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Equity Investment at Risk Less Than 10% of Assets

Is the equity at risk calculated less than 10% of total assets, both measured at fair value? If so, then the answer to this question is ‘no’ UNLESS the legal entity can demonstrate that the equity investment at risk is sufficient. Sufficiency of equity investment at risk should be, if possible, demonstrated qualitatively. This can be very difficult to do for a legal entity with a complex capital structure. A simple capital structure may appear easier to handle from a qualitative perspective, but this may not always be true. The most convincing qualitative evidence is to compare the legal entity’s equity at risk to that of another entity with similar assets and comparable investment equity at risk. If that entity operates with no additional subordinated support, that is strong evidence that the legal entity can do so also.

Without that comparison, most of the qualitative evidence available will likely provide evidence that investment equity at risk is not sufficient. The existence of loan guarantees, for example, is strong evidence that the lender found the entity’s investment equity and credit quality insufficient. Similar types of lender/investor risk mitigating arrangements will have the same impact on a qualitative analysis.

If a qualitative analysis is not possible or is not sufficient, then a quantitative analysis should performed. The legal entity has sufficient investment equity at risk if the equity investment at risk exceeds the expected losses.

See _________ for a detailed discussion on calculating expected losses (and residual returns).

Equity Investment at Risk Greater Than or Equal to 10% of Assets

The analysis of equity investment at risk when greater than or equal to 10% of total assets is actually identical to that when it is less than 10%. The only missing element is the presumption that equity investment at risk is insufficient. So the qualitative analysis, quantitative analysis, or both, must still be performed and for the same purpose.

There has been some misunderstanding in practice that the “10% or greater” hurdle represents a safe harbor that, if met, means the legal entity has sufficient equity investment at risk. Not true. The analysis must still be performed as discussed above.

Development Stage Entities

 

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