Special purpose vehicle (SPV)

In the current financial market, there exists numerous enterprises and entities who are working towards providing goods and services to the nation and contribute to the growth of the economy.

These enterprises need investments in the form of assets and cash which work as wheels in running these organizations. And as we all know, investments are always backed-up by a certain amount of uncertainties and risks which are difficult to be completely separated from the entities.

Hence, in order to curb the level and degree of risks which may be caused due to contingencies in the market, companies form Special Purpose Vehicles/Entities to shred off their part of liability.

Let us understand what these special purpose vehicles are and the risks and benefits which go along.

What are Special Purpose Vehicles/Entities?

Special Purpose Vehicles (SPV) are subsidiary of parent companies which are created to isolate and secure the parent company’s assets from bankruptcy and other financial risks. The SPV has a separate legal identity and asset/liability structure and hence remains distinct and secure even if the parent company goes into liquidation. Normally a company transfers assets to the SPE for the management or use the SPE to finance a large project and therefore achieve a narrow set of goals without putting the entire firm at risk.

What are Off-balance sheet SPVs?

In an off-balance sheet SPV the assets and liabilities are recorded in a separate balance sheet from that of the parent company and are not included in the assets and liability owned and owed by the parent company. These are preferred when the risk associated with the parent company is higher and is beneficial when the company needs to cut capital requirements set by the government for trust preferred securities.

An off-balance sheet special purpose vehicle has the following characteristics:

1. Limited capital requirement
2. No possibility of filing for bankruptcy
3. No independent employees and managers.
4. A service agreement that documents that how the assets are to be managed.

Uses of special purpose vehicles:

1.Risk sharing-
When the parent company receives a project that has a huge risk associated with it then it might create an SPE in order to isolate the project risk and share it with other investors.

2.Securitization-
Just by creating a Special Purpose Vehicle the bank can separate out the loans from the other obligations it has in the case of mortgage-backed securities. This SPV, therefore, allows its investors to receive monetary benefits before any other debtors or stakeholders of the company.

3.Asset transfer
Many assets are difficult to transfer because they require various permits to be obtained in the process. Therefore, by creating an SPV the parent company can own these assets and sell them off as a part of mergers and acquisitions when it wants to transfer them.

4.Property sale
In a case where the property sales tax is higher than the capital gain tax, the parent company can first create an SPE that have the properties which are for sale and then sell it off  which will help reduce the payments in taxes for the company.

5.Protection of intellectual property
Some companies which do not want to reveal their new technologies and ideas with their competitors beforehand can create an SPV to maintain the secrecy of such intellectual property. Example: As done by HP and Intel to keep their AI-64 processor architecture secret from their competitor AMD.

6.Financing
A SPE can be used to finance a new venture without diluting the existing shareholders value and increasing the debt burden of the issuing firm. Some amount may be provided by the sponsoring firm while the remaining can provided by outside investors. Such financing gives an opportunity to investors to invest in certain projects without directing investing in the parent firm.

7.Raising capital
They can be used to raise additional capital at reasonable borrowing rates. Because the assets are owned by SPVs, the credit quality is based on collateral and not on the credit quality of sponsoring firm.

Benefits of SPEs:

1. Isolated risk factor
It protects the parent company from high risks related to few projects without putting the solvency of the whole company in danger.

2.Direct ownership
The SPVs have a separate legal existence and hence provides independence in the operations and functioning and an undiluted ownership.

3.Easy to setup
The capital requirements to set up an SPE are minimum and also the compliances to be followed are similar to that of any other limited liability partnership/ company which are very easy.

4.Reliable for investors
The credit rating of the SPEs remain good and therefore gain the trust of investors.

Risks of SPEs:

1. The options through which a Special Purpose Vehicle can raise funds are limited because it does not have the same creditability as the parent company.
2. In case where the parent company has to take back the assets, the cost incurred is huge.
3. The tax benefits which apply to the parent company may not necessarily be applicable to a SPE.
4. The independent third party/investor must hold a three percent stake in the ownership of the SPE.

Detailed analysis of securitization:
Securitization is a method of collecting and keeping together various types of contractual debt such ascommercial mortgages,residential mortgages, auto loans or credit card debt liabilities and selling off the cash flows related to them to other investors as securities, which can be bonds, pass-through securities or collateralized debt liabilities. Repayment to the investors is made from the principal and interest cash flows collected from the debt and redistributed through the capital structure of the new financing.  The securities which are secured by mortgage receivables are called Mortgage-Backed Securities (MBS), while those who are secured by other types of receivables are known as Asset-Backed Securities (ABS).

Types of securitization:

1. Owner trust-
   The flexibility in allocating principal and interest received to different classes of issued securities in an owner trust is much more. Also, the principal and interest due to subordinate securities can be used to pay senior securities and thuscan alter maturity, risk and return profiles of issued securities as per the needs of the investor. Usually, any additional income after paying the expenses is kept in a reserve account up to a specified amount and the remaining is returned to the seller.
    
2. Grantor trust-
   Grantor trusts are used in automobile-backed securities and Real Estate Mortgage Investment Conduits. An originator pools together loans and sells them to a grantor trust, which issues various classes of securities backed by these loans. Principal and interest received from these loans, after considering the expenses are passed to the holders of the securities on a pro-rata basis.
    
3. Master trust-
   A master trust is ideally suited to handle revolving credit card balances and is also flexible to handle different securities at different times. In an ideal master trust transaction, an originator of credit card receivables transfers a pool of receivables to the trust which then issues securities backed by such receivables. After the transaction the originator continues to service the credit cards.
    
4. Issuance trust-
   Issuance trust was introduced by the Citibank in 2000 and uses a new structure for credit card backs securities that do not have limitations that master trusts sometimes have. The benefits to an issuance trust include:
    
5. More flexibility in issuing senior/subordinate securities,
    
6. Ability to increase demand because pension funds are eligible to invest in investment-grade securities issued by them,
    
7. They can significantly reduce the cost of issuing securities.

Because of such benefits, issuance trusts are now dominantly used by major issuers of credit card-backed securities.

Conclusion
Poor risk mitigation strategies and lack of understanding of risk have led to the downfall of big SPE companies.

Due to these the restrictions and regulations have been made strict such as:

1. Stricter legal risk management by the company and regulators.
2. Higher emphasis levied on counterparty risk, specifically in case of the capital market structures practices by a company.
3. Tightening of lending documentation process.
4. Increased use of ratios like debt-to-equity and other valuation ratio in case a company’s capital goes under restructuring.