What is a Special Purpose Entity

A special-purpose entity (SPE) is a subsidiary company created by a parent company to isolate financial risk. This entity is legally separate from the parent company. It aims to absorb risks that the parent company faces. In some cases, SPEs can hold assets if the parent company enters bankruptcy. Another name used for a special-purpose entity is a special-purpose vehicle (SPV).

SPEs have their own assets and liabilities. Similarly, investors can buy their stocks, which are legally separate from the parent company. SPEs may not be a part of the parent company’s financial statements or accounting record. However, there are some specific account criteria that they have to meet first.

How does a Special Purpose Entity work?

SPEs start with a parent company that creates the entity to isolate its assets or liabilities. Some other companies may use these entities to securitize their assets in case of bankruptcy. However, SPEs stay off the parent company’s balance sheet. Usually, companies create these entities when investing in risky projects to protect the parent company from the associated risks.

In case the risks realize, the parent company always stays clear of any consequences. Since most SPEs remain off the balance sheet, the parent company does not suffer due to it. However, there are only particular cases where the use of these entities might be relevant. For example, special-purpose entities may serve as a counterparty for swaps and other similar credit-sensitive derivative instruments.

SPEs may come in different forms, such as corporations, limited partnerships, trusts, etc. It usually depends on the parent company’s preference. However, they may also be helpful in creating joint ventures or performing financial transactions. Similarly, SPEs may come as either on- or off-balance sheet entities.

What are the advantages of a Special Purpose Entity?

SPEs can have various advantages. Firstly, it allows parent companies to isolate the financial risk associated with an investment. The parent company usually doesn't have to disclose these entities on their balance sheets, given they meet some conditions. Therefore, it allows companies to mask investments or projects from competitors or even investors.

SPEs are also helpful in tax saving and planning. Usually, there is not much effort involved in creating these entities, making them easier to set up and use. Overall, SPEs allow parent companies to perform high-risk transactions. In case of failure, however, the parent company does not suffer the consequences.

What are the disadvantages of a Special Purpose Entity?

SPEs have several disadvantages. Parent companies can use these entities to mask information from stakeholders, which is not ethical in some cases. On top of that, they require a significant capital investment. Special-purposes entities may not get the same opportunities and exposure that established parent companies do.

Some regulations may also apply to SPEs, which can cause problems for the parent companies. These may change regularly, which may have an adverse impact on the parent company's financial position. Similarly, some accounting standards may apply to these entities. Therefore, SPEs may not always stay off-balance sheets.

Conclusion

A special-purpose entity is a subsidiary company used to isolate financial risks or securitize assets. SPEs are useful when parent companies make risky investments or face bankruptcy. With these entities, parent companies can mitigate any risks they face. Special-purpose entities can have various advantages but may also come with some disadvantages.

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