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EX-31.2 - EXHIBIT 31.2 - ZAIS Group Holdings, Inc.v416305_ex31-2.htm
EX-10.4 - EXHIBIT 10.4 - ZAIS Group Holdings, Inc.v416305_ex10-4.htm
EX-32.1 - EXHIBIT 32.1 - ZAIS Group Holdings, Inc.v416305_ex32-1.htm
EX-31.1 - EXHIBIT 31.1 - ZAIS Group Holdings, Inc.v416305_ex31-1.htm
EX-32.2 - EXHIBIT 32.2 - ZAIS Group Holdings, Inc.v416305_ex32-2.htm

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2015

 

o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________to_________

 

Commission file number: 001-35848

 

ZAIS GROUP HOLDINGS, INC.
(Exact Name of Registrant as Specified in Its Charter)

 

Delaware 46-1314400
(State or Other Jurisdiction of Incorporation or
Organization)
(I.R.S. Employer Identification No.)

 

Two Bridge Avenue, Suite 322

Red Bank, NJ 07701-1106

(Address of Principal Executive Offices and Zip Code)

 

(732) 978-7518
(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x  No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨ Accelerated filer  x
   
Non-accelerated filer  ¨ Smaller reporting company  ¨
(Do not check if smaller reporting company)  

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨  No x

 

As of August 6, 2015, 13,870,917 shares of Class A common stock, par value $0.0001 per share, and 20,000,000 shares of Class B Common Stock, par value $0.000001 per share, were issued and outstanding.

  

 
 

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION 1
Item 1. Financial Statements 1
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 40
Item 3. Quantitative and Qualitative Disclosures About Market Risk 57
Item 4. Controls and Procedures 58
PART II − OTHER INFORMATION 59
Item 1A. Risk Factors 59
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 59
Item 3. Defaults Upon Senior Securities 59
Item 4. Mine Safety Disclosures 59
Item 5. Other Information 59
Item 6. Exhibits. 59
SIGNATURES 59
EXHIBIT 31.1  CERTIFICATIONS  
EXHIBIT 31.2  CERTIFICATIONS  
EXHIBIT 32.1  CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 18 U.S.C. SECTION 1350  
EXHIBIT 32.2  CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 18 U.S.C. SECTION 1350  

 

 

 
 

 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

ZAIS GROUP HOLDINGS, INC. AND SUBSIDIARIES
 
Consolidated Statements of Financial Condition
(Dollars in thousands)

 

   June 30,
2015
   December 31,
2014
 
  (Unaudited)     
Assets        
Cash and cash equivalents  $75,198   $7,664 
Income and fees receivable   2,509    4,283 
Investments in affiliates, at fair value       104 
Due from related parties   1,022    648 
Fixed assets, net   1,015    1,091 
Prepaid expenses   2,214    1,543 
Deferred tax asset   2,603     
Other assets   3,232    3,310 
Assets of Consolidated Funds          
Cash and cash equivalents   18,637    94,212 
Restricted cash   2,201    30,265 
Investments, at fair value   35,799    1,126,737 
Investments in affiliated securities, at fair value   28,072    31,457 
Derivative assets, at fair value   2,287    6,648 
Other assets   3,544    11,577 
Total Assets  $178,333   $1,319,539 
           
Liabilities, Redeemable Non-controlling Interests and Equity          
Liabilities          
Notes payable  $1,252   $ 
Compensation payable   1,578    6,094 
Due to related parties   174    32 
Other liabilities   3,146    3,050 
Liabilities of Consolidated Funds          
Notes payable of consolidated CDOs, at fair value       749,719 
Securities sold, not yet purchased   10,829    19,308 
Derivative liabilities, at fair value   1,138    5,785 
Due to broker       21,047 
Other liabilities   5,871    32,863 
Total Liabilities   23,988    837,898 
           
Commitments and Contingencies (Note 14)          
           
Redeemable Non-controlling Interests   61,626    452,925 
           
Equity          
Class A Common Stock, $0.0001 par value; 180,000,000 shares authorized; 13,870,917 and 0 shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively.   1    1 
Class B Common Stock, $0.000001 par value; 20,000,000 shares authorized; 20,000,000 and 0 shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively.        
Additional paid-in capital   58,834     
Retained earnings (Accumulated deficit)   (3,770)   18,189 
Accumulated other comprehensive income (loss)   321    186 
          Total stockholders’ equity, ZAIS Group Holdings, Inc.   55,386    18,376 
Non-controlling interests in ZAIS Group Parent, LLC   26,545     
Non-controlling interests in Consolidated Funds   10,788    10,340 
Total Equity   92,719    28,716 
Total Liabilities, Redeemable Non-controlling Interests and Equity  $178,333   $1,319,539 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

1
 

  

ZAIS GROUP HOLDINGS, INC. AND SUBSIDIARIES
 
Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
(Dollars in thousands)

 

   Three
Months Ended
June 30,
2015
   Three
Months Ended
June 30,
2014
   Six
Months Ended
June 30,
2015
   Six
Months Ended
June 30,
2014
 
Revenues                    
Management fee income  $4,020   $5,069   $7,714   $10,403 
Incentive income   1,213    35,845    2,121    36,790 
Other revenues   106    228    137    369 
Income of Consolidated Funds   1,365    17,018    3,209    57,733 
Total Revenues   6,704    58,160    13,181    105,295 
Expenses                    
Compensation and benefits   7,361    18,126    13,931    28,110 
General, administrative and other   4,764    4,579    9,101    7,614 
Depreciation and amortization   146    143    208    236 
Expenses of Consolidated Funds   445    818    1,514    87,963 
Total Expenses   12,716    23,666    24,754    123,923 
Other income (loss)                    
Net gain (loss) on investments       9        (21)
Other income (expense)   9    (101)   7    60 
Net gains (losses) of Consolidated Funds’ investments   774    (1,858)   1,984    67,793 
Total Other Income (Loss)   783    (1,950)   1,991    67,832 
Income (loss) before income taxes   (5,229)   32,544    (9,582)   49,204 
Income tax (benefit) expense   (1,682)   (304)   (2,583)   14 
Consolidated net income (loss), net of tax   (3,547)   32,848    (6,999)   49,190 
Other comprehensive income (loss), net of tax:                    
Foreign currency translation adjustment   291    43    483    (201)
Total Comprehensive Income (Loss)  $(3,256)  $32,891   $(6,516)  $48,989 
Allocation of Consolidated Net Income (Loss), net of tax                    
Redeemable non-controlling interests  $1,217   $10,656   $2,240   $20,252 
Non-controlling interests in Consolidated Funds   414    1,885    1,276    2,141 
Stockholders’ equity, ZAIS Group Holdings, Inc.   (2,947)       (3,770)    
Non-controlling interests in ZAIS Group Parent, LLC   (2,231)   20,307    (6,745)   26,797 
   $(3,547)  $32,848   $(6,999)  $49,190 
Allocation of Total Comprehensive Income (Loss)                    
Redeemable non-controlling interests  $1,217   $10,692   $2,240   $20,226 
Non-controlling interests in Consolidated Funds   414    1,885    1,276    2,141 
Stockholders’ equity, ZAIS Group Holdings, Inc.   (2,753)       (3,449)    
Non-controlling interests in ZAIS Group Parent, LLC   (2,134)   20,314    (6,583)   26,622 
   $(3,256)  $32,891   $(6,516)  $48,989 
                     
Consolidated Net Income (Loss), net of tax per Class A common share applicable to ZAIS Group Holdings, Inc. – Basic  $(0.21)  $2.90   $(0.47)  $3.83 
Consolidated Net Income (Loss), net of tax per Class A common share applicable to ZAIS Group Holdings, Inc. – Diluted  $(0.21)  $2.90   $(0.53)  $3.83 
                     
Weighted average shares of Class A common stock outstanding:                    
Basic   13,870,917    7,000,000(1)   8,046,665    7,000,000(1)
Diluted   20,870,917(1)   7,000,000(1)   15,046,665(1)   7,000,000(1)

  

(1)Number of diluted shares outstanding takes into account non-controlling interests in ZAIS Group Parent, LLC that may be exchanged for Class A common stock under certain circumstances.  Refer to Note 2 for the details around the number of units used to calculate earnings per share for periods prior to the Business Combination

 

The accompanying notes are an integral part of these consolidated financial statements.

  

2
 

 

ZAIS GROUP HOLDINGS, INC. AND SUBSIDIARIES

 

Consolidated Statement of Changes in Equity,
Non-controlling Interests and Redeemable Non-controlling Interests (Unaudited)
(Dollars in thousands except share amounts)

 

   Class A Common Stock   Class B Common Stock  

Additional

paid-in-capital

  

Retained
earnings

(Accumulated
deficit)

  

Accumulated

other

comprehensive

income

(loss)

  

Non-controlling

interests in

ZAIS Group
Parent, LLC

  

Non-controlling

interests in

Consolidated

Funds

   Total
Equity
  

Redeemable

non-controlling

interests

 
   Shares   Amount   Shares  

 

Amount

                       
December 31, 2014   -   $1    -   $-   $-   $18,189   $186   $-   $10,340   $28,716   $452,925 
                                                        
Cumulative effect of adoption of ASU 2015-02 (See Note 3)   -    -    -    -    -    -    -    -    -    -    (397,594)
Distribution-in-kind   -    -    -    -    -    (1,145)   -    -    -    (1,145)   - 
Equity-based compensation   -    -    -    -    -    63    -    -    -    63    - 
Capital transfer   -    -    -    -    -    (370)   -    -    -    (370)   1,515 
Equity transferred from HF2 Financial Management, Inc.   -    -    -    -    19    -    -    -    -    19    - 
Recapitalization as a result of Business Combination   13,870,917    -    20,000,000    -    73,516              -    -    73,516    - 
Distributions to non-controlling interest in ZAIS Group Parent, LLC   -    -    -    -    (13,416)   (16,737)   (186)   30,339    -    -    - 
Capital contributions   -    -    -    -    -    -    -    -    -    -    2,540 
Capital distributions   -    -    -    -    -    -    -    (374)   (828)   (1,202)   - 
Stock-based compensation charges   -    -    -    -    1,136         -    742    -    1,878    - 
Consolidated Net Income (loss)   -    -    -    -    -    (3,770)   -    (6,745)   1,276    (9,239)   2,240 
Rebalancing of ownership between the Company and non-controlling interest in ZAIS Group Parent, LLC   -    -    -    -    (2,421)   -    -    2,421    -    -    - 
Comprehensive income (loss)   -    -    -    -    -    -    321    162    -    483    - 
June 30, 2015   13,870,917   $1    20,000,000   $-   $58,834   $(3,770)  $321   $26,545   $10,788   $92,719   $61,626 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3
 

 

ZAIS GROUP HOLDINGS, INC. AND SUBSIDIARIES
 
Consolidated Statements of Cash Flows (Unaudited)
(Dollars in thousands)

 

   Six
Months Ended
June 30, 2015
   Six
Months Ended
June 30, 2014
 
         
Cash Flows from Operating Activities          
Consolidated net income (loss)  $(6,999)  $49,190 
Adjustments to reconcile consolidated net income (loss) to net cash provided by (used in) operating activities:         
Depreciation and amortization   208    236 
Net (gain) loss on investments       21 
Non-cash stock-based compensation   1,941     
Operating cash flows due to changes in:          
Income and fees receivable   8,714    981 
Due from related parties   (79)   393 
Prepaid expenses   (671)   (212)
Other assets   80   (67)
Deferred tax asset   (2,603)    
Compensation payable   (4,516)   175 
Due to related parties   142     
Other liabilities   96    (1,451)
Consolidated Funds related items:          
Purchases of investments and investments in affiliated securities   (167,883)   (477,597)
Proceeds from sale of investments and investments in affiliated securities   173,192    523,560 
Amortization of premium and discount   (117)   (4,143)
Net realized (gains) losses on investments   (762)   47,366 
Net change in unrealized (gain) loss on investments   (2,327)   (70,026)
Net change in unrealized (gain) loss on notes payable       (72,010)
Change in cash and cash equivalents   (8,974)   64,579 
Change in due from affiliates       3,698 
Change in other assets   (2,249)   6,042 
Change in due to broker       20,630 
Change in other liabilities   5,699    11,860 
Net Cash Provided by (Used in) Operating Activities   (7,108)   103,225 
           
Cash Flows from Investing Activities          
Continuing Operations          
Purchases of fixed assets, net   (131)   (86)
Proceeds from investments in affiliates   18     
Change in restricted cash   (413)   (60,518)
Net Cash Provided by (Used in) Investing Activities   (526)   (60,604)
           
Cash Flows from Financing Activities          
Net proceeds from Business Combination   73,516     
Equity transferred from HF2 Financial Management, Inc.   19     
Distributions/redemptions to non-controlling interests in Consolidated Funds, net of change in redemptions payable   (1,264)   (78,196)
Net payments on notes payable of consolidated CDOs       (247,178)
Proceeds from issuance of notes payable of consolidated CDOs       306,429 
Proceeds from issuance of notes payable   1,250     
Contributions from non-controlling interests in Consolidated Funds   1,540    5,863 
Distributions to non-controlling interests of ZGP   (374)   (10,800)
Net Cash Provided by (Used in) Financing Activities   74,687    (23,882)
           
Net increase (decrease) in cash and cash equivalents denominated  in foreign currency   481     
Net increase (decrease) in cash and cash equivalents   67,534    18,739 
Cash and cash equivalents, beginning of period   7,664    8,432 
Cash and cash equivalents, end of period  $75,198   $27,171 
           
Supplemental Disclosure of Cash Flow Information          
Cash paid during the period:          
Interest  $462   $80,962 
Income tax (benefit) expense  $   $14 
           
Supplemental Disclosure of Non-Cash Investing Activities          
Change in assets and liabilities of Consolidated Funds due to adoption of ASU 2015-02:          
Total Assets of Consolidated Funds  $1,232,254   $ 
Total Liabilities of Consolidated Funds  $834,661   $ 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4
 

   

ZAIS GROUP HOLDINGS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

1. Organization

 

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

 

ZAIS Group is an investment advisor registered with the SEC under the Investment Advisors Act of 1940 and is also registered with the Commodity Futures Trading Commission as a Commodity Pool Operator and Commodity Trading Advisor. ZAIS Group provides investment advisory and asset management services to private funds, separately managed accounts, structured vehicles and ZAIS Financial Corp., a publicly traded Mortgage REIT, (collectively, the “ZAIS Managed Entities”). The ZAIS Managed Entities predominantly invest in residential mortgage loans and corporate bank loans, as well as a range of specialized credit assets such as collateral loan obligations (“CLOs”), collateral debt obligations (together with CLOs referred to as “CDOs”), residential mortgage-backed securities (“RMBS”), and commercial mortgage-backed securities (“CMBS”). ZAIS Group had approximately $4.359 billion of assets under management (“AUM”) as of June 30, 2015. ZAIS Group also serves as the general partner to certain ZAIS Managed Entities, which are generally organized as pass-through entities for U.S. federal income tax purposes.

 

The Company’s primary sources of revenues are (i) management fee income, which is based predominantly on the assets under management of the ZAIS Managed Entities (ii) incentive income, which is based on the investment performance of the ZAIS Managed Entities and (iii) income of the consolidated ZAIS Managed Entities (the “Consolidated Funds”) which is based on the income generated from the portfolios of the Consolidated Funds, a majority of which is allocated to redeemable non-controlling interests and non-controlling interests in Consolidated Funds. All of the management fee income and incentive income earned by ZAIS Group from the Consolidated Funds is eliminated in consolidation.

 

On March 20, 2015, ZAIS made a decision to terminate the business operations of its Shanghai subsidiary. ZAIS Group ceased conducting regular business activities in Shanghai. The office is now closed. Final clearance from the relevant government authorities on the plan of liquidation is expected in late 2015 or early 2016.

 

Recapitalization as a Result of a Business Combination

 

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

 

On March 9, 2015, the stockholders of HF2 approved the Business Combination and the transaction closed on March 17, 2015 (the “Closing”). In connection with the Closing, HF2 changed its name to ZAIS Group Holdings, Inc. Please refer to Note 2 - "Business Combination" below for additional information. Prior to the Closing, HF2 was a shell company with no operations. Upon the Closing, ZAIS became a holding company whose assets primarily consist of an approximate 66.5% interest in its majority-owned subsidiary, ZGP. Prior to the Closing, Christian Zugel served as the managing member of ZGP. Upon the Closing, ZAIS became the managing member of ZGP.

