If you were to contact Companies House and ask them how many Special Purpose Vehicles or ‘SPVs’ are currently operating, they wouldn’t be able to tell you as they are not legal entities. SPV’s, or as they are also known ‘Special Purpose Entities’, are usually a limited company but could be a Limited Liability Partnership (LLP) or Partnership. They are set up for a specific purpose and, in the case of property development, they are usually set up isolate risk away from the main business, for investors to contribute without the baggage of dealing with the parent company, but to all shareholders of the company, to realise a project.
The appeal with following this delivery method is that you can utilise the skills of a pre-existing property development company, a building contractor, and a finance company that can all contribute towards a development. However, by setting up what is effectively a subsidiary company whose sole purpose is the development, it is more appealing in at least two perspectives:
- It is ring fenced from the parent company who may have on-going legal issues with historic projects that may impact on the business.
- The new company will have no liabilities, no history, and it is able to deliver projects without putting the parent company at risk and is more appealing to investors.
In fact, it is possible that as an SME property developer, by using an SPV you may be able to lower your finance costs on the basis that the final asset, once built, is seen as a better investment than those currently held by the parent company. This could make the SPV less risk adverse and therefore you are able to negotiate better terms with the lender.
If one party has the land to develop, another has the contracting ability and experience, and you approach a lender to provide finance for your joint venture, they may even insist on setting up an SPV as taking this approach will enable project specific financing, risk sharing, and return.
However, there are risks associated and these are:
- The new company’s liquidity
- The lack of transparency involved in operating a parent company and subsidiary company i.e. are they truly operated separately with separate finance systems
- The reputational risk involved to the lender
In general terms, these risks are managed through stringent governance checks, progress reports, and heightened regulatory frameworks.
Why do I need an SPV?
After the development is constructed and a decision is made on whether to sell the asset or extract the profit, then if you have delivered the project via an SPV you will be able to reduce your tax burden as opposed to realising profit as simple income and being taxed accordingly. Equally, should you decide to retain margin in the business, you can use this for future developments of the same site or continue your relationship with the same shareholders and look for another site.
Similarly, if you are an SME property developer then you may not want to put your existing companies profile at risk. For example, you are acting as a management contractor but unforeseen ground conditions or inclement weather delays progress of the scheme and you are faced with increased build costs beyond that which your development finance covers. If you are using an SPV then such losses can be ring fenced and further funding could be sought based on the developments potential yield, but in any case the parent company will not be affected. Equally, as well as ring fencing costs, SPVs can be used to finance property developments without increasing the debt burden of the parent company.
Be mindful that once completed, the route to realise the profit for the SPV parties was historically liquidation where profits are thereby distributed to the shareholders accordingly. However, with the Finance Act 2016 coming into force, there can be a significant wait of over twelve months waiting for the final tax due to be calculated and the release of profit.
Obviously with cash being king to any developer, any wait will hamper your ability to keep finance going for future projects, never mind over twelve months. Therefore, whilst losses can be ring fenced, which undoubtedly provides security under an SPV, the down side to this is that accessing the profit can be more onerous than if you were simply a property developer with numerous projects on-going, you would simply be able to access any profits as they transpire. Of course, the SPV need not be liquidated to realise the profits in the company as the asset can be transferred through sale, leasing or licenses could be sold for example. The key part here is that you need to arrange for suitable taxation advice to find the most tax efficient solution.
However, dependent on the parties involved they may decide to continue using the SPV for different property developments or acquisitions, but this will no doubt be dictated by the success of the parties.
Another big plus point for the use of SPVs is that where several investors are required, rather than contract with each other, or as a developer have multiple funding agreements, you can set up an SPV so that each investor will each own a share of the asset. There are flexible structures available that can give clarity to each party in terms of their rights and how any profits will be distributed.
What are the risks?
Before the global crash of 2008, the use of SPVs was much less regulated and as such companies were able to set up SPVs and load them with costs to hide the parent companies’ true debt and liability position. For example, the much-publicised collapse of US companies Enron and Lehman Brothers lead to increased regulation, and governance is in place to stop financiers lending to SPVs without more scrutiny beforehand.
