Consolidations of Collateralized Financing Entities

Introduction

Financial statements and financial reporting, in general, are designed to provide investors, management, creditors, and other users information about an entity that allows them to make informed economic and business decisions, as well as to gauge the entity’s past, present, and projected future performance. Accounting guidance that requires consolidation of related investment vehicles and managed funds, however, can cloud the transparency of the financial statements with confusing detail.

Financial statement users expressed concern to the Financial Accounting Standards Board (“FASB”) relating to certain situations requiring asset managers to consolidate the investment funds they manage, indicating that the requirement may lead to financial statements that are not relevant on a consolidated basis. The FASB addressed these concerns by issuing Accounting Standards Update (“ASU”) 2015-02 Consolidation (Topic 810): Amendments to the Consolidation Analysis (refer to Marcum’s Winter 2016 article, “The Impact of Revised Consolidation Guidance on Asset Managers”). The issue was again revisited recently with the issuance of ASU 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities. For entities other than private companies, ASU 2018-17 is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The update is effective for private companies for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. All entities are required to apply the update retrospectively with a cumulative-effect adjustment to retained earnings in the earliest period presented. Early adoption is permitted.

This article highlights one type of investment vehicle and the challenges posed when applying the consolidation rules: collateralized financing entities (CFEs). Many non-financial professionals have heard about these through the movie “The Big Short.” CFEs can be complex, are highly regulated, and under certain circumstances, may be required to be consolidated into an asset (or collateral) manager’s financial statements. A CFE is defined as an asset-backed financing or securitization entity typically with no substantive business purpose other than to issue beneficial interests in the financial assets it holds. Some examples of CFEs are collateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”).

Generally, a CFE is classified as a variable interest entity due to its capital structure, qualitatively indicating that there is not enough equity investment at risk. Once the investment manager has identified that the CFE is a variable interest entity (VIE), the manager is required to analyze the CFE both qualitatively and quantitatively to determine if consolidation is required. The typical cycle of a CFE includes planning, warehousing, marketing, pricing, closing, and effective date. The consolidation analysis below primarily focuses on the closing date in the CFE’s life cycle.

Consolidation Analysis

When an asset manager oversees a collateralized financing entity, the manager must ask the following questions to determine if consolidation of the entity into the financial statements is required:

1. Is there a variable interest in the CFE?

If the asset manager does not have a variable interest (ie: a variable interest could be equity, debt, guarantee, certain fees/other interests), then consolidation is precluded and no further analysis is required. The asset manager’s evaluation of variable interests should focus on (1) whether the fees are compensation for services provided and commensurate with the level of effort required to provide the services, (2) whether the asset manager has any other direct or indirect interests that absorb more than an insignificant amount of the CFE’s variability, and (3) whether the arrangement’s terms are customary with arrangements for similar services negotiated at arm’s length. If the asset manager holds certain senior, mezzanine, and subordinated notes, it most likely will have a variable interest in the CFE.

Another example would be an asset manager that guarantees an entity’s outstanding debt. The guarantee provides the asset manager with a variable interest in the legal entity because the value of the guarantee changes with changes in the fair value of the legal entity’s net assets.

ASU 2018-17 was issued in the last quarter of 2018 and allows all indirect interests held through related parties, regardless of these related parties being under common control or not, to be considered proportionately in the determination of whether certain fees represent a variable interest. For example, if the asset manager owns 15 percent in a related party (regardless of common control) and the related party owns 50 percent of the residual tranche of the CFE under evaluation, the asset manager’s interest would be a 7.5 percent direct interest in the residual tranche. For further technical guidance, please refer to ASC 810-10-55-37.

