The design of the legal entity (for example, its capital structure) and the apparent intentions of the parties that created the legal entity are important qualitative considerations, as are ratings of its outstanding debt (if any), the interest rates, and other terms of its financing arrangements. Often, no single factor will be conclusive and the determination will be based on the preponderance of evidence. For example, if a legal entity does not have a limited life and tightly constrained activities, if there are no unusual arrangements that appear designed to provide subordinated financial support, if its equity interests do not appear designed to require other subordinated financial support, and if the entity has been able to obtain commercial financing arrangements on customary terms, the equity would be expected to be sufficient. In contrast, if a legal entity has a very small equity investment relative to other entities with similar activities and has outstanding subordinated debt that obviously is effectively a replacement for an additional equity investment, the equity would not be expected to be sufficient.
ASC 810-10-25-45(a) through (b)
provides two indicators that a reporting entity can consider to demonstrate that an entity is sufficiently capitalized. If either of these qualitative conditions provide evidence that the entity is sufficiently capitalized, the presumption that the entity is thinly capitalized can be overcome and the entity would not be a VIE under Characteristic 1.
- Ability to finance activities without additional subordinated financial support: Entities that have issued investment-grade senior debt may be able to qualitatively demonstrate that the entity can finance its operations without additional subordinated financial support. Entities that have issued low-risk debt demonstrate that they are able to obtain financing that is low-risk with an interest rate that is commensurate with those low-risk activities. Even if the entity has issued subordinated debt, there may be circumstances when the entity can demonstrate that it has sufficient equity at risk, for example, if the subordinated debt carries an investment grade credit rating. The grade and related interest rate of the subordinated debt must be evaluated to determine whether it is comparable with the grade and interest rate of other low-risk (i.e., “debt-like”) investments.
Depending on the nature and grade of the entity’s debt and other financing, the entity may be unable to qualitatively demonstrate that its equity at risk is sufficient, even if it has diversified assets and risks. If the potential VIE issued debt that is more “equity-like” in nature, we believe the reporting entity will be unable to qualitatively conclude that the entity is sufficiently capitalized.
- The entity’s total equity investment at risk is greater than, or equal to, other entities that hold only similar assets of similar quality and amounts and operate with no additional subordinated financial support: It may be difficult to find another entity (1) with assets that are similar in quality and amounts, and (2) without additional subordinated financings in its capital structure. For this reason, it is often difficult to demonstrate this condition exists when qualitatively assessing the sufficiency of total equity investment at risk.
Other non-equity sources of financing may demonstrate that an entity is sufficiently capitalized. Qualitative factors that may be useful in assessing the sufficiency of an entity’s equity investment at risk may include the following:
- The purpose and design of the entity
- The intentions of the parties that established the entity
- The credit rating of the entity
- The rate of interest the entity is required to pay to its lenders
- The terms of the company’s financing arrangements
Since debt may function as a surrogate for additional equity investments, the quality of the debt and associated interest rate are important factors to consider in this analysis. We believe that an entity’s ability to obtain investment-grade debt (at least a rating of BBB by Standard and Poor’s or Baa by Moody’s) may be evidence that the equity investment at risk is sufficient and that the lender’s risk of loss is remote.
On the other hand, higher-risk financing may indicate that the lender (or other parties) shares in the risks of a potential VIE’s activities by absorbing a significant amount of the potential VIE’s expected losses. This assessment becomes more difficult when debt is not the only type of variable interest that may provide additional subordinated financial support. The existence of guarantees on the value of a potential VIE’s assets, put options allowing the equity investors to sell their interests at prices other than fair value, and similar arrangements are also variable interests that may also be a source of additional subordinated financial support. Such interests may also impact the quality of the debt that the potential VIE can procure.
Non-investment grade debt
The mere existence of subordinated debt (i.e., “high yield,” “mezzanine,” or “junk” debt) is not conclusive that an entity is thinly capitalized. If after considering the relevant facts and circumstances, a reporting entity is unable to conclude qualitatively that a potential VIE is sufficiently capitalized, a quantitative analysis would be required to determine whether Characteristic 1 is present. This quantitative analysis would compare the entity’s total equity investment at risk to the entity’s expected losses. If the results of this quantitative analysis demonstrate that the entity’s expected losses exceed the entity’s equity investment at risk, then the entity’s equity investment at risk is not sufficient and the entity would be a VIE.
