T C A Srinivasa-Raghavan: SPVs: Wages of desperation?

OKONOMOS

Do we really need such complicated mechanisms to finance infrastructure?

Desperation can lead to strange behaviour. P Chidambaram's desperation for more revenue "" I wish he would be equally desperate to remove corruption from the tax departments "" could eventually lead him to tax pets, calibrated by the cost of acquiring them. A pedigreed mastiff can cost up to Rs 50,000.

Likewise, it is some months now since the Deputy Chairman of the Planning Commission M S Ahluwalia came up with the idea of using Special Purpose Vehicles (SPVs) to draw down forex reserves and financing infrastructure via these SPVs.

This, too, sounds desperate, like using a hockey stick to play tennis.

Since I don't handle the eels of finance too well, I kept a lookout for something that would explain what these things are. Patience pays and in a recent paper* Gary Gorton and Nicholas S Souleles of Wharton have made the whole thing crystal clear, at least to me.

Basically, they say, SPVs are firm-level devices for transferring assets with a view to get some off-balance sheet financing. And of course, they are often located off-shore.

"By financing the firm in pieces, some on-balance sheet and some off-balance sheet, control rights to the business decisions are separated from the financing decisions," write the authors. The sponsoring firm controls the business while the SPV remains passive.

Off-balance sheet SPVs are also thinly capitalised and have no management or employees. Their tax status has to be strictly specified and they are run by trustees who follow pre-specified rules with regard to the receipt and distribution of cash; there are no other decisions to be made.

Most charmingly, SPVs cannot become bankrupt. They are like those dolls that always come upright. This is the single most attractive feature for investors. Their money is safe.

Such financing separates control rights over assets from the financing. So the fellows who lend to you can't get hold of your assets if you default. But they lend anyway because they know that the sponsor will bail the SPV out. They are not supposed to, but they do anyway.

The sponsors of SPVs have to follow rules and regulations, the most important of which are those that "circumscribe relations between the sponsoring firm and the SPVs." Also, say the authors, whether or not a firm will go for SPVs depends on how likely it thinks it will go bankrupt.

"SPVs are carefully designed to avoid bankruptcy. If the firm's bankruptcy costs are high, off-balance sheet financing can be advantageous, especially for sponsoring firms that are risky."

Enron had 3,000 SPVs, mostly unknown to investors. Typically what happens is this. The sponsor of the projects (assets) finances them by selling to an SPV the revenue (cash flow) they generate.

But it maintains control rights over the assets (projects). The SPV itself has "no need for control rights, because the cash flows have already been generated."

The authors have gone into great and thorough detail about the hows and whys of SPVs. Specialists in finance would do well to read it, if only to be able to ask some relevant questions about why they are needed.

As must be clear, SPVs are complicated financing arrangements designed, perhaps, for the benefit of investors looking both for safety and higher-than-market returns. There is an implicit element of complicity between governments, politicians and big money here.

The question that comes to my mind is: if this is what a SPV is for, why do we need them for the purposes that Ahluwalia mentioned? One reason could be the Reserve Bank of India's concerns over its own balance sheet. It would rightly be worried that the dollars should be kept outside India, but under its control, rather than simply hand them over to the government.

Indeed this what is done in China, Taiwan, Korea etc. Singapore uses its excess dollars to buy foreign firms via Temasek.

Apart from that, however, none of the other motivations that drive firms to set up these SPVs apply.

So what is the advantage, apart from securitisation of the cash flows from the infrastructure projects that will accrue? Or is this such a major advantage in the current fiscal and political that it outweighs all else?

All things considered, it is hard not to feel apprehensive that the government is taking an unnecessary leap in the dark. There must be simpler ways of financing infrastructure. Desperation makes both for bad policy and bad practice.

(Special Purpose Vehicles and Securitization, NBER Working Paper No. 11190, March 2005)