By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated September 11, 2023
What Is a Special Purpose Vehicle (SPV)?
A special purpose vehicle, often referred to as a special purpose entity (SPE), stands as a subsidiary company established by a parent company with the primary aim of containing financial risk. Its distinct legal identity ensures that its responsibilities remain safeguarded, even in the event of the parent company facing bankruptcy. This characteristic has led to the term "bankruptcy-remote entity" being used interchangeably with special purpose vehicles.
These entities with their own legal status are often utilized to structure complex transactions or achieve targeted financial goals, and their investment track record can reflect their effectiveness in fulfilling these purposes.
However, when accounting vulnerabilities are manipulated, these entities can turn into a detrimental method for concealing corporate debt, as exemplified by the Enron scandal of 2001.
Special Purpose Vehicles (SPVs) Explained
A parent company establishes an SPV (Special Purpose Vehicle) as a separate legal entity created with the intention of segregating or securitizing assets within a separate entity, often kept off the parent company’s balance sheet. This move is often undertaken to manage risk and isolate potential negative impacts, particularly in cases where the SPV is involved in a risky venture.
Alternatively, an SPV might be formed exclusively to securitize debt, providing investors with a level of assurance regarding repayment.
In any scenario, the operations of the SPV are confined to acquiring and financing specific assets. The distinct structure of the separate entity serves as a means to insulate the risks associated with these endeavors. Additionally, SPVs can act as counterparties for credit-sensitive derivative instruments like swaps.
The formation of an SPV can take various legal forms, such as a limited partnership, a trust, a corporation, or a limited liability company. Its design might revolve around achieving independent ownership, management, and funding. SPVs enable companies to securitize assets, establish joint ventures, protect corporate assets, and conduct diverse financial transactions.
In the realm of venture capitalism, a collective of investors employs SPVs to pool their resources for the launch of a new business venture or to invest in a startup. Unlike investment funds, which spread multiple investments across a span of time, SPVs generally commit to a single investment into a business.
Advantages and disadvantages of SPVs
Advantages
Enhanced Capital Market Access for Private Entities. Private companies and establishments find improved access to capital markets through the setup of SPVs.
Securitization of Loans. SPVs are commonly created for securitizing loans. Securitized bond interest rates typically outshine those offered on the parent company’s corporate bonds.
Asset Security. By housing company assets within the SPV, they gain a protective shield. This safeguard minimizes credit risk for investors and stakeholders during times of financial turbulence.
Favorable Credit Rating. SPVs maintain favorable credit ratings, rendering their bonds reliable for investors.
Unaltered Ownership. Shareholders and investors retain undisrupted ownership of the company.
Tax Efficiency. Creating an SPV in a tax haven like the Cayman Islands can result in tax savings.
Drawbacks
While the merits of an SPV are substantial, it’s not without limitations. Here are several disadvantages that companies must acknowledge when establishing SPVs:
Asset Retrieval Costs. Upon SPV closure, retrieving assets can incur significant expenses.
Capital Raising Constraints. Crafting an SPV might restrict the parent company’s capacity to raise funds.
Potential Dilution. Direct control over some parent company assets might dilute, diminishing ownership during company dilution instances.
Regulatory Sensitivity. Alterations in regulations can lead to complex complications for companies with SPVs.
Impact on Balance Sheet. When an SPV sells an asset, the parent company’s balance sheet is adversely influenced.
Limited Capital Access. SPVs might encounter reduced access to public capital due to the disparity in market credibility between the SPV and its sponsor or parent company.
How Does an SPV Operate?
The special purpose vehicle (SPV) operates with its own distinct balance sheet, assets, and financial reporting processes, which are kept separate from the parent company’s. This separation is a consequence of the separate legal standing of these two entities. The decision to exclude the SPV from the parent company’s balance sheets symbolizes how this arrangement can effectively safeguard the parent company from potential risks.
Both large corporations and small startups have the capacity to utilize subsidiary companies or SPVs for legitimate and financially prudent reasons. Nonetheless, instances also exist where entities have exploited SPVs for unethical or misguided motives. For example, the utilization of SPVs to sell pools of mortgage loans played a significant role in triggering the real estate bubble that ultimately led to the 2008 financial crisis.
