WEBVTT
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00:00:04.719Thought Leadership from PWC's National Office.
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00:00:11.839Hello, and welcome to PWC's Accounting Podcast.
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00:00:13.279I'm Heather Horn.
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00:00:33.039Today we're continuing our back to basic series on consolidation accounting, where we're revisiting some of our favorite conversations with Matt Sabatini, a deputy chief accountant in PWC's national office, and Alexander Martin, a partner in PWC's Steel's practice, to break down the framework step by step.
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00:00:49.039In our first episode, we covered some of the background on the consolidation framework, including the two consolidation models under US GAP, an overview of the VIE model, and the first step in that analysis, determining whether a scope exception applies.
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00:00:56.719In today's episode, we move to the next step, determining whether the entity is a variable interest entity or VIE.
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00:01:14.560Matt and Alexander start with some important groundwork, including understanding the purpose and design of the entity, identifying variable interests and at-risk equity, and then they walk through the characteristics used to determine whether an entity is a VIE.
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00:01:23.599This is one of those areas where the details can add up quickly, but having that foundational understanding makes the rest of the analysis much easier to follow.
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00:01:27.680With that, let's listen to my conversation with Matt and Alexander.
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00:01:30.640We're going to be talking about step two of that model, right?
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00:01:34.640So I think Matt broke it down into three easily digestible steps, right?
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00:01:36.319When we're applying the VIE framework.
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00:01:41.680So step one that we talked about last episode was determining if a scope exception applies, right?
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00:01:46.640If not, then we're at step two where we have to figure out whether the entity is a VIE, right?
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00:01:51.680And specifically, there's five characteristics that the FASB laid out, and we're going to walk through each one of those.
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00:01:52.799All right, perfect.
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00:02:01.040So with that then, again, just level setting, we're assuming we have a legal entity and that none of the scope exceptions apply.
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00:02:05.359And so long story short, though, I'm in scope of ASCE 10.
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00:02:16.159And just a reminder to listeners that you do have to evaluate if you have a VIE before you just jump straight to the VOE or voting model.
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00:02:18.560So that's an important reminder we talked about last time.
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00:02:21.759So with all that said then, Matt, what does step two look like?
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00:02:22.240Right.
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00:02:28.000So step two is like Alexander said, determining whether or not the entity itself is a variable interest entity.
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00:02:32.879And I know we keep saying there's three simple or easy steps, but we're totally lying when we say that.
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00:02:33.520Exactly.
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00:02:34.000Thank you.
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00:02:36.319Because there are lots of little steps in between.
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00:02:38.800Um, and we're just hiding them into the bigger steps.
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00:02:39.280Yes.
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00:02:40.879Well, and none of them are simple.
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00:02:41.840So Right.
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00:02:51.280Because you're going to be uh annoyed when I say I'm not really going to jump into the first characteristic just yet and identifying whether something is a variable interest entity, because we have to do a few things first.
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00:02:52.000Oh, yes.
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00:02:52.240Okay.
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00:02:53.599That I was not prepared for that.
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00:02:54.960I know.
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00:02:56.400Um that's because we hit it.
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00:03:03.680So the And just for our listeners' benefit, even the heading of this section is called determine if the entity is a VIE.
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00:03:04.560So Yeah.
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00:03:05.840So we're hiding it even from you.
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00:03:06.159Yes.
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00:03:06.719Thank you.
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00:03:07.120All right.
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00:03:10.319Well, because again, we're just trying to make uh make this a little bit easier to follow.
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00:03:13.759So it's it's easier to get your head around three steps than it is 16 steps.
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00:03:15.840Um so we're burying this in step one.
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00:03:20.479But this is a very important kind of precursor to evaluating the five characteristics.
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00:03:32.240Um the first thing I'll say is it's very important, and this is one of the changes the FASB made back in um 2009-ish, was really focusing on what the purpose and the design of the entity is um that you're looking at.
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00:03:41.919Um, the reason why, right, is because generally we're thinking about entities here where there's um significant rights or significant economics that are held outside of the equity interest.
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00:03:43.680Um, and we want to understand why, right?
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00:03:45.360We want to understand why the entity was set up that way.
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00:03:46.560What was it designed to achieve?
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00:03:48.159What are its operations?
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00:03:56.719Um, because that's really the only way to understand how these contractual relationships or these outside of the equity interest relationships um mean anything, right?
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00:03:59.360And whether or not they should be determining who should consolidate.
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00:04:17.680So, so because of this, right, the the VIE guidance is really focused on understanding structure of the entity, understanding um who holds what interests uh and in what form, um, understanding things that maybe aren't necessarily interests in the entity, but are interests around the entity.
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00:04:22.639So you're gonna want to look at relationships between kind of interest holders in the entity as well.
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00:04:29.839Um, all of this is is really coming down to what we're doing now is identifying what are the variable interests in the entity.
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00:04:33.439And the reason we were holding off on this is the terminology does get confusing, right?
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00:04:41.360Because you can hold a variable interest, which is really a contractual relationship in an entity, but that interest, that entity might not be a variable interest entity, right?
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00:04:45.040So that that's why, again, we wanted to try to introduce this concept slowly.
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00:04:47.680Um when I say variable interest, I'm gonna simplify it, right?
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00:04:49.120Because it really is what I've been talking about.
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00:04:55.920It's a contractual relationship or an interest in an entity that exposes you to some kind of economic um risk or reward, right?
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00:05:06.240So it's really something like an interest where the other way to think about it is an interest where the value of that contract that you hold changes based on the changes in the value of the entity's assets.
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00:05:06.720Okay.
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00:05:08.959Simplest example is equity.
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00:05:14.399And now we're talking a lot about equity being important in the voting model, but it can also be important in the variable interest model.
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00:05:16.160So equity is a contract, right?
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00:05:19.519It gives you the rights to the residual economics in an entity.
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00:05:24.560Um, its value changes very much proportional to how the value of the assets in the entity changes.
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00:05:30.639So you're the holder of the equity, the value of your instrument is going to be directly related to the value of the entity itself.
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00:05:32.319Therefore, it's a variable interest.
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00:05:33.040All right.
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00:05:34.079That makes sense.
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00:05:38.800Any other examples you could give, though, that kind of could help people get their head around it?
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00:05:45.759I, of course, immediately jump to power contracts, but maybe you would like to give something outside of the power and utilities industry.
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00:05:48.160Yeah, I think those are the hardest ones to try to describe.
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00:05:50.800So only because I don't come from that industry.
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00:05:53.920Um, yeah, I mean, I I'll give you a concept first, right?
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00:06:02.079And again, to try to help people understand it's generally things that you would think about as being on the right side of the balance sheet or on the credit side of the balance sheet.
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00:06:17.519So I've mentioned equity, so common and preferred, those are things that are exposed to economics of the entity, but also uh debt guarantees, um, whether subordinated or senior, the value of those instruments, again, are related to the value of the assets of the entity, and they're on the right side of the balance sheet.
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00:06:20.800So those are generally pretty simple examples of what variable interests would be.
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00:06:27.920I mean, harder ones would be things like put and call options, um, other derivative instruments, leases.
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00:06:33.839Those really depend on the nature of the contract itself and what the design of the entity is.
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00:06:37.839Because sometimes those are exposed to economic risks and rewards of the entity.
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00:06:40.240Sometimes those are the things that create value in the entity.
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00:06:41.040And that's really where it's.
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00:06:50.319I'm jumping ahead.
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00:06:52.160So it's it's it's it's okay.
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00:07:09.680And we do in our consolidation guide, which we've mentioned a couple of times on the on the previous episode, we have a pretty good listing of examples of things that are oftentimes variable interest, things that may be variable interest, and kind of some qualitative guidance around how to think about some of the more complicated uh contractual relationships with entities.
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00:07:14.000Um, what one of the examples that always sticks out in my mind is uh a decision maker contract.
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00:07:17.600It's not something that like an everyday person understands really what that is, right?
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00:07:18.720But maybe a management.
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00:07:19.600Exactly.
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00:07:20.240Exactly.
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00:07:26.720So the best way to think about it is a management agreement or or anything that gives you the ability to kind of exercise power over the assets of the entity, right?
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00:07:30.319So it could be in the powering utility space where you have an OM agreement.
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00:07:31.920Maybe that's a decision maker contract.
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00:07:39.120We frequently see it in asset management um space where the investment manager, the GP, um has the ability to control what kind of investments.
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00:07:42.480Yeah, I think hotels sometimes have these types of arrangements as well.
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00:07:43.199Absolutely.
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00:07:46.319And and oftentimes those those can be variable interests.
