to our stockholders,
deterioration in the financial condition, earnings or cash flow of ZGP and ZAIS Group for any reason could limit or impair
ZGP’s ability to pay such distributions. Additionally, to the extent that we need funds and ZGP is restricted from
making such distributions under applicable law or regulation or under the terms of our financing arrangements, or is
otherwise unable to provide such funds, it could materially adversely affect our liquidity and financial condition.
Payments of dividends,
if any, is at the discretion of our board of directors after taking into account various factors, including our business, operating
results and financial condition, current and anticipated cash needs (including our obligation to make payments under the Tax Receivable
Agreement), plans for expansion and any legal or contractual limitations on our ability to pay dividends. Any financing arrangement
that we enter into in the future may include restrictive covenants that limit our ability to pay dividends. In addition, ZGP is
generally prohibited under Delaware law from making a distribution to a member to the extent that, at the time of the distribution,
after giving effect to the distribution, liabilities of ZGP (with certain exceptions) exceed the fair value of its assets. ZAIS
Group and its subsidiaries are generally subject to similar legal limitations on their ability to make distributions to unitholders.
Although we may be entitled to tax benefits
relating to additional tax depreciation or amortization deductions as a result of a tax basis step-up we receive in connection
with exchanges of Units for Class A Common Stock and related transactions, we are required to pay the exchanging members of ZGP
85% of these tax benefits under the Tax Receivable Agreement.
Holders of
Units (other than us) may, subject to certain conditions and transfer restrictions, exchange their Units for Class A Common
Stock or cash or a combination of stock and cash at the election of ZAIS pursuant to the Exchange Agreement, dated as of
March 17, 2015, by and among the Company, ZGP, the Company Unitholders (as defined therein) and Christian M. Zugel, as
trustee of the ZGH Class B Voting Trust, as amended on July 21, 2015 (“Exchange Agreement”). These exchanges may
result in increases in our allocable share of the tax basis of the tangible and intangible assets of ZGP. These increases in
tax basis may increase (for tax purposes) depreciation and amortization deductions and therefore reduce the amount of income
or franchise tax that we would otherwise be required to pay in the future, although the Internal Revenue Service
(“IRS”) or any applicable foreign, state or local tax authority may challenge all or part of that tax basis
increase, and a court could sustain such a challenge.
In connection with the
Business Combination, ZAIS entered into the Tax Receivable Agreement, which provides for payment by ZAIS to exchanging holders
of Units of 85% of income or franchise tax benefits, if any, that ZAIS realizes as a result of these increases in tax basis and
of certain other tax benefits related to entering into the Tax Receivable Agreement, including income or franchise tax benefits
attributable to payments under the Tax Receivable Agreement. This payment obligation is an obligation of ZAIS and not of ZGP.
While the actual increase in our allocable share of ZGP’s tax basis in its assets, as well as the amount and timing of any
payments under the Tax Receivable Agreement, varies depending upon a number of factors, including the timing of exchanges, the
price of shares of Class A Common Stock at the time of the exchange, the extent to which such exchanges are taxable, the amount
and timing of our income as a result of the possible size and frequency of the exchanges and the resulting increases in the tax
basis of the tangible and intangible assets of ZGP and ZAIS’s tax position, payments under the Tax Receivable Agreement
could be substantial in certain circumstances and could have a material adverse effect on our financial condition. The payments
under the Tax Receivable Agreement are not conditioned upon continued ownership of us by the holders of Units.
The exchanging holders
of Units will not be required to reimburse us for any excess payments that may previously have been made under the Tax Receivable
Agreement, for example, due to adjustments resulting from examinations by taxing authorities. Rather, excess payments made to
such holders will be netted against payments otherwise to be made, if any, after the determination of such excess. As a result,
in certain circumstances we could make payments under the Tax Receivable Agreement in excess of our actual income or franchise
tax savings, which could materially impair our financial condition.
In certain cases, payments under the Tax
Receivable Agreement may be accelerated or significantly exceed the actual benefits we realize in respect of the tax attributes
subject to the Tax Receivable Agreement.
