GAAP (generally accepted accounting principles) determines whether or not a general partner has "control" of an investment partnership such that the general partner must consolidate the limited partnership financial results with the general partner's own financial statements. Companies that serve as the general partner to one or more funds have struggled for the past two years to adjust to stringent accounting rules which require this consolidation unless the traditional control provisions in fund limited partnership agreements are altered.
In June 2005, the Financial Accounting Standards Board (the "FASB") formally ratified the FASB's Emerging Issues Task Force (the "EITF") consensus on Issue No. 04-5, " Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights " ("Issue 04-5"). Issue 04-5, which applies to any GAAP-based entity that serves as a general partner in a limited partnership, provides authoritative guidance for determining whether a general partner controls, and therefore must consolidate, a fund. In the two years since the adoption of Issue 04-5, increasingly more scrutiny has been imposed on the audited financials and fund documents of general partners.
Prior to the ratification of Issue 04-5, there was little concrete guidance under GAAP as to whether or not a general partner's responsibilities in a limited partnership constitute accounting control such that the general partner must consolidate the limited partnership.1The need for consensus became clear when the FASB adopted Interpretation 46(R)2 , which provides a framework for consideration of certain aspects of "control" in determining whether a company associated with variable interest entities should include the assets, liabilities and other activities of the variable interest entity in the company's financial statements. In particular, Interpretation 46(R) requires an evaluation of "kick-out rights" in regard to the control and consolidation of a variable interest entity.
Limited partnerships had previously analogized the guidance issued by the American Institute of Certified Public Accounts in its Statement of Position 78-9, " Accounting for Investments in Real Estate Ventures " ("SOP 78-9"), which specifically addressed accounting for investments in entities such as real estate ventures, general partnerships and limited partnerships.3SOP 78-9 presumed that a general partner controls a limited partnership such that the general partner should consolidate regardless of the level of economic interest that the general partner has in the fund. Issue 04-5 serves to clarify SOP 78-9 by providing a context for determining whether certain limited partner rights, namely kick-out rights and participating rights, overcome the presumption of control by the general partner.4
The application of Issue 04-5 begins with the presumption that the general partner controls the limited partnership, regardless of the general partner's economic interest in the fund. Unless the presumption of control is overcome, the general partner will consolidate the limited partnership. Issue 04-5 provides for a facts and circumstances analysis of whether or not the presumption is overcome based on the extent to which limited partners have either: (i) the substantive ability to dissolve (liquidate) the fund or otherwise remove the general partner without cause ("substantive kick-out rights"); or (ii) substantive participating rights.
I. Substantive Kick-Out Rights:
Kick-out rights refer to the limited partners' ability to dissolve the partnership or otherwise remove the general partner without cause. If substantive kick-out rights are present in a limited partnership, the presumption of control by the general partner is overcome and the general partner would account for its investment in the fund using the equity method of accounting.
In order to overcome the presumption of control, the rights of the limited partners must be substantive, meaning they meet both of the following criteria:
• the kick-out rights can be exercised by the vote of a single limited partner or a simple majority (or lower percentage) of the limited partners' voting interests (excluding those interests held by the general partner or another entity related to the general partner); and
• the limited partners holding the kick-out rights have the ability to exercise the kick-out rights without significant barriers to their implementation.
A limited partnership agreement that grants limited partners the unilateral right to withdraw from the fund may overcome the presumption of general partner control only if such a withdrawal would cause a dissolution or liquidation of the entire fund.
II. Substantive Participating Rights
Substantive participating rights grant limited partners the ability to participate in important financial and operating decision-making processes for the fund. If substantive participating rights are present in a limited partnership, the presumption of control by the general partner is overcome. "Participating rights" means that limited partners have the ability to approve or veto the actions proposed by the general partner.
Participating rights include decisions on management of the fund and other operating and capital decisions that would be expected to be made in the ordinary course of business for the limited partnership, meaning those that are reasonably expected to impact the limited partnership's current business activities.
Issue 04-5 offers the following examples of participating rights:
1. Limited partner participation in selecting, terminating and setting the compensation for the management team of the fund; or
2. Limited partner participation in establishing operating and capital decisions of the limited partnership, including the budget.
To determine whether a participating right is substantive or not, the issue suggests consideration of the following factors:
1. Related-party relationships between the general partner and the limited partners. For example, consider whether the limited partner and the general partner are family members or are under common control.
2. The level at which decisions are made, as determined by the limited partnership agreement. For example, does the issue require the approval of the limited partners, or of the limited partnership as a whole?
