ZAIS Zais Grp. Holdings, Inc. (delisted)

Notes to Condensed Consolidated Financial Statements

1. Organization

ZAIS Group Holdings, Inc. (“ZAIS”, and collectively with its consolidated subsidiaries, as the context may require, the “Company”) is a holding company conducting substantially all of its operations through ZAIS Group, LLC (“ZAIS Group”), an investment advisory and asset management firm focused on specialized credit which commenced operations in July 1997 and is headquartered in Red Bank, New Jersey. ZAIS Group also maintains an office in London. ZAIS Group is a wholly-owned consolidated subsidiary of ZAIS Group Parent, LLC (“ZGP”), a majority-owned consolidated subsidiary of ZAIS. ZGP became the sole member and 100% equity owner of ZAIS Group on March 31, 2014 pursuant to a merger transaction which is described in detail in ZAIS’s Current Report on Form 8-K filed with the Securities and Exchange Commission (“SEC”) on March 23, 2015 (the “Closing 8-K”).

ZAIS Group is registered with the SEC under the Investment Advisors Act of 1940 and with the Commodity Futures Trading Commission as a Commodity Pool Operator and Commodity Trading Advisor. 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, through October 31, 2016, ZAIS Financial Corp. (“ZFC REIT”), a publicly traded mortgage real estate investment trust (collectively, the “ZAIS Managed Entities”).

On February 15, 2017, the Board of Directors of the Company (the “Board of Directors”) established a Special Committee of independent and disinterested directors to consider any proposals by management or third parties for strategic transactions. The 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 ZAIS Class A common stock (“Class A Common Stock”) 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 on any of these matters except as required by law or regulation.

The ZAIS Managed Entities predominantly invest in a variety of specialized credit instruments including corporate credit instruments such as CLOs, securities backed by residential mortgage loans, bank loans and various securities and instruments backed by these asset classes. ZAIS Group had the following assets under management (“AUM”):

⁽¹⁾ On April 19, 2017, the ZAIS Opportunity Fund, Ltd. received a redemption request for a redemption of approximately $67.7 million (value date of March 31, 2017) from a European investor impacted by regulatory constraints. This redemption is scheduled to occur on December 31, 2017.

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.

The Company’s primary sources of revenues are (i) management fee income, which is based predominantly on the net asset values of the ZAIS Managed Entities and (ii) incentive income, which is based on the investment performance of the ZAIS Managed Entities. Any management fee income and incentive income earned by ZAIS Group from the consolidated ZAIS Managed Entities (the “Consolidated Funds”) is eliminated in consolidation.

Additionally, a significant source of the Company’s other income is derived from net gains of Consolidated Funds’ investments and beneficial interests in collateralized financing entities which invest in bank loans. A portion of these net gains are allocated to non-controlling interests in Consolidated Funds.

Business Combination

On October 5, 2012, HF2 Financial Management Inc. (“HF2”) was formed as a blank check company whose objective was to acquire, through a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination, one or more businesses or entities. On September 16, 2014, HF2 entered into an Investment Agreement, as defined in the Closing 8-K, with ZGP and 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”), under which HF2 agreed to contribute cash to ZGP in exchange for newly issued Class A Units of ZGP (“Class A Units”) representing a majority financial interest in ZGP (the “Business Combination”) and to cause the transfer of all of its outstanding shares of Class B Common Stock, par value $0.000001 (the “Class B Common Stock”) to the ZGP Founder Members. All Class B Common Stock was then immediately deposited into a newly created irrevocable voting trust (the “ZGH Class B Voting Trust”), of which Mr. Zugel is the sole trustee. The Class B Common Stock has no economic rights and therefore is not considered participating securities for purposes of allocation of consolidated net income (loss).

On March 9, 2015, the stockholders of HF2 approved the Business Combination and the transaction closed on March 17, 2015 (the “Closing”). In connection with the Closing, HF2 changed its name to ZAIS Group Holdings, Inc. Prior to the Closing, HF2 was a shell company with no operations. Upon the Closing, ZAIS became a holding company whose assets primarily consisted of a then approximate 66.5% interest in its majority-owned subsidiary, ZGP. Prior to the Closing, Christian Zugel served as the managing member of ZGP. Upon the Closing, ZAIS became the managing member of ZGP.

 2. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited, interim, consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") as contained within the Financial Accounting Standards Board’s ("FASB") Accounting Standards Codification ("ASC") and the rules and regulations of the SEC for interim reporting. In the opinion of management, all adjustments considered necessary for a fair statement of the Company's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for the interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP as contained in the ASC have been condensed or omitted from the unaudited interim condensed consolidated financial statements according to the SEC rules and regulations. The information and disclosures contained in these unaudited interim condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K.

Segment Reporting

The Company currently is comprised of one reportable segment, the investment management segment, and substantially all of the Company’s operations are conducted through this segment. The investment management segment provides investment advisory and asset management services to the ZAIS Managed Entities.

Use of Estimates

The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. While management believes that the estimates used in preparing the consolidated financial statements are reasonable and prudent, actual results may ultimately differ from those estimates.

