VIEs and Consolidation for Investment Managers: A Roadmap

Published: Mar 20, 2014
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Overview
This article summarizes:

When a general partner of a private investment fund (“Fund”) must consolidate the Fund for financial reporting purposes under existing U.S. generally accepted accounting principles (“GAAP”); and,
Recent developments in the long-running “consolidation project” at the Financial Accounting Standards Board (“FASB”) expected to result in issuance of a new accounting standard that will introduce significant changes in the criteria that a general partner would apply in determining whether to consolidate a Fund.

The term “general partner” is used in this article to refer collectively to reporting entities that have a relationship to a Fund that is the functional equivalent of a general partner or investment manager, such as the managing member of an LLC.

Background
FASB Accounting Standards Codification Topic 810 Consolidation (the “Consolidation Topic”) establishes criteria for analyzing entities for consolidation when preparing financial statements in conformity with GAAP.

As a general rule, all entities in which a parent has a controlling financial interest should be consolidated in the parent’s financial statements. The usual condition for a controlling financial interest is ownership by a reporting entity, directly or indirectly, of more than 50% of the outstanding voting shares of another entity.

However, there are entities for which analysis of voting interests, and the holdings of those voting interests, is not the relevant criteria in determining whether a controlling financial interest exists because the entity under consideration does not have adequate equity capital or the equity instruments do not have the typical characteristics of equity that provide its holders with a potential controlling financial interest. Such entities are called variable interest entities (“VIE”).

Application to General Partners and Funds
Depending on its facts and circumstances, a Fund may or may not be a VIE. Consequently, in analyzing a Fund for consolidation, a general partner must first determine whether the Fund is a VIE and, therefore, within the scope of the Variable Interest Entities subsection of the Consolidation Topic. If, after applying the VIE guidance, the general partner determines the Fund is not a VIE (and therefore not within the scope of the Variable Interest Entities subsection of the Consolidation Topic), the general partner must apply guidance in the Control of Partnerships and Similar Entities subsection of the Consolidation Topic to determine whether the rights of the limited partners in the Fund overcome the presumption that the general partner controls, and therefore should consolidate, the Fund.

Determining Whether a Fund is a VIE
In 2009 the FASB issued Accounting Standards Update (“ASU”) 2009-17 which amended earlier guidance and would have revised the criteria that a general partner considers in determining whether a Fund is a VIE and, if so, whether it is the primary beneficiary of a variable interest in the Fund.

In response to comments from the investment management industry, expressing concern that the amendments would result in unduly burdensome requirements and unexpected consequences, particularly for advisors to mutual funds, the FASB in 2010 issued ASU 2010-10 which indefinitely deferred application of ASU 2009-17 for entities that meet both of the following conditions:

The Fund applies the specialized accounting of Topic 946 (“investment company accounting” whereby investments are measured at fair value with changes in fair value recognized in the statement of operations).
The reporting entity and its related parties are not required to fund losses of the Fund that could potentially be significant to the Fund, including through explicit or implicit guarantees.

Although a general partner may have unlimited liability with respect to a Fund, for purposes of meeting the condition for deferral, it would not be considered to be exposed to losses of the Fund that could potentially be significant to the Fund when the general partner is an entity that has few or no assets other than its interest in the Fund and the Fund’s creditors have no recourse to the assets of the owner(s) of the general partner.

Because the deferral was expressly designed to apply to most mutual funds, hedge funds, real estate investment funds and venture capital funds, the remainder of this article addresses the scenario wherein a Fund qualifies for the deferral and discusses the determination of whether a Fund is a VIE, and whether the general partner is the primary beneficiary of a variable interest in the Fund, when the application of ASU 2009-17 does not apply.

The fundamental concept is that a Fund is a VIE if any one of the following conditions exist:

The Fund does not have sufficient equity to finance its activities on its own. Generally, an equity investment at risk (i.e., contributed capital) of less than 10% of a Fund’s total assets would not be considered sufficient to permit the Fund to finance its activities without subordinated financial support in addition to the equity investment.
As a group, the Fund’s investors lack the power to direct the legal activities of the Fund, the obligation to absorb the expected losses of the Fund or the right to receive the expected residual returns of the Fund.
The voting rights of some investors are not proportional to their economic interests and substantially all of the Fund’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights.
- In our experience, condition one is rarely present unless a Fund is highly leveraged by design. Conditions two or three might be present when the general partner, together with related investors under common control, has an insignificant equity investment in the Fund but has the power to direct the activities that most significantly affect the economic performance of the Fund and/or the limited partners, as a group, do not have the right to remove, or kick out, the general partner for any reason. In any event, careful analysis of the specific facts and circumstances is necessary to determine whether a Fund is a VIE.

Upon concluding that a Fund is a VIE, a general partner must further analyze its relationship with the Fund to determine if it is the primary beneficiary of a variable interest, in which case consolidation would be indicated. Conversely, if the Fund is not a VIE, and therefore not within the scope of the Variable Interest Entities subsection of the Consolidation Topic, the general partner must consider whether consolidation of the Fund is required by the Control of Partnerships and Similar Entities subsection of the Consolidation Topic (see the relevant section later in this article).

Determining Whether the General Partner is the Primary Beneficiary of a Variable Interest in the Fund
If a Fund is a VIE, the general partner must determine whether it is the primary beneficiary of a variable interest in the Fund. A variable interest is a contractual, ownership or other interest that changes with changes in the fair value of the Fund’s net assets. Common examples of a general partner’s variable interest in a Fund include the general partner’s capital account (equity investment) in the Fund and a carried interest that allows the general partner to participate in the profits of the Fund based on changes in the fair value of the Fund’s net assets.

Just because the general partner determines that it holds one or more variable interests in a Fund that is a VIE does not necessarily lead to a conclusion that it must consolidate the Fund. Consolidation is only indicated if the general partner is the primary beneficiary of one or more variable interests in a Fund that is a VIE.

A VIE usually has only one (and possibly no) primary beneficiary, which is defined as the party that has the obligation to absorb a majority of the Fund’s expected losses, receive a majority of its expected residual returns, or both.

In the context of a typical Fund, a carried interest arrangement combined with the general partner’s equity investment would be considered in evaluating whether it has the obligation to absorb a majority of the expected losses, receive a majority of the expected residual returns, or both. In making this determination, equity investments by related parties or “de-facto agents” must be considered (for example, limited partner interests belonging to the general partner or under common control with the general partner).

If the general partner is not the primary beneficiary of one or more variable interests, the Fund should not be consolidated and no further analysis is required.

Control of Partnerships and Similar Entities
A Fund that is not a VIE based on the analysis described previously in this article must be evaluated for consolidation under the Control of Partnerships and Similar Entities subsection of the Consolidation Topic (specifically, Topic 810-20, which follows the consensus reached by the Emerging Issues Task Force in Issue No. 04-5). Topic 810-20 presumes that a general partner controls a partnership regardless of its equity interest and must therefore consolidate unless there exist substantive kick-out rights.

Kick-out rights in this instance are substantive if they can be exercised by a single limited partner or a vote of a simple majority of the partners and there are no significant barriers to exercising those rights. Note that this definition of what should be considered “substantive” reflects amendments subsequent to the original issuance of Issue No. 04-5.

Retention of Investment Company Accounting in Consolidated Financial Statements
If required to consolidate a Fund, GAAP generally provides that the specialized industry accounting principles applied at the Fund should be retained in consolidation. Accordingly, general partners typically retain in their consolidated financial statements the specialized investment company accounting followed by the Fund.

Recent Developments
The FASB is currently deliberating a proposed ASU: Principal versus Agent Analysis. Of special interest to the investment management industry, the proposed standard introduces significant changes in the criteria that a general partner would apply in determining whether to consolidate a Fund. Consequently, we anticipate there may be instances in which a general partner that currently consolidates a Fund will no longer be required to do so when the criteria in the proposed standard is applied.

The proposed standard defines an agent as a party that acts on behalf of and for the benefit of another party or parties (the principals) and, therefore, does not control the entity when it exercises its decision-making authority. Thus, decision-making authority (power) may be held and exercisable by an agent on behalf of a principal.

Under the proposed standard, a general partner would determine whether it should consolidate the Fund by evaluating whether it has the ability to use its decision-making authority as a principal or an agent. If the general partner uses its decision-making authority in a principal capacity, it must consolidate the Fund. If the general partner does not use its decision-making authority in a principal capacity, consolidation would not be required.

As a result, rather than focusing on whether a simple majority of the limited partners hold substantive kick-out rights, a general partner would consider the overall relationship between itself, the Fund being managed and the other parties involved with the Fund when evaluating whether it is exercising its decision-making authority as a principal or an agent. In particular, all of the factors below must be considered, but are not necessarily equally weighted or must all be present, in this evaluation:

The rights held by other parties.
The compensation to which the general partner is entitled.
The general partner’s exposure to variability of returns from other interests that it holds in the Fund.

Rights held by other parties – The determination of whether kick-out rights are substantive and would affect the analysis of whether the general partner is a principal or an agent is based on a consideration of all relevant facts and circumstances. For kick-out rights to be considered substantive, the limited partners holding the kick-out rights should have the ability to exercise those rights if they choose to do so; that is, there are no significant barriers to the exercise of the rights. When a single party (including its related parties) holds a substantive kick-out right (or other rights that have a similar effect on the general partner’s ability to exercise its power) and can remove the general partner without cause, this, in isolation, is sufficient to conclude that the general partner is not a principal. In general, the greater the number of unrelated parties required to act together to exercise rights to remove a general partner, and the greater the magnitude of, and variability associated with, the general partner’s other economic interests, the less weighting that is placed on this factor. Conversely, the lack of such kick-out rights, in isolation, is not conclusive that the general partner is a principal.
Compensation – Absent an equity investment in the Fund, the proposed standard suggests that a typical compensation arrangement would not necessarily lead to a conclusion that a general partner is acting in a principal capacity. To illustrate, assume an example of a Fund in which the general partner earns a 2% asset-based management fee and a performance-based carried interest of 20% of the Fund’s profits but does not otherwise hold an equity investment in the Fund. Even absent substantive kick-out rights, the general partner in this scenario likely would conclude that it is not using its decision-making authority in a principal capacity and is therefore not required to consolidate the Fund.
Economic interests in the Fund – The greater the magnitude of, and variability associated with, the general partner’s economic interests, the more likely the general partner is using its decision-making authority in a principal capacity. Consequently, holding an equity investment in a Fund indicates that the general partner may be a principal. A general partner must therefore consider (together with the interests of related parties) the magnitude of, and variability associated with, those interests in assessing whether it is a principal or an agent. To illustrate, assume the same facts as in the example described in the preceding paragraph expanded to include the general partner having an equity investment in the Fund. In this scenario, the general partner’s exposure to economic variability through its equity investment might be deemed sufficient to conclude that the general partner is using its decision-making authority in a principal capacity and must therefore consolidate the partnership.

The implementation examples described above suggest there will be instances, particularly when a general partner has little to no equity investment in a Fund, in which consolidation will not be required. Conversely, it remains to be seen whether additional guidance will emerge to assist in evaluating at what point the percentage of equity interest in a Fund held by the general partner and related parties will tip the scales to require consolidation.

The bottom line is, stay tuned for the final release of guidance in this area as it will introduce substantive changes for the investment management industry. The FASB is expected to release its final standard in the second half of 2014, though the effective date of the final standard has not been specified. In the meantime, general partners must continue to follow existing GAAP in evaluating Funds for consolidation.