After the Enron bankruptcy, the once obscure terms "special purpose vehicle" and "off-balance sheet financing" have burst on the public awareness much the way the term "derivative product" did nearly a decade ago. The subject is relevant for the readers of this column because SPVs have become a part of the landscape for non-traditional risk financing structures. So, while I am not an accountant and therefore may misstate some of the rules, it is in keeping with the purpose of this column to provide an overview of what is going on in this arena.
Special Purpose Entities
Though commonly referred to as special purpose vehicles or "SPVs," the accounting literature uses the term special purpose entities (SPEs). SPEs are legal entities established to serve a special and limited purpose. They can be corporations, trusts, partnerships, or limited liability corporations (LLCs). They are often established in offshore domiciles like the Cayman Islands, Bermuda, or certain European countries, but they are also quite often set up in Delaware or other U.S. jurisdictions. They are quite prevalent and are used for a variety of legitimate purposes. Of course, like a lot of financial techniques, they can be used in connection with questionable transactions.
The main idea is that while most corporations and partnerships have broad leeway to engage in any legally permissible business activity, SPEs will have limitations built into their incorporation documents that specifically limit the scope of allowed activities. The powers of some SPEs are strictly limited to certain ministerial functions (like processing payments), while others may have a more general power to engage in a particular type of business activity.
Broadly speaking, most SPEs are used for one of two purposes. The first is when a corporation wants to isolate a business operation or some corporate assets. The second is when interests in a pool of assets are being sold to investors through a securitization. (There is some overlap in these definitions.)
When companies use SPE's to isolate assets or operations, there can be a couple of motivations. If it is a business operation, the company may be trying to achieve some isolation from potential legal exposure arising from the business. The SPE may also be a vehicle to permit the establishment of a joint venture with another company or investor. SPEs can also be used in connection with corporate tax planning.
One important purpose is when the company wants to make an investment in a project or specialty operation, but wants to limit its downside risk, while providing a way to raise additional financing to support the investment. Typically, in the case of a project, for example a new oil refinery, the sponsor will invest a certain amount of equity capital (in some cases they may also contribute assets, technology, employees, or business operations). The SPE may have other equity investors. The SPE then also will usually also raise debt financing by borrowing from a bank or possibly issuing notes or bonds that will be purchased by investors.
A structure of this type can be very beneficial to the sponsoring company's shareholders. The main reason this is so is that the sponsor typically will get "up-side" benefits if the project is successful, but may significantly limit its risk or liability if the project fails. If an SPE is properly structured, the sponsor may not have to reflect the debt of the SPE on its own balance sheet. Indeed, if the debt of the SPE is "non-recourse" to the sponsor, the structure can be viewed as being beneficial to shareholders of the sponsor by preserving profit potential while limiting risk.
One of the problems that the Enron situation has highlighted, however, is when the sponsor of the SPE has to guarantee the debt or liabilities of the SPE. Then the shareholders do not really have the benefit of the reduction of the risk. Even worse, the company is actually exposed to the debt, but that obligation is not reflected on the company's financial statement.
The issue this is causing for accountants and other interested parties is trying to clarify what the rules should be for recognizing assets and liabilities associated with SPEs. While requiring a company to reflect the liabilities it has with respect to SPEs on its own balance sheet is not too difficult to grasp, the idea of requiring a company to show debt on its balance sheet for which it has no liability is more of a problem, because it may actually paint a misleading picture of the company's balance sheet for investors.
The second general use of SPEs is in connection with asset securitizations. Here, the sponsor will sell a pool of assets (like credit card receivables) to the SPE. The SPE will then issue a series of securities that are purchased by investors. The proceeds of the sale of these securities provide the SPE with the cash it needs to pay the seller of the assets. The proceeds from the assets (in the case of the credit card receivables, the payments made by the credit card holders) are then used to pay interest and principal back to the investors.
SPEs in Risk Finance
SPEs are typically used to isolate assets or operations. This can provide risk management benefits by removing risks associated with those assets or operations. If it's a business operation, the SPE may provide a "corporate veil" against tort claims. If it is a pool of assets, like credit card receivables, the SPE can be used as a device to shift the risk of higher-than-expected default rates.
Less typically, SPEs can be used as a way to transfer liabilities. In a case, the SPE would agree to assume some liability or obligation of the sponsor. The SPE would be funded by a contribution of the sponsor and/or investors willing to expose their capital in exchange for an expected profit. This can be tricky to accomplish under applicable accounting rules but can be a useful strategy in some cases.
SPEs can also to be used to provide financing for contingent risk exposures. This is essentially the idea behind risk securitization. Here, the SPE would sell insurance (or reinsurance) protection against some designated risk. The SPE would raise capital by issuing securities. The investor in the SPE would receive a yield equal to the interest earned on the cash held by the SPE, plus the risk premium paid by the insured, minus any covered claims that occur. While this model has been much discussed, it has only really been applied to any material degree in the area of reinsurance for natural disasters.
As was the case the case with derivatives, care should be taken not to jump to the conclusion that SPEs are inherently evil. SPEs are a prevalent and potentially useful tool in modern corporate finance. What is important is that the balance sheet of the sponsor should accurately reflect the risks to which the company remains exposed when it transfers assets or liabilities to a SPE.
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