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.
Although ZAIS Group’s
AUM has declined significantly from its peak of $11.707 billion prior to the financial crisis in 2008 to $4.512 billion as of December
31, 2017, AUM increased during 2017, primarily due to the formation of new CLOs managed by ZAIS Group. The decline was 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. While ZAIS
Group had historically been profitable, it incurred net losses in 2017, 2016 and 2015 based on U.S. GAAP. However, excluding the
impact of an $8.0 million termination fee received from ZFC REIT in 2016, ZAIS Group incurred a smaller net loss in 2017 as compared
to 2016 due to an increase in total revenues and a decrease in total expenses.
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 2017 and 2016, the alternative asset management industry was under fee pressure and ZAIS Group has not been
able to maintain its historic fee levels. Although AUM decreased during the first quarter of 2017 by approximately $0.1 billion
from approximately $3.444 billion as of December 31, 2016, AUM increased throughout the remaining three quarters of 2017 to approximately
$4.512 billion as of December 31, 2017. The increase in AUM is mostly attributable to the formation of new CLOs managed by ZAIS
which accounted for approximately $1.0 billion of the increase. The CLO business, which generally has a lower embedded management
fee structure than the mortgage and corporate credit funds, has grown and become a significant percentage of ZAIS Group’s
AUM. The typical management fee rates for CLO vehicles generally range between 0.15% 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 2017 and 2016 was approximately $3.842 billion and $3.877 billion, respectively.
Additionally, ZAIS Managed Entities representing total AUM of approximately $0.130 billion as of December 31, 2017 are winding
down and are in liquidation. The termination of the management agreement with ZFC REIT upon completion of the merger between ZFC
REIT and Sutherland Asset Management Corp. resulted in a decrease of approximately $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 have decreased
by approximately $2.5 million in 2017 compared to 2016 (estimated to be approximately $2.8 million on an annualized basis for future
periods).
For the year ended
December 31, 2017, we reported a U.S. GAAP net loss of $(1.2) million, compared with U.S. GAAP net loss of $(3.8) million for the
year ended December 31, 2016. For the year ended December 31, 2017, we reported (i) revenue of $30.8 million as compared with revenue
of $31.7 million for the year ended December 31, 2016 and (ii) expenses of $40.3 million as compared with expenses of $44.0 million
for the year ended December 31, 2016. Revenues for the year ended December 31, 2016 include the non-recurring $8.0 million termination
fee from ZFC REIT as well as total management fee income from ZFC REIT of approximately $2.5 million.
Excluding the termination
fee of $8.0 million from ZFC REIT, total consolidated management fee income increased by approximately $1.8 million in 2017 as
compared to 2016 which was primarily driven by the increase in the AUM of CLOs managed by ZAIS Group. Additionally, total consolidated
revenue decreased by approximately $0.8 million, and total consolidated expenses decreased by approximately $3.7 million. The decrease
in consolidated expenses was primarily due to a reduction in compensation and benefit costs of $7.4 million resulting from (i)
a reduction in force which occurred in 2016 and other departures during 2016 and 2017 and (ii) a decrease in equity compensation
expense primarily relating to the vesting in March 2017 of equity units previously awarded to certain employees, offset by an increase
of $3.0 million increase in General, administrative and other expenses primarily due to an increase in (i) research and data services
used by us for the management of the ZAIS Managed Entities, (ii) information technology costs primarily due to the relocation of
servers to an offsite co-location and (iii) an increase in legal expenses.
The current recurring
revenue base does not cover the current run-rate of total expenses. We currently anticipate that our expenses in 2018 will exceed
our revenues as they did in 2016 and 2017. If we are unable to significantly increase our 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 2018 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, 2017, the Company’s stand-alone (excluding
the activities of the Consolidated Funds, as defined below) net cash used in operations was $7.5 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 2018, 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 $4.512 billion as of December 31, 2017, 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 structured credit related investments because of capital considerations due to regulatory requirements.
On March
12, 2018, ZAIS Group sent notice to terminate its management contracts for the two ZAIS Managed Entities in which it had
made investments that carry first loss risk effective March 16, 2018. In connection with the termination of these management
contracts, ZAIS Group also requested a complete withdrawal of its investment amounts as of March 30, 2018. ZAIS Group’s
aggregate investment in these entities as of December 31, 2017 was approximately $10.0 million (the aggregate AUM of to these
two entities was approximately $0.109 billion as of December 31, 2017). ZAIS Group expects to receive the proceeds from
the withdrawals in second quarter of 2018.
