Special Purpose Entity (SPE)

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Special Purpose Entity Meaning

A Special Purpose Entity is a separate legal entity created to fulfill certain objectives, including devising measures to appropriate financial risk and legal risk profile. This entity generally has a predefined purpose and limited activity scope and is sometimes used as a short-term solution to a current or potential problem. Also, their structure is accordingly devised.

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Also known as a special purpose vehicleSpecial Purpose VehicleA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities.read more, it is the subsidiary of the larger corporation with different liability structures, asset structures, and legal status, which makes all its obligations secure. It is secure even if its parent company becomes bankrupt. It is also designed to serve as the counterpartyCounterpartyA counterparty in a financial transaction is the person or entity on the other side of the agreement. Any trade must have at least two parties who serve as counterparties for each other. For every buyer in a purchasing deal, there must be a seller. And for every seller, there must be a buyer willing to purchase.read more for the swapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more and the other types of derivative instruments that are credit-sensitive.

Key Takeaways

  • Special Purpose Entity is an independent legal entity that meets particular needs. It also includes planning means for sound financial and legal risk profiles.
  • Sometimes, it is called a special-purpose vehicle. It is a vast corporation subsidiary with distinct liability and asset structures and legal statuses.
  • Moreover, it makes all the responsibility secure even if the parent company becomes insolvent. Often, it is used as a short-term solution to a current or potential problem and structured accordingly.
  • On-balance sheet SPE and off-balance sheet SPE are the two types of Special Purpose Entities (SPE).

Special Purpose Entity (SPE) Explained

A special purpose entity (SPV) is a subsidiary company formed to facilitate the parent company’s financial arrangements, which includes speculative investments and leverage, without compromising the whole group.

It means that if the special purpose vehicle becomes bankrupt, then in that case the parent company remains unaffected, and in case the parent company becomes bankrupt. The special-purpose entity remains protected and unaffected. Special purpose entities generally are used for securitization, and they are allowed to buy, sell, and finance the assets.

SPE

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Although Special Purpose Vehicle is used for isolating the financial riskThe Financial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more present because of the different accounting loopholes, at the same time, these entities may become CFO’s financially devastating way for hiding the debts.

The parent company can form the SPE through trusts, corporations, limited partnershipsLimited PartnershipsIn a limited partnership, two or more individuals form an entity to undertake business activities and share profits. At least one person acts as a general partner against one limited partner who will have limited liability enjoying the benefits of less stringent tax laws.read more, limited liabilityLimited LiabilityLimited liability refers to that legal structure where the owners' or investors' personal assets are not at stake. Their accountability for business loss or debt doesn't exceed their capital investment in the company. It is applicable in partnership firms and limited liability companies.read more corporations, etc.

The documentation of the equity, assets, and liabilities is done by the Special-purpose entity (SPE) on a balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more of its own rather than the parent company’s balance sheet as the equity or debt.

SPE may hide crucial information from its investors who might not completely know the company’s financial situation. With this risk, the investors shouldBalance sheet analysis interprets the company's assets, liabilities and owner's capital in a certain period. It provides an accurate picture of the organization's financial health and position to the investors, shareholders and institutions.read more analyze the balance sheetAnalyze The Balance SheetBalance sheet analysis interprets the company's assets, liabilities and owner's capital in a certain period. It provides an accurate picture of the organization's financial health and position to the investors, shareholders and institutions.read more of the Special-purpose entity and the parent company properly before reaching any conclusion regarding investing in the business of any of them.

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Reasons

Though these entities are not controlled or monitored by the central bank, they are still regulated based on the objective they have been created to serve. The reasons or objectives that these SPEs are formed to deal with or take care of include the following:

  • It holds a pool of securities and assets, which can act as collateral for loans when required.
  • It can pass the risks involved in holding the pool of assets to other investors or entities.
  • These entities make it easier for a firm to have access to cash, thereby increasing the liquidity opportunities for it.

Types

The following are the two types of SPE.

#1 – On Balance Sheet SPE

In the case of Balance Sheet SPE, the financial results of the Special-purpose entity are consolidated with the parent company’s financial results. The incomes, in this case by some means, are transferred to the parent company.

#2 – Off-Balance Sheet SPE

In the case of off Balance Sheet SPE, the financial results of the Special-purpose entity are not consolidated with the parent company’s financial results, and the incomes are also not transferred to the parent company by any means.

Examples

Let us consider the following examples to understand what is a special purpose entity and how it works:

Example 1

There is a company named BCF limited which is famous for manufacturing the different types of equipment used for industrial purposes. The company uses a special purpose entity for financial risk leverageFinancial Risk LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more. Out of all the Special-purpose entities of the company, one of the SPE has independent members on the board, which consists of a commercial bank that provides theCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. read more credit facilityCredit FacilityCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. read more and the loan, different equity investors who have the tax free investments, government who provides the subsidies and also permits the company for the operation of the contracts of the Special-purpose entity, and the sponsor protecting the minority investors of the parent company and coverage to the technical risk.

The SPE Company formed acts as the equipment solution provider and other technical consulting issues. Also, the Special-purpose entity (SPE) offers construction engineering and maintenance.

The different advantages which the parent company BCF limited have when its BCF limited is operating involves the high-level project and risk management, which allows the company to collaborate with its stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more and the chain holders effectively. Apart from this, it is easy for the parent company to finance its operations using government funding, long-term debtLong-term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more or equity investors without any compromise to its main operations.

Example 2

KeyBank Community Development Financial Institutions (CDFI) Group offers a $20 million line of credit to support small businesses in the region with Lendistry, An SPE founded by BSD Capital, Inc. Lendistry is an entity that helps small businesses obtain loans when they do not fulfill the conventional lending criteria, be it with respect to cash or credit or collateral, etc. The SPE offers credit facilities and other financial services to small businesses across the United States and helps them deal with shortfalls effectively to enjoy uninterrupted progress and growth.

Advantages

Having a special purpose entity formed gives companies an opportunity to stay away from direct financial risks and losses. These firms are created to fulfill the temporary objectives of their parent company and offer a shield against the expected losses or risks. Some of the benefits of having the SPEs formed are as follows:

Disadvantages

Undoubtedly, creating the SPEs is of huge benefit to the parent companies, but they are not devoid of flaws. Let us have a look at the limitations of these entities:

Special Purpose Entity vs Single Purpose Entity

Special purpose entity and single purpose entity are terms that are synonymously used when it comes to referring to a newly formed firm taking care of the financial risks of a parent company. However, these two differ slightly in their horizon.

Both these entities can be used as a substitute as they have similar objectives to fulfill, but they still have one difference. While a single purpose entity is more expansive with a broader horizon, the special purpose entity is a part of it.

Frequently Asked Questions (FAQs)

Is trust a special purpose entity?

No, trust is not a special purpose entity. A trust is a legal arrangement in which a trustee holds and manages assets on behalf of the trust beneficiaries. At the same time, SPE is created for a specific limited purpose.

What is SPE in private equity?

In private equity, SPE is a legal entity created to hold and manage a particular investment or portfolio. In private equity, SPE is used to isolate financial risk and facilitate the purchase of specific assets.

What is a qualifying special purpose entity?

A qualified SPE is established for a specific and limited purpose and is primarily used in securitization transactions. These are established under the Financial Accounting Standards Boards (FASB)

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