(AG Real estate) Project finance model SPV - as an Extremely Important Tool!

With the initiation of investment cycles in Serbia, development of various finance models has been imposed. “Credit“ solution has become “the most expensive“, whereas, in case of some other finance models, only very small number of legal subjects are able to effectively and positively apply for free funds at banks or some other financial institutions. Therefore, in case of the project finance model, it is necessary that potential clients find complete model both understandable and recognizable. We are witnesses to a difficult process of market’s familiarization with the advantages offered by different finance models! On Serbia’s capital market related to financing of construction of real estates with accompanying equipment, Project finance model is more often present lately. The main and initial characteristic of this model is the obligatory forming of brand new enterprise that is becoming the subject of the project finance. There are numerous definitions and interpretations of such newly founded enterprise, also known as SPV, in practice. That is one of the key reasons why we decided to explain and make its essential and practical meaning completely clear in this text! Definitions and Interpretations

Special Purpose Vehicle / Single Purpose Vehicle (SPV), Special Purpose Company / Single Purpose Company (SPC), Special Purpose Entity / Single Purpose Entity (SPE) or Single Purpose Company (SPC) is juristic person that is founded mainly for the purpose of corporate, that is, Project finance. That is a body corporate (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory risk.

Such companies are often founded when several enterprises unite for realization of some concrete project, such as, for example, construction of some real estate or development of some technical innovation. Financiers often request founding of such company in case of some big project. In that way, credit risk is limited to special projects. There is no danger from appearance of some other risks from other business activities that can not be anticipated by the financier (in most cases, a bank). SPVs are also used with ABS-finance (Asset Backed Securities).

A special purpose vehicle – SPV, may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPVs are set up as "orphan" companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.

In addition, SPVs are used by the banks for registration, so that certain financial risks could be transferred to the capital market. Thus, either credit portfolio, for which there is risk of absence, can be transferred to SPV or SPV can sign Credit Default Swap contract with the bank, in case of which it acts as a donor of guarantee for some credit portfolio. In that way, SPV, that is, its creditors, takes on the bank’s credit risk and, in return, it gets certain premium, because the credit risk is no longer in the bank’s books.

SPVs often have headquarters in the countries with favorable tax policy or smaller obstacles for their founding, so-called Offshore-countries, such as the Bahamas, the Cayman Islands, the Virgin Islands, etc. Expression “offshore“ (along the coast) relates to the fact that these countries are, in most of the cases, islands.

Reasons for forming SPV

Some of the reasons for creating special purpose entities are:

· Securitization: SPVs are commonly used to securities loans (or other receivables). For example, a bank may wish to issue a mortage-backed security whose payments come from a pool of loans. However, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPE, and then transferring the loans from the bank to the SPE. · Risk sharing: Corporates may use SPEs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk. · For competitive reasons: For example, when Intel and Hewlett-Packard started developing IA-64 (Itanium) processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals. · Financial engineering: SPEs are often used in complex financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. Possibly the most famous example of a company using SPVs to achieve the latter goal is Enron. · Regulatory reasons: A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific assets. · Property investing: Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes.

Recommendations for Serbia

Use of SPV (that is, SPC) is of special importance to the real estate market in Serbia, especially to capital city of Belgrade, for two main reasons:

1. For fiscal (tax) reasons, like in the western countries, “Share Deal“ versus “Asset Deal“. Basic turnover tax in Serbia is 5%. This tax of 5% does not exist with “Share Deal“. However, here we should pay attention to the fact that all 100% of “Shares“ do not change their owner immediately, but one “small share“ remains. That “small share“ is transferred to the new owner later.

2. In Serbia, especially in the capital city of Belgrade, one can not gain ownership of most of locations that are intended for business purposes, but only “unlimited right of use“, which is limited on period of up to 99 years. This regulation represents big obstacle, especially for transfer of ownership over some land. Investor can buy land (most often on some public tender), but it can not sell it later. Once a facility is built on that land, the investor can sell this facility with the land beneath and around the facility. In most of the cases, the project for construction should only be started, so that some “facility under construction“ could be sold (of course, in this case, with the related land).

In order to make it easier for the investors to invest effectively and largely in the development of real estate market in Serbia, especially in Belgrade, it is recommended that these investments, if it is possible, be realized by means of SPV, that is, SPC. Concretely, that means that a SPV/SPC should be founded for each Real Estate Development project, which would then appear on certain tenders as the new owner of the location, that is, land. When certain land is owned by a SPV/SPC, the investor can sell this land to some other investor by selling SPV/SPC, and formal owner of the land is still the same SPV/SPC.

As far as privatization of state-owned companies in Serbia are concerned, application of the instrument of SPV/SPC also provides certain benefits. Similar problems with the land ownership and transfer exist in some other “transition countries“ where such problems are also solved by means of the instrument of SPV/SPC.

Expectations for Serbia

Serbia is a country in transition, in its maybe the most delicate phase, and in the period when entrepreneurial spirit finally awakens and develops. Therefore, it is necessary that all participants in that process invest additional efforts, so that additional quality could be finally produced. People on the “finance side“ should make sufficient effort to explain and promote new or specific finance models, because it happens that, due to common unawareness or ignorance, potential clients can not be neatly served, although they maybe meet necessary requirements.

Because of the everything mentioned above, potential clients should master all specific actions that relate to satisfaction of uzance on the occasion of allotment and approval of required funds. Therefore, it is necessary to start with the application of certain activities that would stimulate that. Thus, when they come in situation to apply for some funds, that will be one common and expected process with positive outcome!

author :

Alexander Petritz, MSc,

CEO of Immorent Beograd d.o.o.

alexander.peritz@immorent.co.yu

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