How does one convince lenders or investors to invest millions of dollars in a company which doesn’t have a strong credit rating, or have never generated cash before, or doesn’t have any employees? It looks like an impossible scenario for a company to attract investors. But, every year hundreds of infrastructural projects get financed even with all these scenarios present.

How? Well, one can achieve this with some help from project finance. In this article, we will try to understand what project finance is all about and through it understand the uses and limitations of special purpose vehicles.

What is project finance?

Project finance is a long term source of finance for infrastructural projects. Infrastructural projects are generally risky and require a huge amounts of investment. Therefore, investors raise funds for the project by creating a “Special Purpose Vehicle” (we’ll look into what it means later) and thus, allocate the risk associated with it. The funds can be raised by equity investors who are also known as the sponsors of the project and debts through the lending institutions.

These loans are generally non-recourse in nature. This means that the balance sheet of the investors (their assets or the parent company’s assets) is different from the project company asset (SPV). The debt can only be recovered through the assets of the Project Company or the cash generated from it. Therefore, these projects are financed by assessing their ability to generate cash flow.

So, if we can summarise what project finance means then-

  • Project finance is the funding of long term investment in infrastructural, industrial, or public service projects which is non-recourse in nature.
  • For project finance, the parent company creates something called a ‘Special Purpose Vehicle’.
  • The liability of sponsors is limited and no additional asset can be seized by debtors except the assets of the project. Therefore, the project remains off the balance sheet of the company.

 What is a Special Purpose Vehicle?

Special Purpose Vehicle (SPV), Special Purpose Entity (SPE), or Special Purpose Company is a separate legal entity that is created to isolate financial risk by the parent company. It has its own set of assets and liabilities and is created for a specific purpose. Now, in case the parent company goes bankrupt, the Special Purpose Entity can continue to operate. This is the reason it is also called as “bankruptcy-remote entity”.

Different legal forms of an SPV can be partnership, limited partnership or joint venture. For some special cases, it is required that the SPV should not be owned by the company on whose behalf it is to be created.

 Why SPV is created?

There are several reasons why SPV is created. Some important reasons are as follows-

  • Risk sharing: It is mainly created to isolate or relocate the financial risk of the parent company. This is done by allocating the work (and risk) among various investors. For example, who is obligated to build the project, or who is obligated to operate the project, or who is obligated to sell the output, and so on. Once, the risks are allocated the investors are obligated to deliver them. If they fail to do so, they have to pay penalty as per the contract. In case of bankruptcy of parent company, the SPV can continue to function due to this risk-sharing.
  • Securitization: It is a financial practice of pooling in the various kinds of debts (contractual) like residential mortgages, auto loans, or other commercial mortgages in the SPV and then selling the debts off through various securities like bonds, CMO (collateralized mortgage obligation), etc. to various investors.
  • Asset Transfer: Some assets are non-transferable or difficult to hold. The companies can simply create an SPV for these assets and can easily transfer it by selling the SPV to the investor. It is better than splitting the asset or getting the various permits for it. It happens commonly in mergers and acquisition companies.
  • Property Sale: There are times when the tax on the property sale is higher than its capital gains. The company creates an SPV for such property so that by selling it directly one doesn’t have to pay tax on the property sale.

These uses of SPV suggest its benefits as well. The other benefits include minimal red-tapism as it is relatively easier to set up and there is minimal authorization of government required. If SPV is created in a tax haven like Cayman Island, then it can avail the benefits of tax saving.

What are the main risks in SPV?

There is a lack of transparency about whom the real risk lies due to the complexity of allocation. Some SPVs fail to attract investors because it doesn’t have the creditworthiness like its parent company and is usually set up for risky infrastructure projects. Since SPV allows multiple ownership of assets it can lead to the risk of its regulation, as it might not be regulated as per the norms of the parent company. This also leads to the dilution of the direct control of the parent company.

Though SPV’s are completely legal if the companies exploit their accounting loopholes it can lead to big frauds. Some of the famous cases are:

  • Enron: In 2000, the Enron had created hundreds of SPVs. By doing so, it was covering billions in debts that occurred due to failed projects and contracts. Through SPVs they quickly transferred their profits from the stocks that were rising and receiving cash for them. Finally, in 2001, their debt came into light, and stocks tumbled down in a week from $90 to $1. The shareholders suffered losses worth $11 billion. Enron had to close all the SPV after the charges were held against them.
  • Lehman brothers: This is another famous case of SPV failure. In 2008, Lehman brothers opened several SPVs but most of them were either not registered or lacked proper documentation, or were not maintained by them. This led to an increase in an enormous amount of their liability making them insolvent.

Now, if we look at the present situation of the pandemic in our country, attempts are being made to kick restart the economy. For that, the government of India has announced in the COVID relief package to infuse Rs.5 crores as equity in the special purpose vehicle to help the Non-Banking Financial Companies (NBFCs’) get better credit rating for the bonds issued. This will help in providing more liquidity to these NBFCs through the reliability provided to investors through government guarantee. The guarantee is capped at Rs.30,000 crores as per the relief package. The investors may still find it riskier to invest in these projects during this time.

In conclusion, we have looked at the benefits and the limitations of Special Purpose Vehicle and understood how it works. If they are carried on lawfully one can accomplish huge projects with the impossible scenarios they start with. What is left to see is how the Special Purpose Vehicle with some history of misuse and failures will be able to help the economy gain a foothold in the future?

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