Special purpose vehicles: Financial wizardry or tumbling dominoes?
The answers to preventing SPV failure in infrastructure projects may lie in three key areas of oversight.
Special purpose companies, commonly called special purpose vehicles (SPVs) are standard practice in financing infrastructure projects, and a requirement for many government bid concessions. Once a project is identified directly or through a bid process, an SPV is set up in the local jurisdiction as a corporate entity with specific independent mandate.
The initial shareholders are usually the project promoters, generally through a holding company; other subsidiaries of the holding company; associated companies that are part of the consortium (such as project operators); and financial investors. The SPV also raises debt from banks and nonbank financial institutions.
This structure allows a promoter group to implement several projects through a holding company and subsidiary structure, ensures that each project is separately assessed for its viability, and sandboxes failure. Since each equity investor or lender is exposed to the financing risk only to the extent of its direct contribution, a project failure has limited impact.
However, despite these robust assumptions, there have been spectacular failures of these models, involving intricately complex structures of main and subsidiary companies, cross-holding of equity, and inter-corporate transactions. Enron is probably the best-known example of this, although a more recent one relates to the financial troubles of IL&FS in India.
The question to consider is: Does the complex SPV structure hamper transparency and governance, possibly causing cascade failures as a domino effect? The historical failure of Enron in the US and the recent unraveling of IL&FS in India indicate that this may be true, given certain ground realities.
The broadest assumption is that the SPV stands on its own. Lenders to the SPV generally have recourse only to the project rights and cash flows, not to the holding companies or associate companies of the SPV. However, once promoter groups take on multiple projects—including multiple sectors and types of activities—the corporate structure can become quite complex and intertwined, even though it’s intended to be decentralized and isolated from risk.
Another key problem is that the “independence” of the SPV is a façade for indirect promoter control. Despite different board representatives and lenders, it remains essentially under the same corporate “owner” control. Downstream SPVs are marketed not on their own merits, but under the rubric of the main promoters.
There is also a clear moral hazard that the nominees of the promoter group in the SPV, who are effectively managing the transactions, have other personal and corporate incentives than can undermine the success of the specific SPV.
The web of SPVs can become quite complex and difficult to track, with inter-corporate transactions and cross-holding of debt and equity. For example, when the recent IL&FS crisis first caught media attention, initial reports mentioned over 150 interlinked corporations. After a few days of review, the number rose to more than 350, which is a huge network to track.
As the promoter group gains market size and traction, the audit and rating agencies also develop interlinked relationships and depend more on the promoter’s declarations of the robustness of their business. In the case of Enron, as well as in IL&FS, the auditors and rating agencies appear to have been blindsided when the crises erupted.
In this state of rapid growth, untethered ambition, and blinkered oversight, all it takes is a couple of triggers to start a domino effect. It could be that an SPV, deep inside the system, fails to service its debt. Or, an audit flags a substantial transaction as being false.
When such events are disclosed, and the promoter group is unable to step in to address the concerns of the market, suddenly “the emperor has no clothes.”
In such cases, the failure rapidly ripples through the system in a matter of days. Affected parties are then not only the promoter group, but also every investor and lender, indirect linkages leading even to individuals – and eventually a country’s financial system. In the case of IL&FS, the Indian government had to step in on an emergency basis to replace the IL&FS board, start a forensic audit, and initiate a slew of other measures to calm the market.
Given there is nothing inherently illegal with these deeply nested corporate structures, can nothing be done to prevent crises of this kind? The answers may lie in three key oversight areas.
First, audit and rating agencies tend to claim innocence after a crisis becomes public. Since the stability of financial systems rests on the proper conduct of these critical functions, we need far greater accountability of audit and rating agencies, including delinking them from advisory and related transactions through their related entities. It may be worthwhile to mandate that holding and subsidiary companies beyond a certain number are audited and rated by different firms.
Second, the roots of such failures seem to be anchored in inter-corporate transactions within the web of the promoter group, and there is a need for more effective regulation and scrutiny of such transactions.
Last, some of these entities also dabble extensively in the financial markets—but are not banks—and so avoid the scrutiny that banks would normally experience. Such corporates should not be permitted to engage in shadow banking activities without scrutiny like banks.
Falling dominos may have visual entertainment value, but when they do so in the financial sector they only leave deep pain and insecurity at corporate and individual levels.