Special Purpose Vehicles (SPVs) are in the news these days what with the banks and FIs and the corporates using this powerful tools for various purposes.

Banks and FIs and financial companies use this for undertaking off balance sheet financing or for hiving off their slow moving assets, while corporates are using this tool for funding their acquisitions e.g. TATA - Corus deal.

The use of SPVs originated in the US of A in the 1980s as a method of undertaking tax efficient transactions by establishing companies in tax havens like Cayman islands or Isle of Mann / Gibraltar etc.

However with the passage of time the usage of this product has spread across the globe and for varied uses other than tax efficient transactions.

So what is an SPV?
An SPV is a firm or legal entity established to perform some narrowly-defined or temporary purpose. The sponsoring firm accomplishes that purpose without having to carry any of the associated assets or liabilities on its own balance sheet. The purpose is achieved "off-balance sheet."

Usage of SPV
From the initial use of the SPV to enhance tax efficiency, SPVs are now used for a wide variety of transactions as the financial markets have become more and more sophisticated:
               Securitising loan portfolios of a bank
               Securitising financial assets such as:
               Auto loans
               Credit card and hire purchase receivables
               Finance leases
               Aircraft operating leases
               Real estate mortgages
              Aircraft and ship financing
              Catastrophe bond issues (CAT Bonds - I will be writing on this shortly)
              Specialised financing deals, such as Ijara financing (Ijara financing will be covered in another discussion in this blog)

How is the tool of SPV used?
The originating company transfers its assets into a specially formed company called the SPV. The SPV then issues bonds or notes which are backed by the receivables generated by the assets transferred to it. The investor investing in such bonds / notes does so by evaluating the SPV as a standalone entity and not as an arm of the originating company. Hence an SPV does not impose any strain on the credit limits of the originating company.

How is the ownership of an SPV structured?
The SPV may be a subsidiary of the originating company or may be a "orphan entity"

By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the sponsor, there is no difference between a subsidiary and an SPV.

In most of the cases an SPV is used either for enhancing tax effeciency or for off balance sheet financing. In the case of an SPV being used for tax purposes the originating company does not directly participate in the ownership of the company. The ownership of SPV in such a case is vested with a trust which is formed for this purpose.

In the event of an SPV being used for off balance sheet financing the originating company only has a partial ownership in the SPV. This is because if the entire ownership of the SPV was vested with the originating company then the financial statement of the originating company will have to incorporate the balance sheet of the SPV as well which in turn defeats the very purpose of the SPV.

Advantages of off balance sheet financing
Off-balance sheet financing is attractive from a risk management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them. For example, if a firm transfers credit risky assets to an SPV, the credit risk goes with those assets.

What is a pass through certificate (PTC)?
A pass-through is a security issued by a special purpose vehicle. The SPV holds assets and pays the pass-through's investors whatever net cash flows those assets generate. In this way, the SPV's assets and liabilities are automatically cash matched, so there is no asset-liability risk.

Risks associated with an SPV?
Like any finance structuring tool SPVs come with their own inherent risk of misuse. A classic case of misuse was demonstrated by ENRON which created a number of SPVs (almost 3000) to hide its risk debts.

Why do investors prefer subscribing to SPV notes rather than lend to originating company

Although the subscribers are supposed to be taking the risk on the SPV itself, in most of the case the originating company takes a moral responsibility to repay in case of a default. Hence in practice an SPV can never go bankrupt. Therefore the pricing of the notes should not include any risk premium on account of bankruptcy.However this logic does not apply to the originating company as it is susceptible to bankruptcy risk. Hence the investors might prefer investing in an SPV note at a slightly lesser rate than what they would demand for the originating company note.

But this does not mean that there are no strings attached to the SPV route. Setting up of an SPV would involve a fixed cost and the originating company might not be able to claim the tax break on the interest paid by the SPV

How is a SPV bankruptcy remote?
An SPV is bankruptcy remote i.e even if the sponsoring company goes bankrupt the creditors cannot seize the assets of the SPV. Typically it is structured in such a way that it is ineligible to be a debtor under the US bankruptcy rules - how to structure this kind of an entity is a seperate topic matter for discussion.