Accidental standard-bearer for the credit tenant lease community Kyle Gore, managing director of the structured finance group at Baltimore-based Legg Mason Wood Walker, weighed in on the likely affect FASB Interpretation No. 46 (FIN 46) will have on the net lease arena at the recent IRR industry conference. After months of exposure drafts, evolving abbreviations, and sometimes not-too-tacit jabs between the synthetic lease and sale/leaseback corners, the net effect - at least upon CTLs - seems to be close to nothing.
"While no transaction type is necessarily exempt from the FASB Interpretation," Gore said, "we believe that arm's length' CTLs should not and will not trigger any consolidation result than they had prior to the issuance of the guidelines."
According to Gore's panel presentation, the impact of FIN 46 on private debt transactions - including CTLs - may be limited, given that variable interest entities (VIEs, nee SPEs) exist in the private debt markets generally for purposes completely unrelated to those on which the FASB has appropriately focused.
FIN 46 states that "An enterprise shall consolidate a VIE if that enterprise has a variable interest - including equity investments, loans, leases, etc. - that will (a) absorb a majority of the VIE's expected losses if they occur, or (b) receive a majority of the VIE's expected residual returns if they occur, or (c) both." An enterprise that consolidates a VIE is called the "Primary Beneficiary" of the VIE.
A CTL is a debt financing provided by an arm's-length institutional investor and primarily secured by an asset (generally real property) subject to a lease agreement between a single-asset, special purpose entity landlord as borrower and a completely unaffiliated corporate lessee. In most cases, SPE landlords are formed as limited liability companies or business trusts, and the economic interests are owned by a sole member of beneficial owner; in all cases, the lender, SPE landlord and tenant are and remain completely separate, independent and unaffiliated entities. No distinction exists between tax and GAAP reporting for a CTL.
Contrary to the initial exposure draft of FIN 46 issued last July - in which it was expressly implied that an "arm's-length" lender could, under various circumstances, be deemed to be the primary beneficiary of the VIE - the final interpretation arguably provides relief to arm's-length debt investors. Specifically, institutional debt investors in fixed-rate transactions with no participating interests or other rights to economic upside are essentially left with the same result they would have had, according to Gore, in the absence of FIN 46: zero consolidation risk.
Ten percent or else?
As outlined in Gore's presentation, initial press accounts and accounting firm summaries had incorrectly indicated that the assets and liabilities of an entity with an equity investment of less than 10% of the entity's total assets must be consolidated by another entity - what Gore called "the big myth."
In fact, the interpretation expressly states that "an equity investment of less than 10 percent of the entity's total assets shall not be considered sufficient to permit the entity to finance its activities without subordinated financial support in addition to the equity investment-unless the equity investment can be demonstrated to be sufficient in at least one of the following three ways: the entity has demonstrated that it can finance its activities without additional subordinated financial support; the entity has a least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support; or the amount of equity invested in the entity exceeds the estimate of the entity's expected losses based on reasonable quantitative evidence."
Gore emphasized that the concept of "expected losses" is prevalent throughout FIN 46, yet is intended to be the "third line of defense" in assessing whether an entity with less than 10% equity is a VIE or must be consolidated by some other party. Expected losses and other "tests" set forth in paragraph 9 of FIN 46 should allow many entities - particularly those that hold "ratable" assets such as net leases to investment-grade tenants in the case of CTLs, pools of investment-grade securities, etc. which are susceptible to an actuarial analysis of probability and degree of loss - to either be excluded from consideration as a VIE altogether, or lead all other parties to conclude that the only possible primary beneficiaries are the equity owners of such entities.
Interestingly, Gore said, FIN 46 appears to offer an argument that, merely by virtue of receiving an arm's-length loan from a third-party lender, an entity probably has sufficient equity.
Let's get it on!
No discussion of the leasing arena would be complete without some sparring between the sale/leaseback and synthetic lease corners. Synthetic players argue that the real estate community has unfairly demonized synthetic leases, hoping to see a divergence of synthetic deal flow into the CTL market. Sale/leaseback players, on the other hand, have labeled synthetics as "inherently flawed" instruments that have long deserved the scrutiny they've recently undergone.
"As to synthetics," Gore said, "it appears to us that the synthetic lease lenders/lessors are looking to circumvent FIN 46 by placing their deals in "non-VIE" entities that would hold and consolidate multiple assets." Presumably, he continued, these players assume that such an approach would obviate the need for the tenant to consolidate the assets and liabilities of the lessor.
"What seems incongruous to us," Gore noted, "is the fact that the tenant's residual guarantee of the underlying real estate value is being overlooked and/or downplayed' to the point that the synthetic players assume that the tenant will not consolidate merely because the lender/lessor did. We think this approach may be flawed, as the FASB clearly intended that tenants providing residual guarantees must consider whether consolidation is appropriate."
Gore expects that CTL activity will pick up going forward, if only because the mere issuance of FIN 46 removes a level of uncertainty that had cast a pall over the sale/leaseback and net lease markets in general. He estimates that the CTL market volume is anywhere from $5 billion to $7 billion yearly under normal conditions, but that volume was down 25% to 30% in 2002. Looking ahead, Gore sees the 2003 CTL market on the anemic side of baseline by roughly 10%.
"Given the uncertainty surrounding synthetics - i.e. whether they're still here or not -the economy, geopolitical instability, and how to interpret the new FASB proclamation, we do not expect the boomlet' many others foresee for the market this year," Gore said, "although we do expect a stronger year than last.
"We actually had a great year in our group doing both traditional and nontraditional CTL financings," he noted, "and we expect that our business this year will continue to include a mix of credit-related structured transactions including many outside of the normal' net lease financing business."
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