A special purpose vehicle refers to a firm whose operations are limited to the acquisition and financing of specific assets or projects. SPVs are usually established as subsidiaries whose assets and liabilities are structured in a manner that makes their obligations secure irrespective of the financial difficulties of their parent companies. Thus, a special purpose vehicle will be necessary to generate adequate funds to complete the project.
Project financing refers to the raising of funds on a limited recourse basis for the purposes of developing a large-scale capital intensive project through a special purpose vehicle. Generally, the borrowed funds are often repaid using the revenue from the project.
Reasons of Using SPVs in Project Financing
One of the main reasons for using SPVs is to share the risks associated with implementing large-scale infrastructure projects with the financiers. SPVs are often formed as independent legal entities with several shareholders. The common shareholders of SPVs include lenders such as banks, the sponsoring company, institutional investors, and constructors.
This means that the sponsoring company usually owns just a small percentage of the SPV. As a result, it is able to share the risks associated with the project with other shareholders of the SPV. For instance, in the event that a project fails during implementation, the losses associated with the failure will be shared by the members of the consortium that will implement it. Thus, the overall negative financial impact on the sponsor will be reduced. SPVs are also used because they ensure limited recourse. In particular, the funds borrowed through SPVs can be viewed as limited recourse debts since the creditors have only limited claims on the loan in the event of default.
The limited claim is achieved by transferring the assets and liabilities acquired using the loan to the SPV’s balance sheet. This means that the creditors’ claims will be limited to only the assets of the SPV if the sponsor fails to meet its debt obligations. Thus, the parent company or the sponsor will avoid the risk of losing its assets to the creditors if it fails to repay the loan.
Advantages of Using SPVs in Project Financing
Using SPVs to access funding for a large-scale infrastructure project has the following advantages.
First, it reduces the overall cost of accessing credit and ensures flexibility in financing. SPVs do not depend on the credit lines of their parent companies since they are treated as external entities. As an independent firm, the SPV is expected to establish its own credit lines. In this context, the SPV has to be presented to the creditors as a stand-alone entity with its own risk-reward characteristics. Therefore, the sponsoring firm can improve the credit worthiness of the SPV through adequate capital allocation. As a result, the SPV achieves favorable credit rating, which in turn reduces its cost of borrowing. In addition, the after tax cost of capital will reduce significantly if the interest paid on the debt is deductible from the pretax profit. Conversely, the sponsoring company can transfer its debts to the SPV to reduce its debt-to-equity ratio. As a result, the sponsor will be able to access credit easily and at a low interest rate. Apart from borrowing from banks, the SPV can access funding by selling equity to investors. This reduces the cost of capital since the investors will be compensated using the profits generated by the SPV rather than interest.
Second, using SPVs facilitates high leverage financing. For instance, the SPV can enable the sponsor to finance up to 90% of the project through debt. The main benefit of high leverage to the sponsor is that it makes the project affordable and less risky. For instance, if the SPV that will implement the proposed project achieves a 90-to-10 debt-to-equity ratio, the sponsor will require only 10 percent to invest in the project. This will not only make the project affordable, but will also reduce the financial risks that the sponsor will take by implementing the project.
Third, special purpose vehicle project financing enables the government to achieve fiscal optimisation. In this case, the government uses a public-private partnership (PPP) arrangement to implement a large-scale transport infrastructure project. Specifically, the government uses the PPP to select a private company that finances the project through a special purpose vehicle. As a result, the government shifts the financing responsibility to the private sector, thereby enabling it to avoid tying huge financial resources in a single project. This perspective is based on the fact that the government amortises the cost of the project over its concession period.
Fourth, SPVs allow financiers to earn a level of return on investment that is proportional to the risks associated with the project. This perspective is based on the fact that the financiers directly obtain revenue from the services provided by the project. For instance, the investors in the SPV will be compensated by charging users of the railroad a predetermined fee. This ensures cost recovery and a high return on investment, especially, if efficiency is enhanced during the implementation and operation of the project. In addition, charging a user fee improves the success of the project since the users will only pay the fee if the services are excellent. In this regard, the SPV will focus on improving the quality of the project to avoid losing money during the operation phase. The investors in the SPV are also likely to make excess profits if the internal rate of return (IRR) is higher than the cost of capital. Another benefit is that the assets of the SPV act as collateral for borrowed funds. This allows lenders to recover the borrowed funds if the SPV fails to repay. The sponsor, on the other hand, is likely to benefit from low interest rates if the assets of the SPV can provide adequate collateral.
Fifth, using SPVs enables the sponsor to collaborate with a variety of investors. This not only ensures access to adequate financing, but also access to the technical expertise that is required to deliver the project. For example, technical risks such as poor workmanship can be eliminated if the contractor is one of the investors in the SPV.