Purpose
The establishment of an SPV is primarily aimed at shielding a company from financial vulnerabilities that could arise in the event of bankruptcy. However, there exist various other rationales for the presence of a special purpose vehicle. Some of these motivations are outlined below:
Risk Mitigation. Every company inherently faces a substantial degree of risks involved in its routine operations. The creation of SPVs empowers the parent company to legally isolate financial risk associated with specific projects or operations.
Securitization of Loans/Receivables. A prevalent purpose for crafting an SPV is the securitization of loans and receivables. In instances like mortgage-backed securities, a bank can effectively segregate loans from its other obligations through the establishment of an SPV. Consequently, this specialized entity permits investors to receive financial gains prior to other debtors or stakeholders of the company.
Facilitating the Transfer of Non-Transferable Assets. There are scenarios where assets are deemed non-transferable. In such cases, an SPV is generated to hold ownership of these assets. Should the parent company intend to transfer these assets, it can accomplish this by selling the SPV as a self-contained unit, thereby sidestepping the need to divide individual assets or navigate various permits. Instances of this nature frequently arise during merger and acquisition processes.
Custodianship of Vital Company Properties. An SPV is sometimes established to act as a custodian for a company’s properties. When property sales surpass the company’s capital gains, the preference might lean towards selling the SPV rather than the properties themselves. This strategic choice aids the parent company in managing tax obligations, as taxes are levied on the capital gains rather than on the proceeds derived from the property sale.
Potential Configurations for SPVs
The structural composition of special purpose vehicles (SPVs) can manifest in diverse arrangements. Here are five distinct configurations that an SPV enterprise might adopt:
Joint Venture. SPVs can materialize as joint ventures involving collaboration between multiple enterprises. In cases where two companies envision cooperation on a specific project without the intention of a complete merger, an SPV offers an effective solution.
Limited Liability Company (LLC) or Limited Liability Corporation. Establishing an SPV in the form of an LLC affords business proprietors protection of personal assets in the face of legal actions. Opting for an SPV structured as an LLC provides an extra layer of security; the parent business and individual financial matters remain safeguarded against the risks the SPV assumes.
Limited Partnership. Similar to a joint venture, a limited partnership involves sustained collaboration between two or more companies, but typically on a more enduring basis. Utilizing an SPV simplifies the partnership dynamics for enterprises seeking cooperative endeavors.
Public-Private Partnership. Governments occasionally permit the establishment of SPVs to aid corporations in achieving shared objectives, such as infrastructure development or public defense initiatives. This arrangement serves as an incentive for companies, enabling them to shoulder reduced risk while assisting governmental pursuits through the formation of an SPV.
Structured Investment Vehicle. When an SPV is designed as a structured investment vehicle (SIV), it serves as a mechanism to capitalize on variations between securities and debts, thereby generating profits.
Examples
Let’s examine the subsequent instances to gain insight into the functioning of SPVs and their role in mitigating financial risks:
Enron. By the year 2000, ENRON had orchestrated the creation of numerous SPVs, channeling swiftly amassed profits from surging stocks into them and in return receiving cash. However, the underlying motivation behind most of these SPVs was to conceal massive amounts of debt, originating from unsuccessful projects and deals.
In 2001, the truth came crashing down, unveiling the concealed debts. The aftermath was staggering, with the share price plummeting from $90 to under $1 within a matter of weeks. Shareholders bore the brunt, sustaining losses of approximately $11 billion.
On December 2, 2011, Enron ceased its SPV operations and initiated Chapter 11 bankruptcy proceedings.
Bear Stearns. Bear Stearns adopted the establishment of multiple SPVs with the objective of generating securitized loans using the assets facilitated by these entities. Yet, even after shutting down all SPVs, the company couldn’t resuscitate itself due to its substantial exposure. The eventual collapse led to Bear Stearns being acquired by JP Morgan Chase in 2008 following a futile emergency rescue attempt.
Lehman Brothers. The tale of Lehman Brothers and its downfall is a well-known saga. The firm’s insolvency in 2008 underscored the vulnerabilities in managing the SPVs it had formed, along with the associated documentation. As the Swap Counterparty, Lehman Brothers encountered critical deficiencies in registering most SPVs and maintaining proper documentation protocols. This lapse resulted in accumulating unforeseen liabilities that proved insurmountable. Ultimately, the firm succumbed to bankruptcy in 2008 due to these cascading issues.
