In February of 2015, the FASB issued ASU 2015-02: Amendments to Consolidation Analysis, which has changed both the variable interest and voting models under ASC 810 Consolidations. The FASB stated that the purpose of the ASU was to address criticism that had been voiced from stakeholders. The primary points of concern were that the existing standard was requiring consolidation of entities in situations in which the reporting entity’s contractual rights do not give it the ability to act primarily on its own behalf, the reporting entity does not hold a majority of the legal entity’s voting rights, or the reporting entity is not exposed to a majority of the legal entity’s economic benefits or obligations. The FASB’s amendments to the consolidation analysis are effective for private companies for years beginning after December 15, 2016.
It is vital that companies assess the impact of this ASU early, as it could lead to changes in the consolidation assessments. The amendment will need to be taken into consideration for financial reporting of existing investments as well as when structuring future transactions on a going forward basis. Given the nature of the amendments, it is clear that this ASU will have a significant impact on the real estate industry.
According to the update, the following areas are affected:
- Limited partnerships and similar legal entities
- Evaluating fees paid to a decision maker or a service provider as a variable interest
- The effect of fee arrangements on the primary beneficiary determination
- The effect of related parties on the primary beneficiary determination
- Certain investment funds
In the real estate industry, there are an abundance of structures that are affected by at least one and, often, more than one, of the above mentioned areas. Most real estate properties and investments are owned by a limited partnership and similar legal entities. In addition, it is common for real estate entities to have fee arrangements associated with real estate property or investments, such as property management fees, asset management fees, incentive fees, etc. These fees are usually contractual between the real estate entity and either an owner or a management company. By rule, if a fee is paid by a real estate entity to an owner, it falls under the category of related party. There are also several real estate entities that fall under the category of investment funds. With the majority of the changes in ASU 2015-02 affecting most of the real estate industry, it is important to understand how the consolidation might change.
In accordance with section 810-10-55-37 of ASU 2015-02, three of the six criteria pertaining to a decision-maker fee, that were previously required to be met in order to qualify as having a variable interest, have been removed. The previous standard required that all of the below listed criteria be met:
- The fees are compensation for services provided and are commensurate with the level of effort required to provide those services.
- 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 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.
- 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.
In ASU 2015-02, the update removes the above Criteria B, E, and F. As a result, there is increased likelihood that having a fee arrangement alone would preclude an entity from having a variable interest in another entity.
Limited Liability Company A (LLC A) is equally owned 33.33% by three limited partners (LPs) and is managed by one general partner (GP). There are no kick-out rights by the LPs, individually, or in the aggregate, to another owner or the GP. The GP’s equity increases from 0% to 20% after a 15% IRR is achieved.
Does this fee result in the GP having a variable interest in LLC A?
- Old standard – Under the old model, LLC A is likely considered a VIE because the anticipated fees of the GP are significant to the total amount of the VIE’s economic performance. Therefore, Criterion E has not been met and likely would qualify as having a variable interest in LLC A.
- New standard – In accordance with ASU 2015-02, fees paid to an entity preclude consolidation if the remaining three criteria from above are met. In the example above, the fee of 8% is at or below market, does not expose the GP to any additional losses or significant residual returns, and the structure of the agreement shares characteristics of an arm’s length transaction.
Under the original standard, when a limited partnership fell under the voting interest model, there was a presumption that the GP had control regardless of their ownership percentage and would therefore consolidate. There were two ways that this could be overcome: if the limited partners had a kick out right or substantive participating rights.
Per the ASU, a limited partnership would only fall under the Voting Interest Model if a simple majority vote of LPs could remove a GP without cause, or if the LPs could exercise substantive participating rights; otherwise the entity would be required to be assessed under the Variable Interest Model. If a limited partnership falls under the voting interest model, the sole circumstance in which consolidation would occur would be when a single LP has a majority of kick-out rights (as described in ASC 810-25-14A/B/C) and no other LP has substantive participating rights (as described in ASC 810-10-25-13), in which case that LP would consolidate the entity. Given that most limited partnerships do not have kick-out or participating rights this will result in more partnerships being VIEs.
