What is a Special Purpose Vehicle?

A special purpose vehicle (SPV) is a subsidiary of a company which is protected from the parent company's financial risk. It is a legal entity created for a limited business acquisition or transaction, or it can be used as a funding structure. It is sometimes called a special purpose entity (SPE).

An SPV has assets, liabilities, and a legal status outside of the obligations of the parent company. The primary purpose of an SPV is to carry out a specific business activity outside of the parent company, therein protecting the parent company from risks such as bankruptcy and insolvency issues.

Why is a Special Purpose Vehicle Important?

SPVs are formed as limited partnerships, trusts, corporations, or limited liability companies. They adopt the legal protections of the particular business entity. An SPV is created for independent ownership, management, and funding of a company.

An SPV, for example, can be created to produce a lease that is expensed on the company's income statement rather than recorded as a liability on the balance sheet. An SPV allows companies to secure assets, isolate assets, create and invest in joint ventures, isolate corporate assets, and perform any other specific financial transactions.

Reasons to Consider Using Special Purposes Vehicles

  • Has a single purpose -- It is used to carry out financial transactions, such as asset purchases, joint ventures, or to isolate the companies assets or operations from the parent company. Special purpose vehicles can be on the book or off-book entities.
  • Protects funds and assets -- Allows the parent company to maintain improved management of its assets and liabilities. It also lowers the parent company's risks, acquires a higher credit rating, lowers funding costs, and gives greater financial flexibility with lower capital requirements.
  • Protects against bankruptcy and creditors -- Allows the parent company to make high-risk financial transactions or future investments without endangering the solvency of the entire company. If the special purpose vehicle loses the investment or files for bankruptcy, the actions do not affect the parent company.
  • Easy financing options -- Provides a way for a company to raise cash and to transfer risky debts
  • Less statutory requirements - They are not exposed to the same regulations as the parent company, which offers the SPV more freedom to operate.
  • Investment Strategy -- Allows the parent company to feel out an investment opportunity before the parent company jumps into the investment. It could return double yields or limits the parent company's risk depending on how the investment is fairing.
  • Gives the parent company options -- Can keep projects secret from competitors or parent company investors who may not approve of the particular transaction or asset allocation.

Reasons to Consider Not Using Special Purpose Vehicles

The Enron disaster is a case study on how to not use a special purpose vehicle. Enron used special purpose vehicles to shift rising stock off the parent company's balance sheet. The SPV used the stock as collateral to purchase assets on the parent company's balance sheet. It reduced its risk by showing the value of the SPV, but it did not protect itself when stock prices fell, and creditors wanted their money. All of the information was hidden from the public, and it was too late and too much money lost to allow the company to bail itself out.

When the SPV loses money and access to credit, it draws on the funds of the parent company, but if the parent company is low on capital, it spells disaster for both the SPV and the parent company:

  • Setting up an SPV takes a substantial amount of capital.
  • You do not have the benefit of tax breaks and incentives enjoyed by the parent company.
  • Since the Enron disaster, the Financial Accounting Standards Board (FASB) have created strict guidelines on SPVs.
  • An independent third-party must own at least three percent of the SPV's debt, assets, and equity.
  • The third-party owner must have no equitable connection to the parent company.
  • The third-party owner must have control over the SPV's finances.
  • The third-party owner is independent and not protected by another party.
  • Options for funding the SPV are limited.
  • The legal obligations mirror those of a limited company.
  • There may be conflicting goals with the parent company.

How is a Special Purpose Vehicle Formed?

A special purpose vehicle is set up with the same requirements as any otherlimited partnerships, limited liability companies, or other entities.

  • The parent company can sell a pool of assets to fund the SPV.
  • An independent third-party must pay a percentage of the equity investment. It takes at least three percent before they are considered the legal equity owner of the SPV.
  • The investment must be "at risk," and the percentage of equity investment is based upon the fair market value of the assets transferred.
  • The SPV pays for the assets by issuing securities to investors in the capital markets. The securities can bear interest at fixed or variable rates and are typically highly rated investment grade securities that can attract a broad base of investors.
  • The interest and principal due under the securities are paid from the income stream of the assets purchased by the SPV.

What is an Off-Balance-Sheet Special Purpose Vehicle?

An off-balance-sheet special purpose vehicle records its assets, liabilities, and equity on a separate balance sheet from the parent company. It is not counted as equity or debt for the parent company. When an asset allocation or joint venture offers more risk than the parent company is comfortable with, the SPV protects the parent company.

Characteristics of an Off-Balance SPV Include:

  • Limited capitalization
  • A service agreement that documents how the assets will be managed
  • No independent employees or managers
  • No possibility of filing for bankruptcy

Off-balance is preferred over on-balance when the risk is high for the parent company. The special purpose vehicle needs more financial flexibility to complete the transaction, it needs to secure a higher credit rating or get lower terms for financing, and the parent company needs improved asset-liability management.

An off-balance special purpose vehicle can also be used to cut capital requirements set by the government for trust-preferred securities.

If you need help with special purpose vehicles or entities, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or for companies like Google, Stripe, and Twilio.