Special Purpose Entity Definition
It’s a separate legal entity created to fulfill certain objectives which may include devising measures to appropriate financial risk and/or legal risk profile, this entity generally has a predefined purpose and have a limited scope in terms of activity and sometimes used as a short term solution to a current or potential problem also their structure is accordingly devised.
It is also sometimes called as the 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.. Generally, the SPE is the subsidiaries of the larger corporation with the different liability structure, asset structure and the legal status which makes all its obligations secure. It is secure even if its parent company becomes bankrupt. It is also designed for serving as the counterparty 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. and the other type of derivative instruments which are credit-sensitive.
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. present because of the different accounting loopholes, at the same time these entities may become CFO’s financially devastating way for hiding the debts.
Types of Special Purpose Entity (SPE)
The following are the 2 types of SPE.
#1 – On Balance Sheet SPE
In the case of on 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.
Example of the Special Purpose Entity (SPE)
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. . Out of all the Special-purpose entity’s of the company, one of the SPE has independent members on the board which consists of a commercial bank which provides the 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. 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 in collaborating with its stakeholders 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. or equity investors without any compromise to its main operations.
- By the creation of the Special purpose vehicle, the parent company will be allowed to isolate the financial risk legally which is associated with the project and share it with the other investors.
- SPE helps in the tax saving for the company in case the entity is created in the tax havenTax HavenA tax haven is a place or a country with very low or nil rate of income tax. It provides a business-friendly macroeconomic environment, such as financial and economic stability, as well as financial secrecy from tax authorities. countries.
- It is easy to set up the SPE.
- The Special purpose vehicle and the parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. are not bound with the same rules and regulations, so it offers more freedom to operate Special purpose vehicle
- SPE helps in keeping secrecy with respect to some projects from the competitors of a parent company or from the investors of the parent company whose company thinks may disapprove of the particular transaction.
- There is direct ownership in case of the Special-purpose entity of the specific asset
- The parent company can perform the high-risk transactions using the Special-purpose entity without endangering the solvency of the entire companySolvency Of The Entire CompanySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease..
- It requires a substantial amount of capital for creating the Special-purpose entity.
- The SPE has the lower access to the capital when compared with the parent company because the Special-purpose entity doesn’t have the same level of the credit as the parent company has.
- If there are some unexpected changes in the rules and regulations in the market which are applicable to the particular Special-purpose entity, then it can create a serious problem for the companies which are using these special purpose entity as they might not be able to meet the new rules and regulations that came into existence.
- Accounting rulesAccounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. of Mark to Market could be triggered in case the asset is sold which will impact the balance sheet of parent company negatively.
- There are fewer options available in the market for the purpose of funding the special purpose vehicle.
Important Points to be Noted
- The SPE can be formed by the parent company through the way of trusts, corporations, limited partnershipLimited PartnershipIn 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., 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. corporations, etc.
- The documentation of the equity, assets, and liabilities are 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. of its own rather than the balance sheet of the parent company as the equity or debt.
- SPE may hide crucial information from its investors who might not get aware of the financial situation of the company completely. With this risk, the investors should 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. of the Special-purpose entity and the parent company properly before reaching to any conclusion regarding making the investment in the business of any of them.
Thus the Special-purpose entity (SPV) is the subsidiary company that is formed with the purpose of facilitating financial arrangements of the parent company which includes the speculative investments and leverage, without compromising the whole group.
This means that in case the Special purpose vehicle becomes bankrupt then in that case also the parent company remains unaffected and in case the parent company becomes bankrupt then the Special-purpose entity remains protected and unaffected. Special purpose entities generally are used for the purpose of securitization and they are allowed to buy, sell and finance the assets.
This has been a guide to a Special Purpose Entity (SPE) and its definition. Here we discuss the top 2 types of SPEs along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –