Managing Project Budgets - Special Purpose Vehicle - Case Study Example

Managing Project Budgets: Special Purpose Vehicle Student’s Name: Presented To: Subject: Date: Introduction Public Private Partnership (PPP) has become common and the partnership has led to the establishment of business entities referred to as Special Purpose Vehicles with the sole aim of conducting a clearly defined infrastructure project. On the other hand, SPV are being used by various companies to find their growth initiatives without them being forced to use market loans to finance such growth. In this instance, companies make use of their own assets to guarantee the SPE/SPV loan. Thus SPE can be regarded as a new legitimate method for obtaining cost-effective finance. Neal (2007) in his article argues that special purpose vehicle may in other words be referred to as Special Purpose entities which are the most common term in countries like USA. Special purpose entity is simply structured and goes on to define it as an ‘entity formed for discreet and isolated purpose, to adhere to a specific business or economic objective; a simple premise or starting off point form which the concept builds’ (Chang et al., 2009, p. 99). SPE or SPV aims at narrowing the scope of risk to the assets and liabilities placed in the SPE. In this regard, the fortunes of existing shareholders and/or potential investors are based entirely on what occurs with reference to liabilities and assets put in the SPV/SPE. The Need for having Special Purpose Vehicle (SPV) In order to control and manage complex project budgets, two basic features which are usually common go hand in hand; ‘project finance’ and ‘project management’. Usually, project managers for instance the engineers fully understand the project management aspects but are less concerned with the project financing aspects which are most critical. In this regard, majority of project delays and failures crop up for lacking reliable financial source which can be said to be the key driver in developing infrastructure projects. Currently, the most common project financing methods are in the form of Asset Based Securitization (ABS) and Public Private Partnership (PPP) (Wayne et al., 2008). Besides, these are also being regarded as a necessary investment technique. The paradigm shift has been from the traditional project financing techniques towards securitization and special purpose vehicle via public private partnership (UN ESCAP, Transport and Tourism Division). The formation of special purpose vehicle occurs in a coordinated fashion as opposed to chronology of events with requirements of each stage changing substantially with respect to the specific needs of the sponsor and the use of SPV (either the asset securitization or leasing) (Mei & Gramlich 2009). This coordination of events is illustrated in the figure below. Figure 1. Transactions Involved In Formation of a Special Purpose Vehicle Source: Mei Feng, JD & Gramlich, SG 2009, ‘Special purpose vehicles: empirical evidence on determinants and earnings management’, The Accounting Review, vol. 84, no. 6, pp. 1833–1876. In another perspective, special purpose vehicle can be viewed from two perspectives; the financial and legal perspectives and thus special purpose vehicle may be described as either a special financial purpose vehicle or a special legal purpose vehicle. For that reason, special purpose vehicle is illustrated in the figure below Figure 2. Parties in a Special Purpose Vehicle Source: UN ESCAP, Transport and Tourism Division, ‘Economic and social commission for Asia and the pacific, Public private partnerships –a financial perspective’, pp. 1-81 Chang et al., (2009) agrees with Don (2002) that Special Purpose Vehicle is essentially a legal entity that brings on board diverse parties as well as facilitating in risk allocation and diversification besides financing necessities to different parties. In the legal sense, SPV undertakes a project hence all the contractual agreements among parties in the project are negotiated between the special purpose vehicle and themselves (Don 2002). The government comes in as a key player in SPV and as illustrated in the figure above, a strong commitment must be seen on the part of the government. Reason being public private partnership is partnership between the private sector and the public (government). In case the government contributes capital to exchange with shares in SPV, it then has equivalent interest and equal rights to the assets in SPV same as other stakeholders. On the second note, depending on the project type, project finance is made up of varied amounts of equity and debt and thus the structure and source varies substantially. The private sector is usually the provider of equity financing and they do so in exchange for acquiring ownership in SPV. Financiers of a certain project are for instance private equity and/or public equity, debt financiers, equity financiers, and multilateral institutions (UN ESCAP, Transport and Tourism Division). Another party to a SPV is the experts who are majorly involved in project management. The SPV facilitates cooperation among the experts as well as risk and resource allocation. Based on the type of project, private sector may be asked or chose for themselves to offer services such as building, designing, and/or operation of a project. Another party in SPV is the customers who are the ultimate benefactors and are for instance motorists using a public road. It is imperative to identify the benefactors of a project in order to establish who is going to pay for the services and the ways in which they will benefit a swell as the success criteria. The final element in a SPV is the escrow agent. Usually, an escrow account is established at the request of financiers and managed by a third party so as to safely keep project revenues. This ensures that all the debt service obligations of the project are met. Besides, it can be used to hold financial deposits in trust until such a time when the particular project conditions are met ((UN ESCAP, Transport and Tourism Division). Types of SPV In another perspective, Jalal and Jack (2004) argues that based on the activities of SPE/SPV, they may as well be ‘referred to as off-balance sheet arrangements’ (p. 30). The SPE take different forms in order to accomplish their goals and as Jalal and Jack (2004) explains in their article, types of SPE are for instance synthetic leases, take-or-pay contract, through-put contracts, and securitization. In the same regard, Neal (2007) categorizes Special Purpose Entities into three; joint ventures, synthetic lease, and off-balance sheet financing or asset securitization. Therefore, the authors have some degree of concurrence and the main ones are discussed; in a joint venture, various parties agree to participate and engage in a project which is separate and autonomous form their own projects or entity. To see through such joint ventures, a conduit may occur via the SPE by taking various forms such as corporation, partnership, and LLC, or trust etc. in such a case SPE owns all the assets and liabilities relating to the project. To ensure governance of such joint projects, chartering documents such as the articles of incorporation are used Neal (2007). The second type is the synthetic lease whereby the sponsor establishes SPV –a shell company- in order to buy and finance an asset for a definite use by him/her –self (Jalal & Jack, 2004)). In such a case, SPE may be established for buy-lease or build-to-order or sale-lease-back transactions. Synthetic leases are formed for two main objectives; first objective is the financial accounting purpose in that they facilitate the sponsors/ lessees to treat leases as operating leases thus enabling the company to show a stronger balance sheet compared to capital lease. Second, for the purpose of federal income tax, such contracts are structured in a way the sponsor treats the transactions as it is, materially, the owner of the leased property. Hence, ‘sponsor/lessee treats the payments as debt service enabling it to deduct interest expense and depreciate the asset’ (Jalal & Jack 2004 p. 31). Third is the securitization whereby Special Purpose Entities are widely used ‘in securitization transactions, where a pool of financial assets, such as mortgage loans, automobiles, and other revolving charge accounts are transformed into securities’. (Jalal & Jack 2004 p. 31). In a generic securitization Jalal and Jack (2004) note that the originator (transferor) institutes a SPV or SPE ‘which exists in form of a trust’ with the main objective being to convert various ‘financial assets into cash on behalf of the sponsor’ (p. 31). In this type of Special Purpose vehicle, the assets’ pool is sold by ‘the sponsor for the transfer of the financial assets’ (p. 31). In addition, the sponsor services the debt afterwards forms generated cash flows by the securitized assets. Other types of SPEs are ; take-or pay contract whereby a buyer enters into an agreement to specific periodic amounts for certain services or products; and throughput contracts where one party enters into an agreement to pay particular amounts to another party in order for processing or transporting a product. Reasons and Advantages for Using Special Purpose Vehicles Special purpose vehicles reduce the cost incurred in debt financing. For instance where asset securitization transaction occurs, an enterprise which seeks financing all its assets as per the balance sheet to the SPV/SPE obtains finance for purchasing the enterprise’s assets through issuance of asset-based securities (ABS) (Emre 2003). The fact that SPV owns the assets which afterwards transforms into collateral for issued securities facilitates the lenders to assess the credit quality of both the enterprise and collateral. Thus, it is possible to have reduced funding costs as possible (Kenneth & Brendt 2002). On the other hand, an enterprise may be undergoing credit difficulties may be by virtue of being new in the market. For that reason structured financing provides an alternative. Subsequently, Special Purpose Vehicles plays a major part in debt restructurings, confirmation financings, and debtor in possession financings. In this instance, the main objective making use of structured financings in each case remains the same; to lessen concern in relation to the credit risk of the enterprise which benefits from the financing. Besides, special purpose vehicle aims at identifying assets which can be segregated in order to outsource finance. In case an enterprise has assets which can be segregated as a legal tool, then the entity is well predisposed at using structured financing techniques so as to obtain project financing which it would not have been able access or else at a cost which it would not have afforded (UN ESCAP, Transport and Tourism Division). Allocation and diversification of risk; special purpose vehicle necessitates in distribution of risk among various parties involved and in case of bankruptcy or project failure, the company does not suffer the loss in totality. for instance, special purpose vehicle can be used to source for funds for a major and complex project via a financing transaction, the lenders for the project are usually interested in projects cash flow instead of the cash flow of the entity seeking financing (UN ESCAP, Transport and Tourism Division). Transferring tax benefits is achievable by use of SPE/SPV; generally, a lessor in a lease agreement is entitled to tax benefits related to the ownership of equipment in case the lease meet the requirements of a true lease with respect to tax purposes (BT-Partnership 2005). Therefore, parties which cannot make use of tax benefits resulting form ownership may transfer such benefits to another one via leasing the equipment. In such an exchange for tax benefits, the lessor in the lease agreement avails a reduced market leasing rate which is far much less compared to cost of borrowing finance so as to purchase equipment (UN ESCAP, Transport and Tourism Division). Application of SPV in Project Financing By Romanian Banks Most of the Romanian banks have established a Project Finance department that handles their own capital project financing. Any investment project is evaluated in regard to its credit worthiness and viability. Some of the projects which are usually evaluated are for instance PPP among others which are illustrated in appendix A (Andra–Maria et al., 2009 p. 16). As Andra–Maria et al. (2009) outlines, one of the most outstanding characteristic of project finance is the project sponsor (developer). Reason being all companies are required to set up special purpose vehicles for complex investment projects. Such entities must be fully independent form the parent company and have a limited life span. The rationale that Romanian banks argue is that in case of a project failure, the parent company does not lose mush as well as project continues regardless of any financial problems on the part of the sponsor. In the earlier identified projects, project finance facilitates all potential risks to be shared among all parties to the project; SPV, sponsor, and lenders among others. Most of the Romanian banks ‘pursues a risk-averse credit policy and ensures that any potential risk is well mitigated’ (Andra–Maria et al., 2009, p. 87). In this respect, a two-stage process is assumed; probable risks are established on time; and mitigation measures for such risks are put in place. Consequently, the investing company is required to make a final credit application to the bank’s project finance. For instance, in Real estate development projects, a finance structure proposed by the bank requires the Special purpose vehicle also to be the borrower who should concentrate only on the investment project. Besides, project developers are required to have relevant expertise in investment projects and these acts as a form of guarantee to the bank before release of any funding. Project sponsors are also required to contribute a minimum of 25% finance and this is paid to the borrower at the initial stages of the project in form of shareholders’ debt. On the other hand, there is a set maturity period for every project depending on the type of each. In this regard Andra–Maria et al. (2009) argues that Romanian Banks have been bale to make use of SPV and SPE in implementing various infrastructure projects. Conclusion Generally, most of the infrastructure projects have been being financed via budgetary allotments. This applies widely to public funded projects (government projects). However, the increased demand for infrastructure projects which is coupled by reduction in accessibility to financial resources has forced for the institution of SPV. In this regard, the public sector has thus made a paradigm shift and majorly depends upon the private sector for provision of the necessary financial resources, technical expertise and innovation. Instituting special purpose vehicle permits privately managed infrastructure projects which may either be at construction and/or operation stage (s) to experience a high level of isolation. SPV has therefore necessitated to a greater extent, implementation of various projects. References Andra–Maria V, Alina Mihaela D & Simona V 2009, ‘Credit analysis policies in construction project finance’, Management & Marketing, vol. 4, no. 2, pp. 79-94. BT-Partnership, J 2005, ‘SPVs and beneficial ownership’, International Financial Law Review. London, p. 1. Chang, Chia-Chien , Wang, Chou-Wen and Liao, Szu-Lang 2009, 'The valuation of special purpose vehicles by issuing structured credit-linked notes', Applied Financial Economics, vol. 19, no. 3, pp. 227-256. Don WF 2002, ‘Accounting for SPEs and the impact on the profession’, Petroleum Accounting and Financial Management Journal, vol. 21, no. 2, pp. 1-17. Emre OE 2003, ‘Securitization’, Federal Reserve Bank of Cleveland. Economic Commentary, pp. 1-4. Jalal S & Jack TC 2004, ‘Accounting for Special Purpose Entities Revised: FASB Interpretation 46(R)’, The CPA Journal, vol. 74, no. 7, pp. 30-37. Kenneth N Klee & Brendt C B 2002, ‘Asset-backed securitization, special purpose vehicles and other securitization issues’, Uniform Commercial Code Law Journal, Vol. 35, Iss. 2; p. 23. Mei Feng, JD & Gramlich, SG 2009, ‘Special purpose vehicles: empirical evidence on determinants and earnings management’, The Accounting Review, vol. 84, no. 6, pp. 1833–1876. n.a. 2008, ‘Irish SPVs to be permitted to securitise new classes of assets’, International Tax Review. Neal N 2007, ‘Enron and the special purpose entities-use or abuse?-the real problem’, Law and Business Review of the Americas, vol. 13, no. 1, pp. 97-137. Stephen W 2002, ‘Situating project finance and securitization in context’, Duke journal of comparative & international law, vol 12, pp. 449-452. UN ESCAP, Transport and Tourism Division, ‘Economic and social commission for Asia and the pacific, Public private partnerships –a financial perspective’, pp. 1-81. Viewed January 7, 2011 . Wayne RL, Kenneth V P & Catherine S 2008, ‘Are asset securitizations sales or loans?’, The Accounting Review, vol. 83, no. 5, pp. 1251- 1272. Appendix A Read More