The Tax Receivable Agreement
provides that, in the event that we exercise our right to early termination of the Tax Receivable Agreement, or in the event of
a change in control of ZAIS, the Tax Receivable Agreement will terminate, and ZAIS will be required to make a lump-sum payment
to the ZGP Founder Members and holders of Class B Units (which are parties to the Tax Receivable Agreement and continue to hold
Units as of such date) equal to the present value of all forecasted future payments that would have otherwise been made under
the Tax Receivable Agreement, which lump-sum payment would be based on certain assumptions, including those relating to our future
taxable income and that all holders of Units which are parties to the Exchange Agreement would exchange their Units on the date
of the termination. The change of control payment and termination payments to these holders of Units could be substantial and
could exceed the actual tax benefits that ZAIS receives as a result of acquiring Units from other owners of ZGP because the amounts
of such payments would be calculated assuming that ZAIS would have been able to use the potential tax benefits each year for the
remainder of the amortization periods applicable to the basis increases, and that tax rates applicable to us would be the same
as they were in the year of the termination.
Decisions made by Mr.
Zugel (whether in his capacity as the trustee of the ZGH Class B Voting Trust or as an officer of the Company) in the course of
running our business, such as with respect to mergers, asset sales, other forms of business combinations or other changes in control,
may influence the timing and amount of payments that are received by the ZGP Founder Members and the holders of Class B Units
under the Tax Receivable Agreement. For example, the earlier disposition of assets following an exchange or acquisition transaction
would generally accelerate payments under the Tax Receivable Agreement and increase the present value of such payments, and the
disposition of assets before an exchange or acquisition transaction would increase an existing owner’s tax liability without
giving rise to any rights of the ZGP Founder Members or holders of Class B Units to receive payments under the Tax Receivable
Agreement.
There may be a material
negative effect on our liquidity if the payments under the Tax Receivable Agreement exceed the actual income or franchise tax
savings that ZAIS realizes in respect of the tax attributes subject to the Tax Receivable Agreement or if distributions to ZAIS
by ZGP are not sufficient to permit ZAIS to make payments under the Tax Receivable Agreement after it has paid taxes and other
expenses. Furthermore, our obligations to make payments under the Tax Receivable Agreement could make us a less attractive target
for an acquisition, particularly in the case of an acquirer that cannot use some or all of the tax benefits that are deemed realized
under the Tax Receivable Agreement. We may need to incur indebtedness to finance payments under the Tax Receivable Agreement to
the extent our cash resources are insufficient to meet our obligations under the Tax Receivable Agreement as a result of timing
discrepancies or otherwise which may have a material adverse effect on our financial condition.
Under the Tax Receivable Agreement, ZAIS
may be required to make additional payments to the ZGP Founder Members under certain circumstances.
In the event that the
ZGP Founder Members are required to recognize income or gain as a result of the release of up to an additional 2,800,000 Class
A Units (the “Additional Founder Units”), ZAIS is required to make a payment to the ZGP Founder Members under the
Tax Receivable Agreement in an amount equal to 100% of any actual tax refunds or reductions in taxes otherwise payable that ZAIS
realizes as a result. ZAIS’s obligation to make this additional payment does not terminate as a result of an early termination
or change of control under the Tax Receivable Agreement.
We may not be able to realize all or a
portion of the tax benefits that are expected to result from the acquisition of Units from the other ZGP members.
Under the Tax Receivable
Agreement, we are entitled to retain 15% of the total tax savings we realize as a result of increases in tax basis created by
exchanges of Units for Class A Common Stock or cash, and as a result of certain other tax benefits attributable to payments under
the Tax Receivable Agreement. Our ability to realize, and benefit from, these tax savings depends on a number of assumptions,
including that we earn sufficient taxable income each year during the period over which the deductions arising from any such basis
increases and payments are available and that there are no adverse changes in applicable law or regulations. If our actual taxable
income were insufficient to fully use such tax benefits, as is the case in our current financial projections, or there were adverse
changes in applicable law or regulations, we may be unable to realize all or a portion of these expected benefits and our cash
flows and stockholders’ equity could be negatively affected. Refer to the Risk Factor “
ZAIS is taxable as a corporation
for U.S. tax purposes and a change in projected long-term profitability could materially impact after-tax results of operations.
” for additional information on the impact of taxes on ZAIS.
Our public stockholders may experience dilution as a consequence
of, among other transactions, the release of the Additional Founder Units, the issuance of any equity awards to our employees
or the issuance of preferred stock.