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00:08:00.160But again, you're looking at the the nature of the contract itself and the guidance has specific criteria to work through, which we're not getting into in a ton of detail, but it really does relate to pricing, uh exposure to economics, and whether or not you have other variable interests in the entity.
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00:08:06.240But those decision-maker contracts may or may not be variable interests, and that has a huge impact on your on the rest of the analysis.
00:08:06.720 -->
00:08:13.360So then, Matt, just maybe one other point here that when you're thinking about these interests, it's not every interest you need to think about.
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00:08:14.399So that's right.
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00:08:17.600I think you would ignore generally things that are non-substantive.
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00:08:27.839So terms and conditions that don't have any substance to them really shouldn't weigh into your thinking about the purpose and design of the entity or whether or not the contractual relationship is a VI, because you would ignore things that are non-substantive.
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00:08:29.839So the guidance actually specifically says that.
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00:08:40.720And there's another section in the guidance, which I think is helpful, that says you don't necessarily rely on the legal or accounting determination or characterization of a contract to tell you whether or not something is a variable interest.
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00:08:42.159Um, so that's also helpful.
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00:08:48.159It's really dependent on looking at the entity itself and again, understanding its purpose and design when making uh making that call.
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00:08:48.559All right.
00:08:48.639 -->
00:08:54.320So long story short, sometimes it's obvious that something's a variable interest, other times you need more analysis.
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00:09:02.799But either way, you need these variable interests to have a variable interest entity, but you can have variable interests and not have a variable interest entity.
00:09:02.879 -->
00:09:03.440Is that fair?
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00:09:04.000Yes.
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00:09:04.639All right.
00:09:04.799 -->
00:09:06.879So we kind of, I think, got through that.
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00:09:10.960Although clearly, if someone is dealing with that, they might need to look for more guidance.
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00:09:15.039But let's assume we've passed the test, we do have variable interests.
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00:09:19.679So then, Alexander, going back to you, then now are we going to the five characteristics?
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00:09:21.279Unfortunately, not yet, right?
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00:09:22.639We still have some more to do.
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00:09:22.960Okay.
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00:09:29.919But are these stuffs like 2.negative one and 2.0 or something like that?a.
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00:09:31.519Exactly.
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00:09:33.919No, so we we do all of this to Matt's point, right?
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00:09:43.120There's the reason the guidance was written was basically to try to figure out, okay, I need to understand the structure and design of the entity, and that requires us to basically look at almost everything, right?
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00:09:52.320And so I will say the silver lining is the upfront homework that we're gonna do is actually gonna pay off later because the later steps in the model assume that you already did this.
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00:10:00.480So our later episode is gonna be a lot more streamlined because we're just gonna reference, hey, remember when we said the variable interests, this is what you got to do with them when you're looking at them.
00:10:00.559 -->
00:10:02.559So our next step though, right?
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00:10:06.399Um, we we identified all of the variable interests in the entity.
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00:10:11.840Right now we need to figure out if we actually have one, if our interest constitutes a variable interest, right?
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00:10:16.240So um, if not, right, this is the good news, I can stop my analysis, right?
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00:10:20.480You you have to have a variable interest in an entity in order to consolidate it.
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00:10:30.480So if I had something like a management contract that Matt had mentioned, and I determined it wasn't a variable interest based on the criteria, and that was my only interest in the entity, then I get to stop, right?
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00:10:32.399I get to go home and party, right?
00:10:32.559 -->
00:10:39.519But if not, right, then assuming I do have a variable interest, then I have to then determine who the at-risk equity group is.
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00:10:40.960Again, I'm using my air quotes here.
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00:10:41.360Yeah.
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00:10:44.799So can I just go back to this management contract for a moment?
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00:10:58.320So then one thing I think that can be confusing is it sounds like what you said is that in some cases, for example, you could have a management agreement and it could be a variable interest, but in other cases a management agreement may not be.
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00:11:00.399So it's not always sort of cut and dried.
00:11:00.559 -->
00:11:03.519So what can you just give an example on each side of that?
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00:11:04.000Sure.
00:11:04.159 -->
00:11:11.600So the an example where let's say I have a plain vanilla management agreement where I'm managing the assets of a real estate entity, right?
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00:11:15.120And and I'm getting paid as let's say actually a property manager, right?
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00:11:17.679And I'm just getting paid a market rate.
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00:11:20.960And, you know, if I do my job, I get my paycheck and that's it.
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00:11:27.039I don't have any other interests in the entity, then the guidance would say that's probably not a variable interest, right?
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00:11:28.799You're basically just a service provider.
00:11:29.039 -->
00:11:40.159A different example would be, hey, I'm a property manager, but if the entity loses money, then my fees are slashed, or I may even have to come out of pocket and pay some penalties, right?
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00:11:44.240In that case, you are exposed to the downside risk in the entity.
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00:11:47.120So that probably would be considered a variable interest.
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00:11:47.679All right.
00:11:47.759 -->
00:11:54.000And one thing here, I've been thinking this even in our last episode, but this is not about sustainability.
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00:11:56.639So we're not going to talk deeply about sustainability here.
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00:12:05.679But I do think it's important for listeners that there is an intersection here with the um considerations of your organizational boundaries for a sustainability perspective.
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00:12:07.039That's a whole other episode.
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00:12:11.840But I just every time you guys mention something, it kind of clicks with those frameworks as well.
00:12:11.919 -->
00:12:18.879So I just want to remind our listeners that the sustainability reporting and accounting are not completely separate ideas.
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00:12:20.720So good public service announcement.
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00:12:21.759Exactly.
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00:12:22.399Thank you.
00:12:22.639 -->
00:12:23.039All right.
00:12:23.200 -->
00:12:24.720So let's keep going though, here.
00:12:24.879 -->
00:12:35.360So we've now said we have a legal entity, we don't meet a scope exception, the entity itself has variable interests, and we have a variable interest in the entity.
00:12:35.759 -->
00:12:39.840So the next step is to identify quote at risk equity.
00:12:40.159 -->
00:12:40.480That's right.
00:12:40.639 -->
00:12:41.039That's right.
00:12:41.200 -->
00:12:44.480So when we get into the test, which I promise we will, right.
00:12:44.879 -->
00:12:53.200Um, all of the tests really you'll see are kind of designed or centered around basically trying to determine whether the equity behaves like traditional equity, right?
00:12:53.360 -->
00:13:01.039And so all the tests are really asking, okay, well, do the equity holders have this characteristic or can the equity holders do that, right?
00:13:01.279 -->
00:13:03.360Which again should make sense, right?
00:13:03.440 -->
00:13:05.200That's the whole point of this guidance, right?
00:13:05.360 -->
00:13:10.960If if if we can use equity as an indicator of control, and then we can apply the voting model, right?
00:13:11.120 -->
00:13:19.360But when we're doing this analysis and they're saying, can equity do this or does equity have that characteristic, it makes sense to define what we're talking about when we're saying equity.
00:13:19.440 -->
00:13:21.120So that's what the FASBI did, right?
00:13:21.200 -->
00:13:26.639They created a specific definition of equity to use in these VIE tests, and they called it equity at risk.
00:13:26.799 -->
00:13:29.679Sometimes, you know, people say at risk equity, but same thing, right?
00:13:29.759 -->
00:13:31.120It's a very specific definition.
00:13:31.279 -->
00:13:36.399So in order to qualify for equity at risk, right, an investment has to have two things, right?
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00:13:37.279High level.
00:13:37.519 -->
00:13:41.679The first one, it needs to be classified as equity uh under US gap, right?
00:13:41.759 -->
00:13:43.919So this one's generally straightforward, right?
00:13:44.000 -->
00:13:48.159If it's reported as gap equity in the financial statements, it meets this characteristic, right?
00:13:48.320 -->
00:13:56.639But if you have something like redeemable preferred stock that's classified as a liability under US gap, then even though it's legal form equity, it's not gap equity.
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00:13:58.720So it wouldn't meet this criterion.
00:13:58.960 -->
00:14:01.519The second one is then I got my gap equity.
00:14:01.600 -->
00:14:04.480I need now need to determine whether it's at risk, right?
00:14:04.639 -->
00:14:09.840And so there's a few criteria here, but the real idea is that it needs to act like traditional equity.
00:14:09.919 -->
00:14:14.000So it needs to participate in both the upside and the downside in the entity.
00:14:14.159 -->
00:14:17.360And the the other one is that the the holder needs to have skin in the game.
00:14:17.440 -->
00:14:20.399So they need to they needed to pay for their equity interest, right?
00:14:20.480 -->
00:14:25.679That their interest can't be financed for them either by the entity or other people involved with the entity.
00:14:25.919 -->
00:14:35.200So an example of this that we typically see come up is around sweat equity, where an investor is granted equity for either their past efforts or future efforts that they're going to provide to the entity.