Including the withdrawal
requests discussed in the previous paragraph, ZAIS Managed Entities representing total AUM of approximately $0.130 billion as of
December 31, 2017 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. Although AUM decreased during the first quarter of 2017 by approximately $0.1 billion from
approximately $3.444 billion as of December 31, 2016, AUM increased throughout the remaining three quarters of 2017 to approximately
$4.512 billion at December 31, 2017. The increase in AUM is mostly attributable to the formation of new CLOs managed by ZAIS which
accounted for approximately $1.0 billion of the increase.. Even with this increase in AUM, if ZAIS Group is unable to continue
to raise significant new assets to replace those that have and will be returned to investors, its AUM would be subject to declines
resulting in a lower base of assets on which it receives management fee income and potential 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
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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 revenue 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 income to ZAIS Group. For the year ended
December 31, 2017, incentive income was 37.5% of ZAIS Group’s total revenues, representing a 23.8% increase over the year
ended December 31, 2016. For the year ended December 31, 2016, incentive income was 29.5% of ZAIS Group’s total revenues.
Total revenues for the year ended December 31, 2017 includes $1.5 million of income of Consolidated Funds. Total revenues for the
year ended December 31, 2016 includes the $8.0 million termination fee received by ZAIS Group from ZFC REIT. In the event that
any of the ZAIS Managed Entities perform poorly, ZAIS Group’s revenue and results of operations will decline and may decline
significantly as performance based incentive income is an increasingly large portion of ZAIS Group’s total revenues. It will
also likely be more difficult for ZAIS Group to obtain new investments in ZAIS Managed Entities if these entities perform poorly.
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
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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
fee income and potential incentive income 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, 2017, the ten largest investors, the two largest investors and the largest investor accounted for approximately 39.2%, 28.1%
and 13.9% of ZAIS Group’s AUM (including AUM of the CLO vehicles managed by ZAIS Group), respectively. The same investors
accounted for approximately 94.8%, 68.1% and 33.6% 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 fee income and potential incentive income 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 58.7% 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,
2017, the Company recorded a Deferred Tax Asset (“DTA”) of approximately $4.5 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, 2017 and it is anticipated the expenses will again exceed revenues in 2018. Accordingly,
management believes that it is not more likely than not that it’s deferred tax asset will be realized and the Company has
established a full valuation allowance against the deferred tax assets as of December 31, 2017.
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 2018 will exceed its revenues, as they did in 2017,
2016 and 2015. While ZAIS has increased its total AUM by approximately $1.0 billion in 2017 due primarily to the formation of new
CLOs managed by ZAIS, if ZAIS Group is unable to continue 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.
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.
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, 2017, ZAIS Group served as investment manager to three ZAIS Managed Entities,
excluding CLOs, utilizing various degrees of leverage. These three ZAIS Managed Entities had combined AUM of $1.2 billion. The
weighted average leverage ratio of these ZAIS Managed Entities is approximately 14.8% (based on net asset value). 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 the
ZAIS Managed Entities 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 non-CLO 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 non-CLO ZAIS Managed Entities.
The debt and equity
instruments in which the non-CLO 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 investments
of the relevant non-CLO ZAIS Managed Entities. Most, if not all, of non-CLO 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 non-CLO ZAIS Managed Entities could be 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 non-CLO 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 non-CLO ZAIS Managed Entities’ investments generally
include prices received from third party valuation providers, 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 non-CLO 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 non-CLO ZAIS Managed Entity when such investments are sold. The non-CLO ZAIS Managed
Entity’s net asset value could be adversely affected if determinations regarding the fair value of such non-CLO ZAIS Managed
Entity’s investments were materially higher than the values that such non-CLO ZAIS Managed Entity ultimately realizes upon
the disposal of such investments. Realizations at values significantly lower than the values at which investments have been reflected
in the non-CLO ZAIS Managed Entity’s net asset values would result in losses for the applicable non-CLO ZAIS Managed Entity,
a decline in asset management fee income and the loss of potential incentive income. Also, a situation where asset values turn
out to be materially different than values reflected in a non-CLO 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 non-CLO 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, 2017 one ZAIS Managed Entity, which is consolidated in our December 31, 2017 financial
statements included in Item 8 herein, has uncalled capital commitments of approximately $87.8 million, which includes approximately
$11.7 million of uncalled capital from ZAIS Group. As of March 19, 2018, the uncalled capital commitments were approximately
$67.8 million, which includes approximately $9.0 million of uncalled capital from ZAIS Group. Additionally, during the first half
of 2017, a ZAIS Managed Entity which focuses on investing in non-ZAIS managed CLOs raised capital commitments of $68.3 million,
which includes $5.0 million from ZAIS Group, none of which has been called as of March 19, 2018.
