A special purpose vehicle (SPV) is a legal entity created by a parent company but managed as a separate organization. It is designed to isolate the financial risk of certain assets or ventures of the parent company. Companies create SPVs to securitize assets, make it easier to transfer assets, spread the risk of assets or new ventures, or protect assets from risks associated with the parent company.
Here’s a detailed look at how SPVs work, and what investors should know before investing in SPVs or companies that own them.
Definition and Examples of Special Purpose Vehicles
A special purpose vehicle (SPV), also referred to as a special purpose entity (SPE), is a separate entity created by a parent organization to isolate certain financial risks. An SPV is a subsidiary legal structure that has its own assets and liabilities. It is an asset that is not shown on the balance sheet of the parent company.
- Alternate names: off-balance sheet vehicle (OBSV), special purpose entity
SPVs can be created using different legal structures, such as a limited liability company (LLC), a trust, a limited partnership, or a corporation.
The sole purpose of an SPV is to separate the risk of the ventures in the SPV from the parent company’s operations. The parent company makes the business decisions, not the SPV, which is governed by rules clearly defined upon the entity’s creation.
A company might create an SPV to separate the financial risks associated with a product or department so that the parent company isn’t damaged financially.
For example, banks often convert pools of mortgages into SPVs and sell them to investors to separate the investment risk and spread it among many investors. Another example of why a company might create an SPV is to create a lease that can be expensed on its income statement rather than being a liability on its balance sheet.
How Special Purpose Vehicles Work
A parent company may have projects or assets it would like to keep off its balance sheets to avoid the financial risks these assets may impose on the parent company. To do so, it can create an SPV to isolate the assets and securitize them by selling shares to investors.
The parent company will create an SPV so it can sell assets on its balance sheet to the SPV and obtain financing for the subsidiary projects.
Depending on the subsidiary project, the parent company may choose to create an SPV with one of the following legal entity structures:
Once the SPV has been created, it obtains funds to purchase the assets from the parent company via debt financing and seeking investments from individual equity investors. Since the SPV now owns the assets, those assets become the collateral for the securities issued.
As a result, investors and lenders can evaluate the company by the quality of the collateral rather than the creditworthiness of the parent company, allowing for the potential for lower financing costs.
Some of the most common reasons behind why a company may create an SPV include:
- Securitization: SPVs are often used to securitize loans and receivables.
- Asset transfer: Some assets are difficult or impossible to transfer. Companies create SPVs to own a single asset or multiple assets by selling the asset to the SPV.
- Financing: SPVs are a popular way to secure funding for a new venture without directly affecting the parent company’s financials.
- Raising capital: SPVs may be able to raise capital at more favorable rates as opposed to the parent company raising money.
SPVs do not have independent management or employees and are instead administered by a trustee that follows defined rules to manage the assets. Furthermore, they are structured in such a way that they cannot go bankrupt in practice.
Pros and Cons of Special Purpose Vehicles
Special tax benefits
Spread the risk among many investors
Easy to set up
Corporations can isolate risks from the parent company
Lack of transparency
Lack of regulation
Reputational risk to the parent company
- Special tax benefits: Some assets of SPVs are exempt from direct taxes if they are established in specific geographical locations, such as the Cayman Islands.
- Spread the risk among many investors: Assets held in an SPV are funded by debt and equity investments, spreading the risk of the assets among many investors and limiting the risk to each investor.
- Easy to set up: Depending on where you set up the SPV, it often requires very little cost and can be done in as little as 24 hours in some cases. Furthermore, there is little to no governmental authorization needed to establish the entity.
- Corporations can isolate risks from the parent company: Corporations benefit from isolating certain risks from the parent company. For example, should the assets experience a substantial loss in value, it wouldn't directly affect the parent company.
- Lack of transparency: Some SPVs can be very complex, with many layers of securitized assets. This complexity can make it very difficult to track the level of risk involved.
- Lack of regulation: The regulatory standards that apply to the parent company do not necessarily apply to the assets held in the SPV, posing an indirect risk to the firm and investors.
- Reputational risk to the parent company: If the performance of the assets within the SPV is worse than expected, it could still hurt the reputation of the parent company.
- Liquidity risks: If the assets in the SPV do not perform well, it will be difficult for investors and the parent company to sell the assets back on the open market, creating a risk to the liquidity of the assets.
What It Means for Individual Investors
Individual investors should take note of companies that create SPVs as it may affect the investor’s decision to purchase shares of that company. Investors participating in the funding of an SPV should be clear about the purpose for the SPV, the financials, and the expected performance of its assets.
Investing directly in an SPV poses a higher risk than investing in other companies due to the lack of established reputation and historical performance. Investors may lack overall knowledge of the assets.
Investors should clearly understand why the parent company is raising capital for the SPV rather than showing the venture as an asset on its balance sheet.
- A special purpose vehicle (SPV) is a subsidiary legal entity created by a parent company to isolate the financial risk of certain assets, projects, or ventures.
- SPV’s have their own assets, liabilities, and financial statements. The assets held within an SPV do not appear on the balance sheet of the parent company.
- SPVs are also special purpose entities (SPEs) and are considered off balance sheet vehicles (OBSVs).
- SPVs have unique tax benefits, are easy to set up, help manage risk, and have very few regulation requirements.
- They can also be risky investments and hurt the parent company’s reputation should the assets perform poorly.