00:14:35.360 -->
00:14:38.639The question is, okay, well, is that sweat equity at risk?
00:14:38.799 -->
00:14:43.039And the answer is no, because that equity was financed for the investor.
00:14:43.120 -->
00:14:45.360So it's it's viewed as being not at risk.
00:14:45.679 -->
00:14:48.960And I think just to clarify, I want to make sure this is right.
00:14:49.200 -->
00:14:55.360If we are talking about this at-risk equity, we don't have to be the holder of the at-risk equity.
00:14:55.440 -->
00:14:56.639So I have a variable interest.
00:14:56.720 -->
00:15:01.519We gave this example of the management contract where I have downside risk, no upside risk.
00:15:01.759 -->
00:15:08.559So if I was just thinking, oh, that doesn't meet this at risk, but what you are saying is no, this is an overall evaluation.
00:15:08.639 -->
00:15:11.039Does anyone have at-risk equity?
00:15:11.279 -->
00:15:14.879That's right, because it's going to come into play later on the specific characteristics.
00:15:15.039 -->
00:15:20.799The characteristics are going to say, do the equity at risk holders have this characteristic?
00:15:21.279 -->
00:15:23.919And that's going to dictate whether or not the entity is a VIE.
00:15:24.000 -->
00:15:28.960So even if our interest isn't an at-risk equity interest, we still need to know it to do the VIE tests.
00:15:29.200 -->
00:15:29.440All right.
00:15:29.519 -->
00:15:34.480And then another question, follow-up question is I actually just did an episode with Chip Curry.
00:15:34.559 -->
00:15:36.399We were talking about mezzanine equity.
00:15:36.480 -->
00:15:37.679So how does that fit in?
00:15:37.840 -->
00:15:40.320Do you consider it as equity or do you consider it as debt?
00:15:40.399 -->
00:15:46.080Because as listeners to the episode will know, it can be both, or not at the same time, but one or the other.
00:15:46.399 -->
00:15:47.519Yeah, it's a great question.
00:15:47.679 -->
00:15:50.399Um, the short answer is it depends, right?
00:15:50.559 -->
00:16:02.799So even though they're technically considered gap equity, you have to look at all of the characteristics uh and understand the instrument in a bit more detail to understand if it would be considered at risk for VIE purposes, right?
00:16:02.879 -->
00:16:07.759And there's there's a lot of other questions that come up with whether certain instruments are viewed as at-risk equity or not.
00:16:07.919 -->
00:16:16.240But the big takeaway is that you you do have to have an understanding and identify the at-risk equity group because that's the baseline that we're using to do the testing.
00:16:16.480 -->
00:16:16.960All right.
00:16:17.200 -->
00:16:26.559So, and it sounds like that's something we can save again for another podcast, or someone could look at our very excellent consolidation guide for more information about that.
00:16:26.879 -->
00:16:28.960So I'm almost afraid to ask.
00:16:29.039 -->
00:16:35.600I think we've gone through either two or three steps since we said we were going to start talking about step two in the model.
00:16:35.679 -->
00:16:37.279So that math doesn't quite work.
00:16:37.360 -->
00:16:41.600But are we now finally ready to evaluate the characteristics of a VIE?
00:16:41.840 -->
00:16:43.039So, yeah, we're ready to go.
00:16:43.200 -->
00:16:51.519Um, we've identified the at-risk equity holders, um, and we've identified which equity in the entity is considered at risk.
00:16:51.679 -->
00:16:58.240The reason I said it like that is because not only do we want to know who holds the equity at risk, we want to understand how much equity at risk there is.
00:16:58.320 -->
00:17:00.799Um, and that gets us into characteristic one, right?
00:17:00.960 -->
00:17:06.559Really evaluating the entity itself to see if it has sufficient equity at risk.
00:17:06.720 -->
00:17:16.319And what I mean by that is it has to have enough equity at risk to allow the entity to finance its current operations without additional subordinated financial support.
00:17:16.480 -->
00:17:18.480That's a defined term in GAAP.
00:17:18.559 -->
00:17:25.119I'm never going to use it again on this podcast, I promise, because it doesn't really have a satisfying definition in GAAP.
00:17:25.200 -->
00:17:28.000Um, so I'm gonna try to explain to you what it means, right?
00:17:28.240 -->
00:17:35.839Um, so when we're looking at this characteristic, and remember the whole fundamental concept here is we're trying to figure out if the voting model should apply or the VIE model should apply, right?
00:17:36.079 -->
00:17:39.839Voting model relies on voting rights with common equity.
00:17:40.000 -->
00:17:44.000Well, if there's not a substantial amount of common equity, why would we look to the voting rights?
00:17:44.160 -->
00:17:47.279It doesn't really make a lot of sense to let that dictate who should consolidate.
00:17:47.519 -->
00:17:59.279Um I guess, Matt, just to simplify here, you're basically saying is there a party that has money that they could lose if something goes wrong or that can make a ton of money if something goes right.
00:17:59.599 -->
00:18:01.359I want to make sure that that party is an equity holder.
00:18:01.599 -->
00:18:01.759Right.
00:18:02.000 -->
00:18:04.000And not some other instrument holder.
00:18:04.319 -->
00:18:04.720You got it.
00:18:04.880 -->
00:18:05.039Right.
00:18:05.119 -->
00:18:07.599And I want to make sure there's enough of that equity that's at risk.
00:18:08.000 -->
00:18:12.799Because if there's just a very small amount, then the voting rights should probably and often are meaningless.
00:18:12.960 -->
00:18:13.119Right.
00:18:13.440 -->
00:18:17.359Because somebody else really is is calling the shots if they're the ones exposed to most of the risk.
00:18:17.759 -->
00:18:17.920Right.
00:18:18.000 -->
00:18:20.559And I think we talked about this in the last episode.
00:18:20.880 -->
00:18:35.440And this does not just apply to structured entities, but sometimes I think it is helpful to think of it in that context where you have this very structured entity, very minimal equity, all the decisions and all the interests are held by people other than the equity holders.
00:18:35.839 -->
00:18:37.440It's sort of a classic example.
00:18:37.839 -->
00:18:38.000Right.
00:18:38.079 -->
00:18:46.720If you remember before the uh Fin 46R rules came out, everyone said, well, 3% equity is enough for an SPE to be um not consolidated, right?
00:18:46.799 -->
00:18:50.720And that's kind of where this one criteria evolved from, right?
00:18:50.880 -->
00:18:56.400Was three percent equity is not enough uh for an entity to be not consolidated.
00:18:56.640 -->
00:18:56.799All right.
00:18:57.119 -->
00:18:57.599Said briefly.
00:18:57.839 -->
00:18:59.039Yeah, and I know I interrupted you.
00:18:59.119 -->
00:19:00.160So what are some examples then?
00:19:00.319 -->
00:19:01.119Can you give like yeah?
00:19:01.200 -->
00:19:03.680So I actually had something in my notes that is a highly structured example, right?
00:19:03.759 -->
00:19:04.400So perfect.
00:19:04.559 -->
00:19:13.519If you think about an entity that's a hundred percent debt financed, like a structured financing vehicle that doesn't have any residual interests, that's gonna be a VIE because it's got zero equity at risk.
00:19:13.680 -->
00:19:14.480That's an easy one, right?
00:19:14.880 -->
00:19:27.519But if you think about an entity that's a hundred percent equity financed, right, um, and doesn't have kind of equity commitments to keep funding its current operations, um, generally that's gonna be um that's not gonna meet this criteria.
00:19:27.599 -->
00:19:30.319It's gonna be sufficiently capitalized, right?
00:19:30.559 -->
00:19:32.319So that's generally gonna be enough.
00:19:32.640 -->
00:19:32.960All right.
00:19:33.119 -->
00:19:39.680So then, Matt, of course, you made it sort of easy ones where it's very clear it's either 100% debt or 100% equity.
00:19:39.759 -->
00:19:41.200But what about if it's a mix?
00:19:41.279 -->
00:19:44.000You mentioned the 3% rule that no longer exists.
00:19:44.160 -->
00:19:48.240So how do you decide if the equity at risk is sufficient?
00:19:48.640 -->
00:19:49.200Good question.
00:19:49.440 -->
00:19:59.920So it's really gonna depend, and I know we're gonna say this a lot on the purpose and design of the entity, um, because you're really looking at what the operations of the entity are and whether or not there's enough equity capital to help finance it.
00:20:00.000 -->
00:20:14.480Um, in the guidance itself, there's a presumption that if the total equity at risk is under 10% from a fair value perspective of the total assets of the entity, then you could presume the entity is a VIE under this characteristic that it's thinly capitalized.
00:20:14.720 -->
00:20:20.160So the other way, like if it's greater than 10%, there's no presumption that it's well capitalized, right?
00:20:20.240 -->
00:20:25.680And that's where you would have to get to the analysis because you're never really going to be at one of those bookends where it's all debt or all equity.
00:20:25.759 -->
00:20:32.720So you're gonna be looking at a certain percentage of equity capital, certain percentage that's considered good equity at risk, and you're trying to determine whether or not it's enough.
00:20:32.880 -->
00:20:34.559Um, what are the ways to do that, right?
00:20:34.640 -->
00:20:36.480So the guidance has a couple of ways, right?
00:20:36.640 -->
00:20:46.480One is if you're looking at the entity itself and it has a history of and is currently demonstrating that it can fund its own operations without additional support and financial support.
00:20:46.559 -->
00:20:48.079I know I was gonna say it, but I said it.
00:20:48.160 -->
00:20:52.880Um, that's a good example of a situation where it's it's well capitalized.
00:20:53.039 -->
00:20:56.559And let me break that down because I'm gonna simplify that one a little bit more.
00:20:56.720 -->
00:21:13.039So if you're looking at an entity that has enough equity capital that it can actually go out to the market and raise debt at market rates without guarantees from other parties, that's a good example that there's a lender out there that thinks there's enough capital to rely on to be able to provide good financing to this entity.
00:21:13.279 -->
00:21:20.000The bad financing, the guarantees from the parents or like junk bonds that are necessary to uh finance your current operations.
00:21:20.160 -->
00:21:22.720That's really what we mean by subordinated financial support.
00:21:22.960 -->
00:21:24.799Oh, that's the second time you said it actually.
00:21:25.039 -->
00:21:26.079Well, but I just defined it.
00:21:26.319 -->
00:21:28.880In a way that I think makes a little bit of sense to the listener.
00:21:28.960 -->
00:21:32.000Um, but I but I do have another example because I do think that this helps.
00:21:32.079 -->
00:21:36.480And and this is the way I got my head around this was thinking about when you go buy a house.
00:21:36.640 -->
00:21:41.119And I know maybe not everybody owns a house, but if you think about it, it's a it's a simpler concept, right?
00:21:41.200 -->
00:21:42.880You have to go get a mortgage generally.
00:21:43.039 -->
00:21:49.920And when you're dealing with the mortgage lender, there's a requirement that you put a certain amount down of your own equity in order for them to lend on the property, right?
00:21:50.160 -->
00:21:54.240So they have a security interest, which is nice, and that lets you put less equity down.
00:21:54.400 -->
00:21:59.599Um, but generally, if you put 20% down, the mortgage lender with their security interest is saying, Great, I'm gonna give you a market based loan.
00:22:00.079 -->
00:22:02.720Don't need any guarantees and I don't need any insurance.
00:22:02.880 -->
00:22:05.839That's kind of the test you're doing with an entity, right?
00:22:05.920 -->
00:22:07.599Is do you need any of those guarantees?
00:22:07.759 -->
00:22:09.920Do you need uh mortgage insurance?
00:22:10.160 -->
00:22:13.119Do you have to get your rich uncle to help co-sign on the loan?
00:22:13.359 -->
00:22:14.880Um no, great.
00:22:14.960 -->
00:22:18.160You have enough equity at risk to be able to support the current operations.
00:22:18.480 -->
00:22:23.039And to be clear, you're not suggesting that you need 20% equity to be at risk.
00:22:23.200 -->
00:22:24.160That was just an example.
00:22:24.559 -->
00:22:25.599That's just for mortgage lenders.
00:22:25.759 -->
00:22:26.079Exactly.
00:22:26.160 -->
00:22:29.359I just want to make sure because then I can just see someone coming to you with a question.
00:22:29.519 -->
00:22:30.720Well, I heard you say 20%.
00:22:31.119 -->
00:22:31.759So Yeah.
00:22:31.839 -->
00:22:33.839And there's two other ways to prove you have enough equity.
00:22:33.920 -->
00:22:35.920One is you can you can do comps, right?
00:22:36.000 -->
00:22:42.799So you can qualitatively prove that you have other entities that are similar to you that are operating with the same level of equity that you are.
00:22:42.880 -->
00:22:45.440And that's a good way to demonstrate that it's enough.
00:22:45.599 -->
00:22:52.799If if neither of these qualitative ways get you there, you can um jump into a quantitative analysis to prove that you have enough equity at risk.
00:22:53.039 -->
00:22:54.079That's complicated.
00:22:54.160 -->
00:22:58.079Um, and even if you do a quantitative analysis, you got to then reconcile to some of your qualitative features.
00:22:58.240 -->
00:22:59.200So it's not the best way to do it.
00:22:59.359 -->
00:23:00.559It's definitely not the starting point.
00:23:00.799 -->
00:23:12.640Yeah, I was just gonna ask you, and I guess Alexander as well, if if you really have seen a lot of companies that have been successful in doing this quantitative analysis to quote prove that you have enough.
00:23:13.039 -->
00:23:16.000I haven't seen one since like the Fin 46 days, right?
00:23:16.240 -->
00:23:17.839Yeah, I've seen absolutely zero.
00:23:18.160 -->
00:23:18.880Okay, that's good.
00:23:19.039 -->
00:23:23.599So just as people are thinking things through, probably not the best path to go down to do that.
00:23:23.839 -->
00:23:24.000Right.
00:23:24.319 -->
00:23:24.799All right.
00:23:25.039 -->
00:23:27.839And maybe to that point, it's very judgmental.
00:23:28.240 -->
00:23:28.960Yeah, that's fair.
00:23:29.039 -->
00:23:31.200I mean, I think there's a lot of areas of judgment in this one.
00:23:31.279 -->
00:23:36.640Um, one that we see a lot that comes up is where Andy expects to receive funding in stages.
00:23:36.720 -->
00:23:44.160Um that's an area where there's a lot of judgment because you can look today and you say, well, if I know I'm gonna have to get funding down the road, how do I have enough equity to finance my operations?
00:23:44.319 -->
00:23:45.839But it's not always that simple, right?
00:23:45.920 -->
00:23:51.759Sometimes, right, you're doing a project like think about a biotech that's developing a um a compound, right?
00:23:51.920 -->
00:23:52.720You're in phase one.
00:23:52.799 -->
00:23:55.680Are you gonna go out and raise all the equity capital to get you to FDA approval?
00:23:55.759 -->
00:23:56.480No, no way.
00:23:56.720 -->
00:23:59.440So you're gonna raise enough to get you to a certain inflection point, right?
00:23:59.599 -->
00:24:04.559So you think about the purpose and design of the entity, you think about where those inflection points are where you're gonna have to make another decision.
00:24:04.720 -->
00:24:11.359And a lot of time the biotechs are maybe at the end of phase two thinking I'm either gonna outlicense, collaborate, or sell, or maybe raise more money.
00:24:11.680 -->
00:24:12.720And maybe that's enough, right?
00:24:12.799 -->
00:24:14.880Like to say, yeah, I have enough equity capital.
00:24:15.119 -->
00:24:15.839Not always.
00:24:16.000 -->
00:24:20.480Um, but you know, it's a good kind of rule of thumb to think about where are those inflection points?
00:24:20.640 -->
00:24:21.680What's my time horizon?
00:24:21.759 -->
00:24:22.720What are my current operations?
00:24:22.799 -->
00:24:26.400And do I have any ability to think about smaller chunks of time?
00:24:26.720 -->
00:24:30.720So maybe, Matt, one last question for you before we go on to characteristics two.
00:24:30.960 -->
00:24:33.279And you may have said this, so I just want to make sure.
00:24:33.519 -->
00:24:36.799So, like, let's say you don't have sufficient equity at risk.
00:24:36.960 -->
00:24:42.240Do you automatically say you have a VIE, or do you have to have all five characteristics to be a VIE?
00:24:42.480 -->
00:24:43.359That's a great question.
00:24:43.440 -->
00:24:46.079And it means I didn't emphasize it enough if I did say it.
00:24:46.240 -->
00:24:49.680So you only need to meet one of the characteristics in order to be a VIE.
00:24:49.839 -->
00:24:58.720Um so if you're doing the analysis and you are done with characteristic one and you say, I'm insufficiently capitalized, therefore I'm a VIE, then you don't go necessarily have to keep evaluating the rest.
00:24:58.880 -->
00:25:05.599Sometimes you may want to just for come, you know, documentation, completeness, and just in case anything comes up later on where there's a reconsideration.
00:25:05.680 -->
00:25:07.279You've thought through everything else, right?
00:25:07.359 -->
00:25:10.559Um, but yeah, you don't you don't have to meet more than one to be a VIE.
