TCW faces key test on ability to retain investors

Institutional investors in TCW Asset Management's distressed mortgage limited partnership funds will decide over the next two weeks whether to exit the funds or accept a new management team.

Los Angeles-based TCW gave investors in its Special Mortgage Credits Fund I and II until Feb. 19 to decide whether to remain in the mortgage-backed securities funds or liquidate their investments.

Their decision could be a signal of TCW's ability to keep institutions as investors after the termination of Jeffrey E. Gundlach, the former chief investment officer for fixed income.

The Dec. 4 termination of Mr. Gundlach triggered the limited partnership funds' key-man provision. Mr. Gundlach and his team managed both institutional-only funds with a combined $3 billion.

Later that month, Mr. Gundlach formed his company, DoubleLine Capital LP, Los Angeles, with members of his former TCW team.

TCW was required by the terms of the partnerships' documents to select a new manager within 90 days after Mr. Gundlach's departure. The funds will be invested by specialist mortgage portfolio managers from TCW and Los Angeles-based Metropolitan West Asset Management, which TCW is in the process of acquiring, according to a Jan. 25 letter obtained by Pensions & Investments. The letter was sent by TCW to the more than 200 limited partners.

TCW is offering big fee concessions to investors that decide to remain. The management fee will be reduced to 1% from 2% and the performance fee to 5% from 20% for the remaining term of the funds, which have a private-equitylike structure.

TCW's client letter reminded investors that the MBS funds' agreements permit TCW to manage the fund for its entire term — until July 2015 — after a “key person event.”

TCW spokeswoman Erin Freeman said in an e-mail response to a request for comment about the fund changes: “We have been engaged in an extensive dialogue with the limited partners of SMCF I and II funds. This dialogue has led us to propose amended terms that will offer investors significant flexibility and enhanced terms. We have great confidence in the new investment team.”

In addition to the liquidation option, TCW offered investors two ways to remain in the funds. Both featured reduced fees, shortened investment terms and the ability to liquidate after 18 months. The first option allows the funds' managers to make new investments; the second option does not.

According to the letter, the reduced fee schedule also applies to the total liquidation option. In the letter, TCW said it expected “to liquidate this portfolio within a month after the option becomes effective, subject to market conditions, but in any event, within six months.”

So far, investors said they are evaluating their options.

“I've spent the last six weeks trying to figure out what was going on with TCW, MetWest and DoubleLine. Now it's time to assess the non-agency residential mortgage-backed securities marketplace and get conviction about where it's going. Is it time to trim back or to ride it out? The decision about staying in these funds or going will be based on our conviction,” said Robert L. Borden, chief investment officer of the $25 billion South Carolina Retirement System Investment Commission, Columbia.

In May 2008, the South Carolina fund pension fund committed $750 million to TCW for a credit-oriented strategic partnership that included $280 million split evenly between the two SMCFs.

According to a limited partner who insisted on anonymity, other investors in the SMCFs include the pension funds of Textron Inc., United Technologies Corp., the San Diego County Employees Retirement Association and South Dakota Investment Council; the endowments of the University of Virginia, Vanderbilt University, Northwestern University and Howard Hughes Medical Institute; foundations including The Ford Foundation and The Kresge Foundation; and money management firms Grosvenor Capital Management LP, Commonfund and APG Group.

The limited partner who requested anonymity plans to liquidate, predicated on a decision to get out of the mortgage asset class.

“In Q4 2007 and Q1 2008, I bought into three funds that were investing in distressed mortgages. ... At the end of 2009, all three funds had total returns of flat to down 10% after being spectacularly down in 2008 and spectacularly up in 2009. In hindsight, I invested too early into the developing credit crisis — my timing was poor,” the investor said.

“In the TCW proxy, I opted for choice No. 3, calling for an end to the reinvestment period and an orderly liquidation. ... I trust the professional abilities of the current TCW team to manage an orderly liquidation of the portfolio and will reinvest the cash in better opportunities. I'll take my chips and move on.”

The anonymous investor predicted most of the limited partners will make the same choice to liquidate, “suggesting it would be foolhardy to vote for choice No. 1 or No. 2 and remain an investor” that would end up with “the tailings” — the securities that remain in the fund after the first-round liquidation.

Some investors prefer an alternative to TCW's quick liquidation option.

Larry Swartz, chief investment officer of the $4.2 billion Fairfax County (Va.) Retirement Systems, said he thinks many investors probably would prefer liquidation that includes a transfer of in-kind securities that could be moved in-house or to another manager.

Fairfax County has a total of $62 million in SMCF I and II and another $250 million in TCW's Strategic Mortgage-Backed Securities strategy through a separate account. Mr. Swartz said the Fairfax investment staff is evaluating the investments.

“They're asking us to choose between a fire sale of assets now at whatever price they can get or an unwinding of the fund over time. We're not inclined to choose the fire-sale route, but the final decision is up to the board,” Mr. Swartz said.

Mr. Gundlach, who is also a limited partner of the funds, said in an interview that many limited partners in the Special Mortgage Credits funds have asked him what to do about the funds. He said it was “ironic that TCW investors are coming to me for advice. TCW refuses to give investors the investment they signed up for, that is, with my team managing it. TCW is subordinating investors' interests to its own commercial interests.”

He would not say how much he has invested in the two funds or which option he will select.

Sources said whatever the limited partners decide will serve as a sign of TCW's ability to retain institutional investors after the brouhaha surrounding Mr. Gundlach's departure.

Several prominent institutional investors already have terminated TCW, including the $32.1 billion Colorado Public Employees Retirement Association, Denver, which in December cut the firm for a $425 million mortgage-backed securities separate account managed by Mr. Gundlach's team. Spokeswoman Katie Kaufmanis declined to give the reason for the termination, but noted that staff is managing the securities internally.

The $11.6 billion Kansas Public Employees Retirement System, Topeka, and the $16 billion Texas Municipal Retirement System, Austin, terminated TCW for personnel changes in its core-plus fixed-income strategies, which included mortgages managed by Mr. Gundlach.

The Kansas fund had $463 million in the strategy, while the Texas system invested $350 million.