The advantages to be had through off-balance sheet forms of financing can be ascertained by analyzing the differences between on-balance financing logic (or corporate financing) and that based on the creation of ad hoc companies.
The goal in encapsulating an initiative or a pool of assets in an ad hoc organization is to isolate the fate of these assets in relation to those of the sponsor or sponsors of the transaction. This isolation works both ways.
An initiative with poor prospects, even where default is a possibility, does not impact the performance or the survival of the company, due to the principle of limited shareholder responsibility set down in the regulatory framework of many countries.
On the other hand, a project’s worth should, at least in theory, remain untainted by business dealings that could negatively affect its shareholders. In this sense, a project’s creditors continue to claim rights to the assets and cash flows of the initiative, even if its shareholders go bankrupt.
The clear separation between the initiative and the sponsoring party also means that the two can have very different creditworthiness. One extreme may be strong sponsors and weak initiatives segregated in a vehicle.
The other extreme (more commonly found in practice) could be cases where sponsors have rather low creditworthiness but nonetheless are able to make the initiative hinge on a vehicle company which, appropriately secured by credit enhancement mechanisms, can obtain a higher credit rating than its originators.
The first economic benefit of structured transactions lies in the cost of funding of new financial resources for the initiative. If the benefits of a reduced cost of funding are greater than the cost of credit enhancement (of whatever kind: a purchasing contract or a tranche-based bond issue, a pledge to pay penalties signed by a counterpart of the SPV, insurance coverage), realizing the initiative on a structured basis is advantageous for sponsors.
The second advantage in separating the initiative from the sponsor(s) lies in maintaining financial flexibility of this company or companies. In fact, financing is granted to a legal entity separate from the sponsor, which therefore does not tap into the latter’s credit lines.
A specially secured initiative is proposed to the pool of financers, for which a specific return/risk combination is offered in the face of new credit lines. Prior credit lines are not drawn on, nor are there any induced effects on the cost of already existing funding for the sponsor.
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