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, electronically traded funds or other instruments to manage the exposure certain ZAIS
Managed Entities’ have 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 certain 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,
2017, ZAIS Group served as investment manager to five ZAIS Managed Entities investing a portion of their assets in RMBS or other
asset backed securities secured by residential real estate. The aggregate fair market value of these investments is approximately
$382.6 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 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, 2017, ZAIS Group served as an investment manager to five ZAIS Managed Entities investing a portion of their assets in CMBS,
commercial real estate mortgages, mezzanine loans and direct commercial property ownership. The aggregate fair market value of
these investments is approximately $65.8 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 may be 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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Information on the collateral backing structured finance
securities may be limited;
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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 certain ZAIS Managed Entities that invest in the equity tranches of CLOs which provides exposure to leveraged
loans. Further, the European and United States risk retention requirements currently 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” (as such term is defined in the Dodd-Frank Act) of ZAIS Group
that invests in the debt and equity tranches of certain CLOs for which ZAIS Group serves as the collateral manager. See
“
–
Risks
Related to ZAIS Group’s Regulatory Environment
–
Risk retention requirements in Europe and the United States
may make securitization of assets less profitable, although there is uncertainty regarding the application of the risk retention
requirements to CLO managers”
for a discussion regarding the DC Circuit’s ruling on February 9, 2018 with
respect to the risk retention rules.
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.
Certain of the ZAIS Managed Entities invest in ABS not backed
by mortgages or real estate and are subject to particular risks.
Certain of the ZAIS Managed Entities invest in a variety of
ABS representing interests in a pool of assets not backed by mortgages or real estate (“Non-Mortgage ABS”), including
automobile receivables, consumer loans or credit card receivables. Unscheduled prepayments of such Non-Mortgage ABS may result
in a loss of income for such ZAIS Managed Entities if the proceeds are invested in lower-yielding securities. Movements in interest
rates (both increases and decreases) may quickly and significantly reduce the value of certain types of Non-Mortgage ABS. Borrower
loan loss rates may be significantly affected by delinquencies, defaults, economic downturns or general economic conditions beyond
the control of individual borrowers. In particular, loss rates on consumer loans may increase due to factors such as prevailing
interest rates, the rate of unemployment, the level of consumer confidence, the value of the U.S. dollar, energy prices, changes
in consumer spending, the number of personal bankruptcies, disruptions in the credit markets and other factors. Increases in borrower
loan loss rates reduce the income generated by, and value of, Non-Mortgage ABS.
The value of asset-backed securities may be affected by other factors, such as the availability of information
concerning the pool and its structure, the creditworthiness of the servicing agent for the pool, the originator of the underlying
assets or the entities providing credit enhancements and the ability of the servicer to service the underlying collateral. In addition,
issuers of Non-Mortgage ABS may have limited ability to enforce the security interest in the underlying assets, collateral securing
the payment of loans may not be sufficient to assure repayment, and credit enhancements (if any) may be inadequate in the event
of default. Certain Non-Mortgage ABS may experience losses on the underlying assets as a result of certain rights provided to consumer
debtors under federal and state law and may be adversely affected by changes in government regulations. Adverse changes in the
factors described above could result in a reduction in portfolio yield or increase losses on Non-Mortgage ABS owned by ZAIS Managed
Entities.
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, Daniel Curry, its President and Chief Executive Officer, Nisha Motani, its Chief Accounting Officer and 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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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. 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 has resulted in an estimated 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. We also incurred severance costs in 2017 of approximately $0.1 million unrelated to the
reduction in force that occurred in 2016.
Commencing in 2015,
the Company’s management and its Board of Directors undertook a strategic review of the Company’s business in order
to enhance shareholder value. On February 15, 2017, the Board of Directors of the Company established a Special Committee of independent
and disinterested directors to consider any proposals for strategic transactions, as well as to consider all other strategic options
for the Company. Subsequently, the Special Committee’s review of potential strategic alternatives included capital raising,
asset sales, strategic partnerships, a sale of the entire Company, a sale of component parts of the Company, acquisitions and other
options, including continuing operating as a public company. Thereafter, Mr. Zugel reported to the Board of Directors of the Company
that he was considering making a proposal that would be beneficial to the Company’s stockholders and which would result in
the Company going private. Mr. Zugel made a proposal for a take private transaction to the Special Committee on September 5, 2017.
Over the next several months Mr. Zugel and the Special Committee negotiated his proposal. On January 11, 2018, the Company entered
into the Merger Agreement. Pursuant to the Merger Agreement, at the effective time of the Merger, all shares of Class A Common
Stock, other than shares held by Mr. Zugel, affiliates of Mr. Zugel, and certain other shareholders, will be converted into the
right to receive $4.10 per share in cash without interest, subject to any required withholding taxes. For a discussion of various
risks relating to the Merger, see “Item 1A Risk Factors—Risks Related to the Merger” and for additional information
regarding the Merger, see our Current Report on Form 8-K filed with the SEC on January 12, 2018.
