What is a Special Purpose Entity?

A special purpose entity, also known as a special purpose vehicle, is a sophisticated financial structure that is separated from a company's balance sheet. These structures are primarily designed to provide an efficient form of raising money in the debt markets, but can mislead investors about the amount of debt a company is carrying. Special purpose vehicles can be controversial entities, and the creation of these structures was largely to blame for the demise of former US energy conglomerate Enron. A special purpose entity can also be a means for a company to obtain funding at favorable rates, and if used appropriately, can lead to future profits.

The reason a company might form a special purpose entity is to raise funds for an event, such as an acquisition or construction project. Another option could be to issue stock in the equity markets, but this method dilutes the percentage of shares held by existing shareholders. Often, this is not looked upon favorably by equity investors. On the other hand, tapping the debt markets can be equally contentious. Lenders do not support too much debt on a company's balance sheet, and carrying a large debt load leads to steep financing rates unless another investment vehicle is created.

A special purpose entity is structured similarly to a trust. Once a company establishes this vehicle, its first order of business is to create a transaction by selling an asset or assets from its own balance sheet to the special purpose entity. This bolsters the cash reserves on the larger entity's balance sheet, which is an added bonus.

The company then presents the special purpose vehicle's balance sheet to lenders for the necessary financing. With only the recently acquired asset or assets on the special purpose entity's balance sheet, lenders are more likely to provide financing at a favorable rate, especially because the entity appears to be carrying no additional debt. The larger company that created the special purpose vehicle is considered the parent company, and lenders are well aware that both balance sheets exist. As long as the loan is being made to the special purpose vehicle and not the larger entity, however, the parent company is not responsible for the deal and does not have to report the debt on its balance sheet.

Many major and global companies use special purpose vehicles ethically for the purpose of obtaining cheap financing. In some regions, these are legal investment structures that eliminate risk on a company's books, but that can also be abused. Although a company does not have to report the activities of its special purpose vehicle on its balance sheet, it may refer to "off-balance sheet" activity on its financial statements. This should serve as a red flag to investors that a company's debt load may be larger than it appears to be.