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7.3 Voting interest model–LPs and similar entities
Publication date: 31 Jul 2023
us Consolidation guide
A limited partnership is an association of one or more general partners with unlimited liability and one or more partners with limited liability. It is usually managed by the general partner or partners who may be subject to limitations, as imposed by the partnership agreement. For LPs and similar legal entities, both the general partner (and its affiliates) and the limited partner(s) must first determine the applicability of the VIE consolidation model, including whether (1) the entity is a VIE or (2) the partners or partnership are eligible for one of the scope exceptions. This determination must be performed before considering any other authoritative literature regarding consolidation of the LP. If the partnership is a VIE and the partners or partnership are not eligible for any of the scope exceptions under the VIE guidance, ASC 810 requires that the primary beneficiary, if any, consolidate the VIE. If the partnership is not a VIE, the partners would apply the voting interest model for partnerships in accordance with ASC 810, as further discussed in this section.
The consolidation guidance for LPs also applies to other similar legal entities. A similar legal entity is an entity that has governing provisions and economic characteristics that are the functional equivalent of an LP, and could include entities such as limited liability companies, limited liability partnerships, and others. Therefore, a reporting entity with an interest in a similar legal entity would need to first determine whether the governing provisions of the entity are the functional equivalent of an LP (see CG 7.1.1).
An LP can only be a voting interest entity if the limited partners have kick-out rights (including liquidation rights) and/or substantive participating rights. If the limited partners do not have these rights, the LP is a VIE. Therefore, as illustrated in Figure CG 7-1, under the voting interest model for LPs, only a limited partner can consolidate an LP. Said differently, if a general partner consolidates an LP, the LP is a VIE.
Controlling financial interest
For purposes of assessing a controlling financial interest, one must evaluate whether kick-out rights (including liquidation rights) are held by limited partners, since these rights may be the equivalent of voting interests held by shareholders of a corporation. Therefore, a limited partner with a majority of kick-out rights through voting interests would usually control and consolidate the LP. However, if there are other limited partners holding substantive participating rights, then those rights would overcome the usual condition of control held by the limited partner with a majority of kick-out rights through voting interests. If none of the individual limited partners are able to exercise the kick-out right unilaterally, no partner would have a controlling financial interest in the LP.
Given the purpose and design of limited partnerships, kick-out rights through voting interests are analogous to voting rights held by shareholders of a corporation. For limited partnerships, the usual condition for a controlling financial interest, as a general rule, is ownership by one limited partner, directly or indirectly, of more than 50 percent of the limited partnership’s kick-out rights through voting interests. The power to control also may exist with a lesser percentage of ownership, for example, by contract, lease, agreement with partners, or by court decree.
The guidance states that kick-out rights are exercised “through voting interests,” which refers to the voting interest that a limited partner has in the kick-out right. The voting interest that a limited partner has in the kick-out right is generally equal to its economic interest in the LP.
For example, assume an LP has a general partner with a 20% ownership interest and four limited partners each having a 20% ownership interest. The four limited partners each have an equal vote in the kick-out right based on their ownership interest, thus each limited partner would have a 20% “voting interest” in deciding whether to exercise the kick-out right to remove the general partner. The general partner does not have a voting interest in the kick-out right. In this example, a simple majority of the voting interests in the kick-out right held by the limited partners would be 41% of the voting interests in the kick-out right, calculated as 51% of the 80% held by the limited partners. Since none of the limited partners individually hold more than 41% of the voting interests in the kick-out rights, none of the limited partners would consolidate the LP under the voting interest model. See CG 4.4.5.2 for further analysis and examples of the impact of kick-out rights on the VIE model.
Sometimes the general partner may also have a vote in deciding whether it should be removed. Kick-out rights held by the general partner and its related parties should be excluded when assessing whether a simple majority or lower threshold of limited partners can exercise the kick-out right. Therefore, only the kick-out rights held by the limited partners should be considered in the assessment.
7.3.1 Substantive kick-out rights and liquidation rights (VOE model)
For LPs and similar legal entities, kick-out rights are defined as:
Definition from ASC 810-20-20
Kick-Out Rights (Voting Interest Entity Definition): The rights underlying the limited partner’s or partners’ ability to dissolve (liquidate) the limited partnership or otherwise remove the general partners without cause.
Since an LP would be a VIE if the limited partners do not have kick-out rights or substantive participating rights, the assessment of the kick-out rights and substantive participating rights are generally performed when determining whether the LP is a VIE. If the LP is not a VIE, these same rights are then considered in assessing whether a single limited partner, if any, has a controlling financial interest in the LP. That is, the assessment performed during the VIE determination is carried over to the assessment of whether a single limited partner, if any, has a controlling financial interest in the LP.
