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. An SPV 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)
Let’s see some examples of special purpose vehicles.
#1 – Enron
By 2000, ENRON was known to create hundreds of special purpose vehicles and would transfer the quickly-earned money in 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, the 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 with a view to raising securitized loan using the assets helped by the SPV’s. It continued to take huge 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 insolvency 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 special purpose vehicles were either not registered or no proper documentation process was done. This 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 company 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 out 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 processes.
#4 – Hold Company’s Key Properties
A special purpose vehicle 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. This will help the parent company to pay the tax on its capital gains rather than on the proceeds of the sale of the property.
Benefits of Special Purpose Vehicle (SPV)
- Private companies and establishments have easier access to capital 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 company.
- Since the assets of the company can be held with the SPV, they remain safe and secure and when the company faces financial problems, it ultimately reduces the credit risk for the investors and stakeholders.
- The credit rating of the SPV remains good, therefore the investors find it reliable to buy the bonds.
- 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 haven country like the Cayman Islands.
Limitations of the Special Purpose Vehicle (SPV)
- In the case of closing the SPV, the company would have to take back the assets and this would mean huge substantial costs being involved.
- The creation of 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 could be high chances of serious complications for the companies that have created these special vehicles.
- In case of an asset is sold by the SPV, the balance sheet 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.
A number of 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 of the Basel III norms, earlier Basel II. It is now particularly going through the below checkpoints :
- Stricter legal risk management by the company and regulators.
- Higher emphasis imposed on counterparty risk, specifically in case of the capital market structures practices by any company.
- Lending documentation process tightened.
- Higher use of ratios like debt-to-equity and other valuation ratios in case of restructuring of a company’s capital.
The risks can be further handled better with four basic practices:
Thus, we see SPV’s creation by any company as the two sides of the same coin. Given the failures, the policies have been made tighter to see that the pros of an SPV can be increased effectively.
This has been a guide to what is Special Purpose Vehicle and its definition. Here we discuss its uses, benefits, limitations, and examples of special purpose vehicles. You can learn more about accounting from following articles –