The information presented here is intended solely for
informational purposes and should not be construed as accounting
advice from the author or Ernst & Young, LLP.
In response to the corporate accounting scandals that staggered
financial markets last year, the Financial Accounting Standards
Board (FASB) issued FASB Interpretation Number 46 (FIN 46),
Consolidation of Variable Interest Entities (VIEs), providing
additional interpretation of existing accounting literature
concerning consolidation. The new accounting rules associated with
this measure have the potential to have a dramatic impact on the
affordable housing equity markets. Put simply, under FIN 46,
certain business entities may now be required to consolidate within
their own financial statements the real estate assets, liabilities
and income statement results of the affordable housing partnerships
in which they are invested.
Why does FIN 46 matter?
We estimate that approximately 50% of all affordable housing
equity investments have been acquired by a single limited partner
investing either directly in an operating partnership or through a
so-called private-label fund. As a result of the issuance of FIN
46, these affordable housing investments are subject to potential
consolidation by the investors that made them.
Banks, insurance companies, and other large financial
institutions are providing most of the capital for housing credit
project developments. These investors will likely be reluctant to
consolidate real estate debt and assets onto their balance sheets
because of adverse regulatory and market implications. In short,
having to report debt from these partnerships as if it were
corporate debt could restrict an institution's ability to borrow
and invest. Therefore, the implementation of FIN 46 could result in
reductions in the equity volume or (more likely) changes in the
structure of direct and private-label investments.
How does FIN 46 work?
As it pertains to affordable housing investments, there are
generally three basic steps required to determine whether an
investor is at risk of consolidating its investment. First,
determine whether the partnership will be deemed a VIE as described
in paragraph 5 of FIN 46. Then, if the partnership is considered to
be a VIE, determine whether there are restrictions of substance on
the limited partner's ability to sell its investment. Finally, if
the partnership is a VIE and there are no restrictions on the
limited partner's ability to sell its interest in the partnership,
then calculate which entity, if any, will be considered the primary
beneficiary that must consolidate the financial results of the VIE
based on the variability of potential cash flows to each interest
Is the entity a VIE?
Under FIN 46, an entity shall be subject to consolidation if, by
design, the equity investor at risk either does not have the
ability to make decisions based on voting rights or does not have
the obligation to absorb the expected losses of the entity.
As a general matter in affordable housing investments, FIN 46
seems to lead to the conclusion that the only equity investor at
risk is the limited partner. This results, in part, from the fact
that the general partner will not be considered an equity investor
at risk. The general partner often contributes only a nominal
amount of equity and usually anticipates receiving a development
fee through an affiliate at the conclusion of construction. Under
FIN 46, fees paid to decision-makers must be netted against their
equity investment, resulting in no equity investment at risk by the
general partner. For this purpose, any obligation to advance future
capital under one or more guarantees does not represent equity.
Because the limited partners are the only equity investors at
risk, FIN 46 provides that they must have decision-making ability
through voting rights and the ability to absorb the expected losses
of the entity. Typically, the limited partners in affordable
housing investments do not have decision-making rights because they
can remove the general partner only for cause and have no control
over operating decisions. Likewise, because under the typical
partnership agreement, the local general partner makes
construction-completion guarantees and operating-deficit guarantees
and accepts tax credit adjuster provisions, the only equity
investors at risk (the limited partners) do not have the obligation
to absorb the expected losses of the entity. Therefore, a typical
affordable housing partnership will likely be considered a VIE
because the limited partners lack sufficient decision-making
authority and because they do not have an obligation to absorb the
expected losses of the partnership.
Are there restrictions on an investor's ability to transfer its interests?
Paragraph 16 of FIN 46 states that for purposes of this
interpretation, the term "related parties" includes certain parties
that are acting as de facto agents of the variable-interest holder.
Under paragraph 16(d)(1) of FIN 46, a party is considered to be a
de facto agent of an enterprise if it is subject to an agreement
that it cannot sell, transfer or encumber its interests in the
entity without the approval of the enterprise. What this means for
investors in affordable housing partnerships is that if there are
restrictions on the investor's ability to sell or transfer its
interest in the partnership, then the limited partner will likely
not be required to consolidate under FIN 46.
However, the restrictions must have substance. Common transfer
provisions, such as that the general partner's consent to the
transfer will not be unreasonably withheld or that the transfer can
be prohibited only if it will have an adverse tax impact, are
probably not sufficient for an investor to claim exemption under
If the general partner has the clear power to approve or
disapprove a sale by the limited partner, then this lack of free
transferability could prove to be the key provision in FIN 46 that
investors focus on when determining whether they are exempt from
consolidating their investments. We suspect that some investors
will restructure their partnership agreements to take advantage of
this provision in order to avoid the possibility of consolidating
Who is the primary beneficiary?
