What is a Special Purpose Entity?

A special purpose entity is a legally separate business that absorbs risk for a corporation. A special purpose entity can also be designed for the reverse situation, where the assets it holds are secure even if the related corporation enters bankruptcy (which can be important when assets are being securitized). This entity holds separate assets and has investors who are separate from the initiating corporation. As long as certain accounting criteria are met, the founding corporation does not have to record the special purpose entity in its accounting records. This arrangement allows a corporation to shift unrelated activities and risk away from its financial statements. Special purpose entities have many legitimate purposes, but can be abused to make a company look less risky and more profitable than is really the case.

Example of a Special Purpose Entity

A business wants to securitize its receivables in order to gain more immediate cash flow from them. To do so, it sells its receivables to a special purpose entity, which issues securities based on the cash flows represented by the receivables. These securities are considered by investors to be low risk, since the creditors of the initiating business cannot access the receivables now owned by the special purpose entity.

Advantages of a Special Purpose Entity

There are several advantages associated with a special purpose entity, which are as follows:

Risk isolation. An SPE helps to isolate the financial and legal risks associated with a specific project or asset.
Asset protection. Assets owned by an SPE are separate from the parent company’s assets. This separation ensures that creditors of the parent company cannot claim SPE assets in case of insolvency.
Off-balance sheet financing. SPEs allow companies to finance projects without adding liabilities to their balance sheets, making their financial metrics (like debt-to-equity ratios) appear stronger. This is commonly used in lease financing and securitization.
Tax optimization. SPEs can be domiciled in jurisdictions with favorable tax laws, thereby reducing the overall tax burden of a business. They may also facilitate the use of tax credits or deductions specific to certain activities or locations.
Asset securitization. SPEs are often used to package and sell financial assets (e.g., mortgages, loans, or receivables) as securities. This provides liquidity to the originating company while transferring risk to investors.
Partnership facilitation. SPEs make it easier to structure joint ventures or collaborations, as they provide a neutral legal entity for shared ownership and operations.
Capital raising. SPEs can be created to issue debt or equity to raise funds for specific projects, which may not align with the parent company’s main business. Investors may prefer SPEs for targeted, transparent investment opportunities.
Project-specific focus. SPEs concentrate resources, decision-making, and management on a specific project or activity, improving efficiency and accountability.
Liability limitation. The liability of the parent company is typically limited to its investment in the SPE, protecting the parent’s overall financial health.
Bankruptcy protection. If structured properly, the bankruptcy of the parent company does not necessarily affect the SPE, ensuring that its projects can continue independently.