Principles of Consolidation

The consolidated financial statements included herein are the financial statements of ZAIS, its subsidiaries and certain ZAIS Managed Entities that are required to be consolidated. All intercompany balances and transactions are eliminated in consolidation, including ZAIS’s investment in ZGP and ZGP’s investment in ZAIS Group. The Company's fiscal year ends on December 31.

The consolidated financial statements include non-controlling interests in ZGP which is primarily comprised of Class A Units of ZGP held by the ZGP Founder Members.

The Company’s consolidated financial statements also include variable interest entities for which ZAIS Group is considered the primary beneficiary, and certain entities that are not considered variable interest entities in which ZAIS Group has a controlling financial interest.

 The consolidated financial statements reflect the assets, liabilities, investment income, expenses and cash flows of the Consolidated Funds on a gross basis. If the consolidated ZAIS Managed Entity is a CLO, the revenue and expenses are not reflected on a gross basis. Instead, the Company’s share of the net income of the CLO is reported in Net gain (loss) on beneficial interest of collateralized financing entity in the Consolidated Statements of Comprehensive Income (Loss).

Except for CLOs, the economic interests in the Consolidated Funds, which are held by third-party investors, are reflected as Non-controlling interests in Consolidated Funds in the consolidated financial statements. For CLOs, the majority of the economic interests in these vehicles, which are held by outside parties, are reported as Notes payable of consolidated CLOs in the consolidated financial statements. The notes payable issued by the CLOs are backed by diversified collateral asset portfolios consisting primarily of loans or structured debt. In exchange for managing the collateral for the CLOs, ZAIS Group may earn investment management fees, including, in some cases, subordinated management fees and contingent incentive fees. All of the management fee income, incentive income and net gain (loss) on investments earned by ZAIS Group from the Consolidated Funds are eliminated in consolidation.

The Company has elected the fair value option for the assets and liabilities held by the Consolidated Funds that otherwise would not have been carried at fair value. See Notes 4 and 5 for further disclosure on the assets and liabilities of the Consolidated Funds for which the fair value option has been elected.

The Company uses the measurement alternative included in the collateralized financing entity guidance (the “Measurement Alternative”). The Company measures both the financial assets and financial liabilities of the consolidated CLO in its consolidated financial statements using the fair value of the financial assets of the consolidated CLO, which are more observable than the fair value of the financial liabilities of the consolidated CLO. As a result, the financial assets of the consolidated CLO are measured at fair value and the financial liabilities are measured in consolidation as: the sum of the fair value of the financial assets and the carrying value of any non-financial assets that are incidental to the operations of the CLO less (ii) the sum of the fair value of any beneficial interests retained by the reporting entity (other than those that represent compensation for services) and the Company’s carrying value of any beneficial interests that represent compensation for services. The resulting amount is allocated to the individual financial liabilities (other than the beneficial interest retained by the Company) using a reasonable and consistent methodology. Under the Measurement Alternative, the Company’s consolidated net income reflects the Company’s own economic interests in the consolidated CLO including changes in the fair value of the beneficial interests retained by the Company and (ii) beneficial interests that represent compensation for collateral management services.

The Consolidated Funds, except for consolidated CLOs, are deemed to be investment companies under U.S. GAAP, and therefore, the Company has retained the specialized investment company accounting of these consolidated entities in its consolidated financial statements.

The Consolidated Funds include the following entities for the reporting periods presented:

Reimbursement Revenue

ZAIS Group may pay research and data services expenses relating to the management of the ZAIS Managed Entities directly to vendors and allocates a portion of these costs to the respective ZAIS Managed Entities per the terms of the respective investment management agreements (the “Research Costs”). The Company may also pay other costs to vendors on behalf of the ZAIS Managed Entities in addition to the Research Costs (the “Other Direct Costs”). These amounts may be reimbursable by the respective ZAIS Managed Entities and are recorded as Reimbursement revenue in the Consolidated Statements of Comprehensive Income (Loss) to the extent the Company is the primary obligor for such expenses and if the costs are charged back to the respective funds. The amounts for the three months ended March 31, 2016 were not material and therefore were not separately reported in the Consolidated Statements of Comprehensive Income (Loss).

Non-Controlling Interests

The non-controlling interests within the Consolidated Statements of Financial Condition may be comprised of: (i) redeemable non-controlling interests reported outside of the permanent capital section when investors have the right to redeem their interests from a Consolidated Fund or ZAIS Group; (ii) equity attributable to non-controlling interests in Consolidated Funds (excluding CLOs) reported inside the permanent capital section when the investors do not have the right to redeem their interests and (iii) equity attributable to non-controlling interests in ZGP, if applicable. The Company records redeemable non-controlling interests and non-controlling interests in the Consolidated Funds (excluding CLOs) to reflect the economic interests in those funds held by investors other than interests attributable to ZAIS Group. Income allocated to non-controlling interests in ZGP includes a portion of the management fee income received from ZFC REIT that was payable to holders of Class B interests in ZAIS REIT Management, LLC (“ZAIS REIT Management”), a majority owned subsidiary of ZAIS Group which was the external adviser to ZFC REIT prior to October 31, 2016 (see Note 6 – “Management Fee Income and Incentive Fee Income”).

Recent Accounting Pronouncements

Since May 2014, the FASB has issued ASU Nos. 2014-09, 2015-14, 2016-08, 2016-10 and 2016-12, Revenue from Contracts with Customers . The objective of the guidance is to clarify the principles for recognizing revenue and supersedes most current revenue recognition guidance, including industry-specific guidance. The guidance is to be applied retrospectively to all prior periods presented or through a cumulative adjustment in the year of adoption, for interim and annual periods beginning after December 15, 2017. The Company currently recognizes incentive income subject to contingent repayment once all contingencies have been resolved. Whereas the new guidance requires an entity to recognize such revenue when it concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized will not occur when the uncertainty is resolved. As such, the adoption of the new guidance may require the Company to recognize incentive income earlier than as prescribed under current guidance.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments─Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The amendments, among other things, (i) requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (ii) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (iii) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) and (iv) eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the impact of adopting this new standard. 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees are required to recognize lease assets and lease liabilities on the balance sheet for those leases previously classified as operating leases. The amendments in ASU No. 2016-02 are effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period with early adoption permitted. The Company is currently evaluating the impact of adopting this new standard. 

  In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). This ASU addresses the following eight specific cash flow issues: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (including bank-owned life insurance policies); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early application is permitted, including adoption in an interim period. Adoption of ASU 2016-15 is not expected to have a material effect on the Company's consolidated financial statements.

3. Investments in Affiliates

The Company applied the Fair Value Option to its interests in the ZAIS Managed Entities that are not consolidated. The Company believes that reporting the fair value of these investments is more indicative of the Company’s financial position than historical cost.

The fair value of these investments was as follows:

The Company recorded a change in unrealized gain (loss) associated with the investments still held at the end of each respective period as follows:

 Such amounts are included in Net gain (loss) on investments in the Consolidated Statements of Comprehensive Income (Loss).

At March 31, 2017 and December 31, 2016, no equity investment, individually or in the aggregate, held by the Company exceeded 10% of its total consolidated assets. Additionally, the Company did not have any income related to these investments, individually or in the aggregate, which exceeded 10% of its total consolidated income for the three months ended March 31, 2017 or March 31, 2016. As such, the Company did not present separate or summarized financial statements for any of its investees.

4. Fair Value Measurements

ASC 820 Fair Value Measurements defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements under U.S. GAAP. Specifically, this guidance defines fair value based on exit price, or the price that would be received upon the sale of an asset or the transfer of a liability in an orderly transaction between market participants at the measurement date. Fair value under U.S. GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company was forced to sell assets in a short period to meet liquidity needs, the prices it receives could be substantially less than their recorded fair values.

The Company follows the fair value measurement and disclosure guidance under U.S. GAAP, which establishes a hierarchical disclosure framework. This framework prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment, the characteristics specific to the investment and the state of the marketplace including the existence and transparency of transactions between market participants. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices in an orderly market generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. In all cases, an instrument’s level within the hierarchy is based upon the market pricing transparency of the instrument and does not necessarily correspond to the Company’s perceived risk or liquidity of the instrument.

The Company considers observable data to be market data which is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by independent sources that are actively involved in the relevant market. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the determination of which category within the fair value hierarchy is appropriate for any given investment is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires significant judgment and considers factors specific to the investment.

Assets and liabilities that are measured and reported at fair value are classified and disclosed in one of the following categories:

Level 1 — Fair value is determined based on quoted prices for identical assets or liabilities in an active market at measurement date. Assets and liabilities included in Level 1 include listed securities. As required in the fair value measurement and disclosure guidance under U.S. GAAP, the Company does not adjust the quoted price for these investments. The hierarchy gives highest priority to Level 1.

Level 2 — Fair value is determined based on inputs other than quoted prices that are observable for the asset or liability either directly or indirectly as of the reporting date. Assets and liabilities which are generally included in this category include corporate bonds and loans, less liquid and restricted equity securities and certain over-the-counter derivatives, including foreign exchange forward contracts whose values are based on the following:

Level 3 — Fair value is determined based on inputs that are unobservable for the investment and includes situations where there is little, if any, market activity for the asset or liability. The inputs into the determination of fair value require significant management judgment or estimation and the Company may use models or other valuation methodologies to arrive at fair value. Investments that are included in this category generally include distressed debt, less liquid corporate debt securities, non-investment grade residual interests in securitizations, collateralized debt obligations and certain derivative contracts. The hierarchy gives the lowest priority to Level 3.

The Company has established a valuation process that applies for all levels of investments in the valuation hierarchy to ensure that the valuation techniques are consistent and verifiable. The valuation process includes discussions between the valuation team, portfolio management team and the valuation committee (the “Valuation Committee”). The Valuation Committee consists of senior members of ZAIS Group and is co-chaired by the Chief Risk Officer and Chief Financial Officer of ZAIS Group. The Valuation Committee meets to review and approve the results of the valuation process which are used in connection with the preparation of quarterly and annual financial statements. The Valuation Committee is responsible for oversight and review of the written valuation policies and procedures and ensuring that they are applied consistently.