 

5
 

 

2. Business Combination

 

Basis of Presentation and Accounting Treatment of the Business Combination

 

Upon the Closing, ZAIS acquired approximately 66.5% of the Class A Units of ZGP. The remainder of the Class A Units of ZGP are held by the ZGP Founder Members. In addition, all of the outstanding shares of Class B Common Stock were transferred from the HF2 Class B Trust to the ZGP Founder Members on a pro rata basis, and were immediately deposited into a newly created irrevocable trust (the “ZGH Class B Voting Trust”), of which Mr. Zugel is the initial sole trustee. Mr. Zugel has voting and investment power over the shares of Class B Common Stock held in the ZGH Class B Voting Trust. Each share of Class B Common Stock is entitled to 10 votes and there are currently 20,000,000 shares of Class B Common Stock outstanding. Consequently, Mr. Zugel has effective voting control of the Company.

 

The Business Combination was structured as an “Up-C” transaction. Generally, in an Up-C transaction involving an operating business, a publicly traded entity taxable as a corporation for U.S. federal income tax purposes acquires an interest in a partnership or limited liability company (taxable as a partnership for U.S. federal income tax purposes) that is conducting an operating business. The historic owners of the operating business continue to own an interest in the operating business through a continuing interest in the partnership or limited liability company and may have the ability to exchange their partnership or limited liability company interests for stock in the publicly traded entity under specified circumstances in accordance with the terms of an exchange agreement. Pursuant to the Business Combination, HF2, a publicly traded corporation taxable as a corporation for U.S. federal income tax purposes, became a holding company the assets of which consist primarily of its majority membership interest in ZGP, a partnership for U.S. federal income tax purposes.  ZGP, in turn, is the sole member of ZAIS Group, an operating business.

 

The accounting for the reorganization and recapitalization follows the rules for a reverse acquisition as enumerated in the Accounting Standards Codification, Section 805. In a reverse acquisition, the acquirer for accounting purposes is the target for legal purposes (in this case, ZGP) and the target for accounting purposes is the acquirer for legal purposes (in this case, HF2). The accounting acquirer in a reverse acquisition measures the consideration transferred using the hypothetical amount of equity interests it would have had to issue to keep the accounting target’s owners in the same ownership position they are in after the reverse acquisition. The accounting acquirer adjusts the amount of legal capital in the consolidated financial statements to reflect the legal capital of the accounting target and measures the non-controlling interest using the pre-combination carrying amounts of the accounting acquirer’s net assets and the non-controlling interests’ proportionate share in those pre-combination carrying amounts. No goodwill or other intangible assets were recorded as a result of the Business Combination.

 

For accounting purposes, ZGP is considered the acquirer and has accounted for the Business Combination as a reorganization and recapitalization. ZGP was determined to be the acquirer based on the following facts and circumstances:

 

ZGP retained effective control. There is no change in control since ZGP’s operations comprise the ongoing operations of the combined entity;

 

ZGP is the sole member of ZAIS Group and ZAIS Group’s senior management became the senior management of the combined entity. The officers of the newly combined company consist primarily of ZAIS Group executives, including the Chief Executive Officer, Chief Financial Officer and General Counsel;

 

The ZGP Founder Members own a majority voting interest in the combined entity through the Class B Common Stock that is held in the ZGH Class B Voting Trust. Mr. Christian Zugel, a ZGP Founder Member, the former managing member of ZGP and the founder and Chief Investment Officer of ZAIS Group, is the sole initial trustee. Mr. Zugel has voting and investment power over the shares of the Class B Common Stock held in the ZGH Class B Voting Trust and therefore is able to elect all of the combined entity’s board of directors.

 

Accordingly, the Business Combination does not constitute the acquisition of a business for purposes of ASC 805. As a result, the assets and liabilities of ZGP and ZAIS are carried at historical cost and ZAIS has not recorded any step-up in basis or any intangible assets or goodwill as a result of the Business Combination. All direct costs attributable to the Business Combination were recorded as reductions to additional paid-in-capital. Since the Business Combination is accounted for as a recapitalization of ZGP, the financial statements presented herein for periods prior to the Business Combination are those of ZGP.

 

In the consolidated financial statements, the recapitalization of the number of shares of common stock attributable to the Business Combination is reflected retroactive to December 31, 2014. Accordingly, the number of shares of common stock that was used to calculate ZAIS’s earnings per share for all periods prior to the Business Combination was 7,000,000.

 

The net proceeds from the Business Combination, as reported in the unaudited consolidated statements of cash flows within the financing section, are summarized as follows:

 

Cash in HF2’sTrust  $184,760,079 
Payment of HF2 redemptions   (102,282,526)
Payment for HF2’s Expenses   (4,311,157)
Net Cash Received by ZGP from Business Combination   78,166,396 
Less: Ramsey incentive fee and fees to underwriters   (4,650,000)
Net proceeds from Business Combination  $73,516,396

 

 

6
 

  

In connection with the Business Combination, HF2 redeemed 9,741,193 shares of its Class A common stock resulting in a total payment to redeeming stockholders of $102,282,526. The number of shares of Class A common stock of ZAIS issued and outstanding and the number of Class A Units of ZGP issued and outstanding immediately following the consummation of the Business Combination is summarized as follows:

 

   Number of
Shares of
Class A
Common Stock
of ZAIS
 
HF2 public shares outstanding prior to the Business Combination   23,592,150 
Less: redemption of HF2 public shares   (9,741,193)
Total HF2 shares outstanding immediately prior to the effective date of the Business Combination   13,850,957 
Common shares issued as consideration to transaction underwriter   150,000 
Shares cancelled from HF2 founders’ allocation   (130,040)
Total shares of Class A common stock of ZAIS outstanding at closing, March 17, 2015   13,870,917 

 

   Number of
Class A Units of
ZGP
 
Class A Units of ZGP acquired by ZAIS   13,870,917 
Class A Units of ZGP retained by ZGP Founder Members   7,000,000 
Total Class A Units of ZGP outstanding at closing, March 17, 2015   20,870,917 

 

There were no additional shares of common stock of ZAIS or Class A Units of ZGP issued during the period from the Closing through June 30, 2015. On April 30, 2015, non-employee directors of ZAIS, collectively, were awarded 30,000 restricted stock units (“RSUs”) as part of their compensation for their service as directors of ZAIS. Refer to Note 10 for additional details regarding the RSUs.

 

During the first five years following the Closing, ZGP will release up to an additional 2,800,000 Class A Units (the “Additional Founder Units”) to the ZGP Founder Members if the sum of the average per share closing price over any 20 trading-day period of the Class A Common Stock plus cumulative dividends paid on the Class A Common Stock between the Closing and the day prior to such 20 trading-day period (the “Total Per Share Value”) meets or exceeds specified thresholds, ranging from $12.50 to $21.50.

 

ZGP may also issue up to 6,800,000 Class B Units (“Class B Units”) at any time during the five year period following the Closing, a portion of which have already been awarded as described below. Of these Class B Units, 1,600,000 Class B-0 Units vest on the later of the date of grant and the second anniversary of the Closing. The remaining 5,200,000 Class B-1, Class B-2, Class B-3 and Class B-4 Units (together the “Additional Employee Units”) vest in three equal installments only if the Class A Common Stock of ZAIS achieves certain average closing price thresholds within five years after the Closing ranging, from $12.50 to $21.50 as follows: one-third of such award vests upon achieving the applicable threshold, one-third of such award vests upon the first anniversary of such achievement and the final one-third of such award vests upon the second anniversary of such achievement. Although the Class B Units are outstanding when issued, the Class B Units are not entitled to any distributions from ZGP (and thus will not participate in, or be allocated any, income or loss) or other material rights until such Class B Units vest.

 

As of June 30, 2015, there are 1,402,792 Class B-0 Units outstanding. No Class B-1, Class B-2, Class B-3 or Class B-4 Units have been awarded as of June 30, 2015. Refer to Note 10 for additional information relating to Class B units.

 

The ZGP Founder Members’ Class A Units and all of the vested Class B Units (but not any unvested Class B Units) may be exchanged for shares of Class A Common Stock of ZAIS on a one-for-one basis (subject to certain adjustments to the exchange ratio) or, at ZAIS’s option, cash or a combination of Class A Common Stock and cash, pursuant to the Exchange Agreement that ZAIS entered into with ZGP, the ZGP Founder Members and the other parties thereto. The Exchange Agreement contains certain restrictions on the ability of holders of Class A Units and Class B Units to exchange such units for Class A Common Stock of ZAIS. Subject to certain limited exceptions, including in connection with a change in control of the Company, there is a two-year lock-up period before any exchanges of Class A Units or Class B Units are permitted.

 

7
 

 

Subsequent to the Closing, ZGP paid Neil Ramsey, an affiliate of NAR Special Global, LLC and of dQuant Special Opportunities Fund, L.P. (together, the “Ramsey Investors”), each of which are significant stockholders of ZAIS, an incentive fee of $3.4 million pursuant to an agreement dated March 4, 2015 between ZGP and Mr. Ramsey. The incentive fee of $3.4 million was paid in consideration for Mr. Ramsey causing the Ramsey Investors to purchase from stockholders who tendered their shares of Class A Common Stock of ZAIS for redemption such number of shares of Class A Common Stock of ZAIS as was necessary to meet the closing condition that there be at least $65 million in HF2’s trust account after giving effect to redemptions and expense payments (other than certain notes to ZAIS’s financial advisers). The payment by ZGP to Mr. Ramsey of the incentive fee described above was treated as a direct cost attributable to the Business Combination. Additionally, as described further under “Related Party Transaction”, ZGP entered into a two-year Consulting Agreement with Mr. Ramsey through an entity that he controls.

 

3. Basis of Presentation and Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP") to reflect the financial position, results of operations and cash flows of the Company. These financial statements have been prepared on a going concern basis, which assumes the realization of assets and satisfaction of liabilities in the normal course of business.

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted. These consolidated financial statements should be read in conjunction with the Company's most recent audited consolidated financial statements and related notes for the fiscal year ended December 31, 2014, which are included in the Closing 8-K. In the opinion of management, all adjustments considered necessary have been made for a fair presentation of the results of these interim periods.

 

The Company currently operates as one business segment.

 

Use of Estimates

 

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

 

New Accounting Pronouncements

 

In February 2015, the FASB issued ASU 2015-02 Consolidation (Topic 810): Amendments to the Consolidation  Analysis (“ASU 2015-02”).  ASU 2015-02 rescinds the 2010 indefinite deferral of ASU 2009-17 and ASU 2010-10 for certain investment funds, including mutual funds, hedge funds, mortgage real estate investment funds, private equity funds, and venture capital funds, and amends the pre-existing guidance for evaluating consolidation of voting general partnerships and similar entities. ASU 2015-02 also amends the criteria for determining whether an entity is a Variable Interest Entities (“VIE”) under FASB ASC Topic 810 Consolidation (“ASC 810”), which could affect whether an entity is within its scope. Accordingly, all legal entities are subject to re-evaluation under the revised consolidation model. Specifically, ASU 2015-02: 1) Modifies the evaluation of whether limited partnerships and similar legal entities are VIEs or Voting Interest Entities (“VOE”) 2) Eliminates the presumption that a general partner should consolidate a limited partnership 3) Affects the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships 4) Provides a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.  The amendments are effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The Company has elected to implement ASU 2015-02 using the modified retrospective method, which results in an effective date of adoption of January 1, 2015 and will not require the restatement of prior period results. As a result, amounts relating to the consolidated ZAIS Managed Entities will not be comparable to prior periods presented.

 

Non-Controlling Interests

 

The non-controlling interests within the consolidated statements of financial condition are comprised of: i) redeemable non-controlling interests reported outside of the permanent capital section when investors have the right to redeem their interests from a Consolidated Fund or ZAIS Group; ii) equity attributable to non-controlling interests in Consolidated Funds reported inside the permanent capital section when the investors do not have the right to redeem their interests and iii) equity attributable to non-controlling interests in ZGP. The Company records redeemable non-controlling interests and non-controlling interests in the Consolidated Funds (excluding CDO) to reflect the economic interests in those funds held by investors other than interests attributable to ZAIS Group. Subsequent to March 31, 2014, redeemable non-controlling interests represents investors in the Consolidated Funds who generally have the right to withdraw their capital after the end of a lock-up period as defined in the respective governing documents. Investors may withdraw their capital prior to the expiration of the lock-up period in certain limited circumstances that are beyond the control of ZAIS Group, such as instances in which retaining the equity interest could cause the investor to violate a law, regulation or rule. Prior to March 31, 2014, redeemable non-controlling interests also included membership interests held in ZAIS Group by employees and former employees of ZAIS Group. Non-controlling interests in ZGP includes a portion of the management fee income received from ZAIS Financial Corp. that is payable to holders of Class B interests in ZAIS Group’s consolidated subsidiary, ZAIS REIT Management, LLC.

 

8
 

 

Principles of Consolidation

 

The consolidated financial statements included herein are the financial statements of ZAIS and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation, including ZAIS’s investment in ZGP and ZGP’s investment in ZAIS Group. The Company's fiscal year ends on December 31. The operating results for the interim period presented are not necessarily indicative of the results that may be expected for the Company's fiscal year ending December 31, 2015.

 

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

 

The Company’s consolidated financial statements also include variable interest entities for which ZAIS Group is considered the primary beneficiary, and certain entities that are not considered variable interest entities in which ZAIS Group has a controlling financial interest. Effective January 1, 2015 pursuant to Accounting Standards Codification (“ASC”) Topic 810, as amended by ASU 2015-02, these entities include ZAIS Opportunity Domestic Feeder Fund, LP, ZAIS Atlas Master Fund, LP, ZAIS Atlas Fund, LP and ZAIS Value-Added Real Estate Fund I, LP. For all periods prior to January 1, 2015, these entities include ZAIS Opportunity Master Fund, Ltd., ZAIS Opportunity Domestic Feeder Fund, LP, ZAIS Opportunity Fund, Ltd., ZAIS Atlas Fund, LP, ZAIS Value-Added Real Estate Fund I, LP and certain CDOs. After the adoption of ASC Topic 810, as amended by ASU 2015-02, there were no CDOs required to be consolidated in the Company’s financial statements for the six months ended June 30, 2015 and prior to the adoption of ASC Topic 810, as amended by ASU 2015-02, there were ten CDOs consolidated in the Company’s financial statements for the year ended December 31, 2014. The cumulative effect of the adoption of ASU 2015-02 was a $397,594,000 reduction in redeemable non-controlling interests on January 1, 2015, which is reflected in the consolidated statement of changes in equity, non-controlling interests and redeemable non-controlling interests. All intercompany balances and transactions have been eliminated in consolidation. Refer to Note 7 for additional disclosures around the Consolidated Funds.

 

The consolidated financial statements reflect the assets, liabilities, investment income, expenses and cash flows of the Consolidated Funds on a gross basis. Except for CDOs, the majority of the economic interests in the Consolidated Funds, which are held by third-party investors, are reflected as non-controlling interests in the consolidated financial statements. For CDOs, the majority of the economic interests in these vehicles, which are held by outside parties, are reported as notes payable of consolidated CDOs in the consolidated financial statements. The notes payable issued by the CDOs are backed by diversified collateral asset portfolios consisting primarily of loans or structured debt. In exchange for managing the collateral for the CDOs, ZAIS Group may earn investment management fees, including, in some cases, subordinated management fees and contingent incentive fees. All of the management fee income and incentive income earned by ZAIS Group from the Consolidated Funds are eliminated in consolidation. However, because the eliminated amounts are earned from and funded by the non-controlling interests, income allocated to the non-controlling interests has been reduced, and the income allocated to ZGP has been increased by the amounts eliminated, of which ZAIS is allocated its pro-rata share as a member of ZGP. ZAIS Group does not recognize any incentive income based on the investment performance of ZAIS Managed Entities until the incentive income is (i) contractually receivable, (ii) fixed or determinable (also referred to as “crystallized”) and (iii) all related contingencies have been removed and collection is reasonably assured, (see policy disclosed under Management Fee Income, Incentive Income, and Other Income). Similarly, for any Consolidated Funds, the corresponding potential incentive expense based on the investment performance of the Consolidated Funds has not yet been deducted from the investor capital balances until the above criteria have been met. Therefore, the corresponding potential incentive income based on the investment performance of the Consolidated Funds that has not yet been recognized by ZAIS Group is included in non-controlling interests in the consolidated financial statements.