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 fee income and potential incentive income, 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 even 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 31 at December 31, 2016 to 27 at March 19, 2018, 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 four such investments. ZAIS Group has made (i) a $20.0 million commitment to Zephyr A-6 LP, Zais Group’s
“majority-owned affiliate” (as such term is defined in the Dodd-Frank Act), of which approximately $11.0 million
has been funded as of March 19, 2018, which is focused on investing in the equity tranches of ZAIS managed CLOs, (ii)
an aggregate equity investment of $10.0 million in the first-loss equity tranche of two ZAIS Managed Entities each of
which focuses on investing in high-yield bonds and (iii) a $5.0 million commitment to an entity which focuses on investing
in non-ZAIS managed CLOs, none of which has been called as of March 19, 2018.
On March
12, 2018, ZAIS Group sent notice to terminate its management contracts for the two ZAIS Managed Entities in which it had
made investments that carry
first-loss risk effective March 16, 2018. In connection with the termination of these management contracts, ZAIS Group also
requested a complete withdrawal of its investment amounts as of March 30, 2018. ZAIS Group’s aggregate investment in
these entities as of December 31, 2017 was approximately $10.0 million. ZAIS Group expects to receive the proceeds from
the withdrawals in the second quarter of 2018. In connection with the termination of the management contracts for these two
Zais Managed Entities, ZAIS Group’s assets under management will decrease by approximately $0.109 billion.
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 ZAIS Group 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 fee income and a reduced potential to earn incentive income. 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. If ZAIS Group were found or elected to be subject to broker-dealer 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 capital acquisition broker
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 financing for ZAIS Managed Entities
. 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, lenders 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 many key aspects of regulatory regimes imposed by the Dodd-Frank Act have been defined through final rules, their extent and impact continue to be subject to interpretation (and in some cases legal challenges) and are not yet fully known and may not be known for some time. Several aspects of the Dodd-Frank Act rules will be implemented by various regulatory bodies over the next several years. 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 has adversely affected, and will continue to 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 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 prior law and will require clarification through guidance from the Internal Revenue Service and the U.S. Treasury Department
(the “Treasury”). Proposed regulations were issued on June 14, 2017 and regulations providing guidance with respect
to one aspect of the new rules (the election out provision discussed immediately below) were issued on December 29, 2017.
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.
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, although there is uncertainty regarding the application
of the risk retention requirements to CLO managers.
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 have been 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.
The foregoing regulations
have been implemented in various Member States 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 implemented for alternative investment fund
managers which are required to be authorized under the European Union’s Alternative Investment Fund Managers Directive (Directive
2011/61/EU) (the “AIFMD”). Articles 50 through 56 of the AIFMD’s delegated regulation contain the risk retention
and diligence requirements applicable to authorized 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. In general, ZAIS Managed Entities must comply with legal requirements, securities laws, and company laws in various jurisdictions
where ZAIS Managed Entities are domiciled or offered; however, currently, neither ZAIS Group nor the ZAIS Managed Entities are
required to comply with the AIFMD’s risk retention requirements. 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 January 17, 2018,
Regulation (EU) 2017/2402, the simple, transparent and standardised securitisation regulation (the “STS Regulation”),
and Regulation (EU) 2017/2401, the Securitisation Prudential Regulation (the “SPR”), entered into force. The STS Regulation
and SPR (such regulations, together with any applicable guidance, technical standards or related rules published by relevant supervisory
authorities and any related delegated regulations of the European Commission, the “Securitization Regulations”) establish
a new framework for European securitizations and apply to securitization transactions after January 1, 2019. The STS Regulation
consolidates the patchwork of legislation governing European securitizations, and introduces rules for issuing simple, transparent
and standardized (“STS”) transactions. The SPR replaces the provisions of the CRR Retention Requirements relating to
the regulatory capital treatment of securitization exposures held by EU credit institutions and investment firms. The STS Regulations
contain a set of rules that applies to all European securitizations, regardless who invests and whether the transaction is private
or public. Currently, under the CRR Retention Requirements, determining what set of rules applies depends on the type of investor.
Where an investor falls outside of specified categories of investors, the securitization provisions of the CRR Retention Requirements
do not apply. Among other things, the Securitization Regulations impose the 5% risk retention requirements directly on originators,
sponsors and original lenders, even where there is no requirement for investors to do so.
