Determining the equity investment at risk is a quantitative analysis that starts with GAAP equity associated with the silo measured at fair value as of the appropriate determination date, including equity classified in temporary and mezzanine equity. From this amount, make the following adjustments:
- Subtract silo equity investments that do not participate significantly in the profits and losses of the silo;
- Subtract silo equity investments that the silo issued in consideration of subordinated interests in other VIEs;
- Subtract amounts paid directly or indirectly to any silo equity investors, unless the payor is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the silo investor;
- Subtract silo equity investments that were financed (directly or through guarantees) by the legal entity or its related parties, unless the party providing the financing is a parent, subsidiary or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.
What doesn’t count as equity?
Without regard to whether it is at risk or not, the following should be excluded from equity:
- “Stock” that is classified as a liability under ASC 480;
- Equity-linked instruments classified as a liability under ASC 815;
- Subordinated debt that is effectively a substitute for an equity investment (see ASC 810-10-25-47);
- Equity subscriptions receivable;
- Equity commitments.
All of the above would either not be classified in GAAP equity or, in the case of a subscription receivable, would be recorded as a dedit in the equity section thereby reducing the equity amount. The only purpose of listing these here is to avoid any confusion.
Participates significantly in profits and losses
This refers to GAAP profits and losses, not the expected losses and expected residual returns used elsewhere in the VIE model. Participation simply means that the equity investment shares in the silo’s profits and losses. If an equity investment enjoys a minimum, guaranteed or fixed rate of return (cumulative preferred stock), then that equity investment is not at risk. Similarly, an equity investment that only participates in profits, and not losses, or whose participation in profits and losses is capped (and therefore not proportional), is also not at risk.
There are some exceptions:
- An equity investment whose fixed rate of return is significant relative to the expected rate of return of the silo as a whole (for example, greater than 50%) would probably be considered to participate significantly in profits and losses.
- Puttable and redeemable equity interests that are exercisable at the option of the holder are generally not considered at risk, unless the exercise price is variable or at market, or the exercise period is relatively short.
Issued in consideration of subordinated interests in other VIEs
This condition prevents an interest in one VIE from being used as the equity investment in a different VIE for purposes this calculation. In other words, you can’t use a single equity investment twice.
Amounts paid directly or indirectly to any equity investors
Silo equity investments that are effectively a round trip of fees, charitable contributions, or some other payment by the legal entity or some other party associated with the legal entity, are not considered at risk. Fees that can be excluded from this category include:
- Reimbursements for amounts paid by the silo equity investor to third parties for goods and/or services provided by the third party to the legal entity’s silo;
- Fees payable in the future that are at market rates for services to be provided in the future.
Equity investments that were financed
The funding source of the silo equity investment must be the equity investor, not the legal entity or some other party associated with the legal entity. Therefore, any amounts financed directly or through guarantees by the legal entity or parties involved with the legal entity must be excluded from equity investment at risk.
Activities around the entity
Equity investors and other parties involved with the legal entity may enter into agreements among themselves or with third parties that effectively reduce the equity investment at risk. These arrangements include equity investments between investors in the legal entity, puts and calls between the entity and other investors and/or non-investors, service arrangements between investors and non-investors, and derivatives such as total return swaps. Any relationship that reduces or transfers risk should be evaluated for its potential impact on this calculation.