On-balance sheet financing and off-balance sheet financing are similar in that both forms of financing generate funds for the parent company. The differences between the two forms of financing lie in (a) the ability of the parent company to shield its borrowing activity from some creditors by using off-balance sheet financing and (b) the ability to shield parent company assets from lenders by using off-balance sheet financing.
Technically, the parent company engaging in off-balance sheet financing is not borrowing funds. Rather, the parent company in such a scenario sells an asset to a special purpose entity (SPE), which may be anything of value that has an income stream, but which usually is an interest-bearing financial asset. The SPE buys the asset from the parent company. The parent is the dominant shareholder in the SPE, so the transaction is somewhat like selling an interest bearing asset to oneself. In turn, the SPE pledges the asset to a lender in return for a loan in an amount equal to most of the value of the financial asset.
The SPE must repay the loan and the interest. The SPE (in theory) is able to fund repayment with money from the parent company in the form of (a) interest payments and (b) asset repurchase (in installments). Under such an arrangement, the lender has recourse only to the SPE, which has nothing but an interest bearing asset that the parent company is under no legal obligation to redeem, but is under an obligation to pay the stated interest on the asset.
A parent company may have an existing credit agreement with a financial institution that prevents the company from incurring any additional debts that would or could compromise the financial position of the creditor as a claimant on the assets of the company. Off-balance sheet financing, in effect, allows the parent company to have its cake and eat it too (at least in the short-term or near-term) by shielding the companyÆs assets from the ...