What is the Special Purpose Vehicle?
Special Purpose Vehicle (SPV) is a separate legal entity which is mostly created by the company for a single, well-defined and specific lawful purpose and also acts as the bankruptcy-remote for the main parent company. In case of bankruptcy of the company, the SPV can carry its obligations as the operations are restricted to the buying and financing of specific assets and projects.
The terminology or importance of a special purpose vehicle came into much usage and popularity after the Enron debacle.
Examples of Special Purpose Vehicle (SPV)
#1 – Enron
By 2000, ENRON was known to create hundreds of SPVs and would transfer the quickly-earned money in the form of profit by the rising stock to them and receive cash in return. It had created these SPV’s mostly to hide these billions of dollars in debt, which resulted from failed projects and deals.
In 2001, When the reality came into light and the debts were uncovered, the share price tumbled from $90 to lesser than $1 in just a few weeks; shareholders had to bear a loss of approximately $11 billion.
On Dec 2, 2011, Enron had to shut its SPV’s and filed for Chapter 11 bankruptcy.
#2 – Bear Sterns
Bear Sterns had created multiple SPV’s intending to raise securitized loan using the assets helped by the SPV’s. It continued to take significant exposure and eventually collapsed when it could not revive the company even after closing all the SPV’s. After this failed emergency rescue, Bear Sterns was finally sold to JP Morgan Chase in the year 2008.
#3 – Lehman Brothers
The story of Lehman Brothers and its failure is not hidden. The insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow. of the pillar in 2008 was proof of the weaknesses in maintaining the SPV’s created and their documentation where the Lehman Brothers acted as the SWAP Counterparty. Most of the SPVs were either not registered, or no proper documentation process was done. It resulted in piling unforeseen liabilities, which could never be resolved, and the Lehman Brothers had to announce bankruptcy in the year 2008.
Purpose of Special Purpose Vehicle (SPV)
#1 – Risk Mitigation
Any company entails a significant amount of risk in its regular operations. The SPVs established helps 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. to legally isolate the risks involved in projects or operations.
#2 – Securitization of Loans/Receivables
Securitization of loans and other receivables is one of the most common reasons to create an SPV. In the case of mortgage-backed securities, the bank can separate the loans from the other obligations it has by just creating an SPV. This special purpose vehicle, therefore, allows its investors to receive any monetary benefits before any other debtors or stakeholders of the company.
#3 – Easily Transfer Non Transferable Assets
Transferring a company’s assets are either non-transferable or very difficult, and for the same reason, an SPV is created to own such assets. If the parent company wants to transfer the assets, they simply sell off the SPV as a self-contained package rather than splitting any asset or having various permits to do the same. Such cases occur in the case of mergers and acquisitions processesMergers And Acquisitions ProcessesA merger and acquisitions (M&A) agreement refers to an agreement between two existing companies to merge into a new company, or the purchase of one company by another, which is done generally to benefit from the synergy between the companies, expand research capacity, expand operations into new segments, and increase shareholder value, among other things..
#4 – Hold Company’s Key Properties
An SPV is created sometimes to make it hold a company’s property. In cases when the property sales are much higher than the capital gains for the company, it will choose to sell the SPV rather than the properties. It will help the parent company to pay the tax on its capital gains rather than on the proceeds of the sale of the property.
- Private companies and establishments have easier access to capital marketsAccess To Capital MarketsA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets. through the creation of SPVs.
- Securitization of loans being the most common reason for creating SPVs; generally, the interest rates that are payable on the securitized bonds are lower than those offered on the corporate bonds of the parent companyCorporate Bonds Of The Parent CompanyCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value..
- Since the assets of the company can be held with the SPV, they remain safe and secure. When the company faces financial problems, it ultimately reduces the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. for the investors and stakeholders.
- The credit rating of the SPV remains good; therefore, the investors find it reliable to buy the bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period..
- The shareholders and investors have undiluted ownership in the company.
- Tax saving can be done if the special purpose vehicle is created in any 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. country like the Cayman Islands.
- In the case of closing the SPV, the company would have to take back the assets, and this would mean substantial costs being involved.
- The creation of a special purpose vehicle might mean to restrict the money-raising the capacity of the parent company.
- Direct control over some assets of the parent might be diluted, which may, in turn, may reduce the ownership at the time of dilution of the company.
- In case of any changes in the regulations, there are high chances of severe complications for the companies that created these special vehicles.
- In case an asset is sold by the SPV, the 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 the parent company will get negatively affected.
- The special purpose vehicle might have lesser access to capital and raising capital from the public at times because it does not have the same credibility in the market as the sponsor or parent company.
Poor risk management and no clear understanding of the implied risks have led to the downfall of some high profile companies and businesses.
Several regulatory and transaction methods have been changed for the special purpose vehicles after the collapse of Lehman Brothers in 2008. The documentation process should now be compliant with the Basel III norms, earlier Basel IIBasel IIBasel II is the second set of regulations concerning Minimum Capital Requirement, Supervisory Review, Role and Market Discipline, and Disclosure. The Basel Committee on Bank Supervision developed the regulations for international banks in order to ensure a transparent and risk-free banking environment.. It is now particularly going through the below checkpoints :
- Stricter legal risk management by the company and regulators;
- Higher emphasis imposed on counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract., specifically in case of the capital market structures practices by any company;
- Lending documentation process tightened.
- Higher use of ratios like debt-to-equityDebt-to-equityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. and other valuation ratios in case of restructuring of a company’s capital.
The risks can be further handled better with four essential practices:
Thus, we see SPV’s creation by any company as the two sides of the same coin. Given the failures, policies have been made tighter to see that the pros of an SPV can be increased effectively.
This article has been a guide to what is Special Purpose Vehicle (SPV) and its definition. Here we discuss its uses, benefits, limitations, and examples of SPV. You can learn more about accounting from the following articles –