00:25:10.799 -->
00:25:11.039All right.
00:25:11.200 -->
00:25:17.119That's very helpful and I think important because again, each of these pieces of analysis can be very complicated.
00:25:17.279 -->
00:25:25.279So if you've already concluded one thing, maybe to your point you may want to finish your analysis, but you don't need to go to characteristic two.
00:25:25.440 -->
00:25:28.400But Alexander, let's assume you do have sufficient equity at risk.
00:25:28.480 -->
00:25:29.759So then what do we need to think about?
00:25:30.079 -->
00:25:30.319Sure.
00:25:30.480 -->
00:25:33.279So characteristic two is all about decision making, right?
00:25:33.359 -->
00:25:39.279So specifically whether the at-risk equity group is the one that's making the most significant decisions about the entity, right?
00:25:39.359 -->
00:25:42.160So the rationale here again should make sense by now.
00:25:42.319 -->
00:25:51.279The this characteristic is really asking, okay, well, if the equity doesn't decide what's going on with the entity, then why do I care about who holds a majority of that equity?
00:25:51.440 -->
00:25:51.680Right.
00:25:51.839 -->
00:25:54.160I should be applying the VIE model instead.
00:25:54.400 -->
00:25:58.400So honestly, this characteristic can be a whole podcast by itself.
00:25:58.559 -->
00:26:06.319Um, as you can probably tell, most of the questions, at least that I get, typically center around determining whether an entity is a VIE.
00:26:06.480 -->
00:26:09.839And then most of those questions actually center around this characteristic.
00:26:10.319 -->
00:26:12.160Do the equity holders have power or not?
00:26:12.400 -->
00:26:15.759In order to check this characteristic, we need to do a couple of things, right?
00:26:15.920 -->
00:26:19.839We first need to identify what are the most significant activities of the entity.
00:26:20.000 -->
00:26:27.279Then we need to determine how decisions around those activities are made and if it's the at-risk equity holders that are the ones that are making it.
00:26:27.440 -->
00:26:27.599Right.
00:26:27.680 -->
00:26:31.119So taking each one in turn, I'll start with identifying the most significant activities, right?
00:26:31.279 -->
00:26:32.720So what are we talking about here?
00:26:32.960 -->
00:26:38.000These are the activities that most significantly affect the economic success of the entity, right?
00:26:38.160 -->
00:26:45.759So activities are decisions that meaningfully impact future cash flow prospects, operating metrics, revenues, things like that.
00:26:46.000 -->
00:26:47.920This is really entity specific, right?
00:26:48.000 -->
00:26:52.319So it's kind of hard to give a broad swath of what the most significant decisions are.
00:26:52.480 -->
00:26:58.720Um, but as we mentioned before, this is largely based on the entity's purpose and design, which we should already know by now.
00:26:58.799 -->
00:27:12.000Um, as well as um there's typically industry-specific considerations and the nature of the entity's operations where you can kind of see if an entity is a real estate entity, there's probably certain decisions that are gonna be significant.
00:27:12.240 -->
00:27:12.559All right.
00:27:12.720 -->
00:27:16.240But with all of that said, that's it's still not that easy.
00:27:16.400 -->
00:27:22.960So are there some general guidelines you use and considering what are the most important or significant decisions?
00:27:23.279 -->
00:27:23.519Yeah.
00:27:23.680 -->
00:27:28.960So a lot of things related to strategic direction are gonna be viewed as being significant, right?
00:27:29.119 -->
00:27:51.599Some other ones that that typically transcend industry are things like entering into new lines of business or uh having new product offerings, um, a big one that we see are like negotiating and approving significant acquisitions, uh, selecting the management team, so selecting the C-suite, setting their compensation, those are always typically viewed as being important and significant decisions.
00:27:51.839 -->
00:27:54.240Others are a little bit more industry specific.
00:27:54.319 -->
00:27:55.440So I mentioned real estate.
00:27:55.599 -->
00:28:05.920So if I imagine that I'm a real estate lessor uh and I own a single property, some of the significant decisions there are probably going to involve selecting the tenant and establishing the terms of the lease, right?
00:28:06.000 -->
00:28:08.720Because that's gonna dictate my cash flows over the lease term.
00:28:08.880 -->
00:28:15.920Um and then at the end, right, when the lease expires, the decision whether to sell the property and you know make my money, right?
00:28:16.240 -->
00:28:19.519Realize a return or relay it to another lessee.
00:28:19.680 -->
00:28:26.000That's a significant decision that you would probably expect uh the equity holders to have if if they meet this characteristic.
00:28:26.240 -->
00:28:28.079Other industries have other key activities.
00:28:28.160 -->
00:28:38.400And so I'll say again, the world's best consolidation guide, we have an awesome table in section 4.4 that basically lists out key activities generally by industry.
00:28:38.559 -->
00:28:43.039You know, it's not an end-all be-all, but it's a really good starting point if you're if you're trying to look at that stuff.
00:28:43.279 -->
00:28:49.119So once we figured out what are the most significant activities, then we need to determine who makes the decisions, right?
00:28:49.200 -->
00:28:51.200And if it's the equity holders or not.
00:28:51.359 -->
00:28:59.440And so saying it another way, we basically have to understand how the entity is governed and where the decisions are made about those significant activities.
00:28:59.599 -->
00:29:02.319And this is actually where we get to a bit of a fork in the road.
00:29:02.480 -->
00:29:05.440So, you know, step four point, eight point, whatever.
00:29:05.680 -->
00:29:15.519But when we're evaluating whether the equity holders have the ability to make the most significant decisions, right, the criteria is different depending on whether the entity is a limited partnership, right?
00:29:15.599 -->
00:29:19.440Or maybe saying it even more straightforward, there's special rules for limited partnerships.
00:29:19.599 -->
00:29:25.839The rationale, though, is that limited partnerships are governed fundamentally differently than like a corporate type of entity, right?
00:29:25.920 -->
00:29:32.400Typically they designate a general partner or a GP that makes all of the significant decisions on behalf of the limited partners, right?
00:29:32.480 -->
00:29:41.359And so because of that, they have different criteria than from corporate type entities to determine whether or not the limited partners have a say so in the significant decisions.
00:29:41.519 -->
00:29:41.839All right.
00:29:41.920 -->
00:29:47.599And the real check here is whether the limited partners can block any of the significant decisions that the GP is trying to make.
00:29:48.000 -->
00:29:54.720If so, then the limited partners are viewed as having a check over the GP's power, which means that they actually have power over those key decisions.
00:29:54.880 -->
00:29:57.680So it wouldn't be a VIE based on this characteristic.
00:29:57.920 -->
00:30:10.079Another one, if they don't have blocking rights, if they have the ability to remove or fire the GP, right, then I mean that kind of goes without saying that they have power over the GP, which means they have power over the GP's significant decisions, right?
00:30:10.160 -->
00:30:16.720But if they don't have either blocking rights or kick out rights over the general partner, then the limited partnership's a VIE.
00:30:17.039 -->
00:30:20.160And this goes back to something we said in the last episode, right?
00:30:20.319 -->
00:30:32.079Just to make sure we are connecting dots, that most limited partnerships are going to end up being variable interest entities because we the way we typically see it is that most limited partnerships don't grant the limited partners those rights.
00:30:32.400 -->
00:30:32.720All right.
00:30:32.799 -->
00:30:33.839That's super helpful.
00:30:34.000 -->
00:30:36.319So you just talked about limited partnerships.
00:30:36.480 -->
00:30:41.039I assume there's a different model for corporations, but then how do we think about LLCs?
00:30:41.200 -->
00:30:42.880I'm sure that's a complicated answer.
00:30:43.279 -->
00:30:43.680Good question.
00:30:43.759 -->
00:30:45.920It's actually less complicated than you would think.
00:30:46.160 -->
00:30:49.200Um, really depends on how the LLC is governed, right?
00:30:49.359 -->
00:30:55.359So a lot of LLCs are governed through a managing member, um, which is very similar to the way limited partnership governance works.
00:30:55.519 -->
00:30:58.480So the managing member would be the equivalent of the GP in that case.
00:30:58.559 -->
00:31:00.160And then we would use a limited partnership model.
00:31:00.240 -->
00:31:09.519So we would be looking to see whether or not the non-managing members have the ability to kick out or um have substantive participating rights to figure out um whether or not it's a VIE.
00:31:09.599 -->
00:31:15.200But if it's an LLC that's managed by a board of directors or a board of managers, that's more similar to the way a corporation is covered.
00:31:15.279 -->
00:31:17.519So we would use a corporate model for figuring that out.
00:31:17.759 -->
00:31:17.920All right.
