Published on 31st October 2022
A special purpose vehicle (SPV) is a subsidiary legal entity established by a parent company to meet specific objectives. Through its legal status, it can fulfill two core objectives of any business corporation: Risk mitigation and Access to sufficient liquidity.
Also known as Special Purpose Entity (SPE), it is specially formed when the parent company undertakes a risky venture. In such cases, the parent company forms SPV to isolate the financial risks associated with the project from its main business.
The assets from the parent company are then legally transferred to the SPV. These assets can be subsequently securitized. Based on business requirements, these securities can be divided into tranches based on risk tolerance and sold to investors to raise capital.
This article will explain:
A special purpose vehicle can be defined as a separate legal entity to fulfill specific and temporary objectives such as a business transaction or acquisition. When a company undertakes a new yet risky project, it forms an SPV to safeguard its own finances and assets. In other words, an SPV is a fenced entity with limited and predefined business objectives and legal personality.
It is known by different names. For instance, SPV (special purpose vehicle) in Europe and India and SPE in the US. In some EU jurisdictions, the term FVC (financial vehicle corporation) is used for the same purpose. In some regions, it is known as an off-balance sheet vehicle (OBSV).
Due to its legal position as a separate company, having its own balance sheet of liabilities and assets, an SPV meets its obligations even when the parent organization fails or goes bankrupt. That is why a special purpose vehicle is also known as a bankruptcy remote entity.
A company forms an SPV to isolate or securitize assets in a separate entity with its own balance sheet. The SPV owns assets, accepts liabilities, and is accountable for its own financial reporting as a separate legal company. As a result, the assets and liabilities of the SPV do not reflect on the parent's balance sheet. The parent firm is protected from any financial consequences resulting from the SPV's higher-risk activities.
SPVs can even be formed by a holding company to securitize its debt. This ensures that a bondholder of the holding company is prioritized over an investor.
Special purpose entities are typically used to buy and finance specific assets, and their legal status serves to mitigate the risk of these operations. Companies can use the structure to securitize assets, isolate corporate assets, form joint ventures, and undertake other financial operations.
A special purpose vehicle can be formed as a limited partnership, corporation, trust, or joint venture. It could be set up to allow for independent ownership, management, and finance. In some circumstances, the parent firm is not permitted to own the SPV.
SingSpring Pte Ltd., a Special Purpose Vehicle formed to build-own-operate the Tuas Desalination Plant - Singapore’s first PPP water infrastructure project. The SPV is a consortium between Hyflux Ltd (70%) and Ondeo (30%). SingSpring has entered into a 20 years contract with the Public Utilities Board (PUB) of Singapore to produce 136, 380 m3/day of desalinated water.
The financial modeling of special purpose vehicles can be an attractive option for business owners and equity investors. Apart from risk mitigation and securitizing assets, the low regulatory burdens, financial returns, and protection from insolvency are some of the other reasons why companies, angel investors, investment banking firms, and other financial institutions prefer to invest in an SPV. Here are the main reasons why an SPV or SPE is formed.
One of the primary objectives for the formation of SPVs is to mitigate financial risks. Parent companies can lawfully isolate higher-risk assets by forming SPVs. Moreover, being a bankruptcy-remote entity, the potential insolvency and financial well-being of the SPV and parent company stay isolated.
For example, if something disturbs an SPV's receivables and it is unable to satisfy its debt commitments, the parent business will be unaffected. As a result, many people are more ready to employ SPVs that have a bigger credit risk than their main companies.
Funding and liquidity requirements are major drivers for the formation of various corporate structures. After assets have been securitized, outside investors might assume a portion of the risk. These structures can also be used by promoters to convert illiquid, non-rated risks into rated and liquid securities. After the transformation, issuing institutions increase liquidity by broadening their funding bases and lowering funding costs.
SPVs can enable easy asset transfer between parties. Many times permits to operate a specific asset (like permits to operate a power plant) are difficult or nearly impossible to transfer. By using a separate and new subsidiary structure to own the assets and relevant permits, public and private companies can transfer the SPV as a single package, thereby eliminating the obligations and hassle of transferring permits.
Financial engineering is another context where SPVs are extremely useful. SPVs can be used to finance a new acquisition or a financial transaction. This can be done without raising the debt load of the parent company or diluting the existing equity held by equity investors. This financial model is common for large infrastructure projects that are accomplished PPP project delivery method.
The corporate structure of an SPV plays a key role in investment strategy. Organizations and investors can test the financial viability of a new venture before moving forward with the final investment decision. If the early capital gain and cash flow are favorable, they can push forward with the project. Otherwise, the financial risk can be effectively mitigated. This strategy is often used by financial investment firms like Hedge Fund.
SPVs can be used to safeguard intellectual property in instances where it is at risk. For example, a new subsidiary can be formed to own IP, preventing competitors of the parent firm from obtaining the IP through pre-existing licensing agreements.
The creation of an SPV or SPE allows business owners to legally avoid laws or taxes imposed by authorities. Furthermore, restrictions can occasionally be circumvented by creating SPVs as an orphan structure. This is particularly true for regulations requiring owners of certain assets to be registered in a specific jurisdiction.
The creation of SPVs allows the securitization of loans, and receivables are frequently securitized via SPVs. For example, a bank can create an SPV to isolate asset backed securities from other debt obligations. In this scenario, investors in the mortgage-backed securities held by the SPV are paid before other creditors.
Special purpose vehicles can be built in a variety of corporate structures and financial modeling. Here are five possible SPV structures that are commonly adopted by corporates:
SPVs can be multi-company joint ventures. An SPV is an option for two companies that believe they may work on a specific project without wanting to combine completely.
An LLC allows business owners to protect their personal assets in the case of a lawsuit. As a result of forming an SPV as an LLC, the owners gain double security because the main business and the individual's personal money are protected from the SPV's risks.
A limited partnership is similar to a joint venture in that it is a long-term commitment to collaborate between two or more organizations. For organizations looking to collaborate, forming an SPV simplifies the collaboration procedure.
In this structure, governments allow private businesses to form SPVs to help them achieve a common aim, such as large infrastructure projects. As a result of the SPV formation, businesses will be incentivized to take on less risk in order to aid the state.
The SIV structure SPV is adapted to profit from the difference between securities and loans.
The creation of a Special Purpose Vehicle (SPV) or Project Company is the most common attribute of mega infrastructure projects. The primary function of an SPV is to facilitate financial transactions, set legal norms and regulations, and draft contracts between the parties engaged in the project.
Source: Ministry of Finance, Singapore (2004) Public Private Partnership Handbook
Per the contract, the SPV acts as a managing and operating company for the infrastructure project while legally securing concessions from the government as per a concession agreement.
A concession agreement can be defined as an agreement between the government and the project company to develop, construct, and operate a specific project.
An SPV owns and operates the facility as part of the concession and receives revenue to repay the finance and investment costs, maintain and operate the facility, and make marginal profits. Since the capital required to finance the project is obtained through the SPV, it can be called the heart of the project.
A contractual network revolves around the SPV, with each participant entering into contracts with the SPV for the duration of the project. The SPV is responsible for all legal and financial agreements with project parties/stakeholders. As a result, it serves as a legal body for the formal manifestation of a project consortium.
Infrastructure project financing is contingent on the SPV's expected financial performance, including robust cost estimation. Ambitious and ineffective SPV creation can create project delays and cost overruns, induce debt restructuring, and even lead to project failure.