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Traditionally, equity investors is exposed to the expected losses of their investment. Complex capital structures, contracts and transactions may shift this exposure to parties other than the equity investors. If equity investors at risk do not have ‘first dollar’ exposure to expected losses through arrangements made outside of the equity investment at risk instrument, then their exposure to expected losses has been diverted. A prime example of this would be an asset value guarantee in a lease that absorbs the expected losses of the asset that would otherwise be incurred by the equity investors. Alternatively, a traditional debt guarantee would probably not protect the equity investors from first dollar loss since the guarantee would normally be exercised only after equity has been exhausted. This concept applies to both direct relationships¬†(i.e., explicit variable interests) with the legal entity and indirect relationships (i.e., implied variable interests).

It is important to note that if this evaluation is specific to the equity investments, not the identity of the investor. If the obligation to absorb first dollar losses rests with the equity investors but through an instrument that is not equity investment instrument (say, a asset value guarantee), then the equity investors lack first dollar loss exposure through the equity investment, and the entity is a VIE.

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