3. The level of significance of the limited partners' role in operating and capital decision-making. Limited partners' rights related to items that are not considered significant for directing and carrying out the fund's business are not substantive participating rights.
4. The fact that the chance that the event or issue in which the limited partners have a decision-making role is remote or unlikely to arise over the course of the partnership.
5. Whether the general partner has a contractual right to buy out the interest of the limited partners for fair value or less (a call option), thereby giving the general partner the ability to prevent the limited partners from exercising their participating rights.
Issue 04-5 is careful to distinguish between substantive participating rights and protective rights, which do not serve to overcome the presumption of control by the general partner. Protective rights include the limited partners' voting rights with respect to actions outside the ordinary course of business, such as the approval or veto amendments to the limited partnership agreements, liquidation of the limited partnership, issuance of limited partnership interests, and acquisitions and dispositions of assets that would not be expected to be made in the ordinary course of the fund's business.
III. Initial And Ongoing Assessment Requirements
The assessment of limited partners' rights in a fund and their impact of the presumption of control of the limited partnership by the general partner should initially be made when an investor first becomes the general partner. Thereafter, assessments should occur at each reporting period at which the general partner prepares financial statements.
Compliance with Issue 04-5 has been troublesome for funds and entities serving as general partners. When the consensus was first proposed, many entities argued that consolidation of the limited partnership's financial statements with those of the general partner would not accurately represent the underlying economics, particularly for entities that serve as general partner to several funds. Consolidated financial statements would be inaccurate because they would fail to reflect that most funds are established such that the general partner holds a very small economic interest in the limited partnership. Further, accounting for the large investment assets of a fund on the same balance sheet as the general partner's real assets would create confusion and an inaccurate portrayal of the financial situation of the general partner entity. It would become costly and time consuming to prepare explanations for the inconsistencies.5
In the nearly two years since compliance with Issue 04-5 has been required for general partners, funds have typically responded in one of three ways:
First, some funds have drafted or amended their limited partnership agreements such that only a simple majority vote of limited partners is necessary to remove the general partner. In other words, limited partners have substantive kick-out rights and the presumption of general partner control is overcome. Prior to the adoption of Issue 04-5, most funds had some form of kick-out rights, but such rights usually required the consent of a supermajority of limited partners (67% or more). Many critics of Issue 04-5 argued that supermajority kick-out rights, combined with other important rights such as key-man provisions, liquidation rights and distribution rights, provide a more effective and realistic control scheme than simple-majority kick-out rights. They argued that the ability of a simple majority of limited partners to remove the general partner undermines the expectations of investors that the fund will be managed by a committed and focused general partner through the entire term of the fund.
Second, because many smaller general partners are not required to prepare GAAP financial statements, these funds have elected to minimize their compliance with GAAP. In effect, the general partner chooses to explain why the entity's financial statements are not fully GAAP compliant, rather than incur significant costs in preparing consolidated financials and an explanation of why its financial statements are confusing and inaccurate.
Finally, many larger firms cannot avoid compliance with GAAP. If these firms wish to retain their supermajority kick-out rights, they typically prepare an explanation of the consolidated financial statements to be included with the balance sheet presentations and other reports. Fortunately, these firms typically have the financial capacity to bear this expense.
1 "Breaking Up Is Hard To Do," Deloitte & Touche Heads Up, July 21, 2005.
2 FASB Interpretation No. 46(R), Consolidation on Variable Interest Entities.
3 EITF Issue No. 04-5, "Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Parterns Have Certain Rights."
4 Following the adoption of Issue 04-5, SOP 78-9 was amended to be consistent with the consensus reached in Issue 04-5.Issue 04-5 applies to limited partnerships and other entities that have similarly-structured governing provisions, including limited liability companies, that are not classified as variable interest entities under Interpretation 46(R).It does not apply to a fund whose general partner carries its limited partnership interest at fair value with changes in fair value reported in a statement of operations or financial performance.According to Issue 04-5, an entity that is required to apply the consolidation guidance included in Accounting Research Bulletin No. 51 and FASB Statement 94 to its investment in a limited partnership are within the scope of the consensus.
5See NVCA Comment letter to FASBon EITF 0405, February 19, 2005 5; See also Adams Street Partners Comment Letter to FASB on EITF and FSPSOP 78-9-a of EITF 0405.
Henry Nelson Massey and David A. Sussman are partners at the Florham Park, NJ office of Day Pitney LLP. Jane Helen Broderick is an associate at the firm's New York office.