 

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

 

VIE Model

 

Prior to the adoption of ASU 2015-02, for entities in which the Company has a variable interest, the Company determines whether, if by design, (i) the entity has equity investors who lack, as a group, the characteristics of a controlling financial interest, (ii) the entity does not have sufficient equity at risk to finance its expected activities without additional subordinated financial support from other parties, (iii) the entity is structured with non-substantive voting rights or (iv) the equity holders do not have the obligation to bear potential losses or the right to receive potential gains. If an entity has at least one of these characteristics, it is considered a VIE, and is consolidated by its primary beneficiary. For entities managed by ZAIS Group that qualify for the deferral under ASU 2010-10, Amendments to Statement 167 for Certain Investment Funds (“ASU 2010-10”), the primary beneficiary of these entities that are determined to be VIEs is the party that absorbs a majority of the VIEs’ expected losses or receives a majority of the expected residual returns. For entities managed by ZAIS Group that do not qualify for the deferral under ASU 2010-10, the primary beneficiary of these entities is the party that (i) has the power to direct the activities of the entity that most significantly impact the entity’s economic performance; and (ii) has the obligation to absorb losses or the right to receive benefits from the entity that could potentially be significant to the entity. The Company reassesses its initial evaluation of an entity as a VIE upon occurrence of certain reconsideration events.

 

9
 

 

Subsequent to the adoption of ASU 2015-02, for entities in which the Company has a variable interest, the Company determines whether, (i) the entity does not have enough equity to finance its activities without additional subordinated financial support, (ii) the at-risk equity holders, as a group lack (a) the power, through voting or similar rights, to direct the activities that most significantly impact the entity’s economic performance, (b) the obligation to absorb an entity’s expected losses, or (c) the right to receive an entity’s expected residual returns, or (iii) the entity is structured with non-substantive voting rights. If an entity has at least one of these characteristics, it is considered a VIE, and is consolidated by its primary beneficiary.

 

VOE Model

 

For entities where ZAIS Group has a variable interest, but are determined not to be a VIE, the Company makes a consolidation determination based on the entity’s legal structure. For corporate structures, including companies domiciled in the Cayman Islands, the Company consolidates those entities in which ZAIS Group has a voting interest of greater than 50% and has control over the significant operating, financial and investing decisions of the entity. For limited partnerships and limited liability companies, the Company consolidates entities in which it is a general partner or managing member, and third-party investors have no substantive rights to participate in the ongoing governance and operating activities or substantive kick-out rights.

 

The determination of whether an entity is a VIE or a VOE is based on the facts and circumstances for each individual entity.

 

Cash and Cash Equivalents

 

The Company considers highly liquid, short-term interest-bearing instruments of sufficient credit quality with original maturities of three months or less, and other instruments readily convertible into cash, to be cash equivalents. The Company’s deposits with financial institutions may exceed federally insurable limits of $250,000 per institution. The Company mitigates this risk by depositing funds with major financial institutions.

 

Cash equivalents generally consist of excess cash that is swept daily into a money market fund, or into weekly or monthly term deposit accounts to earn short-term interest, or maintained as a short-term deposit. Additionally, the Company may from time-to-time invest in United States government obligations to manage excess liquidity. These investments are carried at fair value, as the Company has elected the fair value option in order to include any gains or losses within consolidated net income (loss). These investments are also recorded as cash equivalents in the consolidated statement of financial condition. At June 30, 2015 and December 31, 2014, the Company had approximately $29,737,000 and $2,687,000, respectively, invested in money market funds and short-term deposits. At June 30, 2015 and December 31, 2014, the Company had approximately $44,024,000 and $0, respectively, invested in United States government obligations.

 

Investments in Affiliates

 

U.S. GAAP permits entities to choose to measure certain eligible financial assets, financial liabilities and firm commitments at fair value (the “Fair Value Option”), on an instrument-by-instrument basis. The election to use the Fair Value Option is available when an entity first recognizes a financial asset or financial liability or upon entering into a firm commitment. The Fair Value Option is irrevocable and requires changes in fair value to be recognized in earnings. For ZAIS Group’s direct investments in the ZAIS Managed Entities that are not consolidated, and would otherwise be accounted for under the equity method, the Fair Value Option has been elected. In estimating the fair value for financial instruments for which the Fair Value Option has been elected, the Company uses the valuation methodologies as discussed in Note 5.

 

Revenue Recognition

 

ZAIS Group’s sources of revenue are (i) management fees, (ii) incentive fees and (iii) income of Consolidated Funds. The management fee and incentive fee revenues are derived from ZAIS Group’s advisory agreements with the ZAIS Managed Entities. Certain investments held by employees, executives and other related parties in the ZAIS Managed Entities are not subject to management fees or incentive fees/allocations and therefore do not generate revenue for ZAIS Group. All of the management fee income and incentive income earned by ZAIS Group from the Consolidated Funds are eliminated in consolidation. Income of Consolidated Funds is based on the income generated from the portfolios of the Consolidated Funds, a majority of which is allocated to redeemable non-controlling interests and non-controlling interests in Consolidated Funds.

 

Management Fee Income, Incentive Income and Other Income

 

ZAIS Group earns management fees and incentive fees for investment advisory services provided to the ZAIS Managed Entities. Management fees are accrued as earned, and are calculated and paid monthly, quarterly or annually, depending on the applicable agreement. Revenue is accrued as earned for data, funding and analytical services provided to outside parties and affiliated funds. In the event management fee income is received before it is earned, deferred revenue is recorded and is included in other liabilities in the consolidated statements of financial condition.  

 

10
 

 

In addition to the management fee income mentioned above, subordinated management fee income may be earned from the CDOs. The subordinated management fee income is additional revenue earned for the same service, but has a lower priority in the CDO vehicle’s cash flows. The subordinated management fee income is contingent upon the economic performance of the respective CDO’s investments. If the CDOs experience a certain level of investment defaults, these fees may not be paid. There is no recovery by the CDOs of previously paid subordinated fees. Subordinated management fee income is recognized when collection is reasonably assured. When collection is not reasonably assured, the subordinated management fee income is recognized as payments are received.

 

Incentive income is recognized when it is (i) contractually receivable, (ii) fixed or determinable (also referred to as “crystallized”) and (iii) all related contingencies have been removed and collection is reasonably assured, which generally occurs in the quarter of, or the quarter immediately prior to, the payment of the incentive to ZAIS Group by the ZAIS Managed Entities. The criteria for revenue recognition related to incentive income is typically met only after all contributed capital and the preferred return, if any, on that capital have been distributed to the ZAIS Managed Entities’ investors for vehicles with private equity style fee arrangements, and is typically met only after any profits exceed a high-water mark for vehicles with hedge fund style fee arrangements.

 

Income of Consolidated Funds is discussed in the section on Policies of Consolidated Funds.

 

Income and Fees Receivable

 

Income and fees receivable primarily includes management fees and incentive fees due from ZAIS Managed Entities, excluding the Consolidated Funds, and does not include any allowance for doubtful accounts. The Company did not recognize any bad debt expense for the three and six months ended June 30, 2015 and June 30, 2014. The Company believes all income and fee receivable balances are fully collectible.  

 

Compensation and Benefits

 

Compensation and benefits is comprised of salaries, payroll taxes, employer contributions to welfare plans, discretionary and guaranteed cash bonuses and other contractual compensation programs payable to ZAIS Group employees. Compensation and benefits is generally recognized over the related service period. On an annual basis, compensation and benefits comprise a significant portion of total expenses, with discretionary cash bonuses, guaranteed cash bonuses and other contractual compensation programs generally comprising a significant portion of total compensation and benefits.

 

Under the ZAIS Group, LLC Income Unit Plan (the “Income Unit Plan”), a portion of net operating income of ZAIS Group (after making certain adjustments) was due to certain employees of ZAIS Group. These amounts are accrued as compensation expense in the period incurred. This plan was terminated with an effective date of December 31, 2014.

 

Compensation and benefits relating to the issuance of cash-based and equity-based awards to certain employees is measured at fair value on the grant date. Equity-based compensation awards to employees that are settled in shares are classified as equity instruments. The fair value of an equity settled award is determined on the date of grant and is not subsequently remeasured. Cash settled awards are classified as liabilities and are remeasured to fair value at each balance sheet date as long as the award is outstanding. Changes in fair value are reflected as compensation expense. Compensation expense for awards that vest over a future service period is recognized over the relevant service period on a straight-line basis, adjusted for estimated forfeitures of awards not expected to vest. The compensation expense for awards that do not require future service is recognized immediately. Upon the end of the service period, compensation expense is adjusted to account for actual forfeiture rates. Refer to Note 10 for additional details regarding equity awards granted by the Company.

 

Compensation and benefits also includes compensation directly related to incentive income in the form of percentage interests (also referred to as “Points”) awarded to certain employees associated with the operation and management of certain ZAIS Managed Entities in the form of compensation agreements (“Points Agreements”). Under the Points Agreements, ZAIS Group has an obligation to pay certain employees and former employees a fixed percentage of the incentive income earned from the referenced entities. Amounts payable pursuant to these arrangements are recorded as compensation expense when they become probable and reasonably estimable. The determination of when the Points become probable and reasonably estimable is based on the assessment of numerous factors, particularly those related to the profitability, realizations, distribution status, investment profile and commitments or contingencies of certain ZAIS Managed Entities for which Points Agreements have been awarded. Points are expensed no later than the period in which the underlying income is recognized. Payment of the Points generally occurs in the same period the related income is received. Most recipients’ rights to receive payments related to their Points Agreement are subject to forfeiture risks. There are currently outstanding Points Agreements relating to two ZAIS Managed Entities and ZAIS Group does not anticipate awarding additional Points Agreements.

 

11
 

 

Pursuant to ZAIS’s 2015 Stock Incentive Plan, non-employee directors of ZAIS are eligible to receive RSUs as a component of compensation for their service as directors of ZAIS. The awards are unvested at the time they are granted and, as such, are not entitled to any dividends or other material rights until such RSUs vest. The RSUs vest in full on the one year anniversary of the grant date. Upon vesting ZAIS will issue the recipient shares of Class A Common Stock equal to the number of vested RSUs. In accordance with ASC 718, "Compensation - Stock Compensation”, the Company is measuring the expense associated with these awards based on grant date fair value adjusted for estimated forfeitures. This expense will be amortized equally over the one year vesting period and will be cumulatively adjusted for changes in estimated forfeitures at each reporting date. Refer to Note 10 for additional details regarding the RSUs.

 

Fixed Assets

 

Fixed assets consist of furniture and fixtures, office equipment, leasehold improvements and software, and are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization on furniture and fixtures, office equipment and software is calculated using either the double declining balance method or straight-line method over an estimated useful life of three to five years.  Amortization of leasehold improvements is calculated using the straight-line method over the lesser of the lease terms or the life of the asset.. Fixed assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The costs associated with maintenance and repairs are recorded as other operating expenses when incurred.

 

Goodwill

 

Goodwill of approximately $2,669,000 resulted from the acquisition by ZGP of membership interests in ZAIS Group from a strategic founding investor in December of 2012. The goodwill is carried at cost and is included in other assets in the consolidated statements of financial condition. Goodwill is not amortized but is tested for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that a potential impairment may have occurred. The testing of goodwill for impairment is initially based on a qualitative assessment to determine if it is more likely than not that the fair value of the goodwill is less than the carrying value. If facts indicate that it is more likely than not that an impairment may exist, a two-step quantitative assessment is conducted to (a) calculate the fair value of the goodwill and compare it to the carrying value, and (b) if the carrying value exceeds its fair value, the difference is recognized as an expense in the period in which the impairment occurs. No impairment was recorded for the periods presented.

 

Foreign Currency Translation Gains (Losses)

 

Assets and liabilities of foreign subsidiaries that have non-U.S. dollar functional currencies are translated at exchange rates prevailing at the end of each reporting period. Results of foreign operations are translated at the weighted-average exchange rate for each reporting period. Translation adjustments are included as a component of accumulated other comprehensive income (loss) until realized. Gains or losses resulting from foreign currency transactions are included in general, administrative and other in the consolidated statements of comprehensive income (loss).

 

Income Taxes

 

The Company accounts for income taxes using the asset and liability method as prescribed in FASB guidance on Accounting for Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the unaudited condensed consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A valuation allowance is recorded against deferred tax assets if it is deemed more likely than not that those assets will not be realized. In assessing the need for a valuation allowance, the Company considers all available evidence, including past operating results, the existence of cumulative losses in the most recent fiscal years, estimates of future taxable income and the feasibility of tax planning strategies.

 

The measurement of current and deferred income tax assets and liabilities is based on provisions of enacted tax laws and involves uncertainties in the application of tax regulations in the U.S. and other tax jurisdictions. Because the Company’s interpretation of complex tax law may impact the measurement of current and deferred income taxes, actual results may differ from these estimates under different assumptions regarding the application of tax law.

 

Prior to the reorganization and recapitalization due to the Business Combination, no provision was made for U.S. federal income taxes in ZGP’s accompanying consolidated financial statements since ZGP and its subsidiaries were pass-through entities for U.S. income tax purposes and profits and losses were allocated to the partners who were individually responsible for reporting such amounts. ZGP’s foreign subsidiaries, however, paid income taxes in the respective foreign jurisdictions, which were included in income tax (benefit) expense on the consolidated statements of comprehensive income (loss). Following the reorganization, ZGP and its subsidiaries continue to operate as pass-through entities for U.S. income tax purposes. ZAIS is subject to U.S. corporate federal, state and local income taxes which are included in income tax (benefit) expense on the consolidated statements of comprehensive income (loss) along with income taxes related to the foreign subsidiaries.

 

12
 

 

Pursuant to FASB guidance on Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement on Accounting for Income Taxes, the Company provides for uncertain tax positions based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. Management is required to determine whether a tax position is more likely than not to be sustained upon examination by tax authorities, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Because significant assumptions are used in determining whether a tax benefit is more likely than not to be sustained upon examination by tax authorities, actual results may differ from the Company's estimates under different assumptions or conditions.

 

The Company analyzes its tax filing positions in all of the U.S. federal, state, local and foreign tax jurisdictions where it is required to file income tax returns, as well as for all open tax years in these jurisdictions. If, based on this analysis, the Company determines that uncertainties in tax positions exist, a liability is established. The Company recognizes accrued interest and penalties related to uncertain tax positions in income tax (benefit) expense within the consolidated statements of comprehensive income (loss).

 

Policies of Consolidated Funds

 

Certain ZAIS Managed Entities, in which ZAIS Group has only a minority ownership interest or no ownership interest, are consolidated in the Company’s consolidated financial statements. The majority ownership interests in the Consolidated Funds are held by the investors in the Consolidated Funds, and these interests are included in non-controlling interests in the consolidated statements of financial condition. The management fees and incentive income from the Consolidated Funds are eliminated in consolidation, and the income allocated to ZAIS and ZGP Founder Members has been increased by the amounts eliminated. 

 

The Consolidated Funds are considered investment companies for U.S. GAAP purposes. Pursuant to specialized accounting guidance for investment companies, and the retention of that guidance in the Company’s consolidated financial statements, the investments held by the Consolidated Funds are reported at their fair values.

 

Restricted Cash

 

Restricted cash represents the Consolidated Funds’ cash held by counterparties as collateral against the Consolidated Funds’ derivatives or repurchase agreements. Cash held by counterparties as collateral is not available to the Consolidated Funds for general operating purposes, but may be applied against amounts due to derivative or securities repurchase agreement counterparties or returned to the Consolidated Funds when the collateral requirements are exceeded or at the maturity of the derivatives or securities repurchase agreements.

 

Due to Broker

 

Due to broker represents the Consolidated Funds’ payable to a broker for unsettled purchases as of June 30, 2015.

 

Investments at Fair Value

 

Investments and investments in affiliated securities are held at fair value. Please see Note 5 for information regarding the valuation of these assets.

