Two-Minute-Topic: Special-Purpose Entities
A run through of what special purpose entities are, why they are important, and the future.
What is a Special-Purpose Entity?
A special-purpose entity (SPE) in structured finance is, put simply, a subsidiary to a parent company which is used to achieve very specific objectives. The entity may be a trust, corporation, limited liability company, or hold virtually any other legal structure (it largely depends on the purpose, naturally). In addition, a SPE is distinguishable from regular subsidiaries by the fact that whether the parent firm goes bankrupt or not has no impact on the SPE.
It uses two key characteristics to achieve the aforementioned results: bankruptcy remoteness and entity separateness.
Bankruptcy Remoteness: This essentially allows for the parent company to disassociate themselves from the SPE legally, while still reaping many of the economic benefits that come along with the transactions. Additionally, in the case of securitization, or the pooling together of illiquid assets, it gives more security to the investors who are buying the individual tranches — as the bankruptcy of the parent company does not affect the subsidiary.
Entity Separateness: In the context of off-balance sheet financing, something Enron was famous for participating in, under the proper circumstances the parent can use the subsidiary to allow an in increase transaction and balance sheet flexibility. For example, the isolation of debt can allow for decreased finance costs and lower capital requirements for the parent. Given these clear advantages, there are also an equal amount negatives that can be drawn from balance sheet manipulation. As hiding debt is good for the parent company, it is a terrible problem for investors, who rely on balance sheets for a true underlying economic value of the firm. In many cases, this can have tremendously damaging consequences to the firm.
Uses: Primarily, SPEs are used for securitization (commercial mortgage-backed transactions), isolation of risk, creating cheaper funding, regulatory compliance, off-balance sheet financing (famous LJM1 and LJM2 Enron subsidiaries), synthetic leases, and many others. The myriad ways in which these entities can be used makes them particularly valuable for large public corporations, investment banks, and insurance companies.
Why do SPEs Matter for Now and the Future:
Special-Purpose Entities are important because they have affected the business and accounting landscape for tomorrow. Enron’s subsidiaries helped bring down the firm — the 7th largest U.S. firm at the time. This caused the near complete evaporation of Enron employee retirement savings, and market chaos. To prevent tragedies like Enron many regulations and practices have changed. The direction of these changes are to a more transparent and open accounting landscape, one in which would hopefully allow for better financial statement transparency for investors — fighting off the ‘black box’ mentality and financials of some firms.
Thank you for reading this article, I appreciate the time. In the near future, a longer more complex version will come out, hopefully taking on a more research orientation. In the mean time, any feed back would be wonderful, and I hope it was helpful, whether you are a student, professional, academic, or enterprising learner.
Image Citation: The Key Features of a Securitization Transaction. Digital image. Asset Backed Securitization. Investment Peerview, n.d. Web.