There are 1,600,000 authorized
Class B-0 Units issuable to ZAIS Group employees, of which none were outstanding as of December 31, 2016. In addition, if certain
conditions are satisfied, ZGP is required to release 2,800,000 Additional Founder Units to the ZGP Founder Members and may issue
5,200,000 additional Class B Units to ZAIS Group employees. The Company may also issue equity awards to ZAIS Group employees under
the 2015 Stock Plan. The Company also has the ability to issue additional shares of common stock or preferred stock on terms and
conditions established by our board of directors, subject only to the number of authorized shares in our amended and restated
certificate of incorporation. Accordingly, current stockholders may experience substantial dilution. Such dilution could, among
other things, limit the ability of our current stockholders to participate in the future earnings and growth of the business.
In addition, the board
of directors is expressly granted authority to issue shares of the Preferred Stock, in one or more series, and to fix for each
such series such voting powers, full or limited, and such designations, preferences and relative, participating, optional or other
special rights and such qualifications, limitations or restrictions thereof as shall be stated and expressed in the resolution
or resolutions adopted by the board of directors.
The Class B Common Stock, the ZGP LLC Agreement
and other provisions in our amended and restated certificate of incorporation and bylaws and Delaware law may inhibit a takeover
of us, which could limit the price investors might be willing to pay in the future for the Class A Common Stock and could entrench
management.
The concentrated voting
power of the Class B Common Stock may discourage unsolicited takeover proposals that stockholders may consider to be in their
best interests. In addition, the ZGH Class B Voting Trust, as the holder of the Class B Common Stock, generally controls the vote
on all matters presented to our stockholders for a vote, including the election of directors. Under the ZGP LLC Agreement, so
long as the ZGP Founder Members own 10% of us (computed on a basis that excludes certain shares from consideration) with reference
to their Class A Units in ZGP on an as-if-exchanged basis, the ZGP Founder Members can veto a sale of the Class A Units that we
hold, which would prevent many forms of a sale of the Company.
Our amended and restated
certificate of incorporation and amended and restated bylaws contain provisions that may make the merger or acquisition of our
company more difficult without the approval of our board of directors. Among other things, these provisions:
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authorize
the issuance of undesignated preferred stock, the terms of which may be established and
the shares of which may be issued without stockholder approval, and which may include
super voting, special approval, dividend, or other rights or preferences superior to
the rights of the holders of Class A Common Stock;
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provide
that the board of directors is expressly authorized to make, alter, or repeal our bylaws
and that our stockholders may only amend our bylaws with the approval of a majority or
more of the voting power of all of the outstanding shares of our capital stock entitled
to vote; and
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establish
advance notice requirements for nominations for elections to our board or for proposing
matters that can be acted upon by stockholders at stockholder meetings.
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Further, as a Delaware
corporation, we are also subject to provisions of Delaware law, which may impair a takeover attempt that our stockholders may
find beneficial. These anti-takeover provisions and other provisions under Delaware law could discourage, delay or prevent a transaction
involving a change in control of our company, including actions that our stockholders may deem advantageous, or negatively affect
the trading price of the Class A Common Stock.
A change of control could result in termination
of ZAIS Group’s investment advisory and sub-investment advisory agreements.
Pursuant to the Advisers
Act, none of ZAIS Group’s investment advisory and sub-investment advisory agreements may be “assigned” without
the consent of the client. A sale of a controlling block of our voting securities and certain other transactions could be deemed
an “assignment” pursuant to the Advisers Act and the 1940 Act. If such a deemed assignment occurs, there can be no
assurance that we would be able to obtain the necessary consents from clients and, unless the necessary approvals and consents
are obtained, the deemed assignment could adversely affect ZAIS Group’s ability to continue managing client accounts, resulting
in the loss of AUM and a corresponding loss of revenue.
Risk Factors Relating to us and our
Class A Common Stock
We incur increased costs and are subject
to additional regulations and requirements as a public operating company, which could lower our profits or make it more difficult
to run our business.
As a public company, ZAIS
incurs significant legal, accounting and other expenses that historically were not incurred by ZGP as a closely held business,
including costs associated with public company reporting requirements. We also incur costs associated with the Sarbanes-Oxley
Act and related rules implemented by the SEC and NASDAQ. The expenses incurred by public operating companies generally for reporting
and corporate governance purposes have been increasing. These laws and regulations could also make it more difficult for us to
attract and retain qualified persons to serve on our board of directors, our board committees or as our executive officers. Furthermore,
if we are unable to satisfy our obligations as a public company, we could be subject to delisting of our Class A Common Stock,
fines, sanctions and other regulatory action and potentially civil litigation.
