Special Purpose Vehicles (SPV) or Special Purpose Entity (SPE)
In brief, SPV or SPE is a type of entity created to hold any asset, and a parent company can hold the entity.
Special purpose vehicles (SPV) or Special-purpose entities (SPE) are the most commonly used financial tools in the corporate world. SPV or SPE may be treated as a parent holding company. Then the company would hold specific investment entities that are considered subsidiaries of the parent company. The corporate world widely uses SPV or SPE because they are flexible and can be used to raise capital in a very short amount of time. Now let us get started and understand what an SPV or SPE is and how they are used in the corporate world with a special purpose vehicle (SPV) example.
Special Purpose Vehicle (SPV) & Special Purpose Entity (SPE)
In brief, SPV or SPE is a type of entity created to hold any asset, and a parent company can hold the entity. The parent company creates an SPV/SPE and allows the subsidiaries to operate in the same jurisdiction but under a separate legal entity. Read more about special purpose vehicles (SPV) and special purpose entities (SPE).
What is a Special Purpose Vehicle (SPV)?
An SPV is a form of company that can create a separate legal entity. The subsidiary’s assets, liabilities, and other operations are distinct and separated from the parent company. Although the special purpose vehicle (SPV) under the companies act is considered a separate entity from the parent company, the parent company holds the majority vote. It can exercise full control over the separate entity. So, now that you understand what an SPV is, let’s look at the uses.
Uses of Special Purpose Vehicle
The use of a special purpose vehicle (SPV) is mainly utilized in certain situations where the parent company needs to separate a piece of its business to operate on its own. Following are the uses of an SPV:
- Asset Securitization – An asset securitization is a transaction that involves the creation of special purpose vehicles with limited liability, which are used to sell securities. The special purpose vehicle is then used to own the company’s assets that can later be sold to generate funds.
- Joint Ventures – Creating a joint venture can be necessary when a company wishes to enter a new market but has no presence in the target location. However, the parent company’s headquarters may still not want to invest in the new market and maintain its hold on other locations. In such situations, the parent company can create a special purpose vehicle (SPV) for that specific market and partner with an existing firm.
- Operations – An SPV can also be created to handle a specific operation or service. The SPV will then be used to handle the operations daily and generate more revenue for the parent company.
- Property Deals – A special purpose vehicle can be created for the property deals. The parent company will be the one to invest in the SPV and later sell it or retain it as an investment.
- Risks – The main purpose of creating an SPV is to reduce the parent company’s risk. The SPV will take up the operational risks while the parent company enjoys a certain percentage of profits from the SPV. However, if the SPV incurs too high to bear losses, then the parent company will step in and help the SPV.
How Does a Special Purpose Vehicle Work?
First, the company will create the SPV, a separate legal entity from the parent company. The parent company will then hold the majority share in the SPV and sell or retain it as an investment for a certain period. The subsidiaries will run their operations according to the parent company’s rules and guidelines. The parent company will make the special purpose vehicle (SPV) company rules a little flexible by letting the subsidiaries handle operational risks.
In addition to being flexible, the SPV is one of the most beneficial financial tools for raising capital and avoiding the government’s jurisdiction. Therefore, working a special purpose vehicle (SPV) is simple and easy to understand.
Pros and Cons of Special Purpose Vehicles
Every financial tool has its pros and cons, and a special purpose vehicle is not an exception. The following are some of the major pros and cons of creating a SPV:
- Capital Raising – One of the main advantages of using an SPV is to raise funds for the parent company. The parent company will then use the SPV to raise funds by selling or retaining its shares, which can be done at a certain price. This way, the parent company can get all of the funds it needs without paying any taxes or giving away any shares.
- Flexibility – Creating an SPV can be beneficial in more than one way. The SPV can also help increase the flexibility of the parent company because it allows the parent company to own a piece of the subsidiary’s operations.
- Limited Liability – Another advantage of using an SPV is that it allows the parent company to lower its responsibilities. The parent company will only have limited responsibilities and can continue to operate as a separate corporation.
- Convenience – Using an SPV can benefit both the parent company and the subsidiary. The special purpose vehicle is considered convenient for the parent company because it allows it to avoid taxes and for the subsidiaries because it reduces their liabilities.
- Legal Protection – A special purpose entity also offers legal protection to its shareholders. The parent company will hold a stake in the subsidiary, which means that the parent company has legal protection from liens and legal actions.
- Loss of Control – Using a special purpose vehicle (SPV) can also have its fair share of cons. One of the major cons is that the parent company can lose control of its operations using the SPV. The subsidiary will be separate from the parent company, and therefore, can do things independently.
- High Costs – Using an SPV may also lead to high costs for both the parent company and the subsidiary. The parent company might have to pay certain fees and taxes every year to keep the operations running smoothly.
- Regulation – An SPV is legal in all states, but some countries or states might have different regulations. Using a special purpose vehicle in a specific country or state can be difficult because of the different regulations.
- Consideration – There may be certain things that the parent company wants from the subsidiary, but the subsidiary will not agree to them. The subsidiary might be against certain changes the parent company wants to make in its operations or activities. Using a special purpose vehicle (SPV) can also create problems because both parties have to agree on every little thing.
Example of Special Purpose Vehicle
A good example of a special purpose vehicle (SPV) can be seen in the automobile industry. The automobile industry is considered one of the most competitive industries because it has hundreds of companies and thousands of products, making it extremely difficult to sell the product.
Why is it Important to Set Up a Special Purpose Vehicle?
A special purpose vehicle (SPV) can benefit the parent company because of its flexibility and other advantages described above. These advantages can allow the parent company to raise more capital, which is beneficial because it allows the company to expand. In addition to this, the parent company can also use its special purpose vehicle (SPV) to protect itself from legal actions.
This type of protection reduces the financial risks of the parent company, and it can also make the parent company feel as if they are no longer accountable for their own mistakes. Overall, a special purpose vehicle (SPV) can be helpful because it allows a company to run its operations with fewer risks and liabilities.
Accounting Guidelines to Follow
An SPV is a corporate framework that is legally separate from its parent company. Therefore, it can have different accounting treatments from its parent company. The accounting treatment for the SPV can be different based on the type of SPV that is created. Creating an SPV will require the parent company to follow certain guidelines before setting up the SPV, which are discussed as follows:
- The parent company should establish the SPV and consider it a legal entity. This means that before setting up the SPV, the parent company will have to register it as an LLC or an LLP to make it a legal entity.
- The parent company should create a legal paper that will state that the SPV is being created. This document would be a letter of intent, and it will be sent to the shareholders who own its shares.
- The parent company should make sure that its SPV can only use special purpose vehicles (SPVs) as subsidiaries and not as their main business entity, so they can easily set up an SPV in other states or countries interested in doing so.
How to Set Up a Special Purpose Vehicle
In order to form an SPV, the parent company will have to follow a series of steps. The steps are as follows:
- Appointment of one director and one shareholder.
- Memorandum of association and articles of association should be stated.
- Any shareholder with more than 25% of the company’s shares is known as a person with significant control (PSC).
- PSC’s – name, date of birth, service address, and year of nationality
- SIC code (standard industrial classification)
Why Don’t Investors Give Preference to Special Purpose Vehicles?
The reason why investors do not give priority to special purpose vehicles is that they are a new form of business entity. Investors judge the value of a new business by the valuation of a company’s assets, cash, and total liabilities. The SPV can be seen as an asset because it is a separate legal entity with its own set of rules and tax treatments.
Therefore, investors will have a hard time judging the value of an SPV because it is difficult to determine whether or not it has a good investment in it based on its assets, cash, and liabilities. When an investor decides to invest in an SPV, he will have to look at its prospects instead of its current status. This is why many investors do not prefer investing in special purpose vehicles.
An example of a failed SPV can be seen in 2008 by Lehman Bros. The bankruptcy of Lehman Brothers in 2008 highlighted significant structural weaknesses in the SPV documentation, particularly in financial transactions in which Lehman acted as the exchange counterparty. This caused a series of financial problems for Lehman and subsequent bankruptcy.
Recent Regulation Changes for Special Purpose Vehicles
In this modern era, new financial regulations are being invented to ensure that corporations do not misuse SPVs. Here is a list of the most recent regulations that have been imposed:
- An adaptation of the loan documentation agreements is part of the consideration for financing transactions between the SPV and lenders.
- Endorsement of legal risk management practices by both banks and regulators. This will help them to create SPVs properly.
- There has been greater emphasis on counterparty risk in capital market structures to attain greater transparency and control over the party.
How to Manage Risks Around Special Purpose Vehicles
Setting up an SPV is a serious and intricate task that should not be undertaken lightly. There are different ways that a parent company can manage its risks when setting up a special purpose vehicle (SPV) that are as follow:
- Rely on Experts – The parent company will have to rely on experts who will help them with the different operations that need to be taken.
- Efficient and Timely Reporting – A company must communicate with its shareholders and ensure they are updated on the latest information.
- Monitoring Operations – A parent company should monitor its operations to ensure that it is being run correctly.
- Motivation – The parent company will have to motivate those working within the SPV because this can encourage them to work harder and faster.
- Rules and Regulations – Rules and regulations help control an SPV, so a parent company needs to set up rules of conduct for its special purpose vehicle (SPV) to maintain order in its operations.
- Simple structure – The parent company and its shareholders need to set up a simple structure to be easily maintained and operated by the SPV’s management.
- Merge – When the parent company is finally ready, they will have to merge their SPV with another company or other companies, and then they will be able to start operating as a new company.
- External Ratings – This means that when setting up an SPV, the parent company will evaluate their finances and the finances of their SPVs so that they can share information and make sure that everything goes as planned.
Choose Eqvista for Business Valuation to Approach Investors!
Setting up a special purpose vehicle (SPV) is a great way for a company to establish itself and start operating. If you are setting up an SPV, there are certain rules and regulations that you will be expected to follow so that you can maintain good order in your operations. It is also important to make sure that your SPV is not misused and that you can manage your risks properly. For professional guidance, visit Eqvista for the best assistance. We provide you with the best financial compliance, advisory, and business valuation for your company. Contact us today for more information.