Mezzanine, convertible and profit-participating loans: SPPI failure and FVTPL

A DFI's debt book typically mixes plain senior loans with instruments designed to share in the borrower's upside: mezzanine loans with an EBITDA or revenue participation, convertible loans, loans with equity warrants or exit premiums, and quasi-equity facilities whose repayment depends on project cash flows. The same borrower may have a senior tranche at amortised cost and a mezzanine tranche that fails the SPPI test and must be at fair value through profit or loss. Misclassifying a profit-participating loan as amortised cost understates volatility, recognises interest at a contractual rate that ignores the equity-like return, and runs an expected credit loss model on an instrument that should not be in it. Over-classifying senior loans to FVTPL is equally wrong and creates unnecessary volatility.

Does any part of the return depend on the borrower's profit, EBITDA, revenue, share price or exit value, rather than only on time value of money, credit risk, other basic lending risks and costs, and a profit margin? Is a conversion option or warrant contractually part of the loan (so the whole instrument is assessed) or a separate, freely transferable instrument (so the loan may be assessed on its own)? Is repayment limited to the cash flows of a specific project or asset, so that a look-through assessment is needed? Are contingent margin step-ups (for example linked to development impact targets) compensation for basic lending risks, or linked to non-lending variables? Is the senior loan held to collect contractual cash flows, or does the DFI originate to distribute part of it to co-lenders shortly after origination?

1. Identify the unit of account: assess whether warrants, conversion rights, exit premiums and participation rights are contractual terms of the loan or separate instruments with their own unit of account.
2. For each loan or tranche, determine the business model (held to collect for most DFI senior loans; a different model for portions originated to be sold down).
3. Apply the SPPI test to the instrument as a whole: profit or revenue participations, equity conversion features and returns linked to the borrower's equity value introduce exposure to risks unrelated to a basic lending arrangement and fail the test.
4. Do not separate an embedded derivative from a financial asset host; if the hybrid fails SPPI, classify the whole instrument at fair value through profit or loss.
5. Where a warrant is a separate instrument, recognise it as a derivative or equity instrument at fair value through profit or loss, allocate the remaining consideration to the loan and assess the loan on its own.
6. Measure senior loans that pass SPPI and are held to collect at amortised cost with expected credit losses; measure failing instruments at fair value through profit or loss with no separate ECL.

Instruments at fair value through profit or loss are valued as a whole, typically by discounting expected contractual and participation cash flows at a rate reflecting the borrower's credit risk, subordination, country risk and the equity-like component, or by an option-based model for conversion features; credit risk is captured in fair value rather than through a loss allowance. Senior loans at amortised cost are measured using the effective interest rate on the gross carrying amount, less a 12-month or lifetime ECL allowance. Coupons received on FVTPL instruments may be presented separately from other fair value changes, but not within interest revenue calculated using the effective interest method.

Disclose: (1) carrying amounts of debt investments by measurement category (amortised cost, mandatorily FVTPL); (2) the accounting policy and judgments applied in the SPPI assessment, especially for participation, conversion and project-linked features; (3) the presentation policy for interest and coupons on FVTPL instruments; (4) for amortised cost loans, the ECL disclosures by stage, including reconciliation of the loss allowance; (5) for FVTPL debt, fair value hierarchy level, valuation techniques, significant unobservable inputs and sensitivities; (6) credit risk exposure on FVTPL debt instruments, including maximum exposure.

• Bifurcating a conversion option or profit participation from a loan asset and carrying the host at amortised cost
• assuming that subordination alone fails SPPI, when a subordinated loan with plain interest can still pass
• assuming a mezzanine label automatically means FVTPL without reading the terms
• ignoring that repayment limited to project cash flows requires a look-through assessment
• running ECL staging on FVTPL instruments
• including FVTPL coupons in interest revenue calculated using the effective interest method
• treating a freestanding, separately transferable warrant as part of the loan and failing an otherwise plain senior loan