4.2 Identify the equity investment at risk

We believe the term “profits and losses” refers to GAAP profits and losses (as opposed to expected losses and expected residual returns). This means that the equity investment must share (or participate) in the net income or loss of the entity. Some equity investments may share only in the profits of the entity and are not exposed to the losses of the entity. In such circumstances, the equity investment would not be considered equity at risk.

Example CG 4-1 illustrates the determination of whether an equity investment with a guaranteed minimum return qualifies as equity at risk.

EXAMPLE CG 4-1Determining whether an equity investment with a guaranteed minimum return qualifies as equity at risk

Company A contributed $1,000 of cash into Entity B at formation in exchange for 20% of Entity B’s common stock. Company A’s common equity investment participates pro rata in Entity B’s profits and losses; however, the terms of Company A’s interest stipulate that it must receive, at a minimum, an annual 8% rate of return on its investment.

Does Company A’s equity investment participate significantly in Entity B’s profits and losses?

Analysis

Generally, no. Although Company A’s equity investment may participate significantly in Entity B’s profits, the minimum guaranteed return demonstrates that Company A may not necessarily participate significantly in Entity B’s losses. As a result, assuming Company A’s guaranteed minimum return is substantive (i.e., Entity B has adequate equity that is (1) subordinated to Company A’s equity investment, and (2) capable of funding Company A’s guaranteed minimum return in periods where Company B incurs operating losses), Company A’s equity investment may not qualify as equity at risk.

Even when an equity investment participates in the profits and losses of a potential VIE, the investment’s level of participation must be “significant” for that equity investment to qualify as equity at risk. The determination of whether an equity investment participates significantly in profits and losses is based solely on the specific facts and circumstances. The following factors should be considered when making this assessment.

Fixed rates of return or low levels of returns or loss

Investments with a fixed rate of return generally do not participate significantly in the profits and losses of an entity. However, the substance of an arrangement should prevail over its form. If an equity investor is entitled to a fixed rate of return and that return is substantial relative to the entity’s overall equity return, the equity investment may participate significantly in the entity’s profits. To qualify as equity at risk, an equity investment must also participate significantly in the entity’s losses.

Determining whether an equity investment is substantive

An equity investment that participates in an entity’s profits and losses at a level that is consistent with its relative equity ownership (e.g., a 1% general partnership interest that participates in 1% of the entity’s profits and losses) would participate significantly in profits and losses as long as that equity investment is substantive.

Sometimes equity interests are issued for de minimis amounts and, as a result, that investor may not participate significantly in losses.

Example CG 4-2 illustrates the determination of whether a general partner interest participates significantly in a limited partnership’s profits and losses.

EXAMPLE CG 4-2Determining whether a general partner interest participates significantly in a limited partnership’s profits and losses

A general partner purchases a 1% general partner interest for $1,000, while 99 limited partners each receive a 1% interest for their contributions of $1,000,000 ($99 million in total).

Does the general partner’s interest participate significantly in the limited partnership profits and losses?

Analysis

No. Under this scenario, the general partner’s interest would not participate significantly in the profits and losses based on what the general partner paid for its 1% interest relative to the price paid by the LPs for their 1% interests (i.e., it is not substantive). In making this assessment, we believe the dollar amount and percentage of the investment relative to the total equity investments should be considered.

The general partner’s interest would be substantive and therefore qualify as equity at risk if (1) the general partner contributed $1 million for its 1% pro rata equity investment (like all other investors) and (2) the general partner’s investment participated pro rata in the limited partnership’s profits and losses. However, if the general partner’s percentage interest is trivial (i.e., 0.1%) then its investment would not be at risk irrespective of the price paid.

Guaranteed returns

Generally, when an equity investor’s returns are guaranteed by another party involved with the entity, the investor’s equity investment does not participate significantly in the losses of the entity.

Equity instruments that are redeemable or callable

Oftentimes, investors can put (redeem) their equity interests (purchased put options) or are required to sell their equity interests to a third party at the third party’s option (written call options). These put and call options are often exercisable at fixed prices or prices determined based on a formula. In determining whether these features would prevent an equity investment from participating significantly in the profits and losses of the entity, we believe a reporting entity should first determine whether those characteristics are embedded in the terms of the equity investment. Embedded terms are part of the equity investment’s features so they must be considered in the analysis. Freestanding puts and calls on equity may have to be included in the equity at risk analysis, as discussed further below.

Puttable or callable characteristics arising from a freestanding contract

When the puttable or callable characteristics result from a freestanding contract with a third party (i.e., a party that is not involved with the potential VIE) that was not executed as part of the entity’s purpose and design (e.g., as part of the equity investor’s normal trading activities), we do not believe the puttable or callable characteristics would preclude that equity interest from qualifying as equity at risk.

If, however, the equity investor executed the freestanding contract with the potential VIE or a party involved with the potential VIE as part of the purpose and design of the entity, we believe these characteristics would need to be considered in the analysis and may preclude the equity interest from qualifying as equity at risk if they substantively protect the investor from losses or prohibit the investor from participating significantly in the entity’s profits.

If the puttable or callable characteristics are embedded in the terms of the contract, or arise from a freestanding contract executed as part of the design of the potential VIE, the following factors should be considered to determine whether the equity investment qualifies as equity at risk:

The length of the period of time during which the put or call option may be exercised
Terms associated with the put or call option, including the option’s strike price (e.g., fixed, variable, or fair market value)

If an equity investment is puttable or callable at the instrument’s then current fair value, or at a fixed price that is significantly out-of-the-money, that investment would likely participate significantly in the profits and losses of the potential VIE. In contrast, if the equity investment is puttable or callable at a fixed price that is in-the-money or at an amount that is not significantly out-of-the-money, we believe the investor may not participate significantly in the potential VIE’s profits and losses. This would preclude the underlying equity interest from qualifying as equity at risk.

Judgment may be required when an equity instrument is puttable or callable at an amount that is determined by a formula. Specifically, a reporting entity should consider whether the formula amount substantively limits the equity investor’s exposure to the entity’s profits or losses.

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