financing is any form of direct debt or
equity funding of a firm.
If the funding is equity, it appears on the firm's balance sheet as owners
equity. If it is debt, it appears on the balance sheet as a liability. Any
asset the firm acquires with the funding also appears on the balance
financing, by comparison, is any form of funding that avoids
placing owners' equity, liabilities or assets on a firm's balance sheet.
This is generally accomplished by placing those items on some other
entity's balance sheet.
A standard approach is to form a
special purpose vehicle (SPV) and place assets and liabilities on
its balance sheet. Also called a
special purpose entity (SPE),
an SPV is a firm or legal entity established to perform some
narrowly-defined or temporary purpose. The sponsoring firm
accomplishes that purpose without having to carry any of the associated
assets or liabilities on its own balance sheet. The purpose is achieved "off-balance
Under most accounting regimes, if a sponsoring firm wholly
owns an SPV, the SPV's balance sheets is consolidated into its own. Rather
than have the SPV appear on its balance sheet as an asset, the sponsoring
firm has all the SPV's individual assets and liabilities appear on its
balance sheet just as if they were the sponsoring firm's assets and
liabilities. This is on-balance sheet financing, which largely defeats the purpose
of the SPV. For this reason, a sponsoring firm typically takes only a partial
ownership position in the SPV. In other arrangements, it takes no
ownership interest in the SPV whatsoever.
SPVs are used in a variety of transactions, including
finance, and leasing. An SPV
can take various legal forms, including
corporations, US-style trusts or partnerships.
Off-balance sheet financing is attractive from a
risk management standpoint.
When assets and liabilities are moved from one balance sheet to another,
the risks associated with those assets and
liabilities go with them. For example, if a firm transfers
credit risky assets to an SPV,
the credit risk goes with those assets.
Off-balance sheet financing also affords considerable
flexibility in financing. An SPV doesn't utilize the sponsoring firm's credit lines or
other financing channels. It is presented to financiers as a stand-alone entity with its own
risk-reward characteristics. It can issue its own debt or establish its
own lines of credit. Often, a sponsoring firm overcapitalizes an SPV or supplies it
with credit enhancement.
In this circumstance, the SPV may have a
higher credit rating than the sponsoring firm, and it will achieve a lower
cost of funding. A BBB-rated firm can achieve AAA-rated financing costs if
it arranges that financing through a sufficiently capitalized SPV.
Off-balance sheet financing is often employed as a means
management. Obviously, if assets and liabilities are never placed on
the balance sheet, they don't have to be matched! They do need to be
matched on the SPV's balance sheet, but the SPV can be structured in a way
that facilitates this. A pass-through is
a security issued by a special purpose vehicle. The SPV holds assets and
pays the pass-through's investors whatever net cash flows those assets
generate. In this way, the SPV's assets and liabilities are automatically
cash matched, so there is no
Many securitizations are structured as pass-throughs. See, for example,
the discussion of
Off-balance sheet financing has other applications. SPVs
can be used in tax avoidance. Banks use off-balance sheet financing to achieve reductions
in their regulatory capital
requirements. This is a compelling reason for many securitizations. It is
also the purpose of trust preferred
While SPVs and off-balance sheet financing have many
legitimate purposes, they can also be used to misrepresent a firm's
financial condition. Prior to its bankruptcy,
Enron created numerous SPVs
and used them to hide billions of dollars in debt. That abuse, as well as
other scandals during 2001-2002, prompted a reexamination of SPVs. Laws,
regulations and accounting rules were tightened as a result.