00:31:18.000 -->
00:31:23.039And so basically and you should know that answer because you would have considered that when you're thinking about your accounting for the LLC.
00:31:23.200 -->
00:31:24.880But you just mentioned corporate models.
00:31:24.960 -->
00:31:26.640So what is the model for corporates?
00:31:26.880 -->
00:31:27.039Yeah.
00:31:27.440 -->
00:31:33.440While we're on the topic, it's the corporate model is really figuring out whether or not the decision-making rights that Alexander talked about, right?
00:31:33.519 -->
00:31:43.759So the the rights to make decisions over the important activities of those in it uh entity that we identified earlier, whether or not those reside within the group of at-risk equity holders.
00:31:44.000 -->
00:31:46.240Um, sometimes that's straightforward, right?
00:31:46.319 -->
00:31:56.480Sometimes the at-risk equity holders are common stockholders, and oftentimes their voting rights and their ability to nominate a majority of the board of directors or all of the board of directors, that's where power resides.
00:31:56.720 -->
00:32:04.000So in that case, it's going to be a straightforward analysis, and you're going to say, yes, the at-risk equity holders do have the power over the most significant decisions.
00:32:04.240 -->
00:32:06.480Unfortunately, it's not always going to be that easy, right?
00:32:06.559 -->
00:32:12.400Um, it can be trickier in situations where you have kind of these other variable interests that maybe we were talking about earlier, right?
00:32:12.480 -->
00:32:15.039So you could have outsourced decision making through a contract.
00:32:15.279 -->
00:32:25.279In that situation, you may have some rights that reside with the at-risk equity holder group, and then other rights that reside contractually with the manager or the decision maker.
00:32:25.440 -->
00:32:41.440So it's really going to be a careful analysis, a little bit of a push-pull about which rights are the most important and which rights are the ones that are held contractually versus the ones that are held through the equity, or how easy is it for the equity owners to remove the decision maker or take those rights back?
00:32:41.599 -->
00:32:44.400Um, so it's not always that straightforward in that situation.
00:32:44.720 -->
00:32:54.000So another common complexity that we see in this area is where the decision-making rights reside with the equity investors, but the equity investors aren't at risk.
00:32:54.160 -->
00:33:05.680So they've already been disqualified in the earlier step that Alexander was talking about of having the characteristics that we need them to have to be at risk equity, but they still have voting rights, so they still have power, in which case you'd hit this trigger and the entity would be a VIE.
00:33:05.920 -->
00:33:06.880All right, that's helpful.
00:33:07.039 -->
00:33:09.839I want to rewind and I'll ask this question of both of you.
00:33:10.000 -->
00:33:20.799So this whole discussion of characteristic two started with sort of predicated on this idea that you're identifying the significant decisions, like important or significant decisions.
00:33:21.039 -->
00:33:26.240And you guys have referenced, obviously, you get a lot of questions about variable interests and VIEs.
00:33:26.799 -->
00:33:35.599Typically, from your experience, when people are coming to you with questions, are there gaps in what they've identified as the important or significant decisions?
00:33:35.680 -->
00:33:38.880Or is this something people normally are able to identify those?
00:33:38.960 -->
00:33:46.799And then maybe some of the complexity is figuring out who holds the rights, or do we often see they haven't really thought through all of these important decisions?
00:33:47.119 -->
00:33:50.240I'd say it's uh again, you see a little bit of A and a little bit of B.
00:33:50.319 -->
00:33:50.400Yeah.
00:33:50.640 -->
00:33:55.359But a lot of the times um they have identified most of the significant decisions.
00:33:55.440 -->
00:34:02.079So there may be one or two that they haven't fully thought through, or they're giving less weight to one that they've identified than maybe they should.
00:34:02.240 -->
00:34:08.159So it's it's less about, you know, have they identified all of the gaps and it's more about how they're they're weighting them, right?
00:34:08.239 -->
00:34:11.360And and and have they given enough credence to the ones that they've identified.
00:34:11.599 -->
00:34:14.559And I guess thinking them all the way through maybe is the point.
00:34:14.639 -->
00:34:18.000So to like Matt was talking about kick out rights and otherwise.
00:34:18.159 -->
00:34:22.159So are you sort of looking at what's at the surface or what else there is?
00:34:22.400 -->
00:34:22.800That's right.
00:34:22.880 -->
00:34:23.199Yeah.
00:34:23.440 -->
00:34:32.559And to to kind of further on that point, I mean, there are times where we will see analyses where there are 15 decisions laid out on a piece of paper and all of them are being labeled as important.
00:34:32.639 -->
00:34:36.400And we might need to push back a little bit and say, maybe not all of them are the most important, right?
00:34:36.480 -->
00:34:39.039So let's try to narrow that down to really understand.
00:34:39.119 -->
00:34:44.559Um, and there are some times where we get a list of two and it just says budgeting and hiring and firing and management.
00:34:44.639 -->
00:34:45.199And we say, well, okay.
00:34:45.360 -->
00:34:46.559Okay, that's probably right.
00:34:46.639 -->
00:34:46.719Yeah.
00:34:46.800 -->
00:34:46.880Yeah.
00:34:47.039 -->
00:34:51.440So like give us some industry specific or give us this entity, like what's going to drive the economic success of this entity?
00:34:51.519 -->
00:34:52.480What are those decisions?
00:34:52.800 -->
00:34:52.960Yeah.
00:34:53.039 -->
00:35:05.440And I guess the reason I asked the question is I think that if you're not used to doing this type of analysis, just this concept of what are the most important or significant decisions, that's not something you sort of go about and think about every day.
00:35:05.599 -->
00:35:10.480And so that's, I was just curious if from your experience people are able to kind of get their head around that.
00:35:10.639 -->
00:35:14.400Sounds like yes, but may need to kind of dig a little deeper.
00:35:14.639 -->
00:35:14.800Yeah.
00:35:14.880 -->
00:35:17.920Or as Alexander likes to say yes and, right, to be more positive.
00:35:18.159 -->
00:35:20.559Um but he made a good point.
00:35:22.079 -->
00:35:27.199Alexander made a good point earlier that if you put in the effort in this part of the analysis, it's gonna pay off later.
00:35:27.280 -->
00:35:33.760Um, because this part of the analysis is also very consistent with how we're gonna do the primary beneficiary test, which we're gonna talk about in the next episode.
00:35:34.000 -->
00:35:39.599But if, you know, the next episode could be 10 minutes if we just kind of send people back here and say we've done the work.
00:35:39.840 -->
00:35:40.960All right, so let's keep going.
00:35:41.039 -->
00:35:44.320Because I think with that, we're up to characteristic three.
00:35:44.639 -->
00:35:47.280So what do we think about next?
00:35:47.599 -->
00:35:51.039Uh yeah, so I I think this one's gonna be a little bit of a quicker one, hopefully.
00:35:51.440 -->
00:35:51.760Right.
00:35:51.840 -->
00:35:59.119Um, but this one's focused on whether the equity was established with non-substantive voting rights is the words in the in the guidance, right?
00:35:59.280 -->
00:36:03.280But us cool in-the-know people call it the anti-abuse test, right?
00:36:03.360 -->
00:36:13.440And so basically, this test was designed to catch scenarios where an entity might have been intentionally structured to circumvent the voting model by providing non-substantive voting equity to a different party.
00:36:13.679 -->
00:36:13.920Right.
00:36:14.000 -->
00:36:17.679So, as an example, Matt and I set up a legal entity, right?
00:36:17.840 -->
00:36:21.599And I fund 80% of the equity capital, Matt funds the other 20%.
00:36:22.239 -->
00:36:27.840So you'd expect, because I put up 80% of the money, that I would get 80% of the voting interest, right?
00:36:28.000 -->
00:36:30.719But let's say I don't want to consolidate for whatever reason.
00:36:30.800 -->
00:36:36.559So I approach Matt and I say, look, I only want to take 40% of the voting interest, you go ahead and take the other 60.
00:36:36.719 -->
00:36:38.400I assume he probably would agree.
00:36:38.559 -->
00:36:45.840And so if I were applying the voting model, I actually wouldn't consolidate because I don't hold a majority of the vote, even though I have 80% of the economics.
00:36:46.079 -->
00:36:50.719So these are the types of scenarios where the FASB wanted to run through the VIE model.
00:36:50.880 -->
00:36:52.960So that's why they actually came up with this characteristic.
00:36:53.199 -->
00:36:57.760And there's two here, and you have to meet both in order to trip it up, right?
00:36:57.840 -->
00:37:01.199So the first characteristic is around disproportionality.
00:37:01.440 -->
00:37:06.960Basically, uh, does one of the investors have a disproportionately low voting relative to their economics?
