To Consolidate or Not to Consolidate, That Is the Question for Registered Investment Companies
Some investment companies hold direct financial interests in portfolio companies. Some, for jurisdiction or tax purposes, solicit capital in feeder funds, who in turn invest in a master fund that invests directly into portfolio companies (also known as master-feeder funds). Some choose to invest directly through other investment companies that invest in portfolio companies (also known as fund of funds). Last but not least, some investment companies may even set up wholly owned blocker entities as holding companies to hold the financial interest in portfolio companies.
FASB Accounting Standards Codification Topic 810, Consolidation, provides that, in general, an investment company shall not consolidate an investee that is not an investment company (unless the operating entity provides services directly to the investment company). However, do investment companies or funds always consolidate their investees that are qualified as investment companies?
FASB does not address this question directly. However, the SEC issued IM Guidance Update No. 2014-11, “Guidance Regarding Investment Company Consolidation” (IM 2014-11), to provide the view of the SEC staff regarding the presentation of consolidated financial statements for registered investment companies (RIC) under the Investment Company Act of 1940 (1940 Act) and investment companies that have elected to be treated as business development companies (BDC) under the 1940 Act.
IM 2014-11 acknowledged the general rule that “statements of the registrant may be consolidated only with the statements of subsidiaries which are investment companies …” and provides guidance on “what financial presentation is most meaningful in the circumstances.” This view is consistent with ASC Topic 810. IM 2014-11 further highlights examples of various situations that may arise and result in questions concerning whether an investment company should consolidate its subsidiary that also is an investment company. Let’s take a look together.
RIC That Is a Feeder Fund
When a RIC is a feeder fund in a master-feeder funds structure, the feeder fund invests substantially all of its assets in the master fund and the master fund carries out all activities. SEC staff believes that an unconsolidated financial presentation is most meaningful and provides an appropriately transparent presentation of the financial position and results of operation of the feeder fund, provided that the feeder fund 1) attaches the financial statements of the master fund to its financial statements, 2) separately discloses on its statement of operation the net investment income, net realized gain or loss, and net change in unrealized gain or loss allocated from the master fund, and 3) includes these income and expense ratios in its financial highlights.
RIC That Is a Fund of Funds
When a RIC is a fund of funds, it typically invests in multiple underlying funds and may hold controlling financial interests in some underlying funds and noncontrolling financial interests in other underlying funds, and the level of its interests in any particular underlying fund might fluctuate between controlling and noncontrolling. In the SEC staff’s view, if this RIC were to consolidate certain of its underlying funds for certain periods based on if it is controlling financial interests, the resulting financial presentation may not be meaningful and may be confusing to investors. SEC staff did point out that if a RIC has an investment in a single underlying fund that is so significant to the RIC, its presentation of financial statements should be made similarly to a master-feeder structure.
RIC That Has Wholly Owned Subsidiaries or Blockers
When a RIC sets up a wholly owned subsidiary as a blocker or holding company to facilitate investment in a portfolio company, the design and purpose of the subsidiary is viewed to act as an extension of the RIC’s investment operations and facilitate the execution of the investment strategy. SEC staff expressed its view that, generally, the RIC should consolidate such subsidiary because consolidation provides investors with the most meaningful financial presentation.
Nonregistered Investment Companies
Although IM 2014-11 was issued to provide guidance to RICs and BDCs, the guidance also may be considered for nonregistered investment companies. The Investment Companies – AICPA Audit and Accounting Guide also provides further guidance on consolidation by investment companies for both registered and unregistered funds. Each fund should consider what application, showing the blocker as a subsidiary or as an investment, will provide investors with the most meaningful financial presentation.
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