The Impact of Revised Consolidation Guidance on Asset Managers
Determining whether or not an asset manager is required to consolidate its managed funds has long been an industry issue. The purpose of financial statement reporting is to provide management, investors, creditors and other users information on an entity to allow them to make informed business and economic decisions and to gauge the entity’s past, present or projected future performance. While transparency is important, and understanding the relationships with related and controlled entities is a must, consolidating all activity into one financial statement may end up confusing users of the financial statements, and financial results may also be misinterpreted by such users.
Financial statement users have expressed concern to the Financial Accounting Standards Board (FASB) that certain situations requiring asset managers to consolidate the investment funds they manage may lead to financial statements that are not relevant on a consolidated basis. Users asserted that deconsolidated financial statements are preferred, to allow them to better understand and analyze a reporting entity’s operational and economic results. Currently, asset managers (even those that may hold small equity stakes, yet direct the significant activities of the funds they manage primarily on behalf of fund investors) are required to consolidate such managed funds. As a result of this, many asset managers have elected to issue financial statements with a departure from U.S. generally accepted accounting principles (“GAAP”) in order to achieve this result.
To address the concerns of financial statement users, the FASB issued Accounting Standards Update (ASU) 2015-02: Consolidation (Topic 810), Amendments to the Consolidation Analysis (the "ASU" or "Amendment"). The ASU, among other things, introduces changes to the consolidation model that will likely result in fewer instances of consolidation of investment funds by general partners and managing members. The update specifically impacts certain investment funds, limited partnerships and similar legal entities. The ASU was issued in February 2015 and is effective for public business entities for fiscal years beginning after December 31, 2015, and for all other entities, for fiscal years beginning after December 15, 2016, with early adoption permitted. Upon adoption of the ASU, a reporting entity is required to reevaluate all previous consolidation decisions under the revised consolidation model. An entity may apply the amendments in the ASU using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption or may apply the amendments retrospectively.
It is important to note that the ASU does not impact the treatment of an investment company's reporting of non-investment company investments. Investments made by an investment company, a hedge fund for example, in non-investment companies continue to be accounted for at fair value in accordance with the accounting guidance as illustrated by ASC Topic 946. ASU 2015-02 does, however impact asset managers, and more specifically management companies managed by such asset managers, including management companies providing services to an investment company entity (e.g., an asset manager or general partner) and ends the deferral of certain provisions of the consolidation guidance previously granted to asset managers.
The changes introduced by the ASU are not limited to any particular industry. All reporting entities that hold a variable interest in other legal entities will need to reevaluate their consolidation conclusions and potentially revise their disclosures. This process may be time consuming, particularly for reporting entities with large numbers of VIEs and for those that need to apply an entirely new consolidation model to the assessment (for example, many limited partnerships and reporting entities that hold variable interests in investment funds previously subject to an indefinite deferral of certain provisions of the consolidation guidance). The update eliminates the deferrals of Financial Accounting Standards No. 167 ("FAS 167") which required reporting entities with interests in investment funds to follow the consolidation guidance of FASB Interpretation No. 46 ("FIN 46 (R)"). The Amendment impacts both the variable interest entity (VIE) and the voting interest entity consolidation models (from previous consolidation accounting guidance), while not changing the order in which they are applied. The reporting entity must first determine if the entity [Fund] under consideration for consolidation into the reporting entity constitutes a VIE under the VIE model, and if so whether the reporting entity holds a controlling financial interest of the entity under the model. If the entity [Fund] being evaluated is determined not to be a VIE, then the voting interest entity model should be applied in determining the primary beneficiary, having a controlling financial interest in the entity [Fund], and therefore leading to the conclusion that consolidation is required.
Key Amendments to the Standards
Significant changes highlighted in the ASU are as follows:
- The consolidation guidance no longer applies to money market funds registered with the SEC pursuant to Rule 2a-7 of the Investment Company ACT of 1940 ("1940 Act") (registered money market funds) and similar unregistered money market funds; however new disclosures regarding financial support are required.
- As noted above, it is important to mention that the update does not change the definition of a variable interest or the methodology for applying the VIE model. The reporting entity is still required to first determine whether it holds a variable interest in an entity, whether the underlying entity is a VIE, and if the entity is a VIE, whether the reporting entity is the VIE's primary beneficiary.
- The ASU removes the presumption that a general partner should consolidate limited partnerships and similar entities that are not VIEs (currently ASC 810-20 and formerly known as EITF 04-5) and removes three of the six criteria that must be considered in determining whether a decision maker's fee arrangement constitutes a variable interest. Under the amended standard, the fee arrangement will not be considered a variable interest if all three of the following criteria are met:
- The fees are compensation for services provided and are commensurate with the level of effort required to provide those services
- The decision maker or service provider does not hold other interests in the VIE that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE's expected losses or receive more than an insignificant amount of the VIE's expected residual returns
- The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm's length
- Substantially all of the fees are at or above the same level of seniority as other operating liabilities of the VIE that arise in the normal course of the VIE's activities, such as trade payables
- The total amount of anticipated fees are insignificant relative to the total amount of the VIE's anticipated economic performance
- The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE's anticipated economic performance
- The ASU also modifies the way in which equity holder power (the FASB views the rights held by limited partners in a partnership as analogous to voting shares in a corporation), or lack thereof, to direct the activities that most significantly impact an entity's economic performance is analyzed in determining whether a limited partnership is a VIE. Limited partnerships are required, under the amendment, to determine whether the limited partners have power via substantive kick-out rights, or participating rights, excluding the General Partner's rights. A kick-out right is the ability to remove the entity with the power to direct the activities of a VIE that most significantly impact the VIE's economic performance or to dissolve (liquidate) the entity without cause. A participating right is the ability to block the actions through which a reporting entity exercises the power to direct the activities of a VIE that most significantly impact the VIE's economic performance. The lack of substantive participating rights or substantive kick-out rights requiring not more than a simple majority to remove the general partner would lead to the conclusion that the entity is a VIE for purposes of consolidation.
- In performing the consolidation analysis under the VIE model, the determination of which party has a controlling financial interest and therefore the
requirement to consolidate have not changed and include both (1) the power to direct the actives of a VIE that most significantly impact the entity's
economic performance (Power) and (2) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to
receive benefits from the VIE that could potentially be significant to the VIE (Exposure). Under the ASU, a reporting entity that is determining whether it satisfied the benefits criterion will now be able to exclude the majority of fees that meet the following conditions:
- The fees are compensation for services provided and are commensurate with the level of effort required to provide those services
- The compensation arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services negotiated at arms' length
- Under the Amendment, a reporting entity must now consider whether a single variable interest holder has the power to direct the activities of a VIE that most significantly impact its economic performance, or whether power is shared amongst two or more parties. In certain instances where a single decision maker has power but no benefits, it must be taken into consideration whether one or more of the variable interest holders are under common control. If under common control, as a group, the variable interest holders have benefits. In such instances, the party in common control that is most closely associated with the VIE is deemed to be the primary beneficiary and should consolidate. The following criteria is required to be met when a single decision maker individually does not satisfy the characteristics of a primary beneficiary and is also not under common control with one or more entities that, as a group, has the characteristics of a primary beneficiary:
- The single decision-maker and one or more variable interest holders are related parties or de facto agents and as a group they have the characteristics of a primary beneficiary
- Substantially all of the activities of the VIE are conducted on behalf of a single variable interest holder that is a related party or de facto agent of the decision-maker
While numerous factors and considerations must be made in determining the outcome of an entity's consolidation analysis, a common outcome of the revised guidance may be the deconsolidation of a General Partner ("GP") entity (typically the asset manager or management company). For entities in which the GP was required to consolidate under the variable interest model due to fee relationships, the modifications under the update may trigger the use of the voting interest model, particularly in cases where compensation is negotiated at arms' length and fees are compensation for services provided commensurate with the level of effort required. Under the voting interest model, due to the typical GP's insignificant ownership interest, in comparison to that of Limited Partners ("LPs"), the determination may lead to deconsolidation. Therefore, as a result of the Amendment, limited partnerships that are considered voting interest entities would not be consolidated by the general partner.
In conclusion, a reporting entity must make the determination as to whether the variable interest model or voting interest model applies and then subsequently whether or not consolidation is appropriate. Under ASU 2015-02, there are numerous factors impacting a Company's requirement to consolidate a limited partnership or similar entity, including fee arrangements, kick-out and participation rights held by limited investors, interests held by related parties and the Company's own ownership interest in the entity. The Amendment was issued to simplify the consolidation analysis performed and may lead to a consolidation determination in fewer instances; however, the determination will have to be reassessed upon adoption as well as at each reporting period taking into consideration the guidance discussed above.
Upon adoption, this ASU may have a significant impact on an entity's consolidation conclusion, and it may also impact financial statement disclosure, as upon adoption, all reporting entities are subject to reevaluation. The ASU does not amend the existing disclosure requirements for variable interest entities or voting interest entities; however, it does require new disclosures for reporting entities that have explicit arrangements to provide financial support to such entities.