Special Purpose Vehicle (SPV)

A Special Purpose Vehicle (SPV) sometimes referred to as a Special Purpose

Entity (SPE) is a legal entity created by the sponsor or originator, to fulfill a
temporary objective of the sponsoring firm. Its powers are very restricted and its
life is destined to end when the purpose is attained.

SPVs can be viewed as a method of dis-aggregating the risks of an underlying pool

of exposures held by the SPV and reallocating them to investors willing to take on
those risks. This allows investors access to investment opportunities, which would
not have existed otherwise, and provides a new source of revenue generation for
the sponsoring firm.

A SPV may be incorporated as a corporation, a trust, or a partnership firm.

Consequently, the provisions of the parent law for incorporation of such entity, i.e.,
the Companies Act, Trust Act, the Partnership Act, etc. will apply to the formation
of such SPVs.
Types of SPVs

The type of SPV floated depends upon the purpose to be fulfilled by such an SPV.
But just for classification we can categories SPVs as:-

1.       On- Balance sheet SPV; and

2.       Off- Balance sheet SPV

On- Balance sheet SPV Off- Balance sheet SPV

An ‘on-balance sheet SPV’ is that entity An ‘off-balance sheet SPV’ is that entity
whose financial results are consolidated whose financial results are not to be
with the results of its sponsor. consolidated with the results of its sponsor.

In the case of on-balance sheet SPV the In the case of off-balance sheet SPV the
income or receivables are by some way or income or receivables are not transferred to
other transferred to the sponsor company. the sponsor company.

Uses of SPV

Some common uses of SPVs are as follows:-

Securitization

SPVs are the key characteristic of a securitization and are commonly used to
securitize loans and other receivables. This was the case with the US subprime
housing market crisis whereby banks converted pools of risky mortgages into
marketable securities and sold them to investors through the use of SPVs. The SPV
finances the purchase of the assets by issuing bonds secured by the underlying
mortgages.
Asset Transfer

Many assets are either non-transferable or difficult to transfer. By having an SPV

own a single asset, the SPV can be sold as a self-contained package, rather than
attempting to split the asset or assign numerous permits to various parties.

Financing

An SPV can be used to finance a new venture without increasing the debt burden
of the sponsoring firm and without diluting existing shareholders. The sponsor may
contribute some of the equity with outside investors providing the remainder. This
allows investors to invest in specific projects or ventures without investing in the
parent company directly. Such structures are frequently used to finance large
infrastructure projects.

Risk Sharing

SPVs can be used to relocate the risk of a venture from the parent company to a
separate orphan company (the SPV) and in particular to isolate the financial risk in
the event of bankruptcy or a default. This relies of the principle of ‘bankruptcy
remoteness’ whereby the SPV operates as a distinct legal entity with no connection
to the sponsor firm. This has been challenged recently, post financial crisis with
several court rulings that SPV assets and funds should be consolidated with the
originatingfirm.
“A bankruptcy remote company is a company within a corporate group
whose bankruptcy has as little economic impact as possible on other entities within
the group. A bankruptcy remote company is often a single-purpose entity.”

Financial Engineering

The SPV structure can be abused to achieve off-balance-sheet accounting

treatment in order to manipulate more desirable financial and capital ratios or to
manage regulatory requirements (for example to meet Basel II Tier 1 capital ratio
requirement) or as a method for CFOs to hide losses and debts of the firm (as was
the case with Enron, see case study below)

Raising Capital

Such vehicles can be used by financial institutions to raise additional capital at

more favorable borrowing rates. Since the underlying assets are owned by the
SPV, credit quality is based on the collateral and not on the credit quality of the
sponsoring corporation. This is an advantage for non-investment grade companies
which can achieve lower funding costs by isolating the assets in a SPV.

Competitive Purpose

For example, when Intel and HP started developing Itanium processor architecture,
they created a special purpose entity which owned the intellectual technology
behind the processor. This was done to prevent competitors like AMD accessing
the technology through pre-existing licensing deals.
Public-Private-Partnership Model of SPV

Due to the policy of liberalization and encouragement to private sector

participation in the areas reserved for public sector, a trend has been started by
government sector entities by forming SPVs for specific projects. The PSUs
operating in infrastructure industry usually float entities with investment firm’s
government, both central and States and a portion by the private sector participant
(which is usually selected by a Bidding procedure). It is convenient in many ways.
Such a set up provides convenience in obtaining approvals from the State at
various levels. Once the project is completed the government may easily exit. For
Example: Maharashtra government and the Ministry of Railways will be setting up
Maharashtra Railway Infrastructure Development Corporation (MRIDC), a special
purpose vehicle, to provide a boost to the railway infrastructure projects in the
state.

Key Benefits to Sponsoring Firms

Hives off the Risks

By removing assets or liabilities from balance sheets of the sponsor, the SPVs act
as a “bankruptcy remote”. If the sponsoring firm has financial problems, it can
safely escape its creditors because in any way creditors cannot seize the assets of
the SPV. By isolating high risk projects from the parent organization and by giving
to new investors the opportunity to take a share of a very specific risk in a firm
with a simple and clear balance sheet (as it is created for a single purpose only, and
there are no debt obligations), SPVs definitely can help both, firms and investors.

Minimal Red Tape

Depending on the choice of jurisdiction, it is relatively cheap and easy to set up an

SPV. The process may take as little as 24 hours, often with no governmental
authorization required.
Clarity of Documentation

It is easy to limit certain activities or to prohibit unauthorized transactions within

the SPV documentation.