 

Notes Payable of Consolidated CDOs

 

In August 2014, the FASB issued ASU 2014-13, Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity (“ASU 2014-13”). The update allows a reporting entity that consolidates a collateralized financing entity (whose financial assets and liabilities are measured at fair value) to measure both the financial assets and the financial liabilities of that collateralized financing entity in its consolidated financial statements using the more observable of the fair value of the financial assets or the fair value of the financial liabilities. Entities are permitted to apply the guidance using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the annual period of adoption. The amendments of ASU 2014-13 are effective for the Company for annual periods and interim periods beginning after December 15, 2015. Early adoption is permitted as of the beginning of an annual period. A reporting entity also may apply the amendments retrospectively to all relevant prior periods beginning with the annual period in which the amendment was initially adopted. The Company has elected to adopt the guidance retrospectively for the annual period beginning January 1, 2012.

 

The notes payable of Consolidated CDOs are measured using the fair value of the financial assets, as further described in Note 5.

 

The Company’s consolidated net income (loss) reflects the Company’s economic interests in the CDOs, including (1) changes in the fair value of the beneficial interests retained by the Company and (2) beneficial interests that represent compensation for services.

 

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Securities Sold, Not Yet Purchased

 

The Consolidated Funds may enter into short sales whereby a security is sold that it does not own in anticipation of a decline in the value of that security. To enter a short sale, the Consolidated Funds may need to borrow the security for delivery to the buyer. On each day the short sale is open, the liability for the obligation to replace the borrowed security is marked to market, and an unrealized gain or loss equal to the difference between the price at which the security was sold and the cost of replacing the security is recorded. The liability in respect to securities sold short, traded on an exchange, is stated at the last reported sales price on the day of valuation; other securities traded in the over-the-counter market, and listed securities, for which no sale was reported on that date, are stated at the last quoted ask price. While the transaction is open, the Consolidated Funds will also incur an expense for any accrued interest payable to the lender of that security and for borrowing charges for certain positions. A gain or loss is realized and included within net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

  

Redemptions Payable

 

The Consolidated Funds recognize investor redemptions as liabilities when the amount requested in the redemption notice becomes fixed and determinable. Net assets related to redemption notices received for which the dollar amount is not fixed will remain in the net assets of the Consolidated Funds until the amount is determined. As a result, redemptions paid after the end of a reporting period, but based upon capital balances as of the end of the respective reporting period that the redemption relates to are reflected as redemptions payable.

 

Income of Consolidated Funds

 

Investment transactions are recorded on a trade-date basis. Realized gains and losses on investment transactions are determined on the specific-identification basis.

 

Dividends received on equity tranches of structured products are recorded upon receipt and adjusted for any return of capital using the effective interest rate method over the lives of such securities. Interest income is recorded on the accrual basis. Any discounts and premiums on fixed income securities purchased are accreted or amortized into income or expense using the effective interest rate method over the lives of such securities. The effective interest rates are calculated using projected cash flows, including the impact of paydowns on each of the aforementioned securities. Any paydown gains and losses are presented as an adjustment to interest income.

 

Derivative Instruments

 

The Consolidated Funds may, from time to time, acquire assets or liabilities that protect against adverse movements in interest rates or credit performance (each a “Hedge Agreement”) with counterparties. The Consolidated Funds and the counterparty to each Hedge Agreement agree to make periodic payments on a specified notional amount. The payments can be made for a specified period of time, or may be triggered by a pre-determined credit event. The periodic payments may be based on a fixed or variable interest rate; the change in fair value of a specified security, basket of securities or index; or the return generated by a security. The consolidated CDOs, at December 31, 2014, also had a portfolio of credit default swaps which are utilized to obtain synthetic exposure to credit risk. These swaps are used as trading instruments, and not for hedging purposes.

 

The Consolidated Funds recognize all derivatives as assets or liabilities in the consolidated statements of financial condition at fair value. Changes in fair value are recognized in the consolidated statements of comprehensive income (loss).

 

In connection with their derivative activities, the Consolidated Funds have elected not to offset fair value amounts recognized for cash collateral against fair value amounts recognized for net derivative positions executed with the same counterparty under the same master netting arrangement. At June 30, 2015 and December 31, 2014, the Consolidated Funds have cash collateral receivables of approximately $2,201,000 and $30,265,000, respectively with counterparties under the same master netting arrangement and is included in restricted cash in the consolidated statements of financial condition.

 

Income Taxes

 

The Consolidated Funds are generally not subject to U.S. federal and state income taxes and, consequently, no income tax provision has been made in the accompanying consolidated financial statements because individual investors are responsible for taxes on their proportionate share of the taxable income.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014 09”). ASU 2014-09 supersedes the revenue recognition requirements in ASC 605 — Revenue Recognition (“ASC 605”) and most industry-specific guidance throughout the ASC. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Entities are permitted to apply the guidance in ASU 2014-09 using one of the following methods: (1) full retrospective application to each prior period presented, or (2) modified retrospective application with a cumulative effect adjustment to opening retained earnings in the annual reporting period that includes that date of initial application. The requirements of ASU 2014-09 are effective for the Company beginning in the first quarter of 2018. The Company is currently evaluating the impact, if any, that these updates will have on its consolidated financial statements.

 

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4. Investments in Affiliates

 

The Company applied the Fair Value Option to its interests in the ZAIS Managed Entities that are not consolidated, and would have otherwise been subject to the equity method of accounting. As of and for the six months ended June 30, 2015, the Company did not hold any interests in the ZAIS Managed Entities that are not consolidated. At December 31, 2014, the fair value of these investments was approximately $104,000. For the three and six months ended June 30, 2014, the Company recorded an unrealized gain (loss) of approximately $1,000 and $(2,000), respectively associated with the investments still held at the end of each respective period. Such amounts are included in net gain (loss) on investments in the consolidated statements of comprehensive income (loss).

 

At December 31, 2014, no equity investment, individually or in the aggregate, held by the Company exceeded 10% of the total consolidated assets or income. As such, the Company did not present separate or summarized financial statements for any of its investees.

 

5. Fair Value of Investments

 

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

 

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

 

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

 

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

 

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

 

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

 

·Quoted prices for similar assets or liabilities in active markets.

 

  · Quoted prices for identical or similar assets or liabilities in nonactive markets.

 

  · Pricing models whose inputs are observable for substantially the full term of the asset or liability.

 

  · Pricing models whose inputs are derived principally from or corroborated by observable market data for substantially the full term of the asset or liability.

  

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

 

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

 

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

 

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

 

Investments in affiliated funds and securities

 

The Company measures the fair value of its investments in affiliated funds and securities at the net asset value per share (or its equivalent) (“NAV”). If the investment can be redeemed at its NAV at the measurement date, the Company classifies the investment as Level 2. If the investment cannot be redeemed at its NAV as of the measurement date but the investment may be redeemable at a future date, the Company considers the length of time until the investment will become redeemable in determining whether to classify the investment as Level 2 or Level 3. Net gains or losses on investments in affiliated funds and securities are included in net gain (loss) on investments in the consolidated statements of comprehensive income (loss).

 

Investments

 

The Company determines the fair value of investments in CDOs, RMBS and CMBS, corporate bonds, mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”) generally using third party valuation services. ZAIS Group verifies that the quotes received from the valuation services are reflective of fair value as defined in U.S. GAAP, generally by comparing to trading activity for similar asset classes, pricing research provided by banks and brokers, the indicative broker quotes and results from ZAIS Group’s proprietary models.

 

If the values from the third party valuation services are insufficient or unavailable, fair value is determined using observable market data, indicative broker quotes or proprietary models that incorporate market based inputs but also include unobservable inputs. Some of the significant unobservable inputs used are constant prepayment rates, constant default rates, delinquency rates, security ratings, discount rates, credit spreads, and yields. The proprietary models convert future projected cash flows to a single discounted present value. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires significant judgment and considers factors specific to the investment.

 

The Company also employs valuation agents for marks on leveraged loans in connection with CDOs under management and independent valuation agents for certain commercial real estate investments.

 

The Company determines fair value of investments in Exchange Traded Funds (“ETF”) using quoted market prices.

 

Net gains or losses on investments are included in net gain (loss) on investments in the consolidated statements of comprehensive income (loss).

 

Credit Default Swaps

 

A credit default swap contract is an agreement between a Consolidated Fund and a counterparty where one party to the contract either buys protection (short the underlying credit) or sells protection (long the underlying credit) on an index or subset of an index or a single tranche of an index or a single name entity. The buyer of protection pays a fixed coupon in exchange for receiving one or more payments by the other party upon the occurrence of certain credit triggering events related to the specified instrument. The seller of protection receives a fixed coupon as compensation for making one or more payments upon the occurrence of certain triggering events.

 

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An index or a single name entity trading at a premium (price is above par) is one in which the current spread is tighter (lower) than the stated coupon, and so the buyer of protection will receive upfront the current premium to par and pays the stated coupon going forward. An index or a single name entity trading at a discount (price is below par) is one in which the current spread is wider (higher) than the stated coupon, and so the buyer of protection will pay upfront the current discount to par and pay the stated coupon going forward. On a tranche trade, the buyer may pay upfront points which represent the present value of expected future cash flows of the tranche and/or may pay a running coupon on the tranche. The credit default swap contracts are marked to market based upon the valuation policies previously discussed. Changes in the fair value of the credit default swap contracts are reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

 

Interest Rate Swaps

 

An interest rate swap is an agreement between a Consolidated Fund and a counterparty to exchange periodic interest payments where one party to the contract makes a fixed rate payment in exchange for a floating rate payment from the other party. The dollar amount each party pays is an agreed-upon periodic interest rate multiplied by some predetermined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. The Consolidated Funds utilize proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swap agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 in the fair value hierarchy. The Consolidated Funds' interest rate swap agreements are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties. At June 30, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the derivative. Changes in the fair value of the contract are reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

 

Options

 

The Consolidated Funds are authorized to purchase or write options. When the Consolidated Funds purchase an option, an amount equal to the premium paid is reflected as an asset. The amount of the asset is subsequently marked to market to reflect the current value of the option purchased and the change in fair value is reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss). When the Consolidated Funds write an option, an amount equal to the premium received is reflected as a liability. The amount of the liability is subsequently marked to market to reflect the current value of the option written and the change in fair value is reported as net change in net gains of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss). When an option is exercised, the related premium paid (or received) is added to (or subtracted from) the gain or loss recognized on the transaction. When an option expires (or the Consolidated Funds enter into a closing transaction), the Consolidated Fund realizes a gain (loss) on the option to the extent of the premiums received or paid (or gain or loss to the extent the cost of the closing transaction exceeds the premium paid or received). Written and purchased options are non-income producing investments.

 

Swaptions

 

The Consolidated Funds may write swaption contracts (“Swaptions”) to manage exposure to fluctuations in interest rates and credit spreads and to enhance portfolio yield. Swaptions written by the Consolidated Funds represent an option that gives the purchaser the right, but not the obligation, to enter into a previously agreed upon swap contract on a future date. If a written call Swaption is exercised, the writer will enter into a swap and is obligated to pay a fixed rate of interest and receive a floating rate of interest or receive protection payments on a credit index in exchange. If a written put Swaption is exercised, the writer will enter into a swap and is obligated to pay a floating rate of interest or make protection payments on a credit index and receive a fixed rate in exchange. Swaptions are marked to market based upon quotations from market makers, and the change in fair value is reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss). When the Consolidated Funds write a Swaption, the premium received is recorded as a liability and is subsequently adjusted to the current fair value of the Swaption. A gain or loss is recognized when Swaptions expire or are closed. Premiums received from writing Swaptions that expire are treated by the Consolidated Funds as realized gains from Swaptions written. The difference between the premium and the amount paid on effecting a closing purchase transaction is also treated as a realized gain, or if the premium is less than the amount paid for the closing purchase, as a realized loss. The Consolidated Funds bear the market risk on Swaptions arising from any change in index values or interest rates. The Consolidated Funds utilize proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swaption agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 in the fair value hierarchy. The Consolidated Funds’ Swaptions are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties. At June 30, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the derivative.

 

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Total Return Swap

 

A total return swap contract is an agreement between a Consolidated Fund and a counterparty where one party to the contract exchanges the return on a security for a floating rate index plus a spread. The return on the security includes income such as coupons and the change in its value. The total return swap contracts are marked to market based upon quotations from market makers, and the change in fair value is reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

 

 Foreign Exchange Forward Contracts

 

The Consolidated Funds are authorized to enter into foreign exchange forward contracts as a hedge against specific transactions or portfolio positions. A foreign exchange forward contract is marked to reflect the current value of the contract, based upon quoted market prices, and the change in fair value is reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

 

Cashflow Swap

 

A cashflow swap contract is an agreement between two counterparties, whereby the counterparty will fund a portion of the amounts payable on certain CDO notes payable or certain other derivative contracts if the cash flows from the underlying investments are insufficient to pay such amounts. The cashflow swap contracts are marked to market based upon quotations from market makers, and the change in fair value is reported in net gains (losses) of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss).

 

Notes Payable of Consolidated CDOs

 

As a result of the adoption of ASU 2015-02, the CDOs are no longer required to be consolidated effective January 1, 2015. The following policy applies for all periods prior to January 1, 2015.

 

In accordance with ASU 2014-13, the Company can elect to measure both the financial assets and the financial liabilities of the CDOs in its consolidated financial statements using the more observable of the fair value of the financial assets or the fair value of the financial liabilities. The notes payable of Consolidated CDOs’ are measured using the fair value of the financial assets.

 

Upon adoption of ASU 2014-13, the notes are measured as (1) the sum of the fair value of the financial assets and the carrying value of any nonfinancial assets held temporarily, less (2) the sum of the fair value of any beneficial interests retained by the Company (other than those that represent compensation for services) and the Company’s carrying value of any beneficial interests that represent compensation for services.

 

Investment in Affiliates

 

Under U.S. GAAP, the Company is permitted, as a practical expedient, to estimate the fair value of its investments in other investment companies using the NAV (or its equivalent) of the related investment company. Accordingly, the Company utilizes the practical expedient in valuing its investments in the unconsolidated ZAIS Managed Entities, which is an amount equal to the sum of the Company’s proportionate interest in the capital accounts of the affiliated funds at fair value. The fair value of the assets and liabilities of the ZAIS Managed Entities are determined by the Company in accordance with its valuation policies described above. The resulting net gains or losses on investments are included in net gain (loss) on investments in the consolidated statements of comprehensive income (loss).

 

At June 30, 2015, all of the Company’s investments in the ZAIS Managed Entities were required to be consolidated. At December 31, 2014, the Company held investments in one unconsolidated ZAIS Managed Entity. The valuation of the investment in this entity represents the amount the Company would receive at June 30, 2015 and December 31, 2014, respectively, if it were to liquidate its investments in the fund. ZAIS Group has the ability to liquidate its investments according to the provisions of the respective fund’s operative agreements.