The lack of an established, liquid secondary market for some of the Company’s holdings may have an adverse effect on the market value of those holdings and on the Company’s ability to dispose of them. Additionally, the public markets for the Company’s holdings may experience periods of volatility and periods of reduced liquidity and the Company’s holdings may be subject to certain other transfer restrictions that may further contribute to illiquidity. Such illiquidity may adversely affect the price and timing of liquidations of the Company’s holdings.

Net gains or losses on investments are included in Net gain (loss) on investments in the Consolidated Statements of Comprehensive Income (Loss).

The following is a description of the valuation techniques used to measure fair value and the classification of these instruments pursuant to the fair value hierarchy:

Investments in Bank Loans

The Company uses a nationally recognized pricing service to provide pricing for the bank loans held by the Consolidated Funds.

Collateralized Loan Obligation – Warehouses

A Collateralized Loan Obligation Warehouse ("CLO Warehouse") is an entity organized for the purpose of holding syndicated bank loans, also known as leveraged loans, prior to the issuance of securities from that same vehicle.  During the warehouse period, a CLO Warehouse will secure investments and build a portfolio of primarily leveraged loans and other debt obligations. The warehouse period terminates when the collateralized loan obligation vehicle issues various tranches of securities to the market. At this time, financing through the issuance of debt and equity securities is used to repay the bank financing.

The fair value of a CLO Warehouse is determined by adding the excess spread (accrued interest plus interest received less financing cost) to the CLO Warehouse equity contribution made by the Consolidated Funds, unless ZAIS Group determines that the securitization will not be achieved, in which case, the fair value of a CLO Warehouse will be established based on the fair value of the underlying bank loan positions which are valued in a manner consistent with ZAIS Group’s valuation policy and procedures.  CLO warehouses can be exposed to credit events, mark to market changes, rating agency downgrades and financing cost changes. Changes in the fair value of a CLO Warehouse are reported in Net gain (loss) of Consolidated Funds’ investments in the Consolidated Statements of Comprehensive Income (Loss).

Investment in Affiliates

Under U.S. GAAP, the Company is permitted, as a practical expedient, to estimate the fair value of its investments in other investment companies using the net asset value (or its equivalent) of the related investment company. Accordingly, the Company utilizes the net asset value in valuing its investments in the unconsolidated ZAIS Managed Entities, which is an amount equal to the sum of the Company’s proportionate interest in the capital accounts of the affiliated entities at fair value. The fair value of the assets and liabilities of the ZAIS Managed Entities are determined by the Company in accordance with its valuation policies described above. Investments measured at fair value using the practical expedient are not required to be categorized within the fair value hierarchy. The resulting net gains or losses on investments are included in Net gain (loss) on investments in the Consolidated Statements of Comprehensive Income (Loss).

At March 31, 2017 and December 31, 2016, the Company held investments in five unconsolidated ZAIS Managed Entities. The valuation of the investments in these entities represents the amount the Company would receive at March 31, 2017 and December 31, 2016, respectively, if it were to liquidate its investments in these entities. ZAIS Group has the ability to liquidate its investments according to the provisions of the respective entities’ operative agreements.

The following tables summarize the Company’s assets measured at fair value on a recurring basis within the fair value hierarchy levels or based on net asset values, as applicable:

The following tables summarize the changes in the Company’s Level 3 assets:

The Company’s policy is to record transfers between Level 1, Level 2 and Level 3, if any, at the beginning of the period. There were no transfers between Level 1, Level 2 and Level 3 during the three months ended March 31, 2017 or March 31, 2016.

The tables below summarize information about the significant unobservable inputs used in determining the fair value of the Level 3 assets and liabilities held by the Consolidated Funds:

5. Variable Interest Entities

In the ordinary course of business, ZAIS Group sponsors the formation of variable interest entities (“VIEs”) that can be broadly classified into the following categories: hedge funds, hybrid private equity funds and CLOs. ZAIS Group generally serves as the investment advisor or collateral manager with certain investment-related, decision-making authority for these entities. The Company has not recorded any liabilities with respect to VIEs that are not consolidated. Certain ZAIS Managed Entities, including the CLOs, are VIEs.

Funds

The Company has determined that the fee it receives from several of the hedge funds and hybrid private equity funds ZAIS Group manages do not represent a variable interest, because ZAIS Group’s fee arrangements are commensurate with the level of effort performed and include only customary terms that do not represent variable interests. The Company considered investments its related parties have in these entities when determining if ZAIS Group’s fee represented a variable interest.

ZAIS Group owns 51% of a majority-owned affiliate, Zephyr A-6, which was established to invest in collateralized loan obligation vehicles, including the related warehouse stage of such vehicles. The Company has determined that ZAIS Group is the primary beneficiary of Zephyr A-6 and therefore has consolidated Zephyr A-6 in its consolidated financial statements at March 31, 2017 and December 31, 2016 and for the three months ended March 31, 2017 and March 31, 2016. ZAIS Group is the primary beneficiary since it is deemed to have (i) the power to direct activities of the entity that most significantly impact its economic performance and (ii) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the entity.

