Alternative Investments: How Hedge Funds Use Special Purpose Vehicles

The financial markets can be daunting for investors and their advisors. This is especially true when the market is in the dump, as we are now in 2022.

Over the years, though, the industry’s experts have found novel solutions to problems.

These solutions can help investors make better decisions and minimize the amount of risk they undertake. Understanding some of these solutions, such as special purpose vehicles, can be a big benefit to investors from every background.

To learn more about SPV as alternative investments, keep reading. Below, we’ll explore SPVs in detail and why hedge funds use them.

What Are Special Purpose Vehicles?

A special purpose vehicle (SPV) is an alternative investment vehicle used by large firms. They are separate legal structures created for a specific investment opportunity.

SPVs raise funds by pooling together investments from a limited number of investors. This pool of funds is then invested into one thing, and one thing only.

It’s not a fund that buys shares of multiple different assets. It only invests in a single opportunity.

The reason these SPVs exist is to isolate risk. Oftentimes, SPVs are used to invest directly into a startup company. The potential return is very high.

But with angel investing, the risk is also very high. That’s why these vehicles are used.

It isolates these high-risk opportunities from the rest of the portfolio. That way, if the investment goes south, it doesn’t negatively impact the main fund or products offered by the parent company.

Additionally, the independence of the SPV means that if the parent company were to go bankrupt, it wouldn’t impact the SPV, as it’s a separate entity, independent of the parent company.

So what does an SPV do? Not much. It pools funds, invests in one asset, and holds it on its own balance sheet.

How Do Hedge Funds Use Special Purpose Vehicles?

Hedge funds use SPVs to invest in high-risk, high-rewards assets. But they do it so that the SPV is not on the balance sheet of the parent company.

Since the SPV is its own legal entity, it doesn’t show up on the balance sheet of the parent company, for better or for worse. So whether the SPV invests in a roaring success or a dramatic failure, it won’t impact the reputation or the value of the parent company.

As a hedge fund, the goal is to maximize rewards for investors while minimizing risk. To minimize risk, isolating risks is essential so that one failure doesn’t affect other areas.

Another reason a hedge fund might use an SPV is to invest in assets that fall outside the scope of their investing philosophy. A successful hedge fund is focused and limits the scope of its investments.

Sometimes, opportunities arise that may be very promising, but don’t fit their strict criteria for direct investment from the hedge fund itself. So they can use an SPV to invest in it through a subsidiary.

The Pros and Cons of Special Purpose Vehicles

Large companies and hedge funds are subject to high levels of regulation and scrutiny. They aren’t able to move and invest very freely, with lots of rules to follow.

An SPV helps to solve this problem. As a separate entity, not under the same scrutiny as the parent company, it has more freedom and flexibility to invest in assets that wouldn’t pass muster under the parent company.

Hedge funds also prioritize liquid assets. To preserve their liquidity profile, there are many promising assets that they can’t invest directly, as they might not be able to sell them quickly enough if the market turns.

So forming an SPV could allow a hedge fund to invest in less liquid assets, like high-yield bonds.

The problem with SPVs, at least from the perspective of individual investors, is that they can mask a company’s financials. Since the SPV doesn’t show up on the balance sheet of the parent company, the parent company might be hiding financial information from investors.

But if you are considering an investment in the parent company, you would want to know about any SPVs that the company oversees, since that information is pertinent to the overall picture of the parent company.

Structure of SPVs

SPVs are usually formed as LLCs. That means they are pass-through entities.

So the money coming into an SPV is passed through to its members. So a partnership with a 10% membership stake would earn 10% of the income generated by the SPV.

Once the SPV raises the desired level of funds, it will make a single investment, usually in a startup company. As a member of the SPV, you are invested in the SPV, not directly invested in the asset that the SPV purchased.

SPVs allow individual investors to invest in startups, as an angel investor, without having to front a significant amount of capital on their own.

How to Invest in Special Purpose Vehicles

If you’re invested in a hedge fund, your hedge fund manager will inform you of their decision to create an SPV. They will give you the opportunity to invest in the SPV, but you are under no obligation to.

It’s simply an additional opportunity presented by your trusted hedge fund manager. It’s up to you to decide if this additional investment is a good opportunity for you at the time.

Most of the time, the number of individual investors that can participate in an SPV is limited. And since hedge funds typically require investors to be accredited, so too do special purpose vehicles.

In 2022, an accredited investor is someone with an annual income of at least $200,000 (or $300,000 as a joint couple), or if they have a net worth of at least $1 million.

Private entities can also operate as accredited investors if they have a network of $5 million or more.

Do Your Own Research

Special purpose vehicles are unique investment opportunities. They help hedge funds and other large entities enter into various investment opportunities while isolating risk from the rest of the company.

If you have the opportunity to participate in an SPV, it might prove to be very rewarding. However, also perform due diligence before making an investment, even if it sounds promising.

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