How Special Purpose Vehicle Reduces Financial Risk for Companies

Key Takeaways 

• In general, a Special Purpose Vehicle (SPV) is a separate legal entity an organization creates for a specific reason.

• If a project is exceptionally risky, a company will often create an SPV to legally isolate such risk and subsequently share it with other investors.

• While Special Purpose Vehicles are usually associated with corporations, they can help companies of all sizes.

Investors who are interested in participating in venture capital in particular should understand Special Purpose Vehicle (SPV) and how it can be employed to reduce risk. But what is a Special Purpose Vehicle? 

What is a Special Purpose Vehicle (SPV)?

In general, a Special Purpose Vehicle (SPV) is a separate legal entity an organization creates for a specific reason, frequently to isolate financial risk. Because it is a standalone legal entity, with its own liabilities and assets, if the parent company declares bankruptcy, the SPV can keep going. In the eyes of the law, Special Purpose Vehicles are limited partnerships, partnerships, or joint ventures.

There are various uses for SPVs, which are explained below.

Why Do Companies Use SPVs?

There are some common reasons why companies across various industries establish SPVs, including:

• Risk sharing. If a project is exceptionally risky, a company will often create an SPV to legally isolate such risk and subsequently share it with other investors.
• Asset shift. Because some kinds of assets can be difficult to transfer, a company might set up a separate entity for asset ownership. When the company wishes to transfer the assets, it can just sell the Special Purpose Vehicle as part of a merger and acquisition.
• Pool assets in venture capitalism. Groups of investors use SPVs to pool their assets to start a new business or invest in a startup.
• Off-balance-Sheet arrangements. Some companies use vehicles to take assets or liabilities off their balance sheets. This can result in better financial ratios and lure more investors. However, the Enron case, discussed later, resulted in robust regulation to minimize abuse.
• Securitization of loans. Say a bank issues mortgage-backed securities from a mortgage pool. By creating an SPV, it can separate the loans from its other obligations. The entity permits mortgage-backed securities investors to receive loan payments before other bank creditors.
• Property ownership and sale. If property sales taxes exceed the capital gain realized from the sale, a company can establish an SPV to own the for-sale properties. Then, instead of the properties themselves, the company can sell the SPV. That way, it can pay capital gain taxes rather than the property sales tax.
• Financial mergers or acquisitions.
• Financing real estate development or large purchases.
• Engage in joint ventures.
• Finance equipment purchases.

Is an SPV Considered an LLC?

Companies frequently create SPVs as limited liability companies — LLCs. After all, LLCs are easily created and unburdened by the regulations and red tape that corporations face.

Established as an LLC, an SPV can have its own assets, liabilities, and obligations that are distinct from the parent company. Moreover, through amendment of the LLC operating agreement, the vehicle can be easily transferred.

How Does an SPV Differ from a Subsidiary Company?

It is true that SPVs and subsidiaries are entities a parent company creates that have a singular business purpose. However, they are not the same.

A subsidiary often means an operational business that supports the parent company or is separate from it. For example, Alphabet, Google’s holding company, owns YouTube. YouTube is a subsidiary company that is formed as an LLC.

SPVs, meanwhile, frequently do not hold operational businesses. Rather, they are usually just utilized as financing tools or to hold specific company assets.

What are the Benefits of SPVs?

In a nutshell, the potential advantages of a Special Purpose Vehicle include:

• Isolated financial risk.
• Tax favorability. That is, if the vehicle is set up in a “tax haven.” Such places — the Cayman Islands, for example — offer very low tax rates for non-domicile investors.
• Direct asset ownership.
• Ease of creation and setup
• Can provide private businesses with easier access to capital markets.
• Through SPVs, companies can secure capital with lower borrowing rates.

What are the Risks of SPVs?

There are also potential risks with these entities, namely:

• Less access to capital at the vehicle level since the entity lacks the credit the sponsor has.
• Companies using such vehicles could face problematic regulatory changes.
• If an asset is sold that significantly impacts the sponsor’s balance sheet, it could trigger Mark to Market accounting rules.
• SPVs are sometimes seen in an unfavorable light.

About the Enron Case

The practice of using SPVs to move assets or liabilities off company balance sheets to attract more investors ultimately resulted in heavy regulation, owing to the potential for misuse.

Enron shares, at the energy company’s peak, were worth $90.75. When the company filed for bankruptcy, on Dec 2, 2001, the shares were trading at $0.26. The collapse of the company — at one point one of the nation’s largest — is difficult to fathom for some to this day.

Essentially, following the 2000 recession, Enron’s downfall was attributed to irresponsible use of derivatives as well as Special Purpose Vehicles. The company hedged its risks with the entities it owned. In doing so, Enron retained the risks that were associated with the transactions. The net result was that Enron implemented hedges against itself, which proved disastrous.

Can All Businesses Use SPVs?

While Special Purpose Vehicles are usually associated with corporations, they can help all-size companies. These companies can use the entities to secure financing, lower liability risk, and participate in joint ventures or projects.

A small company, for instance, can use a vehicle to build a new office building. By creating SPVs to obtain project financing, companies can acquire building permits and line up contractors. Company assets are shielded from liabilities that can come with such construction.

How to Invest in Venture Capital (VC)

Venture capital — a form of private equity — is generally a type of investor financing that is provided to startups and small businesses.

While no investment is without risk, VC offers a number of enticing potential benefits, including the potential for high returns. 

Investing in a venture capital fund generally occurs in increments over time, with the initial investment typically around 5% to 10% of the total commitment. Subsequently, the investor will regularly continue funding their commitment over the investment period, which is usually between three to five years.

Those interested in entering the venture capital space without worrying about SPVs would do well to consider the alternative investment platform Yieldstreet, a user-friendly platform on which nearly $4 billion has been invested to date, with more than $2.4 billion distributed to investors. 

Yieldstreet has a broad selection of alternative assets — those other than stocks and bonds — available, including accessible opportunities in VC. Its highly curated venture capital program exposes retail investors to private businesses that are either disrupting sectors or creating new ones altogether.

Circumventing public markets for returns also allows investors to diversify their holdings, which can mitigate overall portfolio risk as well as guard against inflation and potentially improve returns. In fact, portfolio diversification is a fundamental pillar of long-term investing success.

Alternative Investments and Portfolio Diversification 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Corporations often turn to Special Purpose Vehicles to mitigate risk. Venture capitalists also use such vehicles to consolidate a pool of capital to invest in a startup business.