Zephyr A-6’s investments are as follows:

ZAIS CLO 5

ZAIS CLO 5, Limited (“ZAIS CLO 5”), which priced on September 23, 2016 and closed on October 26, 2016, invests primarily in first lien senior secured bank loans and had a total capitalization of $408.5 million at the time of closing, which consisted of senior and mezzanine notes with an aggregate par amount of $368.0 million and subordinated notes of $40.5 million. The CLO matures in October 2028. In connection with the closing, Zephyr A-6 recognized a dividend of $8.8 million which represents gains that were realized under the terms of the CLO Warehouse agreement.

Zephyr A-6’s initial investment in ZAIS CLO 5 was $20.3 million ($20.5 million par), which represented approximately a 2.1% economic interest in the senior and mezzanine notes and approximately 31.8% economic interest in the subordinated notes. The Company determined that it is the primary beneficiary of ZAIS CLO 5 based on (i) its ability to impact the activities which most significantly impact ZAIS CLO 5’s economic performance as collateral manger and (ii) Zephyr A-6’s significant investment in the subordinated notes of ZAIS CLO 5. Therefore, the Company consolidated ZAIS CLO 5 in its financial statements at March 31, 2017 and December 31, 2016 and for the three months ended March 31, 2017.

In February 2017 Zephyr A-6 sold its interest in the Class A-1 tranche of ZAIS CLO 5 for a sales price of approximately $5.4 million and recognized a loss of approximately $81,000. Such amount is included in Net gain (loss) on beneficial interest of collateralized financing entity in the Consolidated Statements of Comprehensive Income (Loss).

Zephyr A-6 had an investment of $14.7 million and $19.5 million in ZAIS CLO 5, at fair value, at March 31, 2017 and December 31, 2016, respectively. These investments represented approximately 0.6% and 2.1% economic interest in the senior and mezzanine notes at March 31, 2017 and December 31, 2016, respectively, and approximately 31.8% economic interest in the subordinated notes of ZAIS CLO 5 at March 31, 2017 and December 31, 2016.

During the three months ended March 31, 2016, ZAIS CLO 5 was in the warehouse phase (“ZAIS CLO 5 Warehouse”) and continued to finance the majority of its loan purchases using its warehouse facility. The Company was not required to consolidate ZAIS CLO 5 Warehouse for the three months ended March 31, 2016.

ZAIS CLO 6, Limited – Warehouse

ZAIS CLO 6, Limited (“ZAIS CLO 6 Warehouse”) was formed in November 2016 and was in the warehouse phase at March 31, 2017 and December 31, 2016. During this period, ZAIS CLO 6 Warehouse continued to finance the majority of its loan purchases using its warehouse facility. The Company was not required to consolidate ZAIS CLO 6 Warehouse at March 31, 2017 or December 31, 2016 or for the three months ended March 31, 2017.

  Securitized Structures

ZAIS Group and certain of its wholly owned subsidiaries act as collateral manager for CLOs that are VIEs. These CLOs are entities that issue collateralized notes which offer investors the opportunity for returns that vary commensurately with the risks they assume. The notes issued by the CLOs are generally backed by asset portfolios consisting of loans, other debt or other derivatives. For acting as the collateral manager for these structures, ZAIS Group receives collateral management fees comprised of senior collateral management fees, subordinated collateral management fees and incentive collateral management fees (subject to hurdle rates). In some cases, all of the collateral management fees are waived as a result of certain ZAIS Managed Entities owning equity tranches of the related CLO.

For CLOs in which the Company has no economic interests other than its fee arrangement, the Company has determined that the fee it receives from the CLOs does not represent a variable interest because ZAIS Group’s fee arrangements are commensurate with the level of effort performed and include only customary terms that do not represent variable interests. The Company considered investments its related parties have in the CLOs when determining if ZAIS Group’s fee represented a variable interest. The Company will continue to assess its investments in the CLOs to determine whether or not the Company will be required to consolidate the CLOs in its financial statements.

The Dodd-Frank credit risk retention rules, which became effective on December 24, 2016, apply to any newly issued CLOs or certain cases in which an existing CLO is refinanced, issues additional securities or is otherwise materially amended. The risk retention rules specify that for each CLO, the relevant collateral manager must purchase and hold, unhedged, directly or through a majority-owned affiliate, either (i) 5% of the face amount of each tranche of the CLO’s securities, (ii) an amount of the CLO’s equity equal to 5% of the aggregate fair value of all of the CLO’s securities or (iii) a combination of the two for a total of 5%. The required risk must be retained until the latest of (i) the date that the CLO has paid down its securities to 33% of their original principal amount, (ii) the date that the CLO has sold down its assets to 33% of their original principal amount or (iii) the date that is two years after closing.

