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 holder.
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 paragraph 16(d)(1).
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 these investments.
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 partnership.
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 investments.
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 variability analysis.
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 beneficiary test.
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 experience.
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 consolidate.
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.