  

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The following table summarizes the Company’s assets and liabilities measured at fair value on a recurring basis within the fair value hierarchy levels at June 30, 2015:

 

   June 30, 2015 
   ( Dollars in thousands ) 
   Level 1   Level 2   Level 3   Total 
Assets, at fair value                    
Investments, at fair value                    
Collateralized loan obligations  $   $   $9,731   $9,731 
Residential mortgage-backed securities           13,365    13,365 
Exchange traded funds   2,001            2,001 
Real estate investment           10,702    10,702 
Total investments, at fair value   2,001        33,798    35,799 
Investments in affiliated securities, at fair value       28,072        28,072 
Derivative assets, at fair value                    
Credit default swaps       5        5 
Interest rate swaps       292        292 
Swaptions       1,990        1,990 
Total derivative assets, at fair value       2,287        2,287 
Total assets, at fair value  $2,001   $30,359   $33,798   $66,158 
Liabilities, at fair value                    
Securities sold, not yet purchased                    
Exchange traded funds  $10,829   $   $   $10,829 
Derivative liabilities, at fair value                    
Credit default swaps       141        141 
Interest rate swaps        922         922 
Total return swaps       75        75 
Total derivative liabilities, at fair value       1,138        1,138 
Total liabilities, at fair value  $10,829   $1,138   $   $11,967 

 

The following table summarizes the Company’s assets and liabilities measured at fair value on a recurring basis within the fair value hierarchy levels at December 31, 2014:

 

   December 31, 2014 
   ( Dollars in thousands ) 
   Level 1   Level 2   Level 3   Total 
Assets, at fair value                    
Investments in affiliates  $   $104   $   $104 
Investments, at fair value                    
Collateralized debt obligations           359,211    359,211 
Commercial mortgage-backed securities           4,535    4,535 
Corporate bonds       7,857        7,857 
Residential mortgage-backed securities           78,275    78,275 
Asset-backed securities and other           63,174    63,174 
High yield corporate loans           613,685    613,685 
Total investments, at fair value       7,857    1,118,880    1,126,737 
Investments in affiliated securities, at fair value       31,457        31,457 
Derivative assets, at fair value                    
Options       56        56 
Forward currency contracts       3,794        3,794 
Credit default swaps           2,798    2,798 
Total derivative assets, at fair value       3,850    2,798    6,648 
Total assets, at fair value  $   $43,268   $1,121,678   $1,164,946 
Liabilities, at fair value                    
Notes payable of consolidated CDOs, at fair value                    
Notes payable of consolidated CDOs  $   $   $749,719   $749,719 
Securities sold, not yet purchased                    
Corporate bonds       19,308        19,308 
Derivative liabilities, at fair value                    
Credit default swaps           5,399    5,399 
Cashflow swaps       386        386 
Total derivative liabilities, at fair value       386    5,399    5,785 
Total liabilities, at fair value  $   $19,694   $755,118   $774,812 

 

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The following table summarizes the changes in the Company’s Level 3 assets and liabilities for the six months ended June 30, 2015 subsequent to the adoption of ASU 2015-02:

 

   June 30, 2015 
   ( Dollars in thousands ) 
   Beginning
Balance
January 1,
2015
   Purchases/
Issuances
   Sales/
Redemptions/
Settlements
   Total
Realized
and
Change in
Unrealized
Gains (Losses)
   Transfers
to (from)
Level 3
   Ending
Balance
June 30,
2015
   Change in
Unrealized
Gains/Losses
Relating to
Assets and
Liabilities
Still Held at
June 30, 2015
 
Collateralized loan obligations  $9,626   $3,499   $(3,777)  $383   $   $9,731   $241 
Mortgage-backed securities   9,472    8,166    (4,195)   (78)       13,365    158 
Real estate investment   9,722            980        10,702    980 
Total assets, at fair value  $28,820   $11,665   $(7,972)  $1,285   $   $33,798   $1,379 

 

 The following table summarizes the changes in the Company’s Level 3 assets and liabilities for the year ended December 31, 2014:

 

   December 31, 2014 
   ( Dollars in thousands ) 
   Beginning
Balance
January 1,
2014
   Purchases/
Issuances
   Sales/
Redemptions/
Settlements
   Total
Realized
and
Change in
Unrealized
Gains (Losses)
   Transfers
to (from)
Level 3
   Ending
Balance
December 31,
2014
   Change in
Unrealized
Gains/Losses
Relating to
Assets and
Liabilities
Still Held at
December 31,
2014
 
Collateralized debt obligations  $707,718   $112,518   $(461,995)  $970   $   $359,211   $(47,146)
Commercial mortgage-backed securities   6,738    2,862    (5,424)   359        4,535    (116)
Residential mortgage-backed securities   63,091    32,391    (21,545)   4,338        78,275    461 
Asset-backed securities and other   95,281    63,295    (113,524)   18,122        63,174    1,847 
High yield corporate loans   -    782,501    (160,810)   (8,006)       613,685    (7,285)
Collateralized loan obligations   26,460    14,500    (39,000)   (1,960)            
Total return swaps   2,727        (110)   (2,617)            
Credit default swaps   2,300    3,245    (3,912)   1,165        2,798    550 
Total assets, at fair value  $904,315   $1,011,312   $(806,320)  $12,371   $   $1,121,678   $(51,689)
Notes payable of consolidated CDOs  $730,348   $635,315   $(510,600)  $(105,344)  $   $749,719   $(74,344)
Total return swaps           (196)   196             
Credit default swaps   20,187    26,197    (22,391)   (18,594)       5,399    (2,359)
Total liabilities, at fair value  $750,535   $661,512   $(533,187)  $(123,742)  $   $755,118   $(76,703)

 

 

The Company records transfers between Level 1, Level 2 and Level 3, if any, at the beginning of the period.

 

There were no transfers between Level 1, Level 2 and Level 3 during the six months ended June 30, 2015 and the year ended December 31, 2014.

 

The tables below summarize information about the significant unobservable inputs used in determining the fair value of the Level 3 assets and liabilities held by the Consolidated Funds at June 30, 2015 and December 31, 2014:

 

20
 

 

Investment Type  Fair Value
at June 30,
2015
   Valuation
Techniques
  Unobservable
Input
  Amount/
Percentage
   Min   Max   Weighted
Average
 
   (Dollars in thousands)                        
Investments, at fair value                               
Collateralized loan obligations   9,731   Broker quoted  Not applicable.                    
Residential mortgage-backed securities – Agency IO   1,536   Discounted cash flow model  Yield        8.03    8.03   N/A  
 Residential mortgage-backed securities – Agency Inverse IO   425   Discounted cash flow model  Yield        5.45    5.45   N/A  
Residential mortgage-backed securities   11,404   Broker quoted  Not applicable.                    
Real estate investment   10,702   Capitalization Rate Method  Capitalization Rate   7.00                
Total assets, at fair value  $33,798                           

 

 Investment Type  Fair Value at
December 31,
2014
   Valuation
Techniques
  Unobservable
Input
  Amount/
Percentage
   Min   Max   Weighted
Average 
 
   (Dollars in thousands)                       
Investments, at fair value                               
Collateralized debt obligations  $59,623   Discounted cash flow model  Discount margin (bps)        253    2,138    776 
           Constant prepayment rate        10%   35%   N/A(1) 
           Constant default rate        0%   4%   N/A(1)
           Loss severity        30%   70%   N/A(1)
           Reinvestment price   100                
           Reinvestment spread   3.75                
Collateralized debt obligations   299,588   Broker quoted  Not applicable.                    
Commercial mortgage-backed securities   4,535   Broker quoted  Not applicable.                    
Residential mortgage-backed securities   17,085   Discounted cash flow model  Discount margin (bps)        308    1,975    666 
           Constant prepayment rate        1%   28%   10%
           Constant default rate        0%   22%   3%
           Loss severity        0%   150%   78%
Residential mortgage-backed securities   61,190   Broker quoted  Not applicable.                    
Asset-backed securities and other   63,174   Broker quoted  Not applicable.                    
High yield corporate loans   613,685   Broker quoted  Not applicable.                    
Derivative assets, at fair value                               
Credit default swaps   2,798   Broker quoted  Not applicable.                    
Total assets, at fair value  $1,121,678                           
Liabilities                               
Notes payable of consolidated CDOs, at fair value  $749,719   ASU 2014-13(2)    Not applicable.                    
Derivative liabilities, at fair value                               
Credit default swaps   5,399   Broker quoted  Not applicable.                    
Total liabilities, at fair value  $755,118                           

  

(1)Weighted Average Constant Prepayment Rate, Weighted Average Constant Default Rate and Weighted Average Loss Severity are flat percentages applied to the respective assets to project future cash flows.

 

(2)Valued per ASU 2014-13 as described in Note 3.

 

21
 

 

6. Derivatives

 

In the normal course of business, the Consolidated Funds utilize derivative contracts in connection with their proprietary trading activities. Investments in derivative contracts are subject to additional risks that can result in a loss of all or part of an investment. The Consolidated Funds’ derivative activities and exposure to derivative contracts are classified by the following primary underlying risks: interest rate, credit and foreign currency exchange rate and equity price risks. In addition to its primary underlying risks, the Consolidated Funds are also subject to additional counterparty risks due to the inability of their counterparties to meet the terms of their contracts.

 

The Consolidated Funds may enter into various swap contracts, including currency swaps, interest rate swaps, total return swaps and credit default swaps, as part of their investment strategies, to hedge against unfavorable changes in the value of investments and to protect against adverse movements in interest rates or credit performance. Generally, a swap contract is an agreement that obligates two parties to exchange a series of cash flows at specified intervals based upon or calculated by reference to changes in specified prices or rates for a specified notional amount of the underlying assets. The payment flows are usually netted against each other, with the difference being paid by one party to the other.

 

During the term of the swap contract, changes in fair value are recognized as a net unrealized gain (loss) by marking the contracts at fair value. Additionally, the Consolidated Funds record a realized gain (loss) when a swap contract is terminated, and when periodic payments are received or made at the end of each measurement period.

 

The fair value of open swap contracts reported in the consolidated statements of financial condition may differ from what would be realized in the event the Consolidated Funds terminated their positions in the contracts. Risks may arise as a result of the failure of the counterparty to the swap contract to comply with the terms of the swap contract. The loss incurred by the failure of a counterparty is generally limited to the aggregate fair value of swap contracts in an unrealized gain position, as well as any collateral posted with the counterparty. The risk is mitigated by having a master netting arrangement between each Consolidated Fund and the applicable counterparty and by the posting of collateral by the counterparty to the applicable Consolidated Fund to cover the Consolidated Funds’ exposure to the counterparty. As discussed in Note 2 to the consolidated financial statements, the Consolidated Funds have elected not to offset fair value amounts. Therefore, the Consolidated Funds consider the creditworthiness of the counterparty to each swap contract in evaluating potential credit risk. Additionally, risks may arise from unanticipated movements in the fair value of the underlying investments.

 

The following tables quantify the volume of the Consolidated Funds’ derivative activity, recorded within assets and liabilities in the consolidated statements of financial condition, at June 30, 2015 and December 31, 2014, through a disclosure of notional amounts, in comparison with the fair value of those derivatives. All notional and fair value amounts are disclosed on a gross basis, prior to counterparty and cash collateral netting:

 

    June 30, 2015
    ( Dollars and notional amounts in thousands )
    Derivative Assets   Derivative Liabilities
Primary Underlying
Risk
  Financial
Statement
Location
  Notional     Fair
Value
    Financial Statement
Location
  Notional     Fair
Value
 
Interest rate contracts   Derivative assets, at fair value     162,850     $ 2,282     Derivative liabilities, at fair value     84,250     $ 922  
Credit contracts   Derivative assets, at fair value     1,000       5     Derivative liabilities, at fair value     1,000       141  
Equity contracts   Derivative assets, at fair value               Derivative liabilities, at fair value     5,000       75  
Gross derivative instruments         163,850     $ 2,287           90,250     $ 1,138  

 

    December 31, 2014
    ( Dollars and notional amounts in thousands )
    Derivative Assets   Derivative Liabilities
Primary Underlying
Risk
  Financial
Statement
Location
  Notional     Fair
Value
    Financial Statement
Location
  Notional     Fair
Value
 
Interest rate contracts   Derivative assets, at fair value         $     Derivative liabilities, at fair value     201,612     $ 386  
Credit contracts   Derivative assets, at fair value     72,265       2,798     Derivative liabilities, at fair value     180,172       5,399  
Foreign exchange contracts   Derivative assets, at fair value     201,400       3,850     Derivative liabilities, at fair value            
Gross derivative instruments         273,665     $ 6,648           381,784     $ 5,785  

 

22
 

 

The following tables identify the net realized gains (losses) and change in unrealized gains/losses on derivative contracts included within net gains of Consolidated Funds’ investments in the consolidated statements of comprehensive income (loss) for the three and six months ended June 30, 2015 and June 30, 2014:

  

   Three Months Ended June 30, 2015 
   ( Dollars in thousands ) 
Primary Underlying Risk  Realized
Gains
(Losses)
   Change in
Unrealized
Gains (Losses)
   Total 
Interest rate contracts  $(399)  $26   $(373)
Credit contracts   (7)   (9)   (16)
Equity contracts       87    87 
Total  $(406)  $104   $(302)

 

   Three Months Ended June 30, 2014 
   ( Dollars in thousands ) 
Primary Underlying Risk  Realized
Gains
(Losses)
   Change in
Unrealized
Gains (Losses)
   Total 
Interest rate contracts  $750   $2,021   $2,771 
Credit contracts   (78)   (5,272)   (5,350)
Equity contracts   (4,011)   698    (3,313)
Foreign exchange contracts   39    (12)   27 
Total  $(3,300)  $(2,565)  $(5,865)

 

   Six Months Ended June 30, 2015 
   ( Dollars in thousands ) 
Primary Underlying Risk  Realized
Gains
(Losses)
   Change in
Unrealized
Gains (Losses)
   Total 
Interest rate contracts  $(593)  $364   $(229)
Credit contracts   16    (19)   (3)
Equity contracts       75    75 
Total  $(577)  $420   $(157)

 

   Six Months Ended June 30, 2014 
   ( Dollars in thousands ) 
Primary Underlying Risk  Realized
Gains
(Losses)
   Change in
Unrealized
Gains (Losses)
   Total 
Interest rate contracts  $   $909   $909 
Credit contracts   (479)   (4,816)   (5,295)
Equity contracts   (4,011)   698    (3,313)
Foreign exchange contracts   (63)   87    24 
Total  $(4,553)  $(3,122)  $(7,675)

 

At June 30, 2015, the Consolidated Funds did not hold financial instruments where they were considered to be a seller of credit derivatives. At December 31, 2014, the Consolidated Funds held financial instruments where it is considered to be a seller of credit derivatives under U.S. GAAP. The Consolidated Funds’ written credit derivatives include credit default swaps. The Company believes credit ratings on issuers of underlying reference obligations, together with the period of expiration, are the best indicators of payment/performance risk on written credit derivative contracts. A reference obligation is considered investment grade if its credit rating is BBB- or higher, as rated by Standard & Poor’s (“S&P”). The following tables set forth the information related to the Consolidated Funds’ written credit derivatives held December 31, 2014:

  

23
 

 

    December 31, 2014
    ( Dollars and notional amounts in thousands )
        Notional Amount     Fair Value
Asset
(Liability)
 
CDS Type   Credit Rating   Less than
1 year
    1 – 5
years
    Over
5 years
    Total        
Investment Grade Index Tranche   Not rated           11,000             11,000     $ 925  
Bespoke-Mezzanine   Not rated     22,000       92,000             114,000       (471 )
High Yield Index Tranche   Not rated           15,000             15,000       (889 )
High Yield Single Name   Not rated           4,000             4,000       357  
CDO Tranche on Corporate Debt   Investment Grade           19,500       33,000       52,500       (1,407 )
CDO Tranche on Corporate Debt   Non-Investment Grade           9,000       5,172       14,172       5,172  
CDO Tranche on Corporate Debt   Not rated           8,000             8,000       343  
Total         22,000       158,500       38,172       218,672     $ 4,030  

 

The following tables list the average yearly notional amounts and number of contracts held at June 30, 2015 and December 31, 2014, categorized by primary underlying risk:

 

   June 30, 2015 
   ( Notional amounts in thousands ) 
   Long Exposure   Short Exposure 
Primary Underlying Risk  Average
Yearly
Notional
Amounts
   Number of
Contracts at
June 30,
2015
   Average
Yearly
Notional
Amounts
   Number of
Contracts at
June 30,
2015
 
Interest rate contracts   150,800    9    86,375    11 
Credit contracts   500    1    1,000    1 
Equity contracts           2,500    1 
Total   151,300    10    89,875    13 

  

   December 31, 2014 
   ( Notional amounts in thousands ) 
   Long Exposure   Short Exposure 
Primary Underlying Risk  Average
Yearly
Notional
Amounts
   Number of
Contracts at
December 31,
2014
   Average
Yearly
Notional
Amounts
   Number of
Contracts at
December 31,
2014
 
Interest rate contracts   327,500        150,708    1 
Credit contracts   69,670    34    19,168    8 
Foreign exchange contracts   100,000    1    1,275    1 
Total   497,170    35    171,151    10 

 

Offsetting of Derivatives

 

The Consolidated Funds are required to disclose the impact of offsetting assets and liabilities included in the consolidated statements of financial condition to enable users of the consolidated financial statements to evaluate the effect or potential effect of netting arrangements on their financial position for recognized assets and liabilities. These recognized assets and liabilities are financial instruments and derivative instruments that are either subject to an enforceable master netting arrangement or similar agreement, or meet the following right of setoff criteria: the amounts owed by the Consolidated Funds to another party are determinable, the Consolidated Funds have the right to set off the amounts owed with the amounts owed by the other party, the Consolidated Funds intend to set off and the Consolidated Funds’ right of setoff is enforceable by law.