GP Change (example 1) –LLC XYZ is equally owned 33% by three LPs and 1% by one GP. The GP can be removed if ALL LPs vote for the removal.
Who would consolidate LLC XYZ?
- Old standard – LLC XYZ would be considered a VIE, and under the voting interest model in the old standard, a GP was presumed to have control over the entity and would consolidate.
- New standard – LLC XYZ would not be a voting interest entity (“VOE”), but rather would first have to determine if the entity was a VIE. In this instance, the entity is a VIE because the kick-out rights are not substantive; they require more than a simple majority. Because kick-out rights are not substantive, the GP would likely consolidate, being that it has the power to direct activities and the right to absorb losses and receive returns, even with only 1% ownership.
- What if instead of all LPs needing to vote for the removal of the GP only the vote of one assigned LP is needed? Under the old model, this is a VOE. But, because the GP can be removed by one partner, no one has the ability to consolidate. Under the new model, this is still a VOE and because the one LP can remove the GP, that LP would consolidate.
Related Party Primary Beneficiary Determination
Under the old standard, interests held by the company’s related parties were required to be treated as though they belonged to the company for the purposes of evaluating the primary beneficiary designation. Consistent with the theme of this ASU, limitations were added to the required related party considerations with regards to the primary beneficiary assessment.
Under the update, only when a company has a direct interest in an affiliate that has a direct interest in the entity under consideration would further analysis be required. Additionally, the ASU introduced the concept of indirect interest; whereby, if the company owns a 30% interest in an entity that owns a 50% interest in the entity under consideration, the company would consider its indirect interest to be 15% when performing the VIE other economic interest analysis. If, however, the company and the related party were under common control, the full related party interest would be used in the VIE analysis.
Related Party Example – LLC Go is equally owned 33% by three LPs and 1% by one GP. There are no kick-out rights by the LPs, individually or in the aggregate, to another owner. In addition, LP B is owned 60% by the GP and is deemed to be a related party.
Is the GP the primary beneficiary?
- Old standard – The GP would have to directly take the entire 60% ownership of the LP when assessing the power criterion of the primary beneficiary test.
- New standard – The GP accounts for its ownership of LP B under the indirect method, and therefore has a 19.8% interest (60% of 33%) in LLC Go. The 19.8% plus the 1% are used in determining the power criterion of the primary beneficiary test.
Certain Investment Funds
It should be noted that for certain investment funds, under the old standard the entity was able to defer the consolidation standard. Under the new guidance, the funds are forced to complete the same analysis as a limited partnership or a similar entity. The deferral was previously established to allow time for the FASB to develop a standard that was relevant and maintained the proper amount of transparency for users of the financial statements. The new guidance provides a scope exception for investment funds that are required to comply with Rule 2a-7 of the investment company act of 1940.
Considerations When Structuring Deals
The result of this ASU is that there will be a reduction in entities requiring consolidation going forward. For real estate companies that prefer to consolidate investments, additional attention needs to be paid to the new requirements when structuring deals to ensure the desired treatment is in compliance with GAAP.
- GPs or managing members will no longer automatically be consolidating limited partnerships or similar entities.
- When investing in real estate joint ventures where related parties are involved, the indirect interest assessment provides greater flexibility when looking to avoid consolidation.
- Despite the ASU simplifying the related party assessment, given that the real estate industry commonly structures their companies and investments in ways that involve related parties (investment funds, management companies, etc.), it is vital to understand the relationship, and if entities are under common control.
- Investment funds are required to go through the VIE analysis and can no longer defer FAS 167.
- A deal structured with an equity promote for the managing member compared to a fee, requires the managing member to have the ability to complete the VIE analysis.