Special Purpose Vehicles and Securitization - Literature review Example

Introduction: A special purpose vehicle is a limited partnership or company or legal entity that is formed to carter for specific narrow and temporary objectives. They are employed by companies in order to cushion the company from financial risks. The assets of the company are normally transferred to the SPV to manage them or make use of the SPV for financing a big project and in the process avoid exposing the company at risk. Special purpose Entities are applied in the separation of equity infusion layers within complex financings Baker, M. and J. Wurgler.(2002) They are also important in the ownership of single assets together with contract rights and permits that go with them to facilitate quick asset transfer. Project finance incorporates the new project into SPV, which is an economic entity that has been newly created, and then it is given its finances ‘off the balance sheet (Baker, 2002).The firm and the project do not exist as separate entities. In case the project is a failure the creditors of the firm will not lay claim on the assets and cash flows of the firm. The shareholders of the firm stand to gain when the project is incorporated separately in to the Special Purpose Esty, (2003). In most cases of project financing because of various reasons.They may do this in order to get rid of legal covenants that look restrictive to them as well as obtaining funding on ‘off balance sheet’ basis (Esty,2003).Project financing is an effective way of handling joint ventures as well as those partnerships that display inequality within them. Since obtaining capital is normally a hard task it turns out to be too costly to obtain it. It therefore becomes necessary to protect that capital by all means Cox, M and Harding, RA and Green, NR and Scholl, GW (2007) According to Baker, M. and J. Wurgler. (2002).When there are no other alternative to be used in financing a project, project financing remains the only one within reach since it also promotes risk sharing. In this it makes it possible for risk management to become successful. Risks are therefore apportioned to those with the ability to take care of them by way of contracts. Projects financing reduces the costs incurred in the project and increases the profit margin in the case of projects that are expected to bring in a return. It also acts as a way of diversification for funding sources. On top of this there can be attained a high level gearing which is brought about by the possible loss of higher margins or security (Djankov, 2008). In risk management project financing helps to ‘protect the parent balance sheet’ because the deal is carried out on off balance sheet terms when minority share holders are involved. Risk management takes care of the fact that sponsors can incur high costs when risky assets are being invested in. in cases when these collateral or indirect costs are huge they can be more that the net present value of the assets Cox, M and Harding, RA and Green, NR and Scholl, GW (2007).This can transform a positive net present value project into a negative net present value. When the asset is placed to stand alone in the project risk contamination is reduced and as a result a sponsoring firm will not be dragged into trouble by an asset that is failing. It is also not possible for a risky asset to place indirect costs of distress on a sponsoring firm with no actual default.’Lenders easily achieve their goals of getting fees and interest as expected. There is loan security and the share holders get reasonable dividends from their company. ‘Agency cost motivation’ prompts sponsors to go for project financing since big assets whose cash flows are high can become objects of expensive agency conflicts (Worenklein 2003). In a project company there can be created a new system of governance specifically for the assets to carter for conflicts revolving around control and ownership. Owners can also be assisted to reduce agency conflicts between them and related parties when project structures are used. Debt overhang wipes out the recourse which goes to the balance sheet of the sponsor. It also removes the possibility of new capital subsidizing already existing claims with ‘higher seniority or lower the value of junior claims Esty,(2002). Independent companies, for instance tourism companies are able to avail of tax holidays. Because of supply problems big projects in up coming markets may not get financing from local equity. Getting foreign investors to provide investment specific equity is difficult or too costly. Therefore a debt becomes the lone alternative which means project financing is very likely to be used (Baker, M. and J. Wurgler.2002).Partners that are weak in finances must get project finance to guarantee their participation. With project finance the cost of project provision is catered for. When project finance is used the bigger partner appears to be free riding. However because the bigger partner has the power to make negotiations on terms with banks than smaller partners he must participate in project finance Esty, B.C., (2002). Project financing has a number of advantages and disadvantages that come with it. In project financing participants in any transaction get a high level of risk allocation. It is therefore possible for the deal to sustain ‘a debt-to- equity ratio’ which could not have been reached. From the viewpoint of accounting the SPV and sponsor contracts can be compared to commercial guarantees. However with the initiatives of project financing they don’t appear in the directors’ notes or ‘off balance sheet’ all the time. Financing that is corporate based may depend on guarantees which are availed by the sponsor’s personal assets. These assets are normally different from the ones used for the project Grinblatt M. and S,Titman.(2002). In project financing ‘the loans only collateral’ means the assets used to make the initiative. The resultant effect is always an advantage to the sponsors because their assets may be utilized as collateral at times when more recourse for funding is necessary. When a project company is created sponsors can be easily isolated totally from project events in case finances happen on a limited or non recourse basis Djankov, (2008). The second benefit on the special purpose vehicle is tax savings. In case the SPV has registration in a jurisdiction with low taxes then the payments on tax are reduced greatly. Corporation makes the ‘capital gains charge’ to rise substantially. In order for the charge to be reduced the approach works well with recently acquired brands or posses huge growth opportunities Djankov, (2008).Brands placed in special purpose vehicles also benefit from better management since the Special Purpose Vehicles serve to improve the management of the business and the brand. The focus of a management team is sharpened by the knowledge of brands sent to the market. Every territory, market, product and sector has the responsibility of bringing back a return for making use of the brand. The contribution of each unit is exposed which can make the management to comfortably identify relative performances. The brand’s performance