Depending on the facts and circumstances of the arrangement, the existence of guarantees of an entity’s debt may indicate that the equity investment at risk is insufficient. For example, if a personal guarantee was necessary for the entity to receive financing from a third-party bank, the equity investment at risk may not be sufficient.
Typically in SPEs, other arrangements with the entity or other parties associated with the entity, as opposed to the holders of investments in equity at risk, bear most of the risk of loss related to the entity’s activities and often receive most of the residual benefit of the SPE’s activities. These other arrangements function in a manner that is often associated with an equity investment.
SPEs that are structured in such a manner will often be VIEs because the equity investment at risk will be insufficient. Such entities will likely be insufficiently capitalized because their total equity investment at risk does not exceed the entity’s expected losses.
Equity investors and commitments to fund equity, loans, and guarantees
An equity investment that is issued in return for an obligation to provide additional capital in the future is generally not considered equity at risk. The receivable recorded by the potential VIE is typically recorded as an offset (i.e., reduction) to GAAP equity, thereby reducing the total equity investment at risk. In addition, an entity may be thinly capitalized (and therefore a VIE) if an investor is obligated to fund the potential VIE’s activities on an ongoing basis (i.e., “step” funding arrangements).
Commitments to finance future acquisitions
In some cases, a potential VIE’s equity investors may agree to finance future acquisitions as part of the potential VIE’s strategy or business plan. This agreement to finance future acquisitions does not necessarily mean that an entity is insufficiently capitalized. Rather, if an entity is currently able to operate its business with equity that is currently deemed to be sufficient, the fact that the entity has an agreement with its equity investors to finance future acquisitions does not cause the entity to be insufficiently capitalized. However, care and judgment should be exercised to ensure that the future acquisitions are not currently needed to operate the business in its current state. In addition, an entity’s current ability to independently finance its operations without additional subordinated financial support from its equity investors should be considered. For example, if an entity is currently able to finance its operations with investment grade debt, it would not be considered insufficiently capitalized even if it has an agreement with its equity investors to finance future acquisitions.
Example CG 4-7 illustrates the determination of whether commitments to fund future acquisitions demonstrate that an entity is thinly capitalized.
EXAMPLE CG 4-7
Determining whether commitments to fund future acquisitions demonstrate that an entity is thinly capitalized
Company A forms Company X and contributes an existing business that provides services to retail and business consumers with a fair value of $1 million. The contributed business is in the mature phase of the business life cycle and finances its activities through cash flows generated from its operations. Company X’s capital structure is comprised entirely of common equity.
Company B, a financial investor, contributes $50o thousand to Company X in exchange for a 50% equity interest. Company B’s cash contribution is immediately distributed to Company A, resulting in an equalization of each party’s contribution to Company X.
The business plan of Company X contemplates the acquisition of other similar service businesses, with the intention of growing Company X through acquisition and exiting through a sale or initial public offering. Company A and Company B jointly agreed to fund the acquisition of each target company identified when and if the acquisition closes. Company A and Company B will each fund their respective share of the purchase price in proportion to their relative ownership interest in Company X (i.e., 50/50).
Should Company A and Company B’s contingent commitment to fund future acquisitions result in the conclusion that Company X is insufficiently capitalized as of the formation date?
No. Company A’s evaluation of the sufficiency of Company X’s equity at risk should be based on whether Company X requires additional subordinated financial support to finance its current activities as of the date the analysis is performed. We do not believe contingent commitments to finance future acquisitions should lead to the conclusion that Company X is insufficiently capitalized in isolation. This view is premised on the notion that an investor’s commitment to finance future acquisitions is different from a commitment to finance an entity’s current activities. The decision to acquire a group of assets or a business represents an action that is ordinarily outside the normal course of business for an operating entity. We believe this differs from situations where an investor commits to provide additional capital to finance an entity’s current activities or to fund normal course capital expenditures.
Determining whether such commitments cause an entity to be a VIE under Characteristic 1 requires judgment. This analysis should be based on the entity’s particular facts and circumstances and consider the entity’s purpose and design.