 

At June 30, 2015 and December 31, 2014, the Consolidated Funds hold certain derivative instruments that are eligible for offset in the consolidated statements of financial condition and are subject to master netting arrangements. A master netting arrangement allows each applicable Consolidated Fund and the related counterparty to net derivative assets of each Consolidated Fund or collateral held on behalf of each Consolidated Fund against derivative liabilities or payment obligations of each Consolidated Fund to the counterparty. These arrangements also allow each Consolidated Fund and the applicable counterparty to net any derivative liabilities of each Consolidated Fund or collateral sent to each Consolidated Fund against derivatives assets or counterparty payment obligations to each Consolidated Fund. There are no master netting arrangements between the Consolidated Funds.

 

24
 

 

Balances are presented on a gross basis in the consolidated statements of financial condition prior to the application of the impact of fair value and collateral netting. The following tables present information about certain assets and liabilities that are subject to master netting arrangements (or similar agreements), and can potentially be offset in the consolidated statements of financial condition at June 30, 2015 and December 31, 2014:

 

Offsetting Derivative Assets

 

    June 30, 2015  
    ( Dollars in thousands )  
          Gross
Amounts
Offset in the
    Net Amounts of
Assets
Presented in
the
    Gross Amounts Not Offset
in the Consolidated
Statements of Financial
Condition
       
Description   Gross
Amounts of
Recognized
Assets
    Consolidated
Statements
of Financial
Condition
    Consolidated
Statements of
Financial
Condition
    Financial
Instruments
    Cash
Collateral
Received
    Net
Amount
 
                                     
Investments in derivatives, at fair value   $ 2,287     $     $ 2,287     $ (216)     $     $ 2,071  
Total   $ 2,287     $     $ 2,287     $ (216)     $     $ 2,071  

  

Offsetting Derivative Liabilities

 

   June 30, 2015 
   ( Dollars in thousands ) 
       Gross
Amounts
Offset in the
   Net Amounts of
Liabilities
Presented in
the
   Gross Amounts Not Offset
in the Consolidated
Statements of Financial
Condition
     
Description  Gross
Amounts of
Recognized
Liabilities
   Consolidated
Statements
of Financial
Condition
   Consolidated
Statements of
Financial
Condition
   Financial
Instruments
   Cash
Collateral
Pledged
   Net
Amount
 
                         
Investments in derivatives, at fair value  $1,138   $   $1,138   $(216)  $(922)  $ 
Total  $1,138   $   $1,138   $(216)  $(922)  $ 

 

Offsetting Derivative Assets

 

   December 31, 2014 
   ( Dollars in thousands ) 
       Gross
Amounts
Offset in the
   Net Amounts of
Assets
Presented in
the
   Gross Amounts Not Offset
in the Consolidated
Statements of Financial
Condition
     
Description  Gross
Amounts of
Recognized
Assets
   Consolidated
Statements
of Financial
Condition
   Consolidated
Statements of
Financial
Condition
   Financial
Instruments
   Cash
Collateral
Received
   Net
Amount
 
                         
Investments in derivatives, at fair value  $6,648   $   $6,648   $(2,119)  $   $4,529 
Total  $6,648   $   $6,648   $(2,119)  $   $4,529 

 

25
 

 

Offsetting Derivative Liabilities

 

   December 31, 2014 
   ( Dollars in thousands ) 
       Gross
Amounts
Offset in the
   Net Amounts of
Liabilities
Presented in
the
   Gross Amounts Not Offset
in the Consolidated
Statements of Financial
Condition
     
Description  Gross
Amounts of
Recognized
Liabilities
   Consolidated
Statements
of Financial
Condition
   Consolidated
Statements of
Financial
Condition
   Financial
Instruments
   Cash
Collateral
Pledged
   Net
Amount
 
                         
Investments in derivatives, at fair value  $5,785   $   $5,785   $(2,119)  $(1,801)  $1,865 
Total  $5,785   $   $5,785   $(2,119)  $(1,801)  $1,865 

 

7. Variable Interest Entities

 

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

 

Funds

 

Prior to the adoption of ASU 2015-02, substantially all of the ZAIS Managed Entities qualified for the deferral granted under ASU 2010-10, Amendments to Statement 167 for Certain Investment Funds (“ASU 2010-10”). As such, the Company evaluated these Funds for consolidation pursuant to former guidance in Financial Accounting Standards Board (“FASB”) Interpretation No. 46(R), Consolidation of Variable Interest Entities. Fund investors are entitled to substantially all of the economics of these VIEs, with the exception of management fees and incentive income, if any, earned by ZAIS Group. Accordingly, the determination of whether ZAIS Group is the primary beneficiary of these funds is not impacted by changes in the underlying assumptions made regarding future results or expected cash flows of these VIEs.

 

In adopting ASU 2015-02, the Company re-evaluated all of the ZAIS Managed Entities for consolidation. As a result of the re-evaluation the Company is no longer required to consolidate ZAIS Opportunity Master Fund, Ltd. and ZAIS Opportunity Fund, Ltd. as it has been determined that the Company’s fee is no longer considered a variable interest. However, as a result of the re-evaluation, the Company is now required to consolidate ZAIS Atlas Master Fund, LP since it has been determined that the Company is the related party most-closely associated with the entity.

 

In evaluating whether the Company is the primary beneficiary, the Company evaluates its economic interests in the entity held either directly by the Company or indirectly through related parties. For VIEs that are investment companies subject to ASU 2010-10, the primary beneficiary of the VIE is generally the variable interest holder that absorbs a majority of the expected losses of the VIE, receives a majority of the expected residual returns of the VIE, or both. The Company generally is not the primary beneficiary of VIEs created to manage assets for clients unless the Company’s ownership interest, including interests of related parties, is substantial.

 

The primary beneficiary of a VIE is defined as the variable interest holder that has a controlling financial interest. A controlling financial interest is defined as (i) the power to direct activities of the VIE that most significantly impacts its economic performance and (ii) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. If no single party satisfies both criteria, but the Company and its related parties satisfy the criteria on a combined basis, then the primary beneficiary is the entity out of the related party group that is most closely associated to the VIE. The consolidation analysis can generally be performed qualitatively, however, if it is not readily apparent that the Company is not the primary beneficiary, a quantitative analysis may also be performed.

 

Securitized Structures

 

ZAIS Group acts as collateral manager for CDOs that are VIEs. These are entities that issue collateralized notes which offer investors the opportunity for returns that vary commensurately with the risks they assume. The notes issued by the CDOs are generally backed by asset portfolios consisting of loans, other debt or other derivatives. ZAIS Group receives collateral management fees (which in some cases are waived in lieu of certain ZAIS Managed Entities owning the equity tranches) for acting as the collateral manager for these structures and, subject to hurdle rates, may earn incentive income based on the performance of the vehicles.

 

26
 

 

Prior to the adoption of ASU 2015-02, the deferral granted under ASU 2010-10 did not apply to securitized structures. Accordingly, the determination of whether ZAIS Group was the primary beneficiary that would consolidate these entities was based on a determination of whether ZAIS Group had (i) the power to direct the activities of the entity that most significantly impact its economic performance, and (ii) the obligations to absorb losses or the right to receive benefits from the entity that could potentially be significant to the entity. Prior to the adoption of the ASU 2015-02, ZAIS Group determined that it possessed the power to direct the activities of the CDOs (with the exception of CLOs that were still in the warehouse stage) that most significantly impact their economic performance through its role as the collateral manager. In addition, ZAIS Group determined that it had the right to receive benefits from the CDOs that could potentially be significant, on a quantitative and qualitative basis. As a result, the Company consolidated certain securitized structures that ZAIS Group manages. CLOs that are still in the warehouse phase are VIEs. ZAIS Group did not consider itself to be the primary beneficiary of these entities because it does not have the power to direct the activities that most significantly impact the economic performance of these structures. Therefore, the CLOs that were still in the warehouse phase prior to January 1, 2015 have not been consolidated by the Company.

 

In adopting ASU 2015-02, the Company re-evaluated all of its CDOs that are VIEs. The Company determined that it is no longer the primary beneficiary of these entities because under ASU 2015-02, ZAIS Group’s fee arrangements are commensurate with the level of effort performed and include only customary terms that do not represent variable interests. The Company considered investments its related parties have in the CDOs when determining if ZAIS Group’s fee represented a variable interest. The Company has concluded that for all CDOs its fee does not represent a variable interest and, accordingly, has deconsolidated the CDOs as of January 1, 2015.

 

The following table presents the assets and liabilities of entities that are VIEs, and consolidated by the Company on a gross basis prior to eliminations due to consolidation at June 30, 2015 and December 31, 2014:

 

   June 30, 2015   December 31, 2014 
   Funds   CDOs   Funds   Total 
   (Dollars in thousands) 
Assets                    
Assets of Consolidated Funds                    
Cash and cash equivalents  $18,637   $34,399   $58,971   $93,370 
Restricted cash   2,201        30,265    30,265 
Investments, at fair value   35,799    789,410    327,605    1,117,015 
Investments in affiliated securities, at fair value   28,072        34,762    34,762 
Derivative assets, at fair value   2,287    509    6,139    6,648 
Other assets   3,544    9,832    1,766    11,598 
Total Assets  $90,540   $834,150   $459,508   $1,293,658 
Liabilities                    
Liabilities of Consolidated Funds                    
Notes payable of consolidated CDOs, at fair value  $   $784,481   $   $784,481 
Derivative liabilities, at fair value   1,138    2,374    3,411    5,785 
Securities sold, not yet purchased   10,829        19,308    19,308 
Due to broker       21,047    4,600    25,647 
Other liabilities   5,896    26,248    2,441    28,689 
Total Liabilities  $17,863   $834,150   $29,760   $863,910 

 

The assets presented in the table above belong to the investors in those entities, are available for use only by the entity to which they belong and are not available for use by the Company. The Consolidated Funds have no recourse to the general credit of ZAIS Group with respect to any liability. The Company also consolidates entities that are not VIEs, the assets and liabilities of which are not included in the table above.

 

ZAIS Group has a minimal direct ownership, if any, in the non-consolidated entities that are VIEs and its involvement is generally limited to providing asset management services. ZAIS Group’s exposure to loss from these entities is limited to a decrease in the management fees and incentive income that has been earned and accrued, as well as any direct equity ownership in the VIEs. The net assets of these VIEs were approximately $81.8 million at December 31, 2014. ZAIS Group does not provide, nor is it required to provide, any type of financial support to these entities. At December 31, 2014, ZAIS Group’s maximum exposure to loss as a result of its involvement with the non-consolidated VIEs was approximately $104,000. At June 30, 2015, all entities in which ZAIS Group has a variable interest have been consolidated.

 

27
 

 

8. Management Fee Income and Incentive Income

 

ZAIS Group manages certain funds and accounts from which it may earn incentive income based on hedge fund-style and private equity-style fee arrangements. Funds and accounts with hedge fund-style fee arrangements are those that pay an incentive fee/allocation, that may be subject to a hurdle, to ZAIS Group on an annual basis. Funds and accounts with private equity-style fee arrangements are those that pay an incentive fee/allocation based on a priority of payments under which investor capital must be returned and a preferred return must be paid to the investor prior to any payments of incentive-based income to ZAIS Group.

 

Management fees earned by ZAIS Group for funds and accounts with hedge fund-style fee arrangements generally range from 0.50% to 1.25%, annually, based on net asset value of these funds and accounts prior to the accrual of incentive fees/allocations. Management fees earned by ZAIS Group for funds and accounts with private equity-style fee arrangements generally range from 0.25% to 0.50%, annually, based on either the net asset value of these funds and accounts prior to the accrual of incentive fees/allocations or on the amount of capital committed to these funds and accounts by its investors. Management fees earned for the CDOs generally range from 0.15% to 0.50%, annually, and are generally based on the par value of the collateral and cash held in the CDOs. Management fees earned by ZAIS Group from ZAIS Financial Corp. are 1.50%, annually, based on ZAIS Financial Corp.'s stockholders' equity, as defined in the amended and restated investment advisory agreement between a subsidiary of ZAIS and ZAIS Financial Corp. 20% of management fee income received from ZAIS Financial Corp. is payable to holders of Class B interests in ZAIS Group’s consolidated subsidiary ZAIS REIT Management, LLC.

 

For funds and accounts with hedge fund-style fee arrangements, incentive income earned generally ranges from 10% to 20% of the net realized and unrealized profits attributable to each investor, subject to a hurdle (if any) set forth in each respective entity’s operative agreement. Additionally, all funds and accounts with hedge fund-style fee arrangements are subject to a perpetual loss carry forward, or perpetual “high-water mark,” meaning that the funds and accounts will not pay incentive fees/allocations 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. The funds and accounts pay incentive fees/allocations on any net profits in excess of the high-water mark.

 

For funds and accounts with private equity-style fee arrangements, incentive income earned by ZAIS Group is generally 20% of all profits, subject to the return of contributed capital (and subordinate management fees, if any), and a preferred return as specified in each fund’s operative agreement.

 

For CDOs, incentive income earned generally ranges from 10% to 20% of all profits, subject to the return of contributed capital (and subordinate management fees, if any), and a preferred return as specified in the respective CDOs’ collateral management agreements.

 

The following tables represent the gross amounts of management fee income and incentive income earned prior to eliminations due to consolidation of the Consolidated Funds and the net amount reported in the Company’s consolidated statements of comprehensive income (loss) for the three and six months ended June 30, 2015 and June 30, 2014:

 

   Three months Ended June 30, 2015 
   ( Dollars in thousands ) 
   Gross
Amount
   Elimination   Net
Amount
 
Management Fee Income               
Hedge funds  $1,610   $(61)  $1,549 
Managed accounts   1,042        1,042 
Private equity funds   575        575 
ZAIS Financial Corp.   854        854 
Total  $4,081   $(61)  $4,020 
Incentive Income               
Hedge funds  $612   $   $612 
Managed accounts   463        463 
Private equity funds   138        138 
Total  $1,213   $   $1,213 

 

28
 

 

   Three months Ended June 30, 2014 
   ( Dollars in thousands ) 
   Gross
Amount
   Elimination   Net
Amount
 
Management Fee Income               
Hedge funds  $892   $(856)  $36 
Managed accounts   2,910        2,910 
Private equity funds   1,917    (362)   1,555 
ZAIS Financial Corp.   568        568 
Total  $6,287   $(1,218)  $5,069 
Incentive Income               
Hedge funds  $247   $4   $251 
Managed accounts   827        827 
Private equity funds   35,463    (696)   34,767 
Total  $36,537   $(692)  $35,845 

  

   Six Months Ended June 30, 2015 
   ( Dollars in thousands ) 
   Gross
Amount
   Elimination   Net
Amount
 
Management Fee Income               
Hedge funds  $3,230   $(120)  $3,110 
Managed accounts   2,186        2,186 
Private equity funds   990        990 
ZAIS Financial Corp.   1,428        1,428 
Total  $7,834   $(120)  $7,714 
Incentive Income               
Hedge funds  $625   $   $625 
Managed accounts   463        463 
Private equity funds   1,033        1,033 
Total  $2,121   $   $2,121 

 

   Six months Ended June 30, 2014 
   ( Dollars in thousands ) 
   Gross
Amount
   Elimination   Net
Amount
 
Management Fee Income               
Hedge funds  $904   $(868)  $36 
Managed accounts   5,871        5,871 
Private equity funds   9,978    (6,613)   3,365 
ZAIS Financial Corp.   1,131        1,131 
Total  $17,884   $(7,481)  $10,403 
Incentive Income               
Hedge funds  $339   $(88)  $251 
Managed accounts   827        827 
Private equity funds   45,369    (9,657)   35,712 
Total  $46,535   $(9,745)  $36,790 

 

At June 30, 2015, approximately $1,897,000 and $612,000 were accrued for management fee income and incentive income, respectively but not received, and included in income and fees receivable in the consolidated statements of financial condition. At December 31, 2014, approximately $1,871,000 and $2,412,000 were accrued for management fee income and incentive fee income, respectively but not received, and included in income and fees receivable in the consolidated statements of financial condition.

