Special Purpose Vehicle

What is a Special Purpose Vehicle?

A special purpose vehicle (SPV), also sometimes called a special purpose entity (SPE), is a subsidiary company created for a specific project or business activity. An SPV is a separate legal entity with its own assets and liabilities, which don’t appear on the parent company’s balance sheet. A company creates an SPV to undertake a risky venture while isolating the risk. Since the SPV is a separate company, it is also protected should the parent company go bankrupt.

How Does an SPV Work?

The parent company creates the SPV to isolate or securitize assets in a separate company with its own balance sheet. As a separate legal entity, the SPV owns assets, assumes liabilities, and is responsible for its own financial reporting. Consequently, the SPV’s assets and liabilities do not appear on the parent’s balance sheet. The parent company is shielded from any negative financial repercussions arising from the SPV’s higher-risk activities.

Alternatively, a holding company may create a special purpose vehicle to securitize debt, which ensures that the bondholders will be prioritized over other creditors.

Typically, special purpose vehicles are used to acquire and finance specific assets and the legal status serves to isolate the risk of these operations.  The structure permits companies to securitize assets, isolate corporate assets, create joint ventures, or conduct other financial transactions. An SPV can be considered a “bankruptcy-remote entity” as its operations are restricted to its stated purchase and financing of specific assets or projects.

A special purpose vehicle can be structured as a partnership, limited partnership, corporation, trust, or joint venture. It may be structured for independent ownership, management, and funding. In some cases, the parent company is precluded from owning the SPV.

Large corporations and small startups alike can create special purpose vehicles for ethical and financially sound business reasons. However, certain accounting loopholes make it possible to use SPVs for nefarious purposes. For example, the 2001 Enron scandal saw Enron use an SPV to hide company debt. During the real estate bubble that led up to the 2008 crash, pools of mortgage loans were sold as SPVs. Investors should be cautious when valuing companies with SPVs, as these entities can be used to obscure a company’s true financial situation.

Uses of Special Purpose Vehicles

Special purpose vehicles can be attractive to companies and investors as a tool to mitigate risk or enhance potential returns. The most common reasons for creating an SPV include:

1. Securitization

Debt securitization is a common use for a special purpose vehicle. For instance, a bank can separate mortgage-backed securities from other debt obligations by creating an SPV. In such a scenario, investors in the mortgage-backed securities held in the SPV are paid before other creditors.

2. Asset transfer

It can be hard to transfer certain types of assets. Special purpose vehicles can make the securitization process easier. It can be simpler and more cost-effective to sell off a tranche or pool of asset-backed securities rather than the individual assets. A company can create an SPV to own these assets, and the SPV can then be sold in an M&A transaction. This is especially useful if the parent company needs liquidity.

3. Risk sharing

A corporation might wish to undertake a highly risky project, and an SPV makes it possible to isolate the risk from that project and protect the company against negative financial repercussions. Neither entity’s bankruptcy would affect the other. The company can also use the SPV to share the risk of the project with other investors.

4. Avoid regulatory burdens

Some special-purpose vehicles make it possible to legally avoid regulations from regulatory entities like the US Securities and Exchange Commission (SEC).  An SPV may also offer tax management benefits. For example, if the taxes on a property sale are higher than the realized capital gain, a company can create an SPV to own the properties for sale. The SPV can then be sold and taxed on the basis of capital gains from the transaction.

5. Equity investment

Special purpose vehicles can be used by the parent company to attract equity investors. Accredited investors such as hedge funds are often attracted by the potential for return that accompanies high-risk investments.

Conclusion

Corporations are motivated to create special purpose vehicles for a number of reasons. These structures are legally separate entities with their own balance sheets and offer a mechanism to isolate risk from more speculative projects. While SPVs can be very attractive to sophisticated investors, a robust due diligence process is necessary before making any investment decision. A company can use an SPV to mask important details of its own financial position, so it’s crucial that a potential investor analyzes the balance sheets of any SPVs in conjunction with analyzing the parent’s financials. Since certain accounting loopholes make it possible to use an SPV for nefarious purposes, meticulous analysis is an important component of any potential transaction.

Below is a multiple-choice question to test your knowledge. Please download the Excel exercise sheet for the answer and a comprehensive explanation.