The Company determined that it is not the primary beneficiary of CLO Warehouses, which are VIEs, because the financing counterparty must approve all significant financing requests and, as a result, the Company does not have the power to direct activities of the entity that most significantly impacts its economic performance.

VIEs

  Consolidated VIEs 

At March 31, 2017 and December 31, 2016 the Consolidated Funds consist of Zephyr A-6 and ZAIS CLO 5. Both entities are VIEs.

The assets and liabilities of the consolidated VIEs are, presented in Note 16 – “Supplemental Financial Information” under the heading “Consolidated Funds”, on a gross basis prior to eliminations.

The assets presented belong to the investors in Zephyr A-6 and ZAIS CLO 5, are available for use only by the entity to which they belong and are not available for use by the Company. The Consolidated Funds have no recourse to the general credit of ZAIS Group with respect to any liability.

Unconsolidated VIEs

At March 31, 2017 and December 31, 2016, the Company’s unconsolidated VIEs consisted of the Company’s investments in certain ZAIS Managed Entities as well as the Consolidated Fund’s investments in CLO Warehouses.

The carrying amounts of the unconsolidated VIEs are as follows:

Such amounts are included in the Consolidated Statements of Financial Condition.

ZAIS Group has a minimal direct ownership, if any, in the unconsolidated VIEs and its involvement is generally limited to providing asset management services. ZAIS Group’s exposure to loss from these entities is limited to a decrease in the management fee income and incentive income that has been earned and accrued, as well as any change in fair value of its direct equity ownership in the VIEs.

Zephyr A-6, one of the Consolidated Funds, contributed the following amounts to ZAIS CLO 5 Warehouse and ZAIS CLO 6 Warehouse:

Notes Payable of Consolidated CLO

Notes payable of the consolidated CLO are collateralized by the assets held by the CLO. This collateral primarily consists of bank loans.

The fair value of the assets and liabilities of ZAIS CLO 5 and the eliminations for the Consolidated Fund’s investment in ZAIS CLO 5 are as follows:

The Company has elected to carry these notes at fair value in its Consolidated Statements of Financial Condition. Accordingly, the Company measured the fair value of the notes payable (as a group including both the senior and subordinated notes) as (1) the sum of the fair value of the financial assets and the carrying value of any non-financial assets, less (2) the sum of the fair value of any beneficial interests retained by the Company (other than those that represent compensation for services) and the Company’s carrying value of any beneficial interests that represent compensation for services. The Company allocated the resulting amount to the different classes of notes based on the CLO’s waterfall on an as liquidated basis.

The tables below present information related to the CLO’s notes payable outstanding. The subordinated notes have no stated interest rate, and are entitled to any excess cash flows after contractual payments are made to the senior notes.

6. Management Fee Income and Incentive Income

ZAIS Group earns management fees for the funds and accounts which are generally based on (i) the net asset value of these funds and accounts prior to the accrual of incentive fees/allocations or (ii) drawn capital during the investment period.

Management fee income earned for the CLOs which ZAIS Group manages are generally based on the par value of the collateral and cash held in the CLOs. Additionally, subordinated management fees may be earned from CLOs for which ZAIS Group and certain of its wholly owned subsidiaries act as collateral manager. The subordinated management fee is an additional payment for the same collateral management service, but has a lower priority in the CLOs’ cash flows and is contingent upon the economic performance of the respective CLO. If the CLOs experience a certain level of asset defaults, these fees may not be paid. There is no recovery by the CLOs of previously paid subordinated fees.

Prior to October 31, 2016, ZAIS Group earned management fee income from ZFC REIT, quarterly, 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. The payment to the Class B interests in ZAIS REIT Management was recorded as distributions to non-controlling interests in ZAIS Group Parent, LLC. The income was recorded as Management fee income in the Consolidated Statements of Comprehensive Income (Loss), and the portion of the management fees allocated to the holders of Class B interests in ZAIS REIT Management was included in the Allocation of Consolidated Net Income (Loss) to Non-controlling interests in ZAIS Group Parent, LLC. On October 31, 2016, the management agreement with ZFC REIT was terminated upon the completion of the merger between ZFC REIT and Sutherland Asset Management Corp (the “Termination Agreement”). Pursuant to the Termination Agreement, ZAIS REIT Management received a termination payment in the amount of $8.0 million upon termination.

Management fees are generally collected on a monthly or quarterly basis.

ZAIS Group manages certain ZAIS Managed Entities from which it may earn incentive income based on hedge fund-style and private equity-style fee arrangements. ZAIS Managed Entities with hedge fund-style fee arrangements are those that pay ZAIS Group, on an annual basis, an incentive fee/allocation based on a percentage of 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 ZAIS Managed Entities 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 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. ZAIS Managed Entities with private equity-style fee arrangements are those that pay an incentive fee/allocation 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. For CLOs, incentive income is earned based on a percentage of cumulative profits, subject to the return of contributed capital, payment of subordinate management fees (if any) and a preferred inception to date return as specified in the respective CLOs’ collateral management agreements. The advisory agreement between ZAIS REIT Management and ZFC REIT did not provide for incentive fees.

