Special Purpose Vehicle (SPV)
A SPV is a legal entity that a parent company creates to hold separate assets from the parent's balance sheet
What Is a Special Purpose Vehicle (SPV)?
A special purpose vehicle (SPV), or a special purpose entity (SPE), is a legal entity that a parent company creates to hold separate assets from the parent’s balance sheet.
Its purpose is to isolate the parent company from any potential credit or financial risk that may arise from the SPV and is often used to pursue riskier projects, securitize debt, or transfer assets.
Since an SPV is separate from the parent company, it isn’t affected by the parent's performance, and the parent isn’t typically affected by the performance of the SPV. If the parent goes bankrupt and is no longer in existence, the SPV can carry on.
This makes an SPV bankruptcy remote. This also means that the parent company is unaffected by the loss if the SPV fails.
Special Purpose Vehicle: How It Works
Let’s assume a company wants to invest in a venture with a low probability of success but has both a high IRR (internal rate of return) and NPV (net present value). To avoid potential financial risks that may arise from the venture, the company decided to create an SPV to keep the assets off its balance sheet.
The company is now known as the parent company and will sell assets to the SPV to remove them from its balance sheet. By isolating the financial risks in the SPV, investors of the parent company are protected if the venture in the SPV doesn't perform well.
To set up a special-purpose vehicle, the parent company may choose to set up a:
- Partnerships: The general partner will have unlimited liability and oversee the day-to-day operations. Any risk to the limited partner is limited to their initial investment.
- Limited Liability Company (LLC): The parent and the individual partners will have limited liability. This is the most common type of SPV in the United States.
- Joint Venture: Parties in a joint venture can create an SPV together to complete the venture. This will act as a separate legal entity to achieve the desired project.
- Corporation: A parent company may choose to incorporate the SPV, making it into its own entity.
- Public-Private Partnership (PPP): In the case of capital-intensive projects like infrastructure or defense involving both government and private players, the private players may create an SPV to limit their financial exposure. This type of SPV is referred to as a public-private partnership (PPP).
Once the parent company chooses the proper vehicle for the SPV, the SPV will receive funds from the parent to buy assets from the parent, effectively removing the assets from the balance sheet.
Since the assets are no longer on the parent’s balance sheet, investors no longer have to worry about the company's creditworthiness if the SPV fails.
Special Purpose Vehicle: Uses
Special-purpose vehicles have many different uses. Knowing how and when to use an SPV is essential because it can protect the parent’s creditworthiness. By safeguarding the credit rating, its future financing costs will be low.
Below are a few reasons why a company may create a SPV:
- Securitization: A financial institution may use an SPV to securitize loans to remove them from their balance sheet.
- Risk Sharing: Isolates risk of risky projects or investments and shares the risk with some investors.
- Asset Transfer: A company may have hard-to-transfer or illiquid assets. If a company cannot move these assets, it may create an SPV and sell, or move, these assets to it.
- Financing: A company may use an SPV to raise funds for a new venture. By using an SPV, the new venture won’t impact the company’s financial statement.
- Regulatory Reasons: Depending on the circumstance, a company may use a SPV to acquire an asset. This is only if there are regulations in place that bar the specific company from directly owning the asset.
- Financial Engineering: A less common use is for the parent company to manipulate the balance sheet in order to achieve better capital adequacy ratios, which means less regulatory scrutiny.
SPVs have also been used to hide debt from investors. Hiding debt and other risky assets from investors could be a sign of poor accounting practices and mismanagement in the company.
Special Purpose Vehicles: Benefits And Risks
Using an SPV can provide benefits beyond removing assets or liabilities from the balance sheet, but it doesn’t come without risks.
Some benefits of using a SPV include:
- Easy to Create: Depending on the type and location of the SPV. Creating a SPV can be easy and fast to set up.
- For example, if a company uses a partnership or LLC, it may not need to receive government approvals.
- Risk Sharing: By placing equity and debt investments into an SPV, investors can share the risk of the investments rather than concentrating the risk for one investor.
- Tax Benefit: If the SPV is set up in a tax haven, i.e., the Cayman Islands, assets held inside may be tax-exempt or subject to lower tax rates.
- Legal Protection: In case of the failure of the underlying venture, the parent can limit its legal liability by leveraging a structured SPV.
- Isolate Risk: A company may choose to place risky assets inside the SPV to isolate any chance of failure that would potentially damage the company.
Some risks include:
- Lack of Transparency: Some SPV structures may be very convoluted, making it difficult for investors to analyze any risk involved.
- Liquidity Risks: If the SPV fails, it could be difficult for the parent company and investors to offload the assets.
- Lack of Regulation: Because there isn't a lot of regulation surrounding SPVs, which is also a benefit, investors and the parent company may be subject to more risks than previously thought.
- Negative Association: Due to a few scandals, such as Enron, some investors, and the public, may view a company that uses an SPV poorly.
- Masking Risky Assets: A company may choose to set up an SPV to hide risky assets from investors, which would overstate the company’s creditworthiness.
Special Purpose Vehicles: Financial Reporting
Since the parent company removes assets or liabilities from its own financial statement and sells it to an SPV, the SPV will have its own balance sheet, which means it will do its own financial reporting. This is one of the benefits of using a SPV.
Although removing a risky venture or investment from the parent’s balance sheet isolates risk and protects the parent and its investors from financial and credit risk if the assets in the SPV perform poorly, it may hide risky assets from investors.
There have been several scandals involving the misuse of SPVs, so investors and prospective investors of the parent company should analyze the financials of the parent company and the SPV.
Special Purpose Vehicles: Risk Management
SPVs have been subject to public scrutiny due to, most famously, the Enron scandal. To ensure the parent company and the SPV have a lower likelihood of a scandal, investors should try to make sure that the parent company has a:
- Strong Governance Framework: Strong governance will ensure investor confidence in the SPV.
- Transparent Financials: The parent company’s risk and involvement in the SPV should be accurately reported.
The alternative to managing risks posed by SPVs is to stop using them altogether. Unfortunately, the inherent risks and the potential for a scandal may outweigh any of the benefits SPVs may offer.
Special Purpose Vehicles: Enron Scandal
One of the most notorious scandals involving SPVs is the Enron scandal. Enron used SPVs to manipulate accounts to defraud investors. At the time, Enron was considered a Wall Street darling (a booming company that investors loved).
By 2000, Enron’s management had created hundreds of SPVs to hide billions of dollars of debt from failed projects and deals. They did this to inflate the stock price by creating the illusion of large profits.
To hide the failed projects, they transferred a large amount of the company’s stock to the SPVs, taking cash or security in return. The entity would then use this stock to hedge assets that were held on Enron’s balance sheet.
To boost investor confidence, Enron guaranteed the entity's value to the investors of the SPV. However, Enron's stock price crumbled when investors discovered the significant losses, and Enron was forced to file bankruptcy in December of 2001.
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