00:37:07.119 -->
00:37:07.280Right.
00:37:07.360 -->
00:37:12.159So in my example, I had an 80% economic interest, but I only had a 40% voting interest, right?
00:37:12.320 -->
00:37:16.480So in in this instance, I would fail this characteristic because of that disproportionality.
00:37:16.639 -->
00:37:18.159I go on to the second test.
00:37:18.480 -->
00:37:27.039Second test is checking whether substantially all of the entity's activities are conducted on the behalf of the investor with the disproportionately low vote, right?
00:37:27.280 -->
00:37:29.760This one is super judgmental, right?
00:37:30.000 -->
00:37:34.159You have to have a strong command over all of the facts and it's a holistic analysis.
00:37:34.400 -->
00:37:36.480But you need to look at the economics.
00:37:36.639 -->
00:37:39.840They're not necessarily determinative, but you can't ignore them either.
00:37:40.000 -->
00:37:41.760But you also have to look at other things, right?
00:37:41.840 -->
00:37:43.039Like who are the investors?
00:37:43.199 -->
00:37:45.440What are the relationships with each other, right?
00:37:45.599 -->
00:37:46.480What do they do?
00:37:46.639 -->
00:37:47.920What line of business are they in?
00:37:48.079 -->
00:37:51.280Is that consistent with the line of business from the VIE?
00:37:51.440 -->
00:37:51.679Right.
00:37:51.840 -->
00:37:55.199And, you know, it it can spiral out of control pretty quickly.
00:37:55.360 -->
00:37:59.360Um, but you know, that this is necessary because it is meant to be an anti-abuse test.
00:37:59.440 -->
00:38:02.719So you really want to make sure you do a fulsome and holistic analysis.
00:38:02.880 -->
00:38:05.679But that being said, they do use the word substantially also.
00:38:05.920 -->
00:38:07.599It is a is a high hurdle to heat.
00:38:08.639 -->
00:38:08.880All right.
00:38:08.960 -->
00:38:11.599I mean, the first one obviously is fairly straightforward.
00:38:11.760 -->
00:38:22.159But then I guess the second one, even going back to thinking about some of those decisions, I would think would have some influence here in terms of what that the entity is doing and what's important to that entity.
00:38:22.639 -->
00:38:23.440Purpose and design.
00:38:23.599 -->
00:38:23.920All right.
00:38:24.000 -->
00:38:24.400There you go.
00:38:24.639 -->
00:38:35.199And I think it's fair to say that there are probably certain levels of economic um risk that you might have that make it harder to prove that substantially all the activities aren't on your behalf.
00:38:35.360 -->
00:38:35.840Is that fair?
00:38:36.079 -->
00:38:36.639That's very fair.
00:38:36.960 -->
00:38:37.119All right.
00:38:37.280 -->
00:38:40.320So we made it through three, taking a lot of time to get through those.
00:38:40.480 -->
00:38:41.679So how about the next one, Matt?
00:38:41.920 -->
00:38:43.199Yeah, we're going to do two together in the first time.
00:38:43.360 -->
00:38:43.679All right.
00:38:43.840 -->
00:38:46.239I'm sure our listeners are buy one get from free.
00:38:46.480 -->
00:38:46.800There you go.
00:38:47.039 -->
00:38:47.519Exactly.
00:38:47.760 -->
00:38:51.440So the reason why we're going to do these two together is they're kind of the inverse of each other, right?
00:38:51.519 -->
00:39:00.320So again, to take us back to our um why we're doing this in the first place, it's to really identify situations where the equity at risk isn't behaving like traditional equity.
00:39:00.400 -->
00:39:01.840And I know I mentioned this a few times.
00:39:02.000 -->
00:39:08.880You expect traditional equity to be exposed to downside losses like first dollar loss of the entity, but also to have unlimited upside.
00:39:08.960 -->
00:39:16.960Um, so what characteristic four does is it says, does the equity at risk um have exposure to the expected losses of the entity?
00:39:17.039 -->
00:39:24.079In other words, is it protected by another variable interest holder or another contract from really being exposed to that downside risk?
00:39:24.320 -->
00:39:28.960If it is protected, um then it's meets this characteristic and it's a VIE.
00:39:29.039 -->
00:39:30.960What characteristic five does is the opposite of that.
00:39:31.039 -->
00:39:36.079It basically says, does the equity at risk holder, the group of equity at risk, do they have a limited upside?
00:39:36.239 -->
00:39:45.840And if they don't, if they're capped by some contractual mechanism or again another variable interest holder, then generally you hit this characteristic, the entity would be a VIE, right?
00:39:45.920 -->
00:39:48.639So I'll give you an example kind of on both sides of that, right?
00:39:48.800 -->
00:39:55.039So assume I'm a speculative real estate investor, I have$100 because I'm rich.
00:39:55.199 -->
00:39:57.360And so put all that into an entity.
00:39:57.519 -->
00:39:59.599The entity goes out and buys a property for$100.
00:40:00.480 -->
00:40:08.480As the equity investor in that speculative real estate investment, if the fair value of the property that I bought goes down to zero, my equity is worth zero.
00:40:08.639 -->
00:40:09.119Uh okay.
00:40:09.280 -->
00:40:11.360So in that situation, yeah.
00:40:11.519 -->
00:40:14.639In that situation, I'm exposed to first dollar a loss.
00:40:14.719 -->
00:40:16.480Um, so I don't hit this criteria.
00:40:16.559 -->
00:40:17.280We're clean, right?
00:40:17.360 -->
00:40:18.159On that criteria.
00:40:18.320 -->
00:40:22.400Also, if the fair value of the property goes up to 200, I make 100 bucks.
00:40:22.480 -->
00:40:23.360So I'm not capped.
00:40:23.519 -->
00:40:23.760Great.
00:40:23.840 -->
00:40:25.440I don't hit characteristic five.
00:40:25.599 -->
00:40:37.280I compare that to another situation where I have a legal entity that goes out and buys a building for 100, but the seller of the building guaranteed that when I eventually sold the building, I'm always going to get at least$90 back.
00:40:37.519 -->
00:40:38.719That's a different scenario, right?
00:40:38.800 -->
00:40:45.679Because now I have another contract holder who's made a promise to me, and that promise is protecting me from being exposed to downside loss, right?
00:40:45.840 -->
00:40:49.840So the value of the building goes down to zero, I'm only at 10 bucks, right?
00:40:49.920 -->
00:40:53.360The other uh the seller uh provided that guarantee and they're down the 90.
00:40:53.440 -->
00:41:00.079Um, and there could be a situation right on the opposite side where maybe I buy a building, but the seller has a fixed price purchase option to buy it back, right?
00:41:00.239 -->
00:41:04.639So in that situation, value goes up, but I'm capped at whatever that fixed price is.
00:41:04.719 -->
00:41:08.880So if they could buy it back at 120, if the building goes up to 200, I'm only making 20 bucks.
00:41:09.039 -->
00:41:09.280Right.
00:41:09.360 -->
00:41:17.760So again, those are ways where you can see these contractual relationships either capping the upside or protecting the downside of the equity investors and would cause the NIDA to be a VIE.
00:41:18.000 -->
00:41:18.320All right.
00:41:18.400 -->
00:41:24.480So then just from you gave us some examples there, but do you have sort of a standard list that you would tell people to look out for?
00:41:24.719 -->
00:41:27.280Yeah, and and we do include these in the consolidation guide as well.
00:41:27.360 -->
00:41:40.800But on the downside, you'd see like guaranteed returns on equity investments, significant cost plus arrangements, loss reimbursements, residual value guarantees, like we said in the example, um, or fixed price put options on the entity's assets.
00:41:40.880 -->
00:41:43.920Those are all things that would uh trigger a characteristic four.
00:41:44.079 -->
00:41:47.679And again, it's kind of that you think about inverse contracts for characteristic five.
00:41:47.760 -->
00:41:53.519The most common one we see is like a fixed price call option on the equity interest, which caps the upside for the equity investors.
00:41:53.679 -->
00:41:54.800Those are the most common ones.
00:41:54.880 -->
00:42:01.760I mean, one thing to think about on these call options and these put options, if they're over assets that are in the entity itself.
00:42:01.920 -->
00:42:03.519So remember, we're looking at a legal entity.
00:42:03.679 -->
00:42:10.559If you have a call option over an asset that represents 10% of the total assets of the entity, it's not necessarily a variable interest in the entity.
00:42:10.639 -->
00:42:14.079It wouldn't necessarily trigger this criteria for the entity to be a VIE.
00:42:14.159 -->
00:42:18.480So it's got to be a significant enough asset for it to really trigger this criteria.
00:42:18.800 -->
00:42:19.119All right.
