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Fund Spy

How Will You Play the PPIP?

Early predictions about the Treasury's Public-Private Investment Program were silly, but interesting options are in the works.

Talk is cheap, and, sadly, the written word often is cheap, too. There were plenty of both in late March, when the Treasury announced plans to launch the Public-Private Investment Program (PPIP, these days pronounced pee-pip). A good seven minutes had gone by before predictions were flying about who was going to manage the money and what investment vehicles would be the likeliest beneficiaries of the program.

The speculation frankly wasn't helped by statements attributed to the U.S. Treasury suggesting that the "opportunity" to own distressed assets from the nation's sickly banks should be broadly disbursed so that John Q. Public could "get in" and make a killing like the big guys. Never mind that the same complex and troubled debt that cratered bank balance sheets might not be quite suitable for a good number of small investors with holes in their 401(k)s and home prices.

Particularly odd was the repeated touting of mutual funds and exchange-traded funds as the likeliest buyers. Even if the PPIP were to eventually pump some tangible liquidity into the market, mutual funds would be a lousy fit for the assets that banks are likely to sell. Just ask the bond-fund managers who had their backs against the wall in 2008 as relatively modest outflows wreaked havoc with their asset allocations, forced them to sell the liquid bonds that they liked best, drove up their expenses, and perversely made their portfolios even riskier. The fervor and frenzy around ETFs was truly perplexing given the litany of reasons that they're such an improbable and poor fit, as Morningstar ETF specialist Bradley Kay discussed extensively in a recent piece. Then it became more apparent that some of the starry-eyed talk was wishful thinking coming from people wedded to the ETF industry.

OK, but How about a Little Something for the Effort?
How are PPIP assets likely to make their way into investor portfolios? The first stop will almost certainly be limited partnerships structured like hedge funds or private equity investments. The former, in particular, are the easiest vehicles to get up and running fast, require little regulatory legwork, and can be customized with just about any feature--such as leverage or a lockup period--that would mesh well with the PPIP. In fact, several firms have already signaled their intentions to buy PPIP assets, and buzz in the industry, the press, and the blogosphere suggest that BlackRock, PIMCO, and Western Asset Management might consider rollouts of both hedge funds and closed-end funds.

Of most interest to the average investor, though, will be closed-end funds. A relatively moribund structure during the heady days when liquidity was "sloshing around the globe," the closed-end fund represents just about the most desirable balance between the wants and needs of asset managers and the broadest swath of individual investors.

Here's why. Asset managers get to run a pool of assets that can be leveraged to a reasonable limit (initially by as much as 50% of net assets or 150%, by statute), and that will normally enjoy a very stable asset base in perpetuity, notwithstanding planned tenders or liquidation. Those features theoretically benefit investors, too, particularly by sidestepping the risk that other investors' redemptions will hobble an investment strategy and its performance. Yet because they're usually exchange-traded, investors can get in and out of closed-end funds with relative ease.

Yes, as Bradley Kay's article alludes, it would be great to enjoy the intended benefits of an arbitrage mechanism--minimal premiums and discounts--that really make the ETF a sort of modern, much-improved version of the closed-end structure. But it's the absence of that very arbitrage feature that makes the latter more desirable in this case. Volatile ETF-style cash flows would be nearly impossible to manage in the context of an illiquid portfolio and, absent a very fluid market for the underlying holdings, would lead to the very same premiums and discounts that closed-end funds are likely to feature. Meanwhile, closed-end funds offer most of the same regulatory and governance protections afforded by open-end mutual funds.

Investing Outside the Box
One of the more interesting and unusual ideas that we've heard lately, though, revolves around creating real estate investment trusts to buy PPIP assets. A REIT would in many ways resemble a closed-end fund, particularly in terms of its income distribution and taxation, but would have the ability to carry much more leverage, thereby making it potentially much riskier and also much more lucrative. But while REITs are subject to regulatory schemes that govern most corporations with publicly traded stock, they're not subject to the arguably more stringent oversight afforded by the Investment Company Act of 1940. That makes it potentially less cumbersome for an asset manager, but also less secure for the investor comforted by regulatory oversight.

It's too early to say which investment vehicles will present the most compelling options to get in on what many hope will be a PPIP-fueled bonanza. There are a few different ways in which PPIP assets may make it to market, the highest profile of which involves five asset managers chosen by the U.S. Treasury to run pools comprising both investor and government money. Those firms were set to be notified on May 20, but their identities won't be made public until final terms are worked out with the Treasury.

Plans also call for investors beyond those five to get access to TALF funding from the Federal Reserve, though. (It stands for Term Asset-Backed Securities Loan Facility.) It's still not clear when either program will really get off the ground, but expectations are that we'll begin seeing progress some time this summer or early fall. And while there are good reasons to believe that PPIP-focused offerings could generate lush returns, we'd implore investors to maintain a skeptical eye on the choices they consider and to become increasingly skeptical as the choices become less plain-vanilla. Closed-end funds run by major investment firms, for example, promise some level of clarity and oversight. Particularly given the appeal of the hedge fund structure in this case, though, there are likely to be plenty of small operators with questionable qualifications trying to get in on the action, pitching ill-designed funds with high fees and structures that favor themselves--rather than their investors. Notwithstanding the generous returns that a leverage-fueled, distressed-asset recovery might produce, the old investing saw will still apply: If it looks too good to be true, it probably is.

Mutual fund analyst Michael Herbst contributed to this article.