The
Securitization Regulations set out due diligence requirements that apply to institutional investors. Under the STS
Regulation, institutional investors will need to have (and observe) clearly defined criteria and processes for making
investment decisions and ensuring that the risk retention requirement is satisfied, including establishing procedures for
monitoring asset performance and compliance by the originator, sponsor or original lender of the securitization.
Institutional investors will also need to be able to demonstrate to their regulators that they have a comprehensive and
thorough understanding of the securitized investments and their management. Due diligence and transparency requirements
currently imposed on credit institutions and investment firms under the CRR Regulation and AIFMD will be repealed and
replaced with the standards in the STS Regulation. Under the CRR Regulation, the penalty for an
investor’s non-compliance is a punitive capital charge. In addition the capital charge penalty on investors, the
Securitization Regulations also permit Member States to impose administrative, criminal and other sanctions for
non-compliance against originators and sponsors. The Securities Regulations may result in increased compliance costs for ZAIS Group or ZAIS Managed Entities
that sponsor or originate transactions in EU Member states after January 1, 2019. Failure to comply with the Securities Regulations
could result in penalties or sanctions for ZAIS Group or such ZAIS Managed Entities.
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. Under the risk retention rules as written, for purposes of these regulations, ZAIS Group will most
likely be the “securitizer” or “sponsor” for most CLOs it manages. In February 2018 a decision by the U.S.
Court of Appeals for the District of Columbia generally invalidated the application of those terms (and, therefore, the Risk Retention
regulations) to managers of “open market” CLOs, but it is not yet known whether the agencies will attempt to appeal
that decision. Particularly in light of that decision, it is not possible to 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 currently 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.
However, on February
9, 2018, the U.S. Court of Appeals for the District of Columbia Circuit held (the "DC Circuit Ruling") that the federal
agencies responsible for the U.S. Risk Retention Rules (the "Applicable Agencies") exceeded their statutory authority
when designating the collateral manager of an open-market CLO as the securitizer of the open-market CLO. The DC Circuit Ruling
is not yet effective; however, when the DC Circuit Ruling becomes effective, the U.S. Risk Retention Rules will no longer apply
to ZAIS Group in connection with its management of CLOs, in which case ZAIS Group would be permitted to retain or dispose of the
applicable risk retention interests in its discretion. The effective date of the DC Circuit Ruling is dependent on what steps the
Applicable Agencies take, or do not take, to seek review of the ruling. If the Applicable Agencies elect to not to seek review
of the DC Circuit Ruling, it will become effective early in the second quarter of 2018. Even if the Applicable Agencies were to
seek review and delay implementation of the DC Circuit Ruling, it would still be possible that at some future date the U.S. Risk
Retention Rules would no longer be applicable to ZAIS Group.
In addition to the
DC Circuit Ruling described above, there have been proposals to modify the U.S. Risk Retention Rules as they relate to CLO transactions.
It is therefore possible that applicability of the U.S. Risk Retention Rules could be modified or eliminated entirely.
There are a number
of unresolved questions regarding the application of the U.S. Risk Retention Rules, in particular with respect to a sponsor holding
the required risk retention interest through an entity that is a “majority-owned affiliate” that has raised a majority
of its capital from third-party investors and will, at least initially, be limited in its investment purpose to the acquisition
of retention interests in securitization transactions of the sponsor. There is little regulatory guidance, and no established line
of authority, precedent or market practice, with respect to what is required to comply with the U.S. Risk Retention Rules in those
circumstances. Moreover, the determination of whether an entity is a “majority-owned affiliate” of a sponsor is dependent
on accounting rules which are subject to change. If an applicable regulator were to determine that ZAIS Group had failed to satisfy
the requirements of the U.S. Risk Retention Rules, such a failure could result in regulatory actions and other proceedings, and
any such action could have a material and adverse effect on the business or financial condition, reputation or operations of the
Company or its results of operations.
The impact
of the rule on the loan securitization market and the leveraged loan market generally are uncertain due to the
unpredictable effects of the rule on market expectations and the relative appeal of alternative investments not impacted by
the rule or other factors. The rule may result in a reduction of the number of collateral managers active in the market,
which may result in fewer new issue CLOs and reduce the liquidity provided by CLOs to the leveraged loan market generally. A
contraction or reduced liquidity in the loan market could reduce opportunities for ZAIS Group in the CLO markets. However, by
eliminating the risk retention requirements, the barriers to entry for becoming a CLO manager may be reduced. This could
result in more CLO managers and increased competition for ZAIS Group.
Certain 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 Related 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 that had a material impact on its business operations. 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 its 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 or to our offsite data center location could
have a material adverse effect on ZAIS Group.