By definition, kick-out rights are limited to the rights held by limited partners to remove the general partner(s). As mentioned in ASC 810-10-15-14(b)(1)(ii), in order for an LP to not be a VIE, the kick-out rights must be exercisable by a simple majority or lower threshold of limited partner(s). In determining the simple majority required to kick-out the general partner(s), any kick-out rights held through voting interests by general partner (regardless of whether they are embedded in the general partner interest or through any limited partner interest held by the general partner), by entities under common control with the general partner, and by others acting on behalf of the general partner should be excluded. Also, in determining the simple majority required to kick-out the general partner, the reporting entity needs to calculate and ensure that all possible combinations that represent a simple majority of the limited partners’ voting interests allow for the limited partners to kick-out or remove the general partner. See CG 4.4.5.2 for further analysis and examples of the impact of kick-out rights on the VIE model.
Kick-out rights must be substantive in order for them to be assessed under the VIE model pursuant to ASC 810-10-15-14(b)(1)(ii), as well as under the voting interest model. For kick-out rights to be considered substantive, the partners holding the kick-out rights must have the ability to exercise those rights if they choose to do so; that is, there are no significant barriers to the exercise of the rights. If the general partner or one of its related parties is in a position to block the exercise of the kick-out right, the limited partners will likely not have a substantive kick-out right. Refer to CG 4.4.5.2 for more discussion about evaluating whether kick-out rights (including liquidation rights) are substantive.
Kick-out rights are required to be assessed continuously. This is especially important when limited partners are investing in or divesting from the LP. If the limited partners fail to have a kick-out right that meets the requirements described in ASC 810-10-15-14(b)(1)(ii) and ASC 810-10-25-2 through ASC 810-10-25-14C, the LP would become a VIE. This could lead to a change in any consolidation conclusion.
Rights held by general partners to buy out limited partners are not considered kick-out rights as illustrated in Example CG 7-5.
EXAMPLE CG 7-5
Buy/sell right between general partner and limited partner
Partnership X was formed to acquire a single commercial real estate building and to lease the space to multiple tenants. The sole general partner owns 20% of the LP and the sole limited partner (a party unrelated to the general partner) owns 80% of the LP. The partnership agreement states that either partner has the right to offer to buy the other partner’s interest. The buy/sell provision is as follows:
- Offeror can request that offeree sell its interest to offeror at a price determined by the offeror
- Once an offer is made, offeree must either (1) sell its interest to the offeror, or (2) buy the offeror’s interest at the same price per unit
Once the buy/sell provision is triggered, either the offeror or the offeree would end up owning the partnership assets. The limited partner does not have substantive participating rights or unilateral kick-out rights over the general partner as described in CG 7.3.2.
Does the buy/sell right qualify as a kick-out right or a liquidation right?
Analysis
A buy/sell right is generally not a kick-out right or a liquidation right that enables the limited partner to remove the general partner without cause. If the limited partner initiates the buy/sell right, the general partner would control the ultimate outcome of the transaction. The general partner would have the right to either sell its interest to the limited partner or buy the limited partner’s interest. The determination that the general partner has the financial ability to buy out the limited partner’s interest requires careful consideration. If the general partner has the financial ability to buy out the limited partner’s interest (e.g., the general partner is financially capable of purchasing the limited partner’s interest or attracting new limited partners), the buy/sell right would not be considered a kick-out right.
In this case, the LP would be a VIE because the buy/ sell right does not represent a kick-out right or liquidation right. The partners would apply the guidance in CG 5 to identify the primary beneficiary of the VIE, if any.
Definition of “without cause”
Kick-out rights must be exercisable “without cause” in order to be a valid kick-out right. ASC 810-10 includes the following definitions:
Definition from ASC 810-10
With cause generally restricts the limited partners’ ability to dissolve (liquidate) the limited partnership or remove the general partners in situations that include, but that are not limited to, fraud, illegal acts, gross negligence, and bankruptcy of the general partners.Without cause means that no reason need be given for the dissolution (liquidation) of the limited partnership or removal of the general partners.
Based on the definition of without cause, a provision would only be a kick-out right if it gives the limited partners the right to remove the general partner for no reason, without regard to probability or any condition. Rights to remove the general partner with cause do not meet the definition of a kick-out right (unless the specified causes lack substance). For example, agreements with provisions that give limited partners the right to liquidate the partnership when there is a change in the LP’s key executives, but the general partner controls the change in executives, would not meet the definition of a kick-out right since it can be exercised only with cause.
