Meaning of Special Purpose Vehicle (SPV)

A Special Purpose Vehicle (SPV) sometimes referred to as a Special Purpose Entity (SPE) is a legal entity created by the sponsor or originator, to fulfill a temporary objective of the sponsoring firm. Its powers are very restricted and its life is destined to end when the purpose is attained.

SPVs can be viewed as a method of dis-aggregating the risks of an underlying pool of exposures held by the SPV and reallocating them to investors willing to take on those risks. This allows investors access to investment opportunities, which would not have existed otherwise, and provides a new source of revenue generation for the sponsoring firm.

A SPV may be incorporated as a corporation, a trust, or a partnership firm. Consequently, the provisions of the parent law for incorporation of such entity, i.e., the Companies Act, Trust Act, the Partnership Act, etc. will apply to the formation of such SPVs.

SPV

Types of SPVs

The type of SPV floated depends upon the purpose to be fulfilled by such an SPV. But just for classification we can categories SPVs as:-

1.       On- Balance sheet SPV; and

2.       Off- Balance sheet SPV

On- Balance sheet SPV Off- Balance sheet SPV
An ‘on-balance sheet SPV’ is that entity whose financial results are consolidated with the results of its sponsor. An ‘off-balance sheet SPV’ is that entity whose financial results are not to be consolidated with the results of its sponsor.
In the case of on-balance sheet SPV the income or receivables are by some way or other transferred to the sponsor company. In the case of off-balance sheet SPV the income or receivables are not transferred to the sponsor company.

Features and Uses of SPV

Some common uses of SPVs are as follows:-

Securitization

SPVs are the key characteristic of a securitization and are commonly used to securitize loans and other receivables. This was the case with the US subprime housing market crisis whereby banks converted pools of risky mortgages into marketable securities and sold them to investors through the use of SPVs. The SPV finances the purchase of the assets by issuing bonds secured by the underlying mortgages.

SPV and Sponsor and Public

Asset Transfer

Many assets are either non-transferable or difficult to transfer. By having an SPV own a single asset, the SPV can be sold as a self-contained package, rather than attempting to split the asset or assign numerous permits to various parties.

Financing

An SPV can be used to finance a new venture without increasing the debt burden of the sponsoring firm and without diluting existing shareholders. The sponsor may contribute some of the equity with outside investors providing the remainder. This allows investors to invest in specific projects or ventures without investing in the parent company directly. Such structures are frequently used to finance large infrastructure projects.

Risk Sharing

SPVs can be used to relocate the risk of a venture from the parent company to a separate orphan company (the SPV) and in particular to isolate the financial risk in the event of bankruptcy or a default. This relies of the principle of ‘bankruptcy remoteness’ whereby the SPV operates as a distinct legal entity with no connection to the sponsor firm. This has been challenged recently, post financial crisis with several court rulings that SPV assets and funds should be consolidated with the originating firm.
“A bankruptcy remote company is a company within a corporate group whose bankruptcy has as little economic impact as possible on other entities within the group. A bankruptcy remote company is often a single-purpose entity.”

Financial Engineering

The SPV structure can be abused to achieve off-balance-sheet accounting treatment in order to manipulate more desirable financial and capital ratios or to manage regulatory requirements (for example to meet Basel II Tier 1 capital ratio requirement) or as a method for CFOs to hide losses and debts of the firm (as was the case with Enron, see case study below)

Raising Capital

Such vehicles can be used by financial institutions to raise additional capital at more favorable borrowing rates. Since the underlying assets are owned by the SPV, credit quality is based on the collateral and not on the credit quality of the sponsoring corporation. This is an advantage for non-investment grade companies which can achieve lower funding costs by isolating the assets in a SPV.

Competitive Purpose

For example, when Intel and HP started developing Itanium processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals.

Public-Private-Partnership Model of SPV

Due to the policy of liberalization and encouragement to private sector participation in the areas reserved for public sector, a trend has been started by government sector entities by forming SPVs for specific projects. The PSUs operating in infrastructure industry usually float entities with investment firm’s government, both central and States and a portion by the private sector participant (which is usually selected by a Bidding procedure). It is convenient in many ways. Such a set up provides convenience in obtaining approvals from the State at various levels. Once the project is completed the government may easily exit. For Example: Maharashtra government and the Ministry of Railways will be setting up Maharashtra Railway Infrastructure Development Corporation (MRIDC), a special purpose vehicle, to provide a boost to the railway infrastructure projects in the state.

Key Benefits to Sponsoring Firms

Hives off the Risks

By removing assets or liabilities from balance sheets of the sponsor, the SPVs act as a “bankruptcy remote”. If the sponsoring firm has financial problems, it can safely escape its creditors because in any way creditors cannot seize the assets of the SPV. By isolating high risk projects from the parent organization and by giving to new investors the opportunity to take a share of a very specific risk in a firm with a simple and clear balance sheet (as it is created for a single purpose only, and there are no debt obligations), SPVs definitely can help both, firms and investors.

Minimal Red Tape

Depending on the choice of jurisdiction, it is relatively cheap and easy to set up an SPV. The process may take as little as 24 hours, often with no governmental authorization required.

Clarity of Documentation

It is easy to limit certain activities or to prohibit unauthorized transactions within the SPV documentation.