in every operation sector is made more visible something that makes it the monitoring of return investment easier. Brands placed in Special purpose vehicles make it easier to monitor their health in a way that has no confusion. The sale process of the brand is also enhanced by its isolation. The quality of management is also exposed. ‘When management is forced to pay for the use of the brand on fair market basis people are made accountable Fuaad, (2000).The disadvantage of using Special purpose vehicles is that it is very expensive to structure and organize the deal. The high cost is brought about because the technical, legal, and insurance advisors serving the loan arranger and the sponsor need a lot of time for project evaluation and negotiation of the terms of the contract that need to be put in the documents. Project monitoring also requires a large sum of money. Lenders are charged expensively for certain costs for them to take bigger risks Scott, (2008) Construction risks present a problem where that project construction may not come to the level where operation of the project cannot be carried out in a sustainable way. The assumption of the risk is that the completion of the project will not come at the right time, within the budget and the right criteria Chemmanur, T.J., and K. John. (2001).Many reasons can bring about the failure of a project including flows in technical design and changing government laws. The project cost is raised by delays as well as the accumulation of debt and interest. Delays also erode financial viability, delay repayment of loans and interfere with contracts for selling the out put of the project and contracts for material supply Chemmanur, T.J., and K. John. (2001). International projects are easily affected by fluctuations in the foreign exchange rates. a good examples includes the insurance companies Loan repayment has to be done in foreign currency. For example, when Phuket and Marina development real estate Company in Thailand acquired funds from the Lloyds Capital funds, the issue of differences in currency a rose A loan given in UK pounds could not be paid in Thailand Bah tGorton, Gary, and Nicholas Souleles. (2005). this happens where expenses and revenues of the project are given in a foreign currency. Income gained may be in the local currency while loans and investment are done in foreign currency. Loan repayment has to be done in foreign currency Gorton, Gary, and Nicholas Souleles. (2005). It necessitates the seeking of convertibility from host governments by sponsors of projects. This risk can be reduced by hedging short term transactions done in main currencies in future markets. Project financing processes are accomplished through the acquisition of funds through bonds, loans or debts, grants, aids and equity. Lending of funds is not done directly to those handling the project but to the special purpose vehicle which is responsible for the project ownership and enters into all agreements such as loan agreements (Grinblatt, 2002). The sponsor is the initiator of the project and their obligations depend on the structure of the project. Servicing of debts is done through cash flow via the special service vehicle and the project. The sponsor is to a big extent excluded from the project risks. The balance sheet of the sponsor does not bear any debt and the sponsor’s credit worthiness is not affected by the risks linked to the project Chemmanur, T.J., and K. John. (2001).Project financing is necessary in order to sustain the projects. Sustainability planning is critical if the project is to succeed. A wide range of resources should be considered which will be necessary in sustaining the projects while in progress. Project financing is based on elements that guarantee its sustainability. An example of a project case study with many financing companies is the Cerro Negro oil field development and processing project in Venezuela. BankAmerica, with a group of five international commercial banks and the Export Development Corporation of Canada, arranged US$300 million for the project in order to ensure its sustainability in terms of available resources (Tirole, 2006). Costs are also avoided or cut down where possible through proper utilization of materials. Privately financed large scale projects are normally very much complex due to the many stakeholders involved, the contract, project duration development, high risks and costs. Financing projects must involve many stakeholders because of the complexity of activities involved Scott, (2008) All the stake holders must unite in order to get a good result. They should take into consideration all the major aspects of the project especially in financing so that important stages can be managed. Sustainability is the yardstick on which the success of a project can be measured throughout out its period of existence. Specific project aspects should not be optimized separately form the rest of the project. If this happens it is bound to destabilize the project’s balance Fuaad, (2000). Conclusion: In conclusion Most of the projects may have many partnerships thereby necessitating the involvement of consulting engineers as central pivots in those projects. Sustainability principles should be applied in all the life of the project. Considerations of sustainability have totally changed the decision making methods in big projects (Esty,2003).When sustainability is applied contracts, key indicators of performance, procurement, evaluation, criteria of selection concept and design are all different. The use of a special purpose vehicle helps in risks mitigations whereby participants have a high level of allocation of risks (Djankov, 2008).SPV s can also be used in managing the assets of the project. Major projects should be accomplished through financing via SPV s since a number of ways through which funds can be accessed are available. References Baker, M. and J. Wurgler. (2002)Market Timing and Capital Structure, Journal of Finance 57, 1- 32. Djankov, S., LaPorta, R., Lopez-de-Silanes, F. and Shleifer, A.(2008) The Law and Economics of Self-Dealing, Journal of Financial Economics 88, 430-465. Esty, B. C., 2004, Why Study Large Projects? An Introduction to Research on Project Finance, EuropeanFinancial Management 10, 213-224. Esty, B. C., 2003, The Economic Motivations for Using Project Finance, Working Paper, Harvard University. Esty, B.C., 2002, Returns on Project-Financed Investments: Evolution and Managerial Implications, Journal of Applied Corporate Finance, 71-86. Gorton, Gary, and Nicholas Souleles. (2005). Special Purpose Vehicles and Securitization, Working Paper 11190, National Bureau of Economic Research. New Jersey: Prentice Hall. Kim, Jaemin and Sean S. Yoo, 2008, Project Finance and Determinants of its Leverage, Working Paper, San Diego State University and Belmont University. Baker, Joshua Coval and Jeremy C. Stein (2007): "Corporate financing decisions when investors take the path of least resistance," Journal of Financial Economics 84(2), 266?298. Philip R(2007).Project Finance Research Serboninated Debt. Volume 5.Sweet & Maxwell Limited Publishers, Becles,Suffolk . 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