The following tables represent the gross amounts of management fee income and incentive income earned prior to eliminations due to consolidation of the Consolidated Funds and the net amount reported in the Company’s Consolidated Statements of Comprehensive Income (Loss):

The Company may give credits for management fee income and/or incentive income to investors which invest in ZAIS Managed Entities which invest in other ZAIS Managed Entities where fees are also charged. The Company recorded all credits relating to management fee income and incentive income as Fees payable in the Consolidated Statements of Financial Condition and a reduction of either Management fee income or Incentive income in the Consolidated Statements of Comprehensive Income (Loss).

The management fee income and incentive income amounts above are net of the following credits:

Management fee income and incentive income which was accrued, but not received is as follows:

Such amounts are included in Income and fees receivable in the Consolidated Statements of Financial Condition.   

The Company did not recognize any bad debt expense for the three months ended March 31, 2017 or March 31, 2016. The Company believes all income and fees receivable balances are fully collectible.

7. Notes Payable

On March 17, 2015, in conjunction with the closing of the Business Combination, ZAIS issued two promissory notes with an aggregate principal balance of $1.25 million to EarlyBirdCapital, Inc. and Sidoti & Company, LLC. The notes accrued interest at an annual rate equal to the annual applicable federal rate as published by the Internal Revenue Service (“AFR”) until the principal amount of, and all accrued interest on, the notes were paid in full. The notes matured on March 17, 2017 at which time the principal balance and accrued interest was paid in full. The notes were issued in lieu of paying certain underwriting costs at the closing of the Business Combination and, accordingly, treated as a direct cost attributable to the Business Combination and capitalized to equity. The Company accrued interest on the notes for the three months ended March 31, 2017 and March 31, 2016, which is included in Other income (expense) in the Consolidated Statements of Comprehensive Income (Loss).

The carrying amount of the Company’s notes payable approximates their fair value at December 31, 2016.

Total interest expense was as follows:

8. Compensation

The following table presents a detailed breakout of the Company’s compensation expense:

A summary of the Company’s compensation arrangements are as follows:

Bonus

Incentive Cash Compensation

Employees are eligible to receive discretionary incentive cash compensation (the “Bonus Award”) on an annual basis and certain employees may also be eligible to receive guaranteed incentive compensation (the “Guarantees”). The amount of the Bonus Award is based on, among other factors, both individual performance and the financial results of ZAIS Group. For certain employees, as documented in an underlying agreement (the “Bonus Agreements”), the Bonus Award may be further subject to a retention-based payout schedule that generally provides for 30% of the Bonus Award to vest and be paid incrementally over a three-year period. The Company expenses all current cash incentive compensation award payments ratably in the first year. All future payments are amortized equally over the required service period over the remaining term of the Bonus Award as defined in the Bonus Agreements. Any Guarantees that are paid upon an employee commencing employment are expensed immediately by the Company. All future payments related to Guarantees are amortized equally over the required service period over the remaining term as defined in the agreements for the Guarantees (“Guarantee Agreement”). In the event an award is forfeited pursuant to the terms of the Bonus Agreement or Guarantee Agreement, the corresponding accruals will be reversed.

Levels of incentive compensation will vary to the extent they are tied to the performance of certain ZAIS Managed Entities or the financial and operating performance of the Company. The compensation payable balance includes accrued incentive compensation and severance.

During the period from January 1, 2017 through March 31, 2017, the Company paid approximately $8.5 million related to year end Bonus Awards issued in 2016, Bonus Awards that vested through February of 2017 pursuant to the Bonus Agreements related to a prior year, and Guarantees that vested through February 2017 pursuant to Guarantee Agreements related to a prior year and the current year.

Retention Payment Plan

On March 29, 2016, the Compensation Committee of the Board of Directors adopted a retention payment plan for certain employees of ZAIS Group (the "Retention Payment Plan"). The Retention Payment Plan applied to approximately 60 employees of ZAIS Group all of whom had an annual base salary of less than $300,000. The purpose of the Retention Payment Plan was to enable ZAIS Group to retain the services of its employees in order to ensure that ZAIS Group was not disrupted or adversely affected by the possible loss of personnel or their commitment to ZAIS Group. Under the Retention Payment Plan, the participating employees were entitled to receive cash retention payments on each of April 15, 2016, August 15, 2016 and November 15, 2016, if the employee remained employed by ZAIS Group on such dates. The Company paid an aggregate amount of approximately $4.6 million to all participants pursuant to the Retention Payment Plan during the year ended December 31, 2016.

In addition, on March 1, 2016, the Compensation Committee of the Board of Directors approved a retention payment of $900,000 to Howard Steinberg, the Company's former General Counsel, which was paid on March 15, 2016. This retention payment is included in Compensation and benefits in the Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2016.

 There were no amounts payable under the Retention Payment Plan at March 31, 2017 or December 31, 2016.

