Definition
A Special Purpose Entity (SPE) is a legal entity or corporation created by a corporation to isolate financial risk by undertaking specific risky projects or financial obligations. This helps safeguard the parent company from financial risk by creating a separate credit and legal standing. It’s commonly used in complex financings such as securitization, asset-based lending and leasing arrangements.
Key Takeaways
- Special Purpose Entity (SPE) is a legal entity created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk. They’re typically used by companies to securitize assets, create joint ventures, isolate corporate assets, or perform other financial transactions.
- SPEs can help companies access cheaper financing and provide less risk to shareholders and debt holders. Because SPEs are separate legal entities, they can have a higher credit rating than the sponsoring company, leading to cheaper debt financing.
- Despite their utility, SPEs are not without risk. Lack of transparency and sudden insolvency can pose substantial risks. If not properly managed, the use of an SPE can lead to substantial financial losses, as evidenced in the Enron scandal, where SPEs were utilized to hide debt and inflate profits.
Importance
The finance term ‘Special Purpose Entity (SPE)’ is important because they play a critical role in risk management and financing structures.
SPEs are established by companies, primarily for securitization purposes, which involve pooling various financial assets to back a series of financial instruments like bonds or debt securities.
These entities allow companies to isolate financial risk by segregating particular assets or liabilities, safeguarding assets, simplifying complex finance structures and executing large scale projects without impacting the parent company’s balance sheet directly.
These organizations can also help companies achieve better credit ratings for their financial instruments.
Despite the benefits, SPEs have been at the center of notorious corporate scandals, underscoring the need for transparency and appropriate use.
Explanation
Special Purpose Entities (SPEs) are legal structures created by corporations for specific business operations or objectives. The primary purpose of establishing such an entity is to isolate financial risk by strictly limiting the SPE’s activities to those necessary to accomplish its core business function. SPEs are used to handle specific transactions or business events, like securing financing for large projects, without linking the transactions back to the parent company.
By legally ring-fencing certain aspects, corporations can protect their primary operations from potentially catastrophic risk emanating from the SPEs. Another main use of SPEs is in asset securitization, wherein some type of income-generating assets is sold to the SPE, which then leases the asset back to the parent corporation, or issues securities backed by these assets to investors. This allows the parent company to finance the asset indirectly and can reduce the amount of sunk capital.
Furthermore, SPEs assist in achieving financial engineering through off-balance sheet transactions which can improve business and financial reporting statistics. Despite these uses, it’s crucial to note that SPEs have also been unfortunately linked to financial malpractices due to lack of transparency and oversight. Hence, their use requires careful scrutiny and regulation.
Examples of Special Purpose Entity (SPE)
Securitization of Mortgages: This is a common use of SPEs. Banks and other financial institutions often bundle individual mortgages into a special purpose entity and then sell the cash flows from that entity to investors as securities. This practice was notably involved in the 2008 financial crisis. The largest banks, such as J.P. Morgan and Bank of America, were creating and leveraging SPEs to securitize mortgage loans.
Enron Corporation Scandal: Enron used SPEs to hide losses and debt from their balance sheet, which inflates the company’s profit and equity values. This artificially inflated Enron’s stock price and ultimately led to one of the largest bankruptcies and corporate scandals in U.S. history.
Infrastructure Projects: Governments or corporations sometimes create SPEs to finance large infrastructure projects such as highways, stadiums, or airports. These entities are given the legal authority to raise funds, usually through the issuance of bonds, that are then used to finance the project. The repayment of these funds typically comes from the revenue generated by the infrastructure project itself. An example of this could be the Channel Tunnel between the UK and France. The project was too large and risky to be undertaken by an existing company, so a SPE, Eurotunnel, was created to finance and manage the project.
Frequently Asked Questions about Special Purpose Entity (SPE)
What is a Special Purpose Entity (SPE)?
A Special Purpose Entity (SPE) is a legal entity created by a corporation that is a separate company with its own assets and liabilities. The creation of an SPE allows the parent company to make high-risk investments without endangering the entire company.
What is the main purpose of an SPE?
The main purpose of an SPE is to allow a parent company to manage risk. By conducting high-risk activities outside of the main business, the parent company can keep those risks separate from its main operation.
Can you give me an example of an SPE’s use in finance?
SPEs are often used in complex financings to separate risk from the parent company. For example, they might be used to own a single large asset, like a piece of real estate or a lease. The SPE’s financial results would then be kept separate from the parent company’s books.
How can an SPE influence a company’s financial performance?
SPEs can influence a company’s financial performance by handling certain risks and assets independently. This can help isolate financial risk and can potentially improve a company’s overall financial standing.
What are the possible risks associated with SPEs?
While SPEs can be used to manage risk, they can also create risk. If not properly managed, SPEs can lead to significant financial losses. Their use can also lead to a lack of transparency in a company’s financial statements, which can create uncertainty among investors and stakeholders.
Related Entrepreneurship Terms
- Securitization
- Off-Balance Sheet Transactions
- Bankruptcy Remote
- Structured Finance
- Asset-Backed Securities (ABS)
Sources for More Information
- Investopedia – Comprehensive resource for investing and finance information. Special Purpose Entity (SPE) specific page: https://www.investopedia.com/terms/s/spv.asp
- Corporate Finance Institute (CFI) – Provides a wide range of information about finance and financial analysis. Special Purpose Entity (SPE) specific page: https://www.corporatefinanceinstitute.com/resources/knowledge/strategy/special-purpose-entity-spe/
- AccountingTools – Provides in-depth resources about accounting principles and practices. Special Purpose Entity (SPE) specific page: https://www.accountingtools.com/articles/2017/5/5/special-purpose-entity
- Financial Accounting Standards Board (FASB) – Standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP). SPE specific guidance: https://www.fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176168232906&d=&pagename=FASB%2FFASBContent_C%2FNewsPage