7.3.1.1 Liquidation rights–LP’s and similar entities (VOE model)
As described in ASC 810-10, liquidation rights are included in the definition of kick-out rights. Therefore, the guidance for kick-out rights should be applied in the same manner for liquidation rights (e.g., simple majority concept and no barriers to exercise). However, barriers to exercise for liquidation rights may be different from barriers to exercise for kick-out rights and should be evaluated when assessing whether the rights are substantive. For example, a liquidation right may only allow the limited partners to receive cash upon liquidation as opposed to the assets under management, and thus the limited partners may be less likely to exercise their liquidation rights. However, the mere fact that the limited partners would not receive the assets under management is not by itself a barrier to exercise. All facts and circumstances should be considered in making this assessment, including, for example, why liquidation rights were granted to the limited partners instead of kick-out rights. For example, limited partners of an LP that invest in relatively liquid investments may not have kick-out rights over the general partner because those limited partners have liquidation rights that, if exercised, have the same effect on the general partner as a kick-out right. That is, if the limited partners sought to remove the general partner, they collectively could exercise their liquidation rights. The partnership would terminate, and a new partnership could be formed to make similar liquid investments with a new general partner.
7.3.1.2 Redemption rights–LP’s and similar entities (VOE model)
As an alternative to providing limited partners with liquidation rights, a partnership agreement may provide the limited partners the right to redeem their interest in whole or in part and, therefore, withdraw from the partnership. However, redemption rights are generally not the equivalent of liquidation rights or kick-out rights. Since redemption rights normally do not result in the complete dissolution of the LP (i.e., exercise of those rights only require that the partnership repurchase the requesting limited partner’s interest), the partnership’s activities continue after redemption. Accordingly, redemption rights generally would not be considered in the consolidation analysis, unless the redemption effectively requires liquidation of the partnership.
The partners’ unilateral right to withdraw from the partnership in whole or in part (withdrawal right) that does not require dissolution or liquidation of the entire limited partnership would not be deemed a kick-out right. The requirement to dissolve or liquidate the entire limited partnership upon the withdrawal of a limited partner or partners shall not be required to be contractual for a withdrawal right to be considered as a potential kick-out right.
Normally, it will be difficult to ascertain that redemption rights held by the limited partner(s) could result in an effective liquidation of the partnership. There must be credible evidence that the right is effectively similar to a liquidation right and that there are no barriers to exercising that right.
However, there may be certain limited circumstances in which the right to redeem the partnership interest results in the liquidation of the partnership. In certain cases, if partnership redemptions reach a certain threshold, the automatic liquidation of the partnership may be triggered. In other cases, a limited partner’s right to have its interest redeemed might compel the general partner to liquidate the partnership in order to finance the redemption. Each case should be assessed based on the facts and circumstances in determining whether a redemption right rises to the level of a liquidation right.
7.3.2 Substantive participating rights–LP’s and similar entities (VOE model)
Participating rights are defined as follows under the voting interest model:
Definition from ASC 810-10
Participating Rights (Voting Interest Entity Definition): Participating rights allow the limited partners or noncontrolling shareholders to block or participate in certain significant financial and operating decisions of the limited partnership or corporation that are made in the ordinary course of business. Participating rights do not require the holders of such rights to have the ability to initiate actions.
Excerpt from 810-10-25-14C
Rights of the limited partners to participate in the termination of management (for example, management is outsourced to a party other than the general partner) or the individual members of management of the limited partnership may be substantive participating rights.
As indicated in CG 7.3.1, the assessment of substantive participating rights for LPs is generally performed during the VIE assessment of the LP. This is because if limited partners of an LP do not have either substantive participating rights or kick-out rights, the LP would be a VIE. However, there can be a few exceptions to this assessment sequence. For example, if it is determined that a single limited partner has a kick-out right, any rights that the other limited partners may have might not be assessed during the VIE assessment of the LP. Assuming the LP is not a VIE, any rights that the other limited partners have will have to be assessed during the voting interest assessment in determining whether the single limited partner has a controlling financial interest in the LP.
Some partnership agreements may allow limited partners to participate in decisions that could have a significant impact on the partnership’s business (i.e., significant financial and operating decisions), thereby limiting the rights of the general partner or a limited partner with majority kick-out rights through voting interests. As previously described, if limited partners are able to exercise substantive participating rights over the general partner based on their voting interests, the LP would not be considered a VIE based on the guidance in ASC 810. Assuming none of the other VIE criteria are met, the LP would be considered a voting interest entity. Under the voting interest model, similar to noncontrolling shareholder participating rights in corporations, if limited partners have substantive participating rights, neither the general partner nor the limited partner with a majority of kick-out rights through voting interests would control the LP.
The assessment of whether a limited partner’s participating rights are substantive follows the same guidance in ASC 810-10-25-11 through ASC 810-10-25-13 for the assessment of noncontrolling shareholder participating rights in corporations. A limited partner’s veto right to block actions that are not made in the “ordinary course of business” are protective rights. Refer to CG 7.3.1 for more discussion about distinguishing participating rights versus protective rights, and evaluating whether participating rights are substantive.
The guidance does not require that a substantive participating right be exercised by at least a simple majority or less of the limited partners (as a kick-out right requires). However, if the percentage of limited partners required to exercise a substantive participating right is very high, this should be considered as a potential barrier to exercise of the right.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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