00:42:19.280 -->
00:42:21.679So definitely another important point to look at.
00:42:22.000 -->
00:42:23.599So we've covered a lot.
00:42:23.679 -->
00:42:30.239We've made it through all five, plus a lot of pre-steps or in-between steps that you guys don't officially count.
00:42:30.480 -->
00:42:31.360I call them hidden steps.
00:42:31.599 -->
00:42:32.239Hidden steps.
00:42:32.320 -->
00:42:32.480All right.
00:42:32.719 -->
00:42:34.559That that that's maybe the best way to put it.
00:42:34.639 -->
00:42:39.440I'm not sure in accounting, hidden is the thing we're looking for, but nonetheless in this case.
00:42:39.599 -->
00:42:46.559So we've made it through step one and step two, including all these other steps, but I think it might be helpful because we've gone through a lot just to recap.
00:42:46.639 -->
00:42:48.000So, Alexander, can you do that?
00:42:48.239 -->
00:42:49.199Yes, I can do.
00:42:49.280 -->
00:42:51.119Um, and yeah, we did go through a lot.
00:42:51.280 -->
00:42:53.199My brain is full, and I actually know this stuff.
00:42:53.280 -->
00:42:55.760So I can only imagine what our listeners are thinking right now.
00:42:56.000 -->
00:42:58.480Um, so this episode was all about step two.
00:42:58.559 -->
00:43:01.440We ran through the five characteristics of a VIE, right?
00:43:01.519 -->
00:43:06.800And as we mentioned, before you even get to start looking at the characteristics, you have some upfront homework to do, right?
00:43:06.880 -->
00:43:09.679So you first have to understand the purpose and design of the entity.
00:43:09.840 -->
00:43:16.480Then you have to identify all of the variable interests in the entity, and then you have to identify the at-risk equity holders.
00:43:16.719 -->
00:43:20.079Once you have that, then you get to run through each one of the five characteristics.
00:43:20.159 -->
00:43:23.599And as we reminded everybody, it only takes one to be a VIE.
00:43:23.920 -->
00:43:32.960Uh, but characteristic one was around the sufficiency of equity, or right, basically trying to determine is the at-risk equity sufficient to finance the entity's ongoing operations.
00:43:33.199 -->
00:43:37.519That had a killer mortgage example, which I'm going to refer to later and pretend like I made it up.
00:43:37.679 -->
00:43:43.199Characteristic two is around whether the decision making authority resides with the at-risk equity group, right?
00:43:43.360 -->
00:43:50.800That one was a bit longer and a bit of a doozy, and we reminded people that there's two paths to go down, depending on if it's a limited partnership or a corporate like entity.
00:43:50.960 -->
00:43:58.400Characteristic three was that anti abuse test that we talked about and whether the equity was structured to have non substantive voting rights.
00:43:58.559 -->
00:43:59.760And characteristics four and five.
00:44:00.239 -->
00:44:09.039Matches hit on, and this is where we were basically focusing on whether the equity behaved like equity and was exposed to the entities up and downside on a residual basis.
00:44:09.199 -->
00:44:09.360Right.
00:44:09.440 -->
00:44:18.000And so if any one of those characteristics are met, you have a VIE, which means you move on to step three in the model, and then you finally get to determine who should consolidate this VIE.
00:44:18.239 -->
00:44:18.480All right.
00:44:18.559 -->
00:44:20.719And so for that, we will go to episode three.
00:44:20.800 -->
00:44:24.719But I'm sure there is no surprise here that I do have a final question for both of you.
00:44:24.960 -->
00:44:29.360It's sort of asked this question before, but I want to ask it more directly.
00:44:29.519 -->
00:44:44.960And basically, if you guys think about this step two, what is one of the biggest pitfalls you see people make in terms of when they come to you, something missing in their analysis or someplace where maybe something veered off course?
00:44:45.119 -->
00:44:46.400So, Alexander, you can go first.
00:44:46.639 -->
00:44:49.039I'll go first because my I just had a light bulb in the rank.
00:44:49.519 -->
00:44:49.840Perfect.
00:44:50.000 -->
00:44:55.840And I think you might have referenced it before, but I think it's really understanding the full governance structure of the entity, right?
00:44:55.920 -->
00:45:05.280Because a lot of the times, you know, folks will come to us and they know how the board vote works, but they don't have a full understanding of, okay, well, what happens if there's a tie?
00:45:05.440 -->
00:45:07.679You know, what what are the contingency mechanisms?
00:45:07.760 -->
00:45:10.400Because a lot of the times that actually, you know, really matters.
00:45:10.559 -->
00:45:20.559So if we're thinking about, you know, how how the power is manifest in the entity, that's one that that I typically pe see people mess up on is not understanding the full governing documents.
00:45:20.880 -->
00:45:21.119All right.
00:45:21.280 -->
00:45:21.679Excellent.
00:45:21.920 -->
00:45:23.599Matt, this is a contest.
00:45:23.679 -->
00:45:24.400Can you top that?
00:45:24.639 -->
00:45:25.519I don't think so.
00:45:25.760 -->
00:45:27.920But uh I'll give you my answer.
00:45:28.000 -->
00:45:33.360I I think it's um I think people are intimidated by the VIE model oftentimes.
00:45:34.000 -->
00:45:35.199Or all the time, pretty much.
00:45:35.440 -->
00:45:35.599Yeah.
00:45:35.679 -->
00:45:39.360And it and it can, and there's certain areas that do require a lot of judgment and that are complex.
00:45:39.440 -->
00:45:44.960Um, but I I would advise people don't get caught up or get lost in the terminology or the details, right?
00:45:45.119 -->
00:45:48.320Take a step back and try to remember why we're doing what we're doing, right?
00:45:48.480 -->
00:45:55.760Because a lot of times um you might be doing a lot of work for no reason because the entity is totally well capitalized by common equity.
00:45:55.920 -->
00:45:57.360The common equity gets to vote.
00:45:57.440 -->
00:45:58.239They appoint the board.
00:45:58.320 -->
00:46:00.719There are no other weird contractual relationships.
00:46:00.800 -->
00:46:08.400And we're getting kind of all caught up in the details when we can take a step back and see where we should should be headed is really down a path where it this probably isn't a VIE.
00:46:08.559 -->
00:46:11.199You know, same can be said on the opposite side as as well.
00:46:11.360 -->
00:46:17.360Um, but folks who get caught up in kind of all the terminology and trying to understand what a variable interest is versus, you know, subordinated debt.
00:46:17.599 -->
00:46:21.039Subordinated financial support terminology that I keep using.
00:46:21.199 -->
00:46:30.719Um, it can get it can get a little bit intimidating if you don't step back, remember where you are in the model, remember what we're trying to do, why we're trying to do what we're trying to do, um, and try to keep it a little bit more simple, right?
00:46:31.039 -->
00:46:33.360Yeah, and then maybe I can add to that again.
00:46:33.440 -->
00:46:44.800This my experience with VIEs is a little dated compared to yours, but I think this still applies, which is I think there's sometimes a tendency to just jump in and not make sure you understand the purpose and design.
00:46:44.960 -->
00:46:52.880And you guys mentioned that a few times, but without that sort of foundational understanding, then the rest of the analysis, you're always you're sort of wobbling the whole time.
00:46:53.039 -->
00:46:59.840So I think making sure you you start with that and then get into some of this other detail is also helpful.
00:47:00.079 -->
00:47:00.400That's right.
00:47:00.480 -->
00:47:03.760Yeah, or like jumping in without first identifying who the equity at risk is.
00:47:04.079 -->
00:47:05.679Yes, or the variable interest holders.
00:47:05.760 -->
00:47:07.519Like you really have to do your groundwork.
00:47:07.599 -->
00:47:12.880And then the rest of it actually, to your point, can be more straightforward if you have that full understanding.
00:47:13.119 -->
00:47:13.440That's right.
00:47:13.599 -->
00:47:13.840All right.
00:47:13.920 -->
00:47:15.119They're they're nodding and smiling.
00:47:15.199 -->
00:47:16.239So I think that's a good sign.
00:47:16.480 -->
00:47:19.360So, Alexander, Matt, it's always great to talk to you guys.
00:47:19.440 -->
00:47:20.079Thank you for this.
00:47:20.159 -->
00:47:26.000And for our listeners, stay tuned because next week you'll get to find out if you should be consolidating your VIE.
00:47:26.159 -->
00:47:27.440So thanks again for joining me.
00:47:27.679 -->
00:47:28.000Thank you.
00:47:28.159 -->
00:47:28.960Thanks.
00:47:30.000 -->
00:47:31.920That's our show for today.
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00:47:56.239From Thought Leadership at PWC, I'm Heather Horn.
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