If ZAIS Group’s risk management
techniques and strategies 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. 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 losses of a ZAIS Group investment or losses of a ZAIS Managed Entity to be
significantly greater than the historical measures predict. 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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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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the intellectual property that ZAIS Group has developed is stolen or sabotaged;
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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 93.2% of the combined voting power of our Common Stock at December 31, 2017.
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 or exchangeable 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 93.2% 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 32.5% of the outstanding Class A units
of ZGP (“Class A Units”) as of March 19, 2018. 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 67.5% 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 67.5% of ZGP at December 31, 2017. 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 payments to these holders of Units in such cases could be substantial and could exceed the actual
tax benefits, if any, that ZAIS receives in these circumstances.
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, 2017. 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 Related 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 successfully consummate the Merger or to identify, negotiate and complete an alternative 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 to 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.
On January 8, 2018, we received a letter
from the staff of the Listings Qualifications Department of NASDAQ stating that we failed to hold an annual meeting of stockholders
within 12 months of the Company’s fiscal year ended December 31, 2016, as required by NASDAQ Listing Rule 5620(a). As disclosed
prior to receiving the letter, the Company delayed its 2017 annual meeting of stockholders, which was originally scheduled to be
held on November 7, 2017, because of the contemplated merger transaction.
We had submitted a
plan to regain compliance pursuant to the procedures set forth in the NASDAQ Listing Rules on February 23, 2018. On March 6, 2018
we received a letter from the staff of the Listings Qualifications Department of NASDAQ indicating that they had granted the Company
an extension until June 29, 2018 to regain compliance with the NASDAQ Listing Rule 5620(a).
There can be no assurance
we will be able to regain compliance and 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, if any.
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 $1.07 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.
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,
2017, 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 93.2% 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 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. Total incentive income increased 23.8% from 2016 to 2017. For the year ended December
31, 2017, incentive income was 37.5% of ZAIS Group’s total consolidated revenues compared to 29.5% of total consolidated
revenues for the year ended December 31, 2016. 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 if 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 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.
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.
Risks Related to the Merger
Throughout this Annual Report on Form 10-K
the persons identified below shall be referred to as follows:
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Z Acquisition, Mr. Zugel and Mr. Curry are referred to as the “Parent
Parties,”
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Ramguard LLC, a Delaware limited liability company and successor-in-interest by conversion to d.Quant
Special Opportunities Fund, L.P., a Delaware limited partnership is referred to as “Ramguard,” and
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Parent Parties, the other members of Z Acquisition (including Mr. Zugel’s spouse and
the Zugel Family Trust), and Family Trust U/A Christian M. Zugel 2005 GRAT, taken together, are referred to as the
“Parent Group”.
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On January 11, 2018,
we entered into the Merger Agreement pursuant to which, among other things, Merger Sub will merge with and into the Company, with
the Company surviving the Merger as a subsidiary of Z Acquisition. In connection with the proposed Merger, we are subject to certain
risks including, but not limited to, those set forth below. For additional information related to the Merger Agreement, please
refer to our Current Report on Form 8-K filed with the SEC on January 12, 2018. Any description of the Merger Agreement is
qualified in its entirety by reference to the full text of the Merger Agreement attached as Exhibit 2.1 to the January 12, 2018
Form 8-K.
In addition, Z Acquisition
has agreed to purchase 6,500,000 shares of Class A Common Stock owned by Ramguard at a price of $4.10 per share (the “Target
Shares”) pursuant to the Amended and Restated Share Purchase Agreement, dated as of January 11, 2018, by and among Z Acquisition,
Ramguard and Mr. Zugel (the “Share Purchase Agreement”).
The Company established
April 2, 2018 as the record date for stockholders entitled to vote at its 2017 Annual Meeting of Stockholders (the “Annual
Meeting”), which has not yet been scheduled. Stockholders of record at the close of business on April 2, 2018 may vote at
the Annual Meeting. At the Annual Meeting, stockholders will be asked to consider and vote upon a proposal to adopt the Merger
Agreement. Stockholders will also be asked to elect the Company’s Board of Directors, approve the adjournment of the Annual
Meeting, if necessary, to solicit additional proxies if there are insufficient votes at the time of the Annual Meeting to approve
adoption of the Merger Agreement, and vote on any other matter properly brought before the Annual Meeting or any adjournments or
postponements of the Annual Meeting.
Completion of the Merger is subject
to various conditions which, if not satisfied, may cause the Merger not to be completed in a timely manner or at all.
