For some time, Real Estate development in the UK has been perceived as risky business for individuals or companies looking to cash in on lucrative opportunities within the built asset sector. This assertion is somewhat validated given that two-thirds of construction and infrastructure projects do not finish on time and run over budget.
Whilst high levels of volatility and uncertainty remain a consistent theme throughout the construction industry, attitudes towards risk and exposure can vary considerably from developer to developer. Selecting an appropriate procurement route for a project is a key element in the lifecycle that may determine if a development achieves value for money.
A developer under pressure to deliver a complex build by a certain date will likely prioritise construction speed and flexibility. These drivers create a compelling case for either Construction Management or Management Contracting as these procurement routes enable an overlap between design and construction as opposed to traditional procurement where there is a clear distinction between the design and build phase.
In the case of a Construction Management contract, the developer acts as principal contractor and engages in contracts with the trade contractors whilst having separate agreements with a team of specialist design consultants. The client will appoint a Construction Manager who will act as a consultant to manage the trade contractors and co-ordinate the design team on their behalf. Whilst this route may lead to a quicker completion of a complex development, it doesn’t deliver cost certainty because the design develops as the works are being performed.
Special Purpose Vehicles – what are they?
One measure that can be utilised by development companies as a way of managing risk whilst raising capital for a development is through the creation of a legal entity known as a Special Purpose Vehicle (SPV). An SPV is an off-balance sheet vehicle created as a subsidiary to a parent company as a way of isolating risk for a specific purpose or a temporary objective i.e. a development project.
The SPV is created by the parent company and is recognised as a separate entity with its own assets, liabilities, and legal status. The main objective of the SPV is to disaggregate risks and exposures held within the entity by reallocating them to external investors. An SPV is unique in the sense that it provides opportunities to investors that would not ordinarily be available and facilitate a risk sharing model which is beneficial to the originator (the parent company).
Allowing access to this separate underlying pool of assets can be advantageous for investors, as they don’t have to invest in the parent company. From the originator’s perspective, it is an effective way to raise finance for a venture without increasing their own debt burden. The clear legal distinction between the SPV and the parent company provides assurance to the originator and investors, as in the event of bankruptcy of the parent company, the SPV can continue and fulfil its obligations. Likewise, if the SPV goes bankrupt then the parent company will not be adversely affected. This mechanism could be extremely useful to a developer looking to commence with a complex project that needs to be completed within a tight timescale.
These drivers make it likely that a developer will opt for a construction management contract. In such a scenario, a developer will look for a way to mitigate risks associated with this procurement route and the creation of an SPV is a viable option to allocate this specific project exposure in a separate pool without endangering their main development business (the parent company).
Typically, a developer looking to pursue a construction management contract will be experienced in development and possess a good knowledge of the construction process and related concepts such as buildability. These skills and experience can be crucial in ensuring that the funding obtained is robust enough to facilitate the development in which cost certainty is not achieved until the final trade package has been tendered.
There have been numerous cases in recent years where developers have been poorly advised and have opted for a procurement route that was not suited to their requirements. Holyrood, The Government HQ in Scotland is a prime example. This project was delivered over three years late and the final outturn cost was £414M against an initial estimate of £50M.
SPVs provide value to developers as their formation leads to the creation of a brand-new company that has no liability or baggage attached to it. This entity will represent fewer risks and liabilities to willing lenders looking to invest in the SPV. Lenders often prefer to invest in SPVs as they are more straightforward to understand as opposed to a limited company meaning the underwriting process is often easier and faster.
Common practices used by lenders, such as stress testing, do not need to be as rigorous, which delivers further value for the developer. There is another train of thought in that SPVs can drive further value for property developers as the built assets created and owned by the SPV are good collateral from a quality point of view. It is conceivable that lenders will judge this collateral to be of higher quality than the credit quality of the parent company, which may lead to lower funding costs for a development.
Once the project is complete, the developer can either retain or sell the built asset. The SPV could then be shut down and another can be newly created for a different project with no ties or associated links with any other businesses. By limiting the business structure to one specific project, the developer increases transparency and collaboration between the parties associated with the project. These ideas of alignment and co-ordination are key ingredients for successful development.
Off-Balance Sheet Financing
In terms of matters related to taxation, specifically VAT, there are more potential benefits for companies opting to use SPV’s. Broadly speaking, the main advantage stems from the fact that SPV’s are off-balance sheet vehicles, which is a component of off-balance sheet financing (OBSF). OBSF is an accounting practice whereby a company does not include a liability, for example on its balance sheet.
This type of treatment has been subject to misuse in the past. For example, Enron used SPVs to conceal the vast of amounts debt it had accrued so that prospective investors would not be discouraged from investing. Since this scandal regulation has been tightened, but in principle off-balance sheet treatment remains a valuable tool for parent companies as they can use it to their advantage for tax and financial reporting purposes.
When considering the specific case of a development project, a business group can make considerable gains in VAT by creating an SPV for an individual scheme. Essentially, the SPV can be created purely as a building contracting business, meaning ownership of the land being developed on is still held by the parent company. In a Construction Management arrangement, the development company can form this separate legal entity to act as principle contractor, thus engaging directly in contracts and service agreements with trades contractors and design consultants respectively. The profits generated from the development will remain in the SPV and once the project is finished, the parent company can liquidate the SPV, extracting the profits less corporation and capital gains tax. When it comes to VAT, nothing will be due as the SPV in this instance has zero-rated its services to the parent company, which is correct as they are the services of a building contractor who will have rightly reclaimed the VAT on costs for carrying out the build. A group who has several developments within their portfolio can therefore generate worthwhile gains if they embark on this type of SPV for every project.
The challenges for developers deploying SPVs
It is evident that huge amounts of value can be extracted from forming SPVs but there are challenges that development companies must consider before choosing this option. When closing an SPV on completion of a project, there could be substantial costs involved in moving the built assets created over to the parent company. Alternatively, if the parent company sells the SPV that contains the asset, then this may have a negative effect on the group balance sheet.
There are several other complexities associated with the overlap between the parent company and SPV related to issues such as liquidity, credibility and finance raising capacity. As SPVs are new entities, they may not have a credit rating comparable to the parent company, which could have an impact on access to capital. On the flip side, parent companies may face mirroring challenges in that the creation of an SPV could lead to a restriction on the cash raising capacity of the group.
Another potential problem for parent companies’ centres around dilution, as direct control over some assets of the group might be diluted leading to a reduction of ownership if the group embarks on a dilution initiative. Finally, the overarching issue is the potential for changes in regulations regarding SPVs. Regulations around SPVs have changed following misuse in the past, and if further changes were made they could bring serious complications for the parent companies that have created special purpose vehicles.
Conclusion – Due Diligence and Systems
For a development business looking to create an SPV, there are some basic principles that need to be embedded within the strategy. Firstly, governance is key. A company must have a system of rules, procedures, and processes that provide a framework as to how the company is controlled. Stakeholders of the company should be aware of such practices leading to consistency in how the business is governed.
A detailed oversight is a crucial factor. Leaders should have tools in place that enable an environment in which a complete set of data and information is readily available, allowing more effective decision making and assessment. Finally, a clear understanding of the motivating factors for choosing an SPV should not go unnoticed. Groups need to be sure of the reasons as to what they are looking to achieve by creating an SPV and should always seek impartial advice from professionals who are qualified to advise on such matters.
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