Points

ZAIS Group has entered into agreements with certain of its employees whereby certain current and former employees have been granted rights to participate in a portion of the incentive income received from certain ZAIS Managed Entities (referred to as “Points Agreements”). There are currently outstanding Points Agreements relating to one ZAIS Managed Entity and ZAIS Group does not anticipate awarding additional Points Agreements. The Company did not incur any compensation expense relating to the Points Agreements for the three months ended March 31, 2017 or March 31, 2016.

Severance

On March 8, 2016, the Company commenced a reduction in force which resulted in a decrease of 23 employees of ZAIS Group. The Company had incurred total severance charges of approximately $762,000 related to this reduction in force which was recognized and paid during the year ended December 31, 2016.

Equity-Based Compensation

Class B-0 Units

In conjunction with the closing of the Business Combination on March 17, 2015, ZGP authorized 1,600,000 Class B-0 Units eligible to be granted to certain employees of ZAIS Group. The Class B-0 Units were subject to a two year cliff-vesting provision, whereby all Class B-0 Units granted to an employee would be forfeited if the employee resigned or was terminated prior to the two year anniversary of the closing of the Business Combination. Subsequent to the two year anniversary of the Business Combination, an employee would only forfeit vested Class B-0 Units if the employee was terminated for cause. The Class B-0 Units were not entitled to any distributions from ZGP (and thus would not participate in, or be allocated any, income or loss) or other material rights until such Class B-0 Units vested. Upon vesting the Class B-0 Units would have had the same rights as Class A Units of ZGP and were exchangeable on a one for one basis for shares of Class A Common Stock or cash (or a combination of shares and cash), at the Company’s election, subject to the restrictions set forth in the Exchange Agreement included in the Closing 8-K. This compensation expense was amortized equally over the two-year vesting period and was cumulatively adjusted for changes in estimated forfeitures at each reporting date.

On December 1, 2016, the Board of Directors authorized ZGP to offer the 28 employees holding unvested Class B-0 Units the right to receive in consideration for the cancellation of their Class B-0 Units, at the holder’s option, either (a) Restricted Stock Units (“RSUs”) of ZAIS, on a one-for-one basis, or (b) an amount of cash per Class B-0 Unit cancelled (the “Cash Amount”) equal to $1.92, which was the average of the daily closing prices of Class A Common Stock of ZAIS for the three calendar months ended November 30, 2016 (the “Proposal”). The RSUs and the Cash Amount were both subject to vesting requirements and, collectively, are referred to as the “Election Consideration”. The offer period expired on December 30, 2016.

All holders decided to accept the Proposal to receive either RSUs or the Cash Amount. Upon the expiration of the offer period, the holders’ Class B-0 Units were cancelled. For those holders of Class B-0 Units who elected to receive RSUs, ZAIS granted the RSUs under the ZAIS 2015 Stock Incentive Plan (the “2015 Stock Plan”). The RSUs vested on March 17, 2017, the same date that the Class B-0 Units were scheduled to vest. The RSUs entitled the holders to receive ZAIS Class A Common Stock, which was issued, subject to applicable wage withholding requirements, immediately upon the vesting of the RSUs. In consideration of the issuance of such stock by ZAIS to the employees of ZGP’s subsidiary, ZAIS Group, LLC, ZGP issued a number of Class A Units to ZAIS equal to the number of shares of stock that were issued to the holders of RSUs. As a result of the issuance of these Class A Units, ZGH owned 67.4% of ZGP at March 31, 2017. If the B-0 Unit holder elected to receive the Cash Amount, provided the holder remained employed by ZAIS Group or its subsidiaries through the date of vesting, the Cash Amount was paid by ZAIS Group to the holder, subject to applicable wage withholding requirements, on March 22, 2017 . See disclosures below for additional information relating to the issuance of the RSUs in exchange for the cancellation of the B-0 Units.

The number of Class B-0 Units cancelled and Election Consideration provided as a result of the Proposal is as follows:

 The Company accounted for the cancellation of B-0 Units as follows:

RSUs Provided as a Replacement for the Cancellation of B-0 Units

The Company accounted for the issuance of RSUs as a modification of the award pursuant to ASC 718, “Compensation - Stock Compensation”, treating it as a cancellation of the limited liability company units accompanied by the concurrent grant of RSUs. The Company determined that the fair value of the RSUs and the Class B-0 Units at the modification date were equal and therefore there was no incremental compensation cost required to be recognized. ZAIS completed the amortization of the related compensation expense equally over the two-year vesting period subject to cumulative adjustment for changes in estimated forfeitures at each reporting date.

 Cash Provided as a Replacement for the Cancellation of Class B-0 Units

The Company accounted for the cash payment to be made in consideration for the cancellation of certain B-0 Units described above as a modification of the award pursuant to ASC 718, “Compensation - Stock Compensation”. However the modification of these awards changed the classification from equity awards to a liability awards. The fair value of the modified award at the time of the modification was approximately $256,000. The Company recognized a liability of approximately $230,000 at December 31, 2016 which reflects the vested amount of the modified award’s measurement date fair value. The remaining fair value of approximately $26,000 was amortized ratably over the remaining vesting period which ended on March 17, 2017.

The following table presents the Class B-0 Units’ activity: