Asset Management Intelligence - May 2015 - Consolidation for Investment Managers

NEW CONSOLIDATION GUIDANCE ADDRESSES CONCERNS OF THE INVESTMENT MANAGEMENT INDUSTRY

Background

The consolidation analysis required under existing Generally Accepted Accounting Principles (“GAAP”) is complex and often results in general partners having to consolidate investment funds that they manage even when they  hold a small equity stake and direct the significant activities of the fund primarily on behalf of investors.  Stakeholders have expressed dissatisfaction with this consolidation model, asserting that in many instances, deconsolidated results would provide users of a reporting entity’s financial statements with information that better reflects the financial position and performance of the entity.

In response to those and other concerns, the Financial Accounting Standards Board (“FASB”) has issued Accounting Standards Update No. 2015-02 Consolidation: Amendments to the Consolidation Analysis (ASU 2015-02) which, among other things, introduces changes to the consolidation model which will likely result in fewer instances of consolidation of investment funds by general partners and managing members. 

Key Changes Affecting Limited Partnerships and Similar Entities

1. More limited partnerships (or similar entities) are likely to be considered variable interest entities (“VIEs”); however, it is less likely that the general partner of such entities will be required to consolidate them.
2. The presumption in current GAAP 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) is eliminated.
3. Limited partnerships that are considered voting interest entities would not be consolidated by the general partner.
4. The deferral of ASU 2009-17 (often referred to as the “FAS 167 deferral”) is eliminated. 

The New Model for Evaluating Limited Partnerships (or Similar Entities) for Consolidation Under ASU 2015-02

Variable Interests
The first step in determining whether a general partner needs to consolidate a limited partnership or similar entity is to determine whether the general partner holds any “variable interests.”  Generally speaking, a variable interest is a contractual, ownership, or other interest that changes with changes in the fair value of the entity’s net assets.  Under existing GAAP, a general partner would often conclude that its equity interests in the limited partnership it manages and certain fees, such as incentive and management fees, are variable interests.  ASU 2015-02 reduced the number of conditions that must be met in order to conclude that a fee paid to a decision maker is not a variable interest; it retained the following three criteria in making this determination: a) whether the fees are commensurate with the level of effort required for the services provided; b) whether the general partner has any direct or indirect interests in the limited partnership that absorb more than an insignificant amount of the entity’s variability; and c) whether the arrangement includes customary terms only.  We expect that this change will result in fewer fee arrangements being considered variable interests.

Variable Interest Entities
Next, a general partner must determine whether the entity being considered for consolidation is a VIE. Under ASU 2015-02, limited partnerships and similar entities are classified as VIEs unless a simple majority (or lower threshold) of limited partners with equity at risk lack substantive kick-out rights (including liquidation or participation rights).  As a result, a greater number of limited partnerships and similar entities in the investment management industry are expected to be evaluated for consolidation as VIEs under the new guidance.

If the limited partners or investors in similar entities have substantive kick out rights or participating rights, the entity is a voting interest entity.  Under ASU 2015-02, a general partner would not consolidate a limited partnership that is a voting interest entity.

Primary Beneficiary
Once the determination has been made that the general partner holds variable interest(s) in the limited partnership under consideration for consolidation and that the limited partnership is a VIE, the final step is to determine whether the general partner is the primary beneficiary.

The Effect of Fee Arrangements on the Primary Beneficiary Determination

An entity is considered the primary beneficiary of a VIE if it has both (1) the power to direct the activities of the VIE that most significantly affect performance and (2) the obligation to absorb losses of and the right to receive benefits from a VIE that could potentially be significant to the VIE.

In an attempt to reduce the frequency with which investment management firms are required to consolidate the limited partnerships they manage, ASU 2015-02 excludes from the analysis of (2) above fees that are both customary and commensurate with the level of effort required for the services provided.  In other words, compensation arrangements such as management fees and carried interests/incentive allocations will no longer be considered variable interests if they include only customary terms and are at market rates.  Accordingly, under ASU 2015-02, the primary beneficiary determination will focus almost entirely on the extent to which the general partner and related parties hold equity investments in the partnership being analyzed for consolidation.   

The Effect of Related Parties on the Primary Beneficiary Determination

Under the new guidance, an investment management firm considers its own direct interest(s) together with any indirect exposure through related parties on a proportionate basis when evaluating whether it is required to consolidate a limited partnership or similar entity.  This is a significant change from current practice, in which a reporting entity must evaluate indirect exposure through related parties as if those interests are its own (i.e., not on a proportionate basis).

ASU 2015-02 retains the existing related party analysis if the reporting entity and its related party are under common control, in which case the reporting entity must consider the interests of the related party under common control as its own (i.e., not on a proportionate basis) when analyzing whether it is required to consolidate a limited partnership or similar entity.  For purposes of this analysis, common control refers to subsidiaries controlled (directly or indirectly) by a common parent, or a subsidiary and its parent.

Transition

ASU 2015-02 is effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015.  For all other entities, it is effective for fiscal years beginning after December 15, 2016.  Early adoption is permitted.  Importantly, upon adoption of ASU 2015-02, a reporting entity is required to reevaluate all previous consolidation decisions under the revised consolidation model.  An entity may apply the amendments in ASU 2015-02 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.

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