Updated July 21, 2023
What is Special Purpose Vehicle?
The special purpose vehicle or a unit is regarded as a vehicle that has separate legal status created to fulfill certain temporary legal objectives, and such entities are created with the intent of mitigating financial risk.
It can be regarded as an entity with limited roles and powers specifically formed to cater to some predefined business objects, and such entities normally have their own financial statements.
Explanation
The special purpose vehicles are created with the intent of catering to some business objectives. Such entities are generally created as the subsidiary of the main or parent company to mitigate financial risk. Financial risk is defined as the type of risk which comes up when a business is not able to meet its obligation to service fixed costs and non-current debts. If the main company or parent organization fails, then the subsidiary, which has its own separate legal status, can come in and continue to service the debt of the parent company and meets its financial obligations.
Features of Special Purpose Vehicle
- A special purpose vehicle or an entity is a business that incorporates contracts of financial nature.
- They can be regarded as housing devices as they house the assets that are transferred from the parent company.
- It has separate legal status, and it is an independent going concern.
- It has its financial statements and normally has limited powers.
How is SPV Formed?
The special purpose vehicle is formed when two broad conditions are met. To create a special purpose vehicle, an independent owner coming from the parent company should make an equity investment of 3 percent or more into the assets of a special purpose entity. The second condition to create a special-purpose entity is to ensure that it creates independent management, which is separate from the management of the parent company.
These two steps are undertaken by the parent company either to finance a new risky project or to safeguard some of its key assets. The parent company may securitize its assets or isolate some assets that are generally not shown on the balance sheet of the parent company and are strictly off the books.
Examples of SPV
One of the top Investment banks in New York, USA, Bear Sterns, had created several special purpose vehicles with the intent of securitizing its loaned assets. However, by doing so, it failed miserably as it continued to take high exposures resulting in a collapse. The parent company was then sold to JP Morgan Chase.
Reasons for Creating Special Purpose Vehicles
The special purpose vehicles are created primarily to raise funds from the capital markets. The special purpose vehicles protect the parent company from the negative impacts that generally result from undertaking a new project for facilitating business growth. Additionally, the entity so formed is independent in nature and shares no financial risks of the parent company, with the possible case of bankruptcy looming over the parent entity itself.
It is therefore regarded as a bankruptcy-remote entity.
Importance and Uses of Special Purpose Vehicle
- The special purpose vehicle becomes important when undertaking high-impact projects. Such projects could be infrastructure projects or business impact projects.
- Special purpose vehicles help in easy asset transfers, which are generally hard to acquire or transfer.
- Special purpose vehicles are used for the process of securitization. Normally banks with the intent of separating their loans, such as mortgages, from their other obligations tend to pool such assets and securitize them to attract more investors and hence help raise additional money for the business.
SPV vs Joint Venture
Joint ventures are generally undertaken by two or more companies or businesses. To meet the strategic goals along with fruitful usage of limited resources and to gain maximum economic benefit, two businesses come together to form a new single entity termed a joint venture. Joint ventures allow the two-business access the new emerging markets as well as utilize the economies of scale to their full potential and, at the same time, mitigate the potential risks arising out of the new project.
The special purpose vehicle is generally formed by two or more investors rather than two or more businesses. It is generally utilized for funding requirements and has separate legal status. These are generally formed from the asset transfers of the parent company, and it helps mitigate the financial risks of the parent company.
Advantages and Disadvantages of Special Purpose Vehicle
Below are the advantages and disadvantages:
Advantages
- It allows the business to access capital markets easily.
- It helps in the securitization of assets.
- It can be created with ease, provided all the compliance and regulatory norms of the government are met.
- The interest rates applicable to bonds that are securitized are generally lower than the traditional corporate bonds issued by the main business.
- The assets of parent companies are safeguarded by the creation of a special-purpose vehicle.
- When the parent company faces financial risk, the special purpose vehicles could be utilized to reduce the credit risk for the stakeholders.
- The shareholding of the special purpose vehicle remains to be separate from the shareholding of the parent company, and it remains to be undiluted throughout the lifetime of the special purpose vehicle.
- The credit rating of the special purpose vehicle remains to be favorable, and it attracts new investors to invest in such companies.
Disadvantages
- After some point in time, if the parent company wishes to take back its assets from the special purpose vehicle, then the parent company has to bear huge transaction costs.
- Once special purpose vehicles are created, it puts restrictions and limits on the borrowing as well as the funding capacity of the parent company.
- The special purpose vehicles can easily be manipulated and could be utilized for unlawful activity.
- The ownership of the parent company towards the assets of the special purpose vehicle may get diluted.
- The special purpose vehicles generally do not share the reputation and goodwill of the parent company. Therefore, even though the financial markets are readily accessible to such entities, they may not be able to raise finance for the business easily.
Conclusion
Special purpose vehicles are entities that have separate legal status formed by the parent company to mitigate its financial risk or isolate its financial risk. The SPV helps in safeguarding the business from the negative impacts arising from the risky project.
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