The issue at hand pre-2008 was that deregulation meant that lending to SPVs was less rigorous. In the example of Enron, the level of debt was unsustainable despite it being partially loaded onto SPVs and therefore they sought investment, but once the true underlying position was uncovered and they re-wrote five years of earnings, wiping out $600m in profit, it started to unravel and the stock price plummeted. The company eventually spiralled into billions of dollars of debt and liquidation.
Taking this back down to the SME property developer, by using SPVs to deliver developments the temptation will be to consider running them alongside each other and managing them as a portfolio of projects, which you can do as long as there is no third party investment. However, if there is not external funding, the reality is there is no real benefit in doing so and there is also the increased administrative burden to manage.
What are the legal issues to watch out for?
Dependent on your appetite for risk exposure, you might want to think about limiting your liability for any potential losses. As property development inherently requires serious funding and financial outlay before yielding a return, you should consider what liability you are prepared to underwrite in the SPV operating terms and conditions.
You want the SPV to be flexible enough that you can change the structure of the agreement through the development, as you may decide to add more investors. You do not want to be too constrained with the existing partners such that it would require significant legal costs to alter your current arrangements. Also, you will need to be clear on each party’s obligations in terms of how the project will be managed, how the parties intend to work together, and who has controlling power to make key decisions. Getting bogged down in project governance or being hindered by slow decision making will not be good for the projects or the partners involved in the SPV.
Depending on the nature of your relationship between the shareholders, you may need to consider confidentiality clauses and limiting certain information from the public domain.
Delivering the Project
If you are one of the SPV partners and you consider that the best way to deliver the project is to contract directly with the different trades, as opposed to employing a main contractor, you should consider what share you will hold in the SPV. Taking a construction management role will undoubtedly increase the level of resource you require and therefore you may wish to negotiate a bigger share of the SPV.
For example, as the client and the managing contractor you will hold ultimate programme risk including the unenvious task of coordinating all the works and subcontractors.
Notwithstanding this, you may need to co-ordinate the supply of materials for each trade in good time so as not to incur additional charges from your suppliers. Finding somewhere to set up and manage a compound including offices will be required and you will need to ensure they are secure or face the prospect of replacing any stolen materials, which if you fail to do so in time will put you back in the position of standing time!
If you are setting up an SPV, when attracting investors ensure that you have made adequate risk allowance within the budget if your intention is to deliver on a construction management basis. It may be prudent to allow for a proficient and independent project manager to act on your behalf and assist in project delivery.
You will need to appoint a designer for the pre-construction phase and assign Principal Designer duties to them in order to delegate your legal responsibilities for co-ordinating pre-construction information. Once you move into the build phase and remain operating in a construction management capacity, you will need to appoint yourself Principal Contractor and ensure that you issue a construction phase plan in advance of construction works starting.
Acting as Principal Contractor – what does this entail?
Acting as the Principal Contractor, as per the Construction Design and Management Regulations 2015, is an important role with their primary focus being to manage health and safety risks during the construction phase.
Co-ordinating the trades to a programme all the way through to completion is not enough as you will need to ensure that each contractor is vetted in order to satisfy yourself they have the relevant skills and experience to carry out their work safely. They will need to be inducted, during which you will need to explain the risks associated with working on the site and what they need to do to ensure those working on the site and members of the public affected by the works are aware of the health and safety risks to everyone affected by the work.
The Principal Contractor will also need to provide a written construction phase plan that details the risks and how they intend to manage them. This will need to be kept up to date during the works, as the risks will change during the build. Also, you will need to ensure adequate welfare facilities are in place throughout the duration of the works and they are maintained.
In summary, if you are considering your next property development venture and believe the best way to plan, finance, and deliver it is via an SPV, ensure that the mechanics of the relationship are expressly written down and agreed by all parties involved as part of a separate operating plan.
If you are operating on a construction management basis then remember to factor in the true resource costs of safely managing and coordinating all trades as investment here will pay dividends in mitigating your risk allowance in delivery.
Image credit: iStock.com/FG Trade
About Dean Suttling
A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.