The completion of the
Merger is subject to certain conditions. The obligations of the Company, on the one hand, and Z Acquisition, on the other hand,
to consummate the Merger are subject to the satisfaction or mutual waiver by the Company and Z Acquisition (if permissible under
applicable law), at or before the effective time of the Merger (the “Effective Time”), of the following conditions
(provided that the first conditions listed immediately below cannot be waived by any person in any circumstance):
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that holders of a majority of the outstanding shares of Class A Common Stock—other than shares
held by (i) any member of the Parent Group, (ii) any director or officer of the Company, (iii) holders of Rollover Shares or Exchange
Shares (each, as defined in the Merger Agreement), (iv) Ramguard, and (v) any affiliate of any of the foregoing persons—have
voted in favor of adoption of the Merger Agreement (this condition is referred to as the “Majority of the Minority Stockholder
Approval” requirement);
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that holders of a majority of the aggregate voting power of all of the shares of the capital stock
of the Company entitled to vote at the meeting have voted in favor of adoption of the Merger Agreement (this condition is referred
to as the “Statutory Stockholder Approval” requirement, and, together with the Majority of the Minority Stockholder
Approval requirement, is referred to as the “Requisite Stockholder Approval” requirement);
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that no law has been enacted or promulgated and no judgment is in effect, in either case, which
renders illegal or prohibits the consummation of the transactions contemplated by the Merger Agreement; and
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that the Company shall have obtained a favorable solvency opinion from an independent appraisal
or valuation firm.
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The obligation of the
Company to effect the Merger is subject to the satisfaction or waiver by the Company, at or before the Effective Time, of the following
conditions:
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the continued accuracy in all material respects of the representations and warranties of Z Acquisition
in the Merger Agreement as of the closing date;
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that Z Acquisition shall have performed and complied in all material respects with all of the covenants
and agreements required by the Merger Agreement to be performed or complied with by it at or prior to the closing of the Merger;
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that the purchase of the Target Shares shall have been consummated in accordance with the terms
of the Share Purchase Agreement; and
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that the acquisition of Class A Units of ZGP by Z Acquisition pursuant to the Investment Agreement,
dated as of January 11, 2018 (the “ZGP Investment Agreement”), by and among ZGP, Z Acquisition and, for limited purposes,
Mr. Zugel, shall have been consummated in accordance with the terms of the ZGP Investment Agreement.
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The obligation of Z
Acquisition to complete the Merger is subject to the satisfaction or waiver by Z Acquisition, at or before the Effective Time,
of the following conditions:
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the continued accuracy of the representations and warranties of the Company and Sub in the Merger
Agreement as of the closing date (except for certain representations and warranties which must remain accurate as of a specified
date) except to the extent that the failure of such representations and warranties to be accurate as of the closing date does not
individually or in the aggregate have a material adverse effect on the Company and its subsidiaries, provided that certain fundamental-type
representations and warranties of the Company and Sub must be true and correct in all material respects as of the date of the Merger
Agreement and the closing date (except representations and warranties made as of a specific date shall have been true and correct
only as of such date);
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that the Company and Sub shall have performed and complied in all material respects with all covenants
and agreements required by the Merger Agreement to be performed or complied with by each of them at or prior to the Effective Time;
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that the Company shall not have suffered a material adverse effect;
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that certain transaction expenses of the Company in connection with the Merger shall not exceed
$4,500,000;
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that the number of shares of Class A Common Stock as to which a properly executed notice of appraisal
has been received by the Company and not withdrawn as of immediately prior to the Effective Time shall not exceed 500,000 shares
of Class A Common Stock (excluding any shares held by any member of the Parent Group, Ramguard or any holder of Rollover Shares
or Exchange Shares, or any of their respective affiliates); and
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that no legal proceedings of the type agreed among the Company, Sub and Z Acquisition shall be
pending.
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As a result of these conditions, we cannot
provide assurance that the Merger will be completed on the terms or timeline currently contemplated, or at all.
We will continue to incur substantial
transaction-related costs in connection with the Merger.
We have incurred significant
legal, advisory and financial services fees in connection with our Board of Directors’ and the Special Committee’s
review of strategic alternatives and the process of negotiating and evaluating the terms of the Merger. We expect to continue to
incur additional costs in connection with the satisfaction of the various conditions to closing, including seeking approval from
our stockholders and from applicable regulatory agencies. Such costs may be material and could have a material adverse effect on
our future results of operations, cash flows and financial condition.
We are required to reimburse the Parent Group for all documented
fees and expenses incurred by them (including reasonable attorneys’ fees) in connection with the Merger Agreement and the
transactions contemplated thereby, up to a maximum of $1.5 million in the aggregate, if the Company or Z Acquisition terminates
the Merger Agreement because of an Adverse Company Recommendation (as defined in the Merger Agreement).