If the operating results of ZAIS Group
do not improve, the expectations of investors, stockholders or financial analysts may not be met and the market price of our securities
may decline further.
The price and
trading volume of our Class A Common Stock has fluctuated significantly and has been impacted by our financial results, the
lack of securities analysts following our stock, the relatively low liquidity of our stock and apparent program driven
trading activity. If the financial results of ZAIS Group do not improve, the expectations of investors in ZAIS or securities
analysts may not be met and the market price of the Class A Common Stock may further decline. Fluctuations in the price of
the Class A Common Stock could contribute to the loss of all or part of your investment. The trading price of our Class A
Common Stock may continue to be volatile and subject to wide fluctuations in response to various factors, some of which are
beyond our control. Factors affecting the trading price of the Class A Common Stock may include:
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our ability to identify and successfully negotiate a strategic transaction;
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our ability
to grow and manage growth profitably which may be affected by, among other
things, competition, and the ability of the company, retain its management
and key employees;
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the outcome
of or cost associated with any legal proceedings that may be instituted against us or
our affiliates;
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the inability
to meet NASDAQ’s continued listing requirements;
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costs related
to operating as a public company;
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changes
in political, economic or industry conditions, the interest rate environment or financial
and capital markets, which could result in changes in demand for products or services
or in the value of AUM;
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the annual
or quarterly results of operations or financial condition of companies perceived to be
similar to us;
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the relative
and absolute investment performance of advised or sponsored investment products;
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the impact
of future acquisitions or divestitures;
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the unfavorable
resolution of legal proceedings;
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the extent
and timing of any share repurchases (which have not been authorized by the Board at this
time);
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the impact,
extent and timing of technological changes and the adequacy of intellectual property
protection;
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the impact
of legislative and regulatory actions and reforms and regulatory, supervisory or enforcement
actions of government agencies relating to us or ZGP or its subsidiaries;
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terrorist
activities and international hostilities, which may adversely affect the general economy,
financial and capital markets, specific industries, and us or ZGP and its subsidiaries;
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the
ability to attract and retain highly talented professionals; and
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the
impact of changes to tax legislation and, generally, our tax position.
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Broad market and industry
factors and general economic conditions may also materially harm the market price of the Class A Common Stock irrespective of
our operating performance. The stock markets, in general, and NASDAQ, in particular, have experienced price and volume fluctuations
that have often been unrelated or disproportionate to the operating performance of the particular companies affected. A loss of
investor confidence in the market for investment management companies, or the stocks of other financial services companies which
investors perceive to be similar to us could depress the price of the Class A Common Stock regardless of our business, prospects,
financial conditions or results of operations.
Any of the above described
factors or circumstances could have a material adverse effect on your investment in the Class A Common Stock. In such circumstances,
the trading price of the Class A Common Stock may not recover and may experience a further decline. A decline in the market price
of the Class A Common Stock also could adversely affect our ability to issue additional securities and our ability to obtain additional
financing in the future. The decline of our Class A Common Stock may also cause reputational harm to ZAIS which may impact our
ability to attract additional commitments to the ZAIS Managed Entities. Failure to raise additional AUM for the ZAIS Managed Entities
would have a negative impact on our results of operations. If securities or industry analysts commence publishing research or
reports about us, and such reports, or reports on our industry and sector, are negative or unfavorable, the price and trading
volume of the Class A Common Stock could decline.
If any analyst who may
cover us were to cease coverage or fail to regularly publish reports on us, we could lose visibility in the financial markets,
which could cause the price or trading volume of the Class A Common Stock to decline.
NASDAQ may delist our shares which could
limit investors’ ability to trade our shares and subject us to additional trading restrictions.
There can be no assurance
we will be able to maintain our listing on the NASDAQ Capital Market. If NASDAQ delists our shares of Class A Common Stock, we
could face significant material adverse consequences, including:
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a
limited availability of market quotations for our shares;
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reduced
price and liquidity with respect to our shares which may materially limit your ability
to sell shares of Class A Common Stock;
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a determination
that the Class A Common Stock is a “penny stock” which would require brokers
trading in our shares to adhere to more stringent rules, possibly resulting in a reduced
level of trading activity in the secondary trading market for our shares;
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a limited
amount of news and analyst coverage for our company; and
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a
decreased ability to issue additional securities or obtain additional financing in the
future.
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The market price of the Class A Common Stock may decline due to the large number of shares of Class A Common Stock eligible for exchange and future sale.
The market price of shares
of the Class A Common Stock could decline as a result of sales of a large number of shares of Class A Common Stock in the market
or the perception that such sales could occur. These sales, or the possibility that these sales may occur, also might make it
more difficult for us to sell shares of Class A Common Stock in the future at a time and at a price that we deem appropriate.
Pursuant to the
registration rights agreement that we entered into in connection with the Business Combination, holders of Units can demand
that we register the resale of shares of Class A Common Stock issued upon the exchange of Class A Units and vested Class B
Units of ZGP. Although there are timing and other limitations on these exchanges as set forth in the Exchange Agreement, the
possibility that these exchanges may occur may adversely impact the trading price of the Class A Common Stock.
We are an “emerging growth company”
and a “smaller reporting company” and we cannot be certain if the reduced disclosure requirements applicable to emerging
growth companies and smaller reporting companies make our shares of Class A Common Stock less attractive to investors.
We are an “emerging
growth company,” as defined in the Jumpstart Our Business Startups Act (the “JOBS ACT”), enacted in April 2012.
For as long as we continue to be an “emerging growth company,” we may choose to take advantage of exemptions from
various reporting requirements applicable to other public companies but not to “emerging growth companies.” We are
currently, and in the future anticipate, taking advantage of these exemptions that do not require us to comply with the auditor
attestation requirements of Section 404 of the Sarbanes-Oxley Act, provide the full disclosure regarding executive compensation
that would otherwise be needed in our periodic reports and proxy statements, hold a nonbinding advisory vote on executive compensation
or shareholder approval of any golden parachute payments not previously approved. We could remain an “emerging growth company”
until December 31, 2018, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues
exceed $1 billion, (ii) the date that we become a “large accelerated filer” as defined in Rule 12b–2 under the
Exchange Act, which would occur if the market value of the Class A Common Stock that is held by non–affiliates exceeds $700
million as of any January 31 before the end of that five-year period, or (iii) the date on which we have issued more than $1 billion
in nonconvertible debt during the preceding three-year period.
In addition, Section 107
of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period
provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an
“emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise
apply to private companies. We have elected to take advantage of this provision, and, as a result, our financial statements may
not be comparable to companies that comply with public company effective dates.
As of December 31, 2016,
we qualify as a “smaller reporting company” as defined under Rule 12b-2 of the Exchange Act. Various reporting requirements
applicable to other public companies are not applicable to “smaller reporting companies” or are modified and generally
less stringent. We are currently, and in the future anticipate, taking advantage of the “smaller reporting company”
reporting requirements, including rules that do not require us to comply with the auditor attestation requirements of Section
404 of the Sarbanes-Oxley Act, provide the full disclosure regarding executive compensation, provide selected and supplemental
financial information, market risk analysis and other information that would otherwise be needed in our periodic reports and proxy
statements.
We cannot predict whether
investors will find the Class A Common Stock less attractive because we have chosen to rely on these exemptions and modified reporting
requirements. If some investors find the Class A Common Stock less attractive as a result of any decisions to reduce future disclosure,
there may be a less active trading market for the Class A Common Stock and our stock price may be more volatile.
We qualify as a “controlled company”
within the meaning of NASDAQ’s rules and, as a result, qualify for, and may choose to rely on, exemptions from certain corporate
governance requirements. In such a circumstance, you would not have the same protections afforded to stockholders of companies
that are subject to such requirements.
The ZGH Class B Voting
Trust holds approximately 93.5% of the combined voting power of all classes of our stock entitled to vote generally in the election
of directors. As a result, we qualify as a “controlled company” within the meaning of the corporate governance standards
of NASDAQ. Under these rules, a company of which more than 50% of the voting power in the election of directors is held by an
individual, group or another company is a “controlled company” and may elect not to comply with certain corporate
governance requirements. For example, controlled companies:
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are not required
to have a board that is composed of a majority of “independent directors,” as defined under the rules of such
exchange;
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are not required
to have a compensation committee that is composed entirely of independent directors; and
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are not required
to have a nominating and corporate governance committee that is composed entirely of independent directors.