Regulatory Compliance

A special purpose entity can sometimes be set up to overcome regulatory

restrictions, such as regulations relating to nationality of ownership of specific
assets.
Case: As we see in case of Vishal Retail Limited, the firm will transfer all its fixed
assets to a special purpose vehicle (SPV) that will be predominantly owned by the
foreign private equity firm – Texas Pacific Group (TPG). Once the assets are
parked in the SPV, TPG will run the entity because present regulations do not
allow foreign direct investment in multi-brand retail companies.

Freedom of Jurisdiction

The firm originating the SPV is free to incorporate the vehicle in the most
attractive jurisdiction from a regulatory perspective whilst continuing to operate
from outside this jurisdiction. For example: Companies prefer having SPVs in
countries like Singapore, which are top rated in ease of doing business.

Tax Benefits

There are definite tax benefits of SPVs where assets are exempt from certain direct
taxes. For example, in the Cayman Islands, incorporated SPVs benefit from a
complete tax holiday for the first 20 years. Further, SPVs are often used to make a
transaction tax efficient by choosing the most favorable tax residence for the
vehicle. SPVs are often used in financial engineering schemes which have, as their
main goal, the avoidance of tax or the manipulation of financial statements. Some
countries have different tax rates for capital gains and gains from property sales.
For tax reasons, letting each property be owned by a separate company can be a
good thing. These companies can then be sold and bought instead of the actual
properties, effectively converting property sale gains into capital gains for tax
purposes.

Legal Protection

By structuring the SPV appropriately, the sponsor may limit legal liability in the
event that the underlying project fail.

Meeting Regulatory Requirements

By transferring assets off-balance sheet to an SPV, banks are able to meet

regulatory requirements by freeing up their balance sheets.

Key risks to sponsoring firms

Lack of Transparency

The ownership structure of SPVs is often very complex as it is developed in the

form of layers upon layers of securitized assets. This can make it nearly impossible
to monitor and track the level of risk involved and who it lies with.

Reputation Risk

The firm’s own perceived credit quality may be blemished by the under
performance or default of an affiliated or sponsored SPV. For this reason it is not a
credible risk that the firm will abandon the SPV in times of difficulty.

Signaling Effect
The poor performance of collateral in an SPV attracts a high degree of attention
and assumptions are made that the quality of the firm’s own balance sheet can be
judged on a similar basis.

Franchise Risk

There is a risk that investors in an affiliated SPV are upset and this affects other
relationships between the sponsor and these investors, for instance as holders of
unsecured debt.

Liquidity and Funding Risk

The poor performance of an affiliated SPV may affect the firm’s access to the
capital markets.

Equity Risk

The firm might hold a large equity tranche in a vehicle (e.g. an SIV). If the firm
does not step in and support or save the vehicle from collapse in difficult
situations, the resulting wind-down of the SPV and sale of the assets at depressed
valuations is likely to erode the firm’s equity in the SPV, to a greater extent than
the firm stepping in and either affecting an orderly wind-down of the vehicle or
bringing its assets back onto its balance sheet.

Mark-to-Market Risk

The forced sale of assets from an affiliated SPV could depress the value of related
assets that the firm holds on the balance sheet. The firm will want to prevent a
large negative mark-to-market impact on its own balance sheet.

Regulation

The same regulatory standards do not apply to assets contained within an SPV as
to the firm’s assets on balance sheet. This is a reason that many firms opt for these
vehicles in the first place. However, this lax regulation poses an indirect risk to the
originating firm.

Enron Case Study

ONE OF THE BIGGEST ACCOUNTING FRAUDS OF THE US HISTORY

The first case that comes to mind, when we discuss about off balance sheet SPVs is
that of Enron. Enron was a US company, whose main business was trading in
electricity and other electricity commodities. Enron was the first company to spot a
niche in the energy market. In the 1990s, it converted itself from a humdrum
producer and seller of energy to a market-maker in energy-related products and
became an energy bank. It almost single-handedly created a market for energy
contracts and swaps. These were just what a deregulated energy market needed.
Then it started creating many off-balance sheet SPVs and raised huge debts
through them. The company had hidden its debt by moving its non-performing
assets to the SPVs and even booking revenues on these sales. The Board of
Directors of these SPVs were related to the management of Enron which was a
clear conflict of interest. The company penalized all its employees who protested
against what was happening within the company.
Initially Enron was using SPVs appropriately by placing its energy related business
into separate legal entities. What they did wrong was that they apparently tried to
create earnings by manipulating the capital structure of the SPVs, hide their losses.
The real failures of Enron relate to lack of  transparency, corporate arrogance, a
cozy relationship with its auditors (which prevented the latter from blowing the
whistle), a somnolent board, and poor external vigilance (the SEC and the rating
agencies acted only after Enron’s share prices crashed). Due to accounting
loopholes, these vehicles became a way for CFOs to hide debt. In order to maintain
transparency, there should be no inter locking management: The managers of the
off balance sheet entity cannot be the same as the parent company in order to avoid
conflicts of interest. The scope and importance of the off-balance sheet vehicles
were not widely known among investors in Enron stock but after the Enron
collapse, the public has come to know for the first time the all kinds of obscure
SPVs floated by US companies.

Conclusion

Creating an SPV is simple but maintaining it is a tedious job. It involves all

secretarial compliances like conducting of requisite board meetings, general
meetings as prescribed by law, maintenance of statutory registers, filing of various
forms and returns etc. As the board of directors of such subsidiaries are the
employees of the holding company, the meetings are reduced to mere formalities.
However, non-compliance of any provision of law can create trouble at the time of
disposal of the SPV, in the form of unnecessary delays. Therefore, creation of SPV
must be considered after deliberating all other options available such as executing
an exhaustive agreement which clearly defines the rights and liabilities of both the
parties without creating any separate entity.