 

29
 

 

 9. Debt Obligations

 

Notes Payable

 

On March 17, 2015, in conjunction with the closing of the Business Combination, ZAIS issued two promissory notes with an aggregate principal balance of $1,250,000 to EarlyBirdCapital, Inc. and Sidoti & Company, LLC. The notes accrue interest at an annual rate equal to the annual applicable federal rate as published by the Internal Revenue Service (“AFR”) until the principal amount of, and all accrued interest on, the notes have been paid in full. The notes mature on March 31, 2017. The notes were treated as a direct cost attributable to the Business Combination. The Company accrued interest on the notes for the three and six months ended June 30, 2015, which is included in other income (expense) in the consolidated statements of comprehensive income (loss).

 

Notes Payable of Consolidated CDOs

 

Prior to adopting ASU 2015-02, the Company consolidated the CDOs that ZAIS Group manages. As a result, the senior and subordinated notes issued by the CDOs are included in the Company’s consolidated statements of financial condition. Notes payable of the consolidated CDOs are collateralized by the assets held by the CDOs, and the assets of one CDO may not be used to satisfy the liabilities of another. This collateral generally consists of loans, other debt and other derivatives. The stated maturity dates for the notes issued by the CDOs range from 2019 to 2057.

 

At June 30, 2015 no CDOs were consolidated due to the adoption of ASU 2015-02. At December 31, 2014, the fair value of the CDOs’ net assets is approximately $749,719,000. At December 31, 2014, the components of the CDOs’ assets and liabilities and the eliminations for the Consolidated Fund’s investments in CDOs, are as follows:

 

   December 31,
2014
 
   ( Dollars in
thousands )
 
Cash and cash equivalents  $34,399 
Investments, at fair value:     
Collateralized debt obligations   138,637 
Commercial mortgage-backed securities   1,606 
Residential mortgage-backed securities   13,174 
Asset-backed securities and other   22,308 
High yield corporate loans   613,685 
    789,410 
      
Derivative assets (liabilities), net, at fair value   (1,864)
Other assets (liabilities), net   (37,464)
Notes payable of consolidated CDOs, at fair value   784,481 
Elimination of Consolidated Funds’ investments in CDOs   (34,762)
Notes payable of consolidated CDOs, at fair value (net of eliminations)  $749,719 

 

As discussed in Note 3, the Company has elected to carry these notes at fair value in its consolidated statements of financial condition. Accordingly, the Company measured the fair value of notes payable (as a group including both the senior and subordinated notes) as (1) the sum of the fair value of the financial assets and the carrying value of any non-financial assets held temporarily, less (2) the sum of the fair value of any beneficial interests retained by the Company (other than those that represent compensation for services) and the Company’s carrying value of any beneficial interests that represent compensation for services. The Company allocated the resulting amount to the different classes of notes based on the CDOs’ waterfall on an as liquidated basis.

 

The tables below present information related to the CDOs’ notes outstanding at December 31, 2014. The subordinated notes have no stated interest rate, and are entitled to any excess cash flows after contractual payments are made to the senior notes.

 

   December 31, 2014 
   ( Dollars in thousands ) 
   Borrowings
Outstanding
   Fair
Value
   Weighted
Average
Interest Rate
   Weighted
Average
Maturity in
Years
 
Senior Secured Notes  $892,112   $749,344    1.74%   17.80 
Subordinated Notes   58,802    375    N/A    21.76 
Total  $950,914   $749,719           

 

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10. Compensation

 

Employees are eligible to receive discretionary incentive cash compensation (the “Bonus Award”) on an annual basis. The amount of the Bonus Award is based on, among other factors, both individual performance and the financial results of ZAIS Group. For certain employees, as documented in an underlying agreement (the “Bonus Agreement”), the Bonus Award may be further subject to a retention-based payout schedule that generally provides for 30% of the Bonus Award to vest and be paid incrementally over a three-year period. The Company expenses all current cash incentive compensation award payments ratably in the first year. All future payments are amortized equally over the required service period over the remaining term of the Bonus Award as defined in the Bonus Award Agreements. In the event an award is forfeited pursuant to the terms of the Bonus Agreement, the corresponding accruals will be reversed. For the three months ended June 30, 2015 and June 30, 2014, the Company recorded compensation expense of approximately $681,000 and $2,735,000, respectively, related to Bonus Awards. For the six months ended June 30, 2015 and June 30, 2014, the Company recorded compensation expense of approximately $1,459,000 and $5,615,000, respectively, related to Bonus Awards. At June 30, 2015, ZAIS Group expects to pay approximately $5,001,000 in bonuses that will vest over the next two years subject to Bonus Agreements.

 

ZAIS Group has entered into Points Agreements with certain of its employees whereby certain employees and former employees have been granted rights to participate in a portion of the incentive income received from certain ZAIS Managed Entities. For the three months ended June 30, 2015 and June 30, 2014, the Company recorded compensation expense of approximately $32,000 and $7,692,000, respectively, related to incentive fee compensation for Points Agreements. For the six months ended June 30, 2015 and June 30, 2014, the Company recorded compensation expense of approximately $32,000 and $7,784,000, respectively, related to incentive fee compensation for Points Agreements. 

 

In 2013, ZAIS Group established the Income Unit Plan. Under the Income Unit Plan, certain employees were entitled to receive a fixed percentage of ZAIS Group’s distributable income, as defined in the Income Unit Plan agreement. Payout of 85% of the estimated award was made in December of the applicable performance year, and the remaining balance was payable within 30 days of the issuance of ZAIS Group’s audit report for the prior year. An employee must have been actively employed by ZAIS Group on each scheduled payment date to receive the relevant distribution. The Income Unit Plan was terminated effective December 31, 2014. ZAIS Group recorded compensation expense of approximately $2,070,000 and $4,140,000 related to the Income Unit Plan for the three and six months ended June 30, 2014, respectively.

 

Stock-Based Compensation

 

In conjunction with the close of the Business Combination on March 17, 2015, ZGP authorized 1,600,000 Class B-0 units which are eligible to be granted to certain employees of ZAIS Group. The Class B-0 units are subject to a two year cliff-vesting provision, whereby all units granted to an employee will be forfeited if the employee resigns or is terminated prior to the two year anniversary of the closing of the Business Combination. Subsequent to the two year anniversary of the Business Combination, an employee will only forfeit vested units if the employee is terminated for cause. The Class B Units are not entitled to any distributions from ZGP (and thus will not participate in, or be allocated any, income or loss) or other material rights until such Class B Units vest. Upon vesting the B-0 units will have the same rights as Class A units of ZGP and are exchangeable on a one for one basis for Class A common shares subject to the restrictions set forth in the Exchange Agreement included in the Closing 8-K. In accordance with ASC 718, "Compensation - Stock Compensation”, the Company is measuring the compensation expense associated with these awards based on grant date fair value adjusted for estimated forfeitures. This compensation expense will be amortized equally over the two year vesting period and will be cumulatively adjusted for changes in estimated forfeitures at each reporting date.

 

The following table presents the unvested Class B-0 units’ activity during the period from March 17, 2015 through June 30, 2015:

 

  

Number of

B-0 units

   Weighted
Average Grant
Date Fair
Value per Unit
 
Offered – Upon Closing of Business Combination   1,369,119   $9.70 
Awards not accepted due to resignation   (16,327)   9.70 
Net granted – Upon Closing of Business Combination   1,352,792    9.70 
Granted – Post-Closing of Business Combination   50,000    8.80 
Forfeited        
Vested        
Balance at June 30, 2015   1,402,792   $9.67 

 

The total compensation expense expected to be recognized in all future periods associated with the B-0 units, considering estimated forfeitures of 4%, is $11,191,000 at June 30, 2015, which is expected to be recognized over the remaining weighted average period of 1.72 years. The Company recorded compensation expense of $1,567,000 and $1,828,000 related to the B-0 units for the three and six months ended June 30, 2015, respectively. The expense relating to these B-0 Units is included in compensation and benefits on the consolidated statements of comprehensive income (loss).

 

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Pursuant to ZAIS’s 2015 Stock Incentive Plan, non-employee directors of ZAIS are eligible to receive RSUs as a component of compensation for their service as directors of ZAIS. The awards are unvested at the time they are granted, as such, are not entitled to any dividends or distributions from ZAIS or other material rights until such RSUs vest. The RSUs vest in full on the one year anniversary of the grant date. Upon vesting ZAIS will issue the recipient shares of Class A Common Stock equal to the number of vested RSUs. In accordance with ASC 718, "Compensation - Stock Compensation”, the Company is measuring the expense associated with these awards based on grant date fair value adjusted for estimated forfeitures. This expense will be amortized equally over the one year vesting period and will be cumulatively adjusted for changes in estimated forfeitures at each reporting date.

 

The following table presents the unvested RSU activity during the three months ended June 30, 2015:

 

  

Number of

RSUs

   Weighted
Average Grant
Date Fair
Value per Unit
 
Granted   30,000   $9.85 
Forfeited        
Vested        
Balance at June 30, 2015   30,000   $9.85 

 

The total expense expected to be recognized in all future periods associated with the RSUs, considering estimated forfeitures of 0%, is $246,000 at June 30, 2015, which is expected to be recognized over the remaining weighted average period of 0.84 years. The Company recorded expense of $49,000 related to the RSUs for the three and six months ended June 30, 2015. The expense relating to these RSUs is included in compensation and benefits on the consolidated statements of comprehensive income (loss).

 

11. Income Taxes

 

ZAIS is taxable as a corporation for U.S. tax purposes. The Company’s effective tax rate includes a rate benefit attributable to the fact that the Company’s subsidiaries operate as limited liability companies and limited partnerships which are treated as pass-through entities for U.S. federal and state income tax purposes. Accordingly, the Company’s consolidated financial statements include U.S. federal, state and local income taxes on the Company’s allocable share of the consolidated results of operations, as well as taxes payable to jurisdictions outside the U.S. The tax liability or benefit related to the partnership income or loss not allocable to the Company rests with the equity holders owning such non-controlling interests in ZAIS subsidiaries. As such, the non-controlling interest’s tax liability or benefit is not reflected in ZAIS’s unaudited consolidated financial statements. As a result of the significant variations in the customary relationship between income tax expense and pre-tax accounting income, the Company is unable to estimate the annual effective tax rate for 2015. Consequently, the actual effective tax rate for the interim period is being utilized.

 

The Company’s foreign operations are conducted in “pass-through” entities for U.S. income tax purposes. The Company provides for U.S. income taxes on a current basis for those earnings. The Company’s foreign subsidiaries pay income taxes in the respective foreign jurisdictions, which are included in provision for income taxes.

 

The Company recorded income tax (benefit) expense of $(1,682,000) and $(2,583,000) for the three and six months ended June 30, 2015, respectively, related to U.S. federal, state and local income taxes on the Company’s allocable share of the consolidated results of operations, as well as foreign taxes payable to jurisdictions outside the U.S. related to Company’s foreign subsidiaries. The Company recorded income tax (benefit) expense of $(304,000) and $14,000 for the three and six months ended June 30, 2014, respectively, which were only related to foreign taxes.

 

As of June 30, 2015, the Company had total deferred tax assets of $2,603,000 related to net operating losses and other temporary differences related to the Company’s allocable share of the consolidated results of operations. There were no deferred tax assets or liabilities recorded in the period prior to the Business Combination, as all the earnings were attributable to ZGP, which is taxed as a partnership for U.S. tax purposes, and were allocated to ZGP’s partners. Deferred tax assets are included in deferred tax assets on the accompanying consolidated statements of financial condition.

 

Additionally at June 30, 2015, the Company had deferred tax assets of $784,000 related to ZAIS’s net operating losses and capitalized development stage expenses incurred during the period from its inception and prior to the closing of the Business Combination with ZGP. The Company has established a full valuation allowance on the deferred tax assets of $784,000 as of June 30, 2015 as it continues to analyze the deductibility of these expenses and the resulting tax benefit.

 

32
 

 

The Company’s effective tax rates were 38.92% and 27.17% for the three and six months ended June 30, 2015, respectively. The difference between the U.S. federal statutory rate of 35.0% and the effective tax rates reflected above principally relates to (i) the effect of income and loss included in pre-tax operating income related to non-controlling interests that are not taxable to the Company, (ii) U.S. state and local taxes, which are incremental to the U.S. federal statutory tax rate, (iii) and other permanent differences. In the period prior to the Business Combination, the earnings of the Company related to the operations of ZGP, which is taxed as a partnership for U.S. income tax purposes. The below table provides the reconciliation of the Company’s effective tax rate to the U.S. federal statutory rate.

 

   Effective Tax Rate
– Three months
ended June 30, 2015
   Effective Tax Rate
– Six months
ended June 30, 2015
 
         
Pre-Tax Income   35.00%   35.00%
           
State and Local Income Tax, Net of Fed Benefit   5.57%   3.89%
Other Permanent Differences   0.00%   0.00%
Redeemable non-controlling interests   8.15%   8.18%
Non-controlling interests in Consolidated Funds   2.77%   4.66%
Non-controlling interests in ZGP   -12.57%   -24.56%
           
Total   38.92%   27.17%

 

As of June 30, 2015, and June 30, 2014 the Company did not have any unrecognized tax benefits.

 

12. Related Party Transactions

 

ZAIS Group offers a range of alternative and traditional investment strategies through private accounts and pooled investment vehicles. ZAIS Group earns substantially all of its management fee income and incentive income from the ZAIS Managed Entities, which are considered related parties as the Company manages the operations of, and makes investment decisions for, these entities. The Company considers ZAIS Group’s principals, executives, employees and all ZAIS Managed Entities to be affiliates and related parties.

 

ZAIS Group invests in some of its subsidiaries and some of the ZAIS Managed Entities. Investments in subsidiaries and certain ZAIS Managed Entities that are consolidated are eliminated. Investments in certain ZAIS Managed Entities not consolidated are further described in Note 3.

 

On September 30, 2014, ZGP made a distribution-in-kind to its members of its full partnership interest in ZAIS Value-Added Real Estate Fund I, LP, a Consolidated Fund. The value of the partnership interest at the time of the distribution was approximately $5,310,000 and is reflected as a distribution-in-kind from members’ equity and a corresponding increase to equity attributable to non-controlling interests in Consolidated Funds in the consolidated statement of changes in equity, non-controlling interests and redeemable non-controlling interests. ZAIS Group did not charge management fees or earn incentive income on investments made in the ZAIS Managed Entities (excluding CDOs) by ZAIS Group’s principals, executives, employees and other related parties. The total amount of investors’ capital balances that are not being charged fees are approximately $30,949,000 and $35,304,000 at June 30, 2015 and June 30, 2014, respectively.

 

Additionally, ZAIS Group did not charge management fees or earn incentive income on ZAIS CLO 1 and ZAIS CLO 2 since investments were made in these entities by ZAIS Managed Entities, with existing fee arrangements, representing 100% of the equity tranche of ZAIS CLO 1 and ZAIS CLO 2. The total amounts of asset under management that are not being charged fees are approximately $558,288,000 and $431,858,000 at June 30, 2015 and June 30, 2014, respectively.

 

From time to time, ZAIS Group may pay related research expenses directly to vendors, and subsequently invoices these costs to the respective ZAIS Managed Entities based upon certain criteria. At June 30, 2015 and December 31, 2014, approximately $804,000 and $400,000, respectively, was due to ZAIS Group from the ZAIS Managed Entities as a result of this arrangement. These amounts are included in due from related parties in the consolidated statements of financial condition.

 

In an effort to simplify the corporate structure of ZAIS Group’s operations, ZAISGroup International, LLP transferred, as of August 12, 2014, its business assets, liabilities, operations and staff, as well as its FCA authorization, to a new company named ZAIS Group (UK) Limited. ZAIS Group (UK) Limited is a wholly-owned subsidiary of ZAIS Group, and carries out the same roles and functions from the same premises, and with the same personnel, as ZAISGroup International, LLP had previously carried out.