2. Is the CFE a variable interest entity (VIE)?

An entity is classified as a variable interest entity if it meets any one of the following characteristics:

1. If the legal entity in question is not sufficiently capitalized with equity investors that participate in profits and losses to permit the entity to finance its expected activities without additional subordinated financial support. Collateralized loan obligations, for instance, are generally capitalized with notes; thus no equity is at risk as of the closing date, and the entity would be considered a VIE.
2. The holders of the CFE lack any one of the following three characteristics of a controlling financial interest:


1. The power to direct the activities that have the most significant impact on the economic performance of the CFE. It can be implied that a party other than the equity investors likely controls the entity.
2. The obligation to absorb the expected losses of the CFE. The investor does not have that obligation if it is directly or indirectly protected from the expected losses or is guaranteed a return by the CFE itself or by other parties involved with the CFE.
3. The right to receive the expected residual returns of the CFE. The investor does not have that right if its return is capped by the CFE’s governing documents or arrangements with other variable interest holders or the entity.

3. If the CFE is a VIE, is the asset manager the primary beneficiary (“PB”) of, and therefore should consolidate, the VIE? The asset manager is a PB if it has both of the following characteristics:

1. The power to direct the activities of a VIE that most significantly impacts the VIE’s economic performance. In most cases, the asset manager will have the power to direct the activities; however, there are instances where the asset manager may not have the power. For example, if all significant decisions require the approval of unrelated parties, the asset manager manages a minority portion of the assets in the VIE, or the asset manager can be removed as the asset manager without cause by an unrelated entity (i.e., kick-out rights). As stated earlier, these are not the norm, but there can be instances where one of these conditions exists.
2. The obligation to absorb the losses of or receive benefits from the VIE, that potentially could be significant to the VIE. If the fees the asset manager collects are considered a variable interest due to the asset manager having other direct interests (or indirect interest through a related party) that are significant economic interests in the CFE, then it could meet the criteria of a PB.

4. If the CFE is not a VIE, is the CFE a voting interest entity (“VOE”), and does the asset manager have a controlling financial interest?

For entities that are not VIEs, the usual condition for a controlling financial interest is ownership of more than 50 percent of the outstanding voting shares. Under the provisions of the ASU, all majority-owned subsidiaries (i.e., all companies in which a parent has a controlling financial interest through direct or indirect ownership of a majority voting interest) must be consolidated unless control does not rest with the majority owner. Further, if stipulated in the by-laws or other governing documents, it’s possible that more than a simple majority may be required for major decisions.

Accounting Treatment

Once the consolidation analysis has been completed, the work has just begun! If the CFE does not require consolidation, the asset manager must determine the accounting for the interests it holds in the CFE. In most instances, the CFE interests will meet the definition of a debt security; therefore, the accounting treatment will follow ASC 320, Investments – Debt and Equity Securities. The asset manager will have the ability to elect the fair value option. If the manager decides to forego electing the fair value option, it will need to determine if the interests are to be classified as trading, available for sale, or held to maturity.

If the CFE is required to be consolidated, then the asset manager needs to determine if it can elect the measurement alternative as prescribed by ASU 2014-13. To eliminate the measurement differences that often arise when financial assets and financial liabilities of a CFE are measured at fair value under the requirements of ASC 820, due to varying factors including liquidity discounts and duration mismatches, the FASB issued ASU 2014-13. This ASU provides a measurement alternative for entities that consolidate CFEs. Under this alternative, to simplify the reporting, an entity may elect to measure both the CFE’s assets and its liabilities by using the fair value of the more observable of either, thus eliminating the measurement differences between the financial assets and financial liabilities. Once the asset manager has made its election on how to account for its interests in the consolidated CFE, the next step is to combine similar accounts and eliminate intercompany balances and transactions between the two entities (including fees paid to the asset manager and receivables and payable due to/from each of the entities). All necessary information needs to be obtained from the CFE’s trustee to prepare the statement of cash flows and required disclosures on the investments and terms. Remember to include all relevant footnotes for both entities.

Conclusion

Consolidating a collateralized financing entity can be a daunting task; however, Marcum LLP is here to assist you along the way. If you are an asset manager that has collateralized financing entities and is required to report under Generally Accepted Accounting Principles (GAAP), it is important that you go through the outlined steps above to determine if consolidating your CFE is required under the standards. If you have any questions, please contact your advisor at Marcum LLP.