What is a Special Purpose Entity?

A special purpose entity is a legally separate business that absorbs risk for a corporation. A special purpose entity can also be designed for the reverse situation, where the assets it holds are secure even if the related corporation enters bankruptcy (which can be important when assets are being securitized). This entity holds separate assets and has investors who are separate from the initiating corporation. As long as certain accounting criteria are met, the founding corporation does not have to record the special purpose entity in its accounting records. This arrangement allows a corporation to shift unrelated activities and risk away from its financial statements. Special purpose entities have many legitimate purposes, but can be abused to make a company look less risky and more profitable than is really the case.

Example of a Special Purpose Entity

A business wants to securitize its receivables in order to gain more immediate cash flow from them. To do so, it sells its receivables to a special purpose entity, which issues securities based on the cash flows represented by the receivables. These securities are considered by investors to be low risk, since the creditors of the initiating business cannot access the receivables now owned by the special purpose entity.

Advantages of a Special Purpose Entity

There are several advantages associated with a special purpose entity, which are as follows:

Risk shielding. Risks can be shifted to a special purpose entity, which provides a shield against these risks impacting the corporation.
High-risk activities. A business can opt to pursue high-risk activities through a special purpose entity that it might not do through the main corporate entity, if these activities might result in substantial losses.
Secrecy. A special purpose entity generally does not have to report its detailed financial and operating results to outsiders. This can be a major benefit when the entity is working on projects that might enhance the competitive position of the corporation.