 

33
 

 

ZGP has entered into a two-year Consulting Agreement with Mr. Ramsey through an entity controlled by Mr. Ramsey (the “Consulting Agreement”), under the terms of which, among other things, Mr. Ramsey will provide consulting services to ZGP, its senior management team and ZAIS, as requested by ZGP’s managing member, from time to time during the 24-month period beginning on, the closing of the Business Combination. Mr. Ramsey may not compete against ZGP during the term of the Consulting Agreement, and for two years following its termination. In consideration for his undertakings under the Consulting Agreement, ZGP will pay Mr. Ramsey a consulting fee of $500,000 per annum payable in monthly installments. ZGP may terminate the Consulting Agreement for cause, as defined in the Consulting Agreement.

 

ZAIS Group is a party to a consulting agreement with Tracy Rohan, Mr. Zugel’s sister-in-law, pursuant to which Ms. Rohan provides services to ZAIS Group relating to event planning, promotion, web and print branding and related services. Pursuant to the consulting agreement, Ms. Rohan earned approximately $29,000 and $32,000 for her services for the three months ended June 30, 2015 and June 30, 2014, respectively. Ms. Rohan earned approximately $58,000 and $63,000 for her services for the six months ended June 30, 2015 and June 30, 2014, respectively.

 

Related Party Transactions of Consolidated Funds

 

For the three months ended June 30, 2014, ZAIS Opportunity Master Fund, Ltd. entered into purchase and sale transactions with Deutsche Bank Securities, Inc., an entity affiliated with the Board of Directors for the ZAIS Opportunity Master Fund, Ltd. Total purchases at fair value of approximately $0, and total sales at fair value of approximately $4,000, with net losses of approximately $459,000 for the three months ended June 30, 2014 were made with this affiliated party.

 

Also, for the six months ended June 30, 2014, ZAIS Opportunity Master Fund, Ltd. entered into purchase and sale transactions with Deutsche Bank Securities, Inc., an entity affiliated with the Board of Directors for the ZAIS Opportunity Master Fund, Ltd. Total purchases at fair value of approximately $0, and total sales at fair value of approximately $4,000, with net losses of approximately $459,000 for the six months ended June 30, 2014 were made with this affiliated party.

  

13. Fixed Assets

 

Fixed assets consist of the following:

 

   June 30,
2015
   December 31,
2014
 
   ( Dollars in thousands ) 
Office equipment  $3,160   $3,073 
Leasehold improvements   944    938 
Furniture and fixtures   584    569 
Software   428    402 
    5,116    4,982 
Less accumulated depreciation and amortization   (4,101)   (3,891)
Total  $1,015   $1,091 

 

For the three months ended June 30, 2015 and June 30, 2014, depreciation and amortization expense amounted to approximately $146,000 and $143,000, respectively. For the six months ended June 30, 2015 and June 30, 2014, depreciation and amortization expense from continuing operations amounted to approximately $208,000 and $236,000, respectively. The change in accumulated depreciation and amortization also includes the change in foreign currency spot rates for each respective period presented.

 

14. Commitments and Contingencies

 

Lease Obligations

 

ZAIS Group is obligated under operating lease agreements for office space expiring through October 2017. The Company recognizes expense related to its operating leases on a straight-line basis over the lease term. Aggregate future minimum annual rental payments for the periods subsequent to June 30, 2015 are approximately as follows:

 

Period   Amount  
    ( Dollars in
thousands )
 
Six Months Ending December 31, 2015   $ 470  
Year Ending December 31, 2016     940  
Year Ending December 31, 2017     730  
    $ 2,140  

 

34
 

 

Rent expense is amortized on a straight-line basis and is included in general, administrative and other in the consolidated statements of comprehensive income (loss). For the three months ended June 30, 2015 and June 30, 2014, rent expense amounted to approximately $282,000 and $421,000, respectively. For the six months ended June 30, 2015 and June 30, 2014, rent expense amounted to approximately $818,000 and $837,000, respectively.

 

Litigation

 

From time to time, ZAIS Group may become involved in various claims and legal actions arising in the ordinary course of business. Management is not aware of any contingencies that would require accrual or disclosure in the financial statements at June 30, 2015.

 

Other Contingencies

 

In the normal course of business, ZAIS Group enters into contracts that provide a variety of indemnifications. Such contracts include those with certain service providers, brokers and trading counterparties. Any exposure to ZAIS Group under these arrangements could involve future claims that may be made against ZAIS Group. Currently, no such claims exist or are expected to arise and, accordingly, the Company has not accrued any liability in connection with such indemnifications.

 

15. Segment Reporting

 

The ZAIS Managed Entities segment is currently the Company’s only reportable segment, and represents the Company’s core business, as substantially all of the Company’s operations are conducted through this segment. The ZAIS Managed Entities segment provides investment advisory and asset management services to ZAIS Group’s private funds, structured vehicles, separately managed accounts and ZAIS Financial Corp., a publicly traded Mortgage REIT.

 

16. Earnings Per Share

 

Shares of Class B common stock have no impact on the calculation of consolidated net income (loss) per share of Class A common stock as holders of Class B common stock do not participate in net income or dividends, and thus, are not participating securities.

 

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted earnings per share:

 

   Three
Months Ended
June 30,
2015
   Three
Months Ended
June 30,
2014
   Six
Months Ended
June 30,
2015
   Six
Months Ended
June 30,
2014
 
   (Dollars in thousands, except shares and per share data) 
Numerator:                    
Consolidated Net Income (Loss), net of tax, attributable to ZAIS Group Holdings, Inc. Class A common stockholders (Basic)  $(2,947)  $20,307(1)  $(3,770)  $26,797(1)
Effect of dilutive securities:                    
Consolidated Net Income (Loss), net of tax, attributable to non-controlling interests in ZGP   (2,231)       (6,745)    
Less: Consolidated Net Income (Loss), net of tax, attributable to ZAIS REIT Management, LLC Class B Members(2)   (283)       (283)    
Income tax (benefit) expense(3)   1,027        2,871     
Consolidated Net Income (Loss), net of tax, attributable to stockholders, after effect of dilutive securities  $(4,434)  $20,307   $(7,927)  $26,797 
Denominator:                    
Weighted average number of shares of Class A Common Stock   13,870,917    7,000,000(5)   8,046,665    7,000,000(5)
Effect of dilutive securities:                    
Weighted average number of Class A Units of ZGP   7,000,000        7,000,000     
Dilutive number of B-0 Units and RSUs(4)                
Diluted weighted average shares outstanding(6)   20,870,917    7,000,000    15,046,665    7,000,000 
Consolidated Net Income (Loss), net of tax, per Class A common share – Basic  $(0.21)  $2.90   $(0.47)  $3.83 
Consolidated Net Income (Loss), net of tax, per Class A common share – Diluted  $(0.21)  $2.90   $(0.53)  $3.83 

 

35
 

 

(1)Consolidated Net Income (Loss), net of tax for all periods prior to the Business Combination is attributable to ZGP Founder Members
(2)Amount represents portion of the management fee income received from ZAIS Financial Corp. that is payable to holders of Class B interests in ZAIS Group’s consolidated subsidiary ZAIS REIT Management, LLC.
(3)Income tax (benefit) / expense is calculated using an assumed tax rate of 40.85%.
(4)The treasury stock method is used to calculate incremental Class A common shares on potentially dilutive Class A common shares resulting from unvested Class B-0 Units granted in connection with and subsequent to the Business Combination and unvested RSUs granted to non-employee directors. These units are anti-dilutive and, consequently, have been excluded from the computation of diluted weighted average shares outstanding.
(5)Refer to Note 2 for the details around the number of units used to calculate earnings per share for periods prior to the Business Combination
(6)Number of diluted shares outstanding takes into account non-controlling interests of ZAIS Group Parent, LLC that may be exchanged for Class A Common Stock under certain circumstances.

 

17. Supplemental Financial Information

 

The following supplemental financial information illustrates the consolidating effects of the Consolidated Funds on the Company’s financial position at June 30, 2015 and December 31, 2014, and results of operations for the three and six months ended June 30, 2015 and June 30, 2014:

  

   June 30, 2015 
   ZAIS   Consolidated
Funds
   Eliminations   Consolidated 
   ( Dollars in thousands ) 
Assets                    
Cash and cash equivalents  $75,198   $   $   $75,198 
Income and fees receivable   2,509            2,509 
Investments in affiliates, at fair value   263        (263)    
Due from related parties   1,047        (25)   1,022 
Fixed assets, net   1,015            1,015 
Prepaid expenses   2,214            2,214 
Deferred tax assets   2,603            2,603 
Other assets   3,232            3,232 
Assets of Consolidated Funds                    
Cash and cash equivalents       18,637        18,637 
Restricted cash       2,201        2,201 
Investments, at fair value       35,799        35,799 
Investments in affiliated securities, at fair value       28,072        28,072 
Derivative assets, at fair value       2,287        2,287 
Other assets       3,544        3,544 
Total Assets  $88,081   $90,540   $(288)  $178,333 
Liabilities, Redeemable Non-controlling Interests and Equity                    
Liabilities                    
Notes payable  $1,252   $   $   $1,252 
Compensation payable   1,578            1,578 
Due to related parties   174            174 
Other liabilities   3,146            3,146 
Liabilities of Consolidated Funds                    
Notes payable of consolidated CDOs, at fair value                
Securities sold, not yet purchased       10,829        10,829 
Derivative liabilities, at fair value       1,138        1,138 
Other liabilities       5,896    (25)   5,871 
Total Liabilities   6,150    17,863    (25)   23,988 
                     
Commitments and Contingencies (Note 14)                    
                     
Redeemable Non-controlling Interests       61,875    (249)   61,626 
                     
Equity                    
Class A Common Stock   1            1 
Class B Common Stock                
Additional paid-in-capital   58,834            58,834 
Retained earnings (Accumulated deficit)   (3,770)           (3,770)
Accumulated  other comprehensive income (loss)   321            321 
Total stockholders’ equity, ZAIS Group Holdings, Inc.   55,386            55,386 
Non-controlling interests in ZAIS Group Parent, LLC   26,545            26,545 
Non-controlling interests in Consolidated Funds       10,802    (14)   10,788 
Total Equity   81,931    10,802    (14)   92,719 
Total Liabilities, Redeemable Non-controlling Interests and Equity  $88,081   $90,540   $(288)  $178,333 

 

 

36
 

 

   December 31, 2014 
   ZAIS   Consolidated
Funds
   Eliminations   Consolidated 
   ( Dollars in thousands ) 
Assets                    
Cash and cash equivalents  $7,664   $   $   $7,664 
Income and fees receivable   11,223        (6,940)   4,283 
Investments in affiliates, at fair value   1,752        (1,648)   104 
Due from related parties   968        (320)   648 
Fixed assets, net   1,091            1,091 
Prepaid expenses   1,543            1,543 
Other assets   3,310            3,310 
Assets of Consolidated Funds                    
Cash and cash equivalents       94,212        94,212 
Restricted cash       30,265        30,265 
Investments, at fair value       1,126,737        1,126,737 
Investments in affiliated securities, at fair value       66,219    (34,762)   31,457 
Derivative assets, at fair value       6,648        6,648 
Other assets       11,599    (22)   11,577 
Total Assets  $27,551   $1,335,680   $(43,692)  $1,319,539 
                     
Liabilities, Redeemable Non-controlling Interests and Equity                    
Liabilities                    
Compensation payable  $6,094   $   $   $6,094 
Due to related parties   32            32 
Other liabilities   3,050            3,050 
Liabilities of Consolidated Funds                    
Notes payable of consolidated CDOs, at fair value       784,481    (34,762)   749,719 
Securities sold, not yet purchased       19,308        19,308 
Derivative liabilities, at fair value       5,785        5,785 
Due to broker       21,047        21,047 
Other liabilities       40,144    (7,281)   32,863 
Total Liabilities   9,176    870,765    (42,043)   837,898 
                     
Commitments and Contingencies (Note 14)                    
                     
Redeemable Non-controlling Interests       452,925        452,925 
                     
Equity                    
Class A Common Stock   1            1 
Class B Common Stock                
Additional paid-in-capital                
Retained earnings (Accumulated deficit)   18,188    1,650    (1,649)   18,189 
Accumulated  other comprehensive income (loss)   186            186 
Total stockholders’ equity, ZAIS Group Holdings, Inc.   18,375    1,650    (1,649)   18,376 
Non-controlling interests in ZAIS Group Parent, LLC                
Non-controlling interests in Consolidated Funds       10,340        10,340 
Total Equity   18,375    11,990    (1,649)   28,716 
Total Liabilities, Redeemable Non-controlling Interests and Equity  $27,551   $1,335,680   $(43,692)  $1,319,539 

 

  

37
 

 

   Three months Ended June 30, 2015 
   ZAIS   Consolidated
Funds
   Eliminations   Consolidated 
   ( Dollars in Thousands ) 
Revenues                    
Management fee income  $4,081   $   $(61)  $4,020 
Incentive income   1,213            1,213 
Other revenues   106            106 
Income of Consolidated Funds       1,365        1,365 
        Total Revenues   5,400    1,365    (61)   6,704 
Expenses                    
Compensation and benefits   7,361            7,361 
General, administrative and other   4,764            4,764 
Depreciation and amortization   146            146 
Expenses of Consolidated Funds       505    (60)   445 
        Total Expenses   12,271    505    (60)   12,716 
Other Income (loss)                    
Net gain (loss) on investments   2        (2)    
Other income (expense)   9            9 
Net gains of Consolidated Funds’ investments       774        774 
        Total Other Income (loss)   11    774    (2)   783 
Income (loss) before income taxes   (6,860)   1,634    (3)   (5,229)
Income tax (benefit) expense   (1,682)           (1,682)
Consolidated net income (loss) , net of tax   (5,178)   1,634    (3)   (3,547)
Other Comprehensive Income (Loss), net of tax                    
Foreign currency translation adjustment   291            291 
Total Comprehensive Income (Loss)  $(4,887)  $1,634   $(3)  $(3,256)

 

   Three months Ended June 30, 2014 
   ZAIS   Consolidated
Funds
   Eliminations   Consolidated 
   ( Dollars in Thousands ) 
Revenues                    
Management fee income  $6,287   $   $(1,218)  $5,069 
Incentive income   36,537        (692)   35,845 
Other revenues   245        (17)   228 
Income of Consolidated Funds       10,181    6,837    17,018 
        Total Revenues   43,069    10,181    4,910    58,160 
Expenses                    
Compensation and benefits   18,126            18,126 
General, administrative and other   4,579            4,579 
Depreciation and amortization   143            143 
Expenses of Consolidated Funds       11,484    (10,666)   818 
        Total Expenses   22,848    11,484    (10,666)   23,666 
Other Income (loss)                    
Net gain (loss) on investments   1,444        (1,435)   9 
Other income (expense)   (101)           (101)
Net gains of Consolidated Funds’ investments       (129,093)   127,235    (1,858)
        Total Other Income (loss)   1,343    (129,093)   125,800    (1,950)
Income (loss) before income taxes   21,564    (130,396)   141,376    32,544 
Income tax (benefit) expense   (304)           (304)
Consolidated net income (loss) , net of tax   21,868    (130,396)   141,376    32,848 
Other Comprehensive Income (Loss) , net of tax                    
Foreign currency translation adjustment   43            43 
Total Comprehensive Income (Loss)  $21,911   $(130,396)  $141,376   $32,891 

 

38
 

 

   Six months Ended June 30, 2015 
   ZAIS   Consolidated
Funds
   Eliminations   Consolidated 
   ( Dollars in Thousands ) 
Revenues                    
Management fee income  $7,834   $   $(120)  $7,714 
Incentive income   2,121            2,121 
Other revenues   137            137 
Income of Consolidated Funds       3,209        3,209 
        Total Revenues   10,092    3,209    (120)   13,181 
Expenses                    
Compensation and benefits   13,931            13,931 
General, administrative and other   9,101            9,101 
Depreciation and amortization   208            208 
Expenses of Consolidated Funds       1,633    (119)   1,514 
        Total Expenses   23,240    1,633    (119)   24,754 
Other Income (loss)                    
Net gain (loss) on investments   45        (45)    
Other income (expense)   7            7 
Net gains of Consolidated Funds’ investments       1,984        1,984 
        Total Other Income   52    1,984    (45)   1,991 
Income (loss) before income taxes   (13,096)   3,560    (46