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Although we do not currently
intend to use this exemption, we may choose to do so in the future. In such an event, a majority of the directors on our board
would not be required to be independent. Accordingly, you would not have the same protections afforded to stockholders of companies
that are subject to all of the corporate governance requirements of NASDAQ. Being a controlled company may also adversely impact
the trading price of the Class A Common Stock.
If we are deemed to be an investment company,
we may be required to institute burdensome compliance requirements and our activities may be restricted.
In general (and as applicable
to us), a company is an “investment company,” as defined in the Investment Company Act of 1940 (the “Investment
Company Act”), if either (1) it is “primarily” in the business of investing, reinvesting or trading in securities
(Section 3(a)(1)(A) of the Investment Company Act) or (2) the value of any “investment securities” it holds
constitute more than 40% of the value of the entity’s total assets, computed on an unconsolidated basis, excluding cash
items and U.S. government securities (Section 3(a)(1)(C) of the Investment Company Act). The term “investment securities”
for purposes of Section 3(a)(1)(C) is a broad term, but it excludes investments in majority-owned subsidiaries that are not themselves
investment companies or exempted from investment company status merely by one of the “private investment company”
exemptions under the Investment Company Act.
We believe we are not
an investment company because we are not primarily in the business of investing, reinvesting or trading in securities and because
less than 40% of our assets (excluding cash items and government securities) are investment securities. For all practical purposes,
our only asset (other than cash items and government securities) consists of our interest in ZAIS Group, our majority-owned subsidiary.
In turn, less than 40% of the value of ZAIS Group’s assets (excluding cash items and government securities) consists of
investment securities. We note that most of ZAIS Group’s assets (other than cash items and government securities) consist
of investment management contracts and the right to receive incentive compensation, neither of which we believe are investment
securities. Accordingly, we believe that neither we nor ZAIS Group is an investment company.
ZAIS Group currently
holds a portion of the proceeds of the Business Combination in U.S. treasury securities and money market funds, which, as
described above, are excluded from the calculation of the 40% Test. If, however, ZAIS Group deployed those proceeds as
investments in registered investment companies (such as mutual funds) or private investment companies, including
as investments to allow ZAIS Group to satisfy risk retention requirements, the assets in question would constitute
investment securities for purposes of Section 3(a)(1)(C) of the Investment Company Act. In addition, if ZAIS Group
deployed those proceeds to satisfy risk retention requirements as investments in securitization vehicles that are not
investment companies (because they qualify for exemptions from investment company status other than the private investment
company exemptions) and those securitization vehicles were not majority owned subsidiaries of ZAIS Group, those interests
would also constitute investment securities. As a result of investments of that kind, we could fail to satisfy the 40%
Test, and, if there were no other exclusions or exemptions available, we would be considered an investment company and
required to register as such.
A determination that
we were an investment company would have a significantly adverse effect upon us, for at least the following reasons:
(1) in the absence of receiving an exemptive order from the SEC, under Section 12(d)(3) of the Investment Company Act we
might not be permitted to control an investment adviser registered under the Advisers Act; (2) our current governance
structure would not comply with the requirements of the Investment Company Act; (3) we would be subject to significant
restrictions on transactions with affiliates unless those transactions were approved by the SEC; (4) in the absence of
receiving an exemptive order from the SEC, we could be subject to restrictions on the kind of incentive compensation that
could be offered to employees; and (5) we would be subject to numerous other rules, both substantive and procedural, that
apply to investment companies, compliance with which would be difficult and expensive. If ZAIS Group were subject to these
additional burdensome and potentially costly requirements, ZAIS Group may not be able to deploy its assets and an inability
to do so could also have a significant adverse effect upon ZAIS Group’s business and upon us.
A portion of ZAIS Group’s revenue
and cash flow is variable, which may impact ZAIS Group’s ability to achieve steady earnings growth on a periodic basis and
may cause volatility of our Class A Common Stock.