Regulatory Compliance

A special purpose entity can sometimes be set up to overcome regulatory restrictions, such as regulations relating to nationality of ownership of specific assets.
Case: As we see in case of Vishal Retail Limited, the firm will transfer all its fixed assets to a special purpose vehicle (SPV) that will be predominantly owned by the foreign private equity firm – Texas Pacific Group (TPG). Once the assets are parked in the SPV, TPG will run the entity because present regulations do not allow foreign direct investment in multi-brand retail companies.

Examples of SPV

Freedom of Jurisdiction

The firm originating the SPV is free to incorporate the vehicle in the most attractive jurisdiction from a regulatory perspective whilst continuing to operate from outside this jurisdiction. For example: Companies prefer having SPVs in countries like Singapore, which are top rated in ease of doing business.

Tax Benefits

There are definite tax benefits of SPVs where assets are exempt from certain direct taxes. For example, in the Cayman Islands, incorporated SPVs benefit from a complete tax holiday for the first 20 years. Further, SPVs are often used to make a transaction tax efficient by choosing the most favorable tax residence for the vehicle. SPVs are often used in financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes.

Legal Protection

By structuring the SPV appropriately, the sponsor may limit legal liability in the event that the underlying project fail.

Meeting Regulatory Requirements

By transferring assets off-balance sheet to an SPV, banks are able to meet regulatory requirements by freeing up their balance sheets.

Key risks to sponsoring firms

Lack of Transparency

The ownership structure of SPVs is often very complex as it is developed in the form of layers upon layers of securitized assets. This can make it nearly impossible to monitor and track the level of risk involved and who it lies with.

Reputation Risk

The firm’s own perceived credit quality may be blemished by the under performance or default of an affiliated or sponsored SPV. For this reason it is not a credible risk that the firm will abandon the SPV in times of difficulty.

Signaling Effect

The poor performance of collateral in an SPV attracts a high degree of attention and assumptions are made that the quality of the firm’s own balance sheet can be judged on a similar basis.

Franchise Risk

There is a risk that investors in an affiliated SPV are upset and this affects other relationships between the sponsor and these investors, for instance as holders of unsecured debt.

Liquidity and Funding Risk

The poor performance of an affiliated SPV may affect the firm’s access to the capital markets.

Equity Risk

The firm might hold a large equity tranche in a vehicle (e.g. an SIV). If the firm does not step in and support or save the vehicle from collapse in difficult situations, the resulting wind-down of the SPV and sale of the assets at depressed valuations is likely to erode the firm’s equity in the SPV, to a greater extent than the firm stepping in and either affecting an orderly wind-down of the vehicle or bringing its assets back onto its balance sheet.

Risk in Special Purpose Vehicle

Mark-to-Market Risk

The forced sale of assets from an affiliated SPV could depress the value of related assets that the firm holds on the balance sheet. The firm will want to prevent a large negative mark-to-market impact on its own balance sheet.

Regulation

The same regulatory standards do not apply to assets contained within an SPV as to the firm’s assets on balance sheet. This is a reason that many firms opt for these vehicles in the first place. However, this lax regulation poses an indirect risk to the originating firm.

Enron Case Study
ONE OF THE BIGGEST ACCOUNTING FRAUDS OF THE US HISTORY

The first case that comes to mind, when we discuss about off balance sheet SPVs is that of Enron. Enron was a US company, whose main business was trading in electricity and other electricity commodities. Enron was the first company to spot a niche in the energy market. In the 1990s, it converted itself from a humdrum producer and seller of energy to a market-maker in energy-related products and became an energy bank. It almost single-handedly created a market for energy contracts and swaps. These were just what a deregulated energy market needed. Then it started creating many off-balance sheet SPVs and raised huge debts through them. The company had hidden its debt by moving its non-performing assets to the SPVs and even booking revenues on these sales. The Board of Directors of these SPVs were related to the management of Enron which was a clear conflict of interest. The company penalized all its employees who protested against what was happening within the company.

Enron Case Study

Initially Enron was using SPVs appropriately by placing its energy related business into separate legal entities. What they did wrong was that they apparently tried to create earnings by manipulating the capital structure of the SPVs, hide their losses. The real failures of Enron relate to lack of  transparency, corporate arrogance, a cozy relationship with its auditors (which prevented the latter from blowing the whistle), a somnolent board, and poor external vigilance (the SEC and the rating agencies acted only after Enron’s share prices crashed). Due to accounting loopholes, these vehicles became a way for CFOs to hide debt. In order to maintain transparency, there should be no inter locking management: The managers of the off balance sheet entity cannot be the same as the parent company in order to avoid conflicts of interest. The scope and importance of the off-balance sheet vehicles were not widely known among investors in Enron stock but after the Enron collapse, the public has come to know for the first time the all kinds of obscure SPVs floated by US companies.

Conclusion

Creating an SPV is simple but maintaining it is a tedious job. It involves all secretarial compliances like conducting of requisite board meetings, general meetings as prescribed by law, maintainance of statutory registers, filing of various forms and returns etc. As the board of directors of such subsidiaries are the employees of the holding company, the meetings are reduced to mere formalities. However, non-compliance of any provision of law can create trouble at the time of disposal of the SPV, in the form of unnecessary delays. Therefore, creation of SPV must be considered after deliberating all other options available such as executing an exhaustive agreement which clearly defines the rights and liabilities of both the parties without creating any separate entity.

Sources:
1.       wilmingtontrust.com
2.       PwC
3.       Investopedia
4.       Economic Times
5.       Financial Express

Author:
Sahil Goel | LinkedIn