By James Dugdale
What is structured finance?
Structured finance refers to a broad range of ways in which a purchase can be financed by using a number of different financing techniques. The aim of structuring the financing of a purchase in such varied and complex ways is usually to manage risk, minimise costs, and to be tax efficient. This tailored approach can be particularly useful for companies who operate across multiple jurisdictions, and are therefore subject to different laws and finance authorities.
Structured finance is greatly customisable and personalised for the party who requires assistance in financing a purchase. For this reason, it can be an attractive means of financing for large companies whose needs and requirements cannot be met by standard financing options.
Securitisation as a form of structured finance
Securitisation is a type of structure finance, and refers to the pooling of different types of debts and assets whose cash flow is sold to investors. The term ‘receivables’ is used to refer to these debts and assets, and the originator is the party from whom the receivables are purchased. The purchaser of these receivables is usually a special purpose vehicle (SPV), which is a legal entity which is used by a company, or companies, to isolate risk. Since an SPV is legally a separate company from its parent company, they do not have any pre-existing debts.
Since securitisation presents a means of cashing capital and mitigating credit risk, it can be a useful component in structured finance deals. Additionally, because securitisation pools a range of debts and assets together for purchasing by investors, it provides risk diversification and liquid capital to the originators and lenders. For the investors, they also benefit from risk diversification, as well as the possibility of risk sharing with multiple other investors.
Steps in securitisation
An SPV is created – In order to be tax efficient, SPVs are commonly established in jurisdictions with a low corporate tax rate, or in rare instances no corporate tax. A number of jurisdictions charge 0% corporate tax, such as Bermuda, the Cayman Islands, and the Channel Islands. Countries with low corporate tax rates include Ireland and Liechtenstein. SPVs established overseas are known as ‘offshore SPVs’.
Additionally, since the SPV is its own company, its balance sheets, and thus solvency, are separate from those of the originators. This means that any risk the SPV takes on is isolated from the originators, and vice versa.
The SPV issues securities – Once the SPV has been established, it will issue securities to investors. These securities can be in the form of bonds, or in some instances, equity securities. The capital raised by issuing securities will then be used to fund the purchase of receivables from originators.
Originators sell receivables to the SPV – Using the funds gathered from investors, the SPV will then purchase receivables from originators. Receivables can include all sorts of debt, from consumer debt such as credit card debt and mortgages, to commercial debt, such as debt from the purchase of assets or an acquisition of a company.
The receivables are used to secure the SPV – The receivables are then used to secure the SPV’s obligations to its investors. Investors will usually be owed capital in the form of interest, and there may also be additional fees, such as when establishing the SPV or during transactions, that the SPV may need to pay.
The SPV pays interest to its investors – The SPV will then use the capital that it gathers from its receivables to continue to pay interest to its investors. It is likely that the investors will be prioritised according to previously agreed terms, which will determine the order in which different investors are to be paid.
How is risk managed in a structured finance transaction?
There are numerous ways that risk can be managed in a structured finance transaction. For example, an SPV can diversify risk by purchasing a wide range of different types of receivables which are influenced by or involved in varied industries. Another way in which risk can be managed is through ‘swaps’.
Swaps – A swap is when two parties agree to exchange, or ‘swap’ cash flow from specified derivatives for a certain amount of time. The International Swaps and Derivatives Association (ISDA) has created a standardised contract which can be used as the basis for swap agreements. Swaps can be used to manage risks such as those associated with a volatile currency. By managing such risks, an SPV can become more attractive to potential investors, and with more investors, the SPV may be able to purchase more receivables.
Derivatives – A derivative is a contract whose value is based on a specified benchmark. Examples of benchmarks include an asset, a group of assets, securities, currencies, commodities, etc. It is from these benchmarks that the contract ‘derives’ its value, hence the name derivatives. Derivatives and swaps can be useful in structured finance transactions, since they provide ways for risk to be distributed amongst varying benchmarks.
If the transaction is taking place across multiple jurisdictions, for example, the SPV may want to swap derivatives that are based on different currencies. This would ensure that the SPV is not solely reliant on the stability or strength of a single currency.
Tax and tax assumptions
As previously mentioned, SPVs can be used to make a structured finance transaction tax efficient. However, all parties involved must be diligent and ensure that they abide by the tax laws in each jurisdiction they are operating in. Calculating how much tax is due in all jurisdictions, as well as how much tax is expected to be due, can be a costly process, but it can be even more costly if these calculations are inaccurate.
These tax assumptions will predict how much tax will be owed based on a series of assumptions about how the relevant tax authorities will assess the company’s earnings. These may include assumptions about tax deductions or exemptions. If, however, these assumptions are incorrect and the company has to pay more tax than anticipated, it can be especially costly if such circumstances are not budgeted for. The risk that tax assumptions may be inaccurate is an additional risk that should be managed.
FMC Corporation uses natural gas derivatives to hedge forecasted purchases – (December 2012) American chemical manufacturing company, FMC, was able to gain a fixed monthly price on natural gas for a year. This ensured that they were be able to plan their future spending more accurately, without having to worry about fluctuating natural gas prices.
Enron scandal and abuse of SPVs – (October 2001) In late 2001, it was revealed that American energy company, Enron, had been hiding billions of dollars of debt in SPVs. Additionally, Enron had transferred some of its own stocks to an SPV, who then used those stocks as collateral when purchasing assets from Enron. This meant that when Enron’s stock price fell, they were unable to pay creditors.
In response to the scandal, US Congress introduced the Sarbanes-Oxley Act (SOX), which was designed “to protect investors by improving the accuracy and reliability of corporate disclosures” (SOX 2002).
Hilton Hotels Chilean currency and inflation swap – (August 2001) Hilton issued $100 million worth of bonds with interest payments to be adjusted according to the Unidad de Fomento (Chilean inflation index). They also entered into a derivative contract that swapped the principal payment from Chilean pesos to a fixed amount of US$100 million.