What is the Special Purpose Vehicle?

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)

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#1 – Enron

In 2001, When the reality came to light, and the debts were uncovered, the share price tumbled from $90 to less than $1 in just a few weeks; shareholders had to bear a loss of approximately $11 billion.

On Dec 2, 2011, Enron shut its SPVs and filed for Chapter 11 bankruptcy.

#2 – Bear Sterns

Bear Stearns had created multiple SPVs intending to raise securitized loans using the assets helped by the SPVs. However, it continued to take significant exposure and eventually collapsed when it could not revive the company even after closing all the SPVs. After this failed emergency rescue, Bear Stearns was finally sold to JP Morgan Chase in 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.read more 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 did not have a proper documentation process. 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.read more to isolate the risks involved in projects or operations legally.

#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 securitiesMortgage-backed SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more, the bank can separate the loans from the other obligations it has by just creating an SPV. Therefore, this special purpose vehicle allows its investors to receive any monetary benefits before any other debtors or stakeholders of the company.

#3 – Easily Transfer Non Transferable Assets

reason, an SPV is created to own such assets. If the parent company wants to transfer the assets, they 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 ProcessesMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more.

#4 – Hold Company’s Key Properties

An SPV is sometimes created 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 pay the tax on its capital gains rather than on the proceeds of the sale of the property.

Benefits

  • 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.read more by creating SPVs.Securitization of loans is the most common reason for creating SPVs; generally, the interest rates 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.read more.Since the company’s assets 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.read more 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.read more.The shareholders and investors have undiluted ownership of the company.Tax savings 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.read more country like the Cayman Islands.

Limitations

  • In the case of closing the SPV, the company would have to take back the assets, which would mean substantial costs being involved.The creation of a special purpose vehicle might mean restricting the money-raising 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.If the SPV sells an asset, the parent company’s 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.read more will get negatively affected.The special purpose vehicle might have lesser access to capital and raise capital from the public because it does not have the same credibility in the market as the sponsor or parent company.

Conclusion

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 IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision.read more 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.read more. 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.read more, specifically in case of the capital market structures practices by any company;The 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. read more and other valuation ratios in restructuring a company’s capital.

The risks can be further handled better with four essential practices:

  • GovernanceOversightMotivationAssessment

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 special purpose vehicles (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 –

  • Equity Swaps ExamplesMeaning of Subsidiary CompanyMerger DefinitionWhat is the Balance Sheet Reconciliation?