Although ZAIS Group believes
that a portion of its revenue is consistent and recurring due to its investment strategy and the nature of its fees, a portion
of ZAIS Group’s revenue and cash flow is variable, primarily due to the fact that the incentive income from the ZAIS Managed
Entities can vary from year to year. For the year ended December 31, 2016, incentive income was 29.5% of ZAIS Group’s total
revenues, representing a 31.1% increase over the year ended December 31, 2015. In addition, ZAIS Group also received a non-recurring
termination payment of $8.0 million from ZFC REIT during the year ended December 31, 2016. ZAIS Group may also experience fluctuations in its results from quarter to quarter and year to year due to a number of other factors,
including changes in the values of the ZAIS Managed Entities’ investments, changes in ZAIS Group’s operating expenses,
the degree to which it encounters competition and general economic and market conditions. Such variability may lead to volatility
in the trading price of Class A Common Stock. Moreover, ZAIS Group’s results for a particular period are not indicative
of ZAIS Group’s performance in a future period.
Potential conflicts of interest may arise
between holders of Class A Common Stock and the ZAIS Managed Entities’ investors.
As an investment adviser,
ZAIS Group has certain fiduciary duties and contractual obligations to the ZAIS Managed Entities. As a result, it expects to regularly
take actions with respect to the purchase or sale of investments by the ZAIS Managed Entities, the structuring of investment transactions
for the ZAIS Managed Entities or otherwise in a manner consistent with such duties and obligations but that might at the same
time adversely affect ZAIS Group’s near-term results of operations or cash flows. This may in turn have an adverse effect
on the price of Class A Common Stock or on the interests of holders of Class A Common Stock. Additionally, to the extent ZAIS
Group fails to appropriately deal with any such conflicts of interest, it could negatively impact ZAIS Group’s reputation
and ability to raise additional assets in the ZAIS Managed Entities.
ZAIS Group’s use of leverage to finance
its business exposes ZAIS Group to substantial risks, which are exacerbated by the ZAIS Managed Entities' use of leverage to finance
investments.
ZAIS Group may eventually
use a significant amount of borrowings to finance ZAIS Group’s business operations and the use of leverage is required to
effectuate certain of ZAIS Group’s initiatives. That would expose ZAIS Group to the typical risks associated with the use
of substantial leverage, including those discussed above under “— Dependence on leverage by certain of the ZAIS
Managed Entities subjects them to potential volatility and contractions in the debt financing markets and could adversely affect
ZAIS Group’s ability to achieve attractive rates of return on those investments.” These risks are exacerbated by the
ZAIS Managed Entities' use of leverage to finance investments.
Our current results of operations may adversely
affect ZAIS Group’s ability to retain and motivate its senior management team, senior investment professionals and other
key personnel and to recruit, retain and motivate new senior professionals and other key personnel, both of which could adversely
affect ZAIS Group’s business, results and financial condition.
ZAIS Group’s
future success and potential for growth depend to a substantial degree on its ability to retain and motivate its senior
management team, senior investment professionals and other professionals and to strategically recruit, retain and motivate
new talented personnel, including new senior professionals. Replacing key individuals would involve significant time and
expense and may cause significant disruption to ZAIS Group’s business, including certain of its initiatives. Members of
ZAIS Group’s senior management team and investment professionals have received a portion of their compensation in the
form of unvested Class B-0 Units which were cancelled on December 30, 2016 in consideration of the receipt, in substitution
therefor, of restricted stock units of the Company or cash, both subject to vesting requirements. The restricted stock units
vested on March 17, 2017 and, in the case of holders of Class B-0 Units who elected cash and remained employed by ZAIS Group
or its subsidiaries through March 17, 2017, cash was paid on
March 22, 2017. The indicative value of restricted stock unit awards has declined since the award date of the original
issuance of the Class B Units based upon our stock price performance.
In order to recruit and
retain existing and future senior professionals, ZAIS Group may need to increase the level of compensation that it pays to them.
Accordingly, as ZAIS Group promotes or hires new senior professionals over time, it may increase the level of compensation it
pays to them, which would cause ZAIS Group’s total employee compensation and benefits expense as a percentage of ZAIS Group’s
total revenue to increase and adversely affect ZAIS Group’s profitability. In addition, issuance of equity interests in
ZAIS Group’s business to future senior professionals would dilute public stockholders.
ZAIS Group believes that
it has a workplace culture of collaboration, motivation and alignment of interests with investors. If ZAIS Group does not continue
to develop and implement the right processes and tools to manage its changing enterprise and maintain this culture, ZAIS Group’s
ability to compete successfully and achieve its business objectives could be impaired, which could negatively impact its business,
financial condition and results of operations.