The holders of variable interests in affordable housing
partnerships are the general partner, the limited partner, the
lenders and the guarantors. FIN 46 requires that we measure the
variability in the discounted cash flows to each of these variable
interests to determine whether any are expected to have a majority
(50% or more) of the variability in partnership cash flows. If one
of the variable interests is determined to have a majority of the
variability, then it will be deemed to be the primary beneficiary,
and that interest holder will be required to consolidate the
results of the partnership into its financial statements.
How does the calculation work?
FIN 46 instructs us to perform variability analysis by
estimating the potential cash flow outcomes for each variable
interest and assigning probabilities to each of these potential
outcomes, and then to discount these cash flows using a risk-free
interest rate. Determining which scenarios to present and which
probabilities to assign to each scenario is a highly subjective and
highly complex exercise. In the scenarios constructed and the
probabilities assigned, however, the total of all of the
risk-adjusted, discounted cash flows under all of the scenarios for
each variable interest should equal the original amount of support
(the original loan or equity amount) provided to the
FIN 46 instructs us to perform this analysis based on pre-tax
cash flows. However, this analysis would be rather meaningless if
we excluded tax benefits because limited partners invest almost
exclusively to acquire only the tax benefits. Therefore, our firm
has concluded that tax benefits to the limited partner should be
included in the cash flow analysis for affordable housing
Additionally, these partnerships typically include "soft debt"
issued by governments, which is debt where the repayment is subject
to the availability of cash flow. The risk-adjusted, discounted
cash flows from these loans generally will not equal the original
amount of support provided.
Determining the primary beneficiary
Two calculations are performed to determine which party is the
primary beneficiary. These calculations are based on developing a
set of cash flows for a number of scenarios. It is beyond the scope
of this article to explain all of the complexities involved in
generating the cash flows by assigning probabilities to various
scenarios used for these calculations.
Prior to performing the variability calculation, FIN 46
instructs us not to take into consideration variability
attributable to fees paid to affiliates of the general partner.
Therefore, and this will come as a surprise to many observers,
variability in development fees will not be considered in this
Under the first test, we measure the downside variability of
each interest holder's cash flows. Often, the limited partner or
the lender will be the primary beneficiary under this first test.
If no variable interest has a majority of the variability under
this test, a second test is performed that adds the fees paid to
the general partner to the variability calculated for its
interests. Under this second test, the general partner often will
be deemed as the primary beneficiary that must consolidate.
The reader should understand that if there is a restriction of
substance on the transferability of the limited partner's interest,
then the variability attributable to the limited partner is added
to the general partner's variability when calculating the primary
First impressions regarding results of calculations
While these impressions are far from conclusive, several factors
seem to drive the variability calculations. First, the size of the
investments relative to each other exerts a significant influence
over the variability calculations. If we assume a $2 million equity
investment and a $4 million loan with the same term and rate of
return, then the loan will likely be assigned variability based on
the relative size of the support provided. Similarly, if we assume
a $2 million equity investment and a $2 million loan, both with
15-year terms but where the rate of return on the equity is higher
than the return on the loan, then the equity should have more
variability assigned to it. Finally, if we assume an equity
investment and loan both for $2 million and with equal returns, but
where the equity investment is for 15 years and the loan is for 30
years, then the loan will likely generate more variability. So the
three determining factors seem to be size of investment, rate of
return and length of term.
Assigning probabilities with FIN 46
In theory, under FIN 46, the difference between the risk-free
interest rate and the interest rate charged by a lender or investor
represents the risks to the lender/investor, and we should be able
to construct an appropriate set of scenarios and probabilities to
account for those risks. However, the reality is that markets are
not always efficient and the risk assumptions and probabilities
required to make the analysis work are much different from the
real-life track record of the industry to date. Therefore, it is
likely that a much higher set of risks (downside risks) must be
assumed than might seem reasonable based on prior industry
I have described how FIN 46 would be applied to a "lower-tier"
housing credit partnership. This is the key test, because if the
real estate assets and liabilities are not consolidated into the
"upper tier," then investors in the upper tier will be largely
indifferent to consolidating an upper tier that has immaterial
assets and liabilities. FIN 46 needs to be applied at the upper
tier (fund level) as well. If an investor owns less than a 50%
interest in either the lower- or upper-tier partnerships, it likely
will not be required to consolidate. Therefore, FIN 46 will likely
not require investors in most multi-investor funds to
Accounting firms are struggling with how to apply this complex
accounting pronouncement to an enormous number of investment
vehicles, of which housing credit investments are just one subset.
In the current accounting environment, firms are applying
increasingly conservative approaches to accounting rules that
require the application of subjective judgment. While FIN 46 poses
some practical difficulties in application, the rule is now
effective for all investments and thus must be applied.
As more analysis is performed in this area, the result of FIN
46's application may result in significant changes in how equity is
raised in the affordable housing tax credit marketplace.