Question

"Off Balance Sheet Financing"

Harold Walker is CEO and Owner of Walker Enterprises (WE), a company that has shown strong and consistent growth over the years. However, WE is struggling with cash flow issues and Harold is looking for a loan and/or line of credit to bolster his company. The problem is that the company’s debt to equity ratio is already high and he knows it will be challenging to find a bank willing to lend him additional funds. Fred, his CFO, has come up with an idea. A large portion of the company’s debt is tied up in the mortgage of their five-story office building. Fred has suggested moving this debt to “off balance sheet” by creating an SPV (Special Purpose Vehicle) that owns the building on behalf of the company and then leases it back. This results in WE entering into an operating lease off the balance sheet and recording only the relatively small monthly “rent” as an operating expense. Fred says this will significantly increase the company’s liquidity and present a balance sheet that will be much more attractive to any potential lenders.

Fred has assured Harold this is legal and common. This arrangement does not feel right to Harold.

• What additional information should Harold request?
• What additional reservations or concerns would you have?

Answer 1

In this case Harold is concerned whether moving debt raised for five story office building to off-balance sheet by creating Special Purpose Vehicle (SPV) or also called Special purpose Entity(SPE) is legal and common in business operations.

Yes SPV is a legal entity and a subsidiary of the firm and its protected from financial risk of the parent company. SPV is created to protect parent organization from financial risk such as insolvency and bankruptcy. Fred has suggested Harold to create SPV to reduce Walker Enterprises's debt-equity ratio by carried a special business activity i.e. ownership of the five story building to off balance sheet. This will help improve the debt-equity ratio and increase the credit worthiness to get additional cash flow by the loan/credit line approval.

Special Purpose Vehicle will help reduce debt-equity ratio by creating a lease of five story building which can be treated as expense in the Walker Enterprises Income Statement otherwise the debt raised will be treated as liability in the balance sheet of the company and will increase the debt-equity ratio. Major benefits of creating off balance sheet SPV are as follows:

• Helping lowering financial risk for the parent company
• Increase the credit rating/ creditworthiness of parent company
• Provide financial flexibility to parent organization through mitigating funding costs.
• SPV is commonly created for Securitization of loans

Walker Enterprise need not show the assets and liability of off-balance SPV in their own financial statements like balance sheet. There are certain factors to be considered by Harold before proceeding with creation of off balance special purpose vehicle. They are as follows:

• Capital required to create SPV- In general, parent company has to invest significant amount of capital to create the SPV. Walker enterprise should assess the cost-benefit analysis before creating SPV.
• Special Purpose Vehicles don't get tax benefits and other incentives which are enjoyed by parent organization.
• Changes in the Market regulations can adversely impact operations of SPV and parent company.

Therefore Harold should take measures to analysis these factors before proceeding to create off-balance sheet SPV of debt raised for their five story office building. Creation of SPV will help Walker Enterprise to lower their debt-equity ratio, improve credit rating and higher chances of getting loan/credit line approval from a bank.