The announcement and pendency of
the Merger could adversely affect our business, results of operations and financial condition.
The announcement and
pendency of the Merger could cause disruptions in and create uncertainty surrounding our business, including affecting our relationships
with our existing and future customers, suppliers and employees, which could have an adverse effect on our business, results of
operations and financial condition, regardless of whether the Merger is completed. In particular, we could potentially lose important
personnel as a result of the departure of employees who decide to pursue other opportunities in light of the Merger. We could also
potentially lose investors or clients and prospective investors or clients could delay subscribing to ZAIS Managed Entities in
light of the transaction. In addition, we have expended, and continue to expend, significant management resources in an effort
to complete the Merger, which are being diverted from our day-to-day operations.
If the Merger is not
completed, our stock price will likely fall to the extent that the current market price of our common stock reflects an assumption
that a transaction will be completed. In addition, the failure to complete the Merger may result in negative publicity and/or a
negative impression of us in the investment community and may affect our relationship with employees, investors, clients and other
partners in the business community.
While the Merger Agreement is in
effect, we are subject to restrictions on our business activities.
Under the Merger Agreement,
we are subject to certain restrictions on the conduct of our business and generally must operate our business in the ordinary course
and in accordance with past practice, and use our reasonable best efforts to maintain our assets and properties and preserve our
business organization and goodwill of those having business relationships with us prior to completing the Merger. Unless we obtain
the consent of Z Acquisition, these restrictions may prevent us from pursuing otherwise attractive business opportunities, making
certain investments or acquisitions, selling assets, engaging in capital expenditures in excess of certain agreed limits, incurring
indebtedness or making changes to our business prior to the completion of the Merger or termination of the Merger Agreement. Further,
we must use our reasonable best efforts to keep available the services of our officers and employees on the date of the Merger
Agreement on terms and conditions substantially similar to those in effect as of the date of the Merger Agreement. These restrictions
could have an adverse effect on our business, financial condition and results of operations.
In addition, the Merger
Agreement: (i) requires us to notify Z Acquisition within two business days of certain alternative acquisition inquiries, proposals,
or offers, (ii) allows our Board of Directors and the Special Committee to participate in discussions for alternative acquisition
proposals, but requires us to keep Z Acquisition reasonably informed, on a reasonably current basis, of the status and terms of
any such proposals or offers and the status of any discussions or negotiations, (iii) subject to certain exceptions set forth in
the Merger Agreement, prohibits our Board of Directors and its committees from making a recommendation to our stockholders that
is adverse to the board’s recommendation to stockholders to approve the Merger Agreement and the Merger. The Merger Agreement
also requires us to reimburse Z Acquisition up to a maximum $1.5 million if the Merger Agreement is terminated under certain circumstances,
including if our Board of Directors fails to recommend the Merger Agreement to stockholders or if the Board of Directors or any
board committee makes a recommendation adverse to the Merger. These provisions limit our ability to solicit offers from third parties
that could result in greater value to our shareholders than the value resulting from the Merger. The expense reimbursement provisions
in the Merger Agreement may also discourage third parties from pursuing an alternative acquisition proposal with respect to us.
If the Merger is completed, our Class
A Common Stock will no longer be publicly traded, and most stockholders will cease to have any ownership interest in the Company
and therefore will not be able to realize the potential benefits to the Company of completing the Merger.
The proposed Merger
is a going-private transaction. Upon completion of the Merger, shares of Class A Common Stock will be converted into the right
to receive $4.10 per share, without interest and less any required withholding taxes, other than shares excluded under the terms
of the Agreement (collectively, “Excluded Shares”), including shares owned by the Parent Group, the Target Shares,
treasury shares, Rollover Shares, Exchange Shares and shares held by stockholders of the Company who have properly and validly
perfected, and not effectively waived, withdrawn or lost, their statutory appraisal rights under Delaware law (“Appraisal
Shares”). Because the merger consideration is all cash, following the Merger, stockholders (other than holders of Excluded
Shares) will not realize any potential benefits to the Company of the Merger, such as reduced expenses, operational efficiencies,
benefits associated with future strategic transactions, improvement in our financial condition, and the elimination of the compliance,
insurance, regulatory, and other costs associated with being a public reporting company.
We may be the target of securities
class action and derivative lawsuits which could result in substantial costs and may delay or prevent the Merger from being completed.
Securities class action
lawsuits and derivative lawsuits are often brought against companies that have entered into merger agreements. Even if the lawsuits
are without merit, defending against these claims can result in substantial costs to us and divert management time and resources.
Additionally, if a plaintiff is successful in obtaining an injunction prohibiting consummation of the Merger, then that injunction
may delay or prevent the Merger from being completed.