An introduction to loan finance
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Although reliance on loan finance has to an extent been reduced by the growth of the capital markets, loan finance remains a key component of corporate finance in most countries. This can be provided either intra-group from related trading or finance companies or from external financing vehicles, whether or not they are connected to the borrower. This section gives an overview of the types of loan finance available. It is not specific to UK companies, however, and sections specify whether they relate to UK matters.
Although this article is intended to be a reference “primer” for the treasurer, it cannot be ignored that the supply and cost of credit has fluctuated since the financial crisis. Some of these facilities may not be offered and treasurers are recommended to fully research their options in the debt marketplace before committing to a particular structure for their financing.
The Loan Market Association (LMA) produces and promotes forms of standardised loan documentation. The documentation is drafted with the objective of meeting reasonable market expectations and therefore reducing the amount of time required to review and negotiate loan agreements. Also, because the documentation creates a recognised format it facilitates the trading of loan interests in the secondary markets.
Types of loan finance
Uncommitted facilities can be cheaper to arrange than committed facilities since a number of formalities associated with negotiating and documenting committed facilities are omitted. Because the lender is under no obligation to make any finance available, it needs fewer protective provisions and where the lender does make finance available, it will often only be for a short period (less than one year) and the credit risk will, therefore, be relatively small.
Short-term uncommitted facilities are often used to finance temporary or seasonal needs such as:
- paying trade creditors during a peak period or to earn any trade discounts;
- one-off transactions, e.g. a small acquisition for cash or the payment of tax;
- meeting salary payments when the collection of trade receivables is slow; and
- the annual business cycle experienced by any seasonal business as working capital requirements fluctuate.
Repayment of short-term credits depends on sources that can generate cash quickly during a single operating cycle. This will usually mean looking to liquid or current assets for repayment. The company should, therefore, when appropriate, try to ensure that the maturity of a loan is matched to the realisation of such assets. Examples of uncommitted facilities include:
- money market line – a company of reasonable size may have a line with its bank under which it can borrow up to a certain limit each day in the money markets on a short-term basis (frequently overnight to a month);
- foreign exchange line – this line will be made available from a dealing room and will be used by companies with frequent foreign exchange needs who might need to take out forward contracts to hedge against exchange risks;
- receivables financing line – this line will usually be made available by the factoring arm of a bank – the amount which will be made available will be determined by reference to a percentage of eligible receivables and to the strength of the company’s customers; and
- overdraft – the overdraft is a highly flexible borrowing tool and provides the basis on which all companies undertake their day-to-day transactions, allowing both payments to be made and receipts to be banked. While strictly it need not be uncommitted, the fact that it is repayable on demand gives it a similar status. It will be subject to a limit and interest will be calculated on a daily basis on the amount outstanding, usually at a margin over base rate.
Committed facilities are generally available for a longer period than uncommitted facilities. Five years is a common period but periods spanning the range from one to seven years are encountered. Because of their committed nature and their longer duration, committed facilities are subject to greater documentation requirements and are more expensive to arrange. However, this higher cost is often justified in order to assure the company of funds for the duration of a foreseen need. Attempts to finance medium-term requirements by short-term methods run the risk that it may not be possible to refinance at the time a short-term borrowing matures and this could, for example, necessitate the sale of a section of business to fund the repayment. Medium-term committed loans are often used to finance:
- the purchase or construction of fixed assets;
- refinancing of long-term debt or replacing equity with debt; and
- working capital purposes while the company is growing.
There are a number of options as to how any loan may be structured. Basic among these is whether the loan is to be bilateral or syndicated (or club) and term and/or revolver. In any case, the lender will only be required to advance the loan after certain conditions set out in the agreement have been satisfied (the “conditions precedent”). In addition, the loan will become repayable (and new advances need not be made) if one of a number of specified events occurs (the “events of default”).
The choice between a bilateral loan and a syndicated loan is driven mainly by the size of the loan. However, another factor to consider is whether it is important for the company to keep the identity of the lender the same throughout the course of an agreement. For example, this would be the case if the company envisaged the need to seek waivers from covenants (undertakings) or events of default in the future. A lender with whom it has a relationship and with whom it does more business is likely to be more willing to sit down and negotiate waivers and even a refinancing than a non-relationship lender. If the company wants to keep a relationship with its lender, the facility is more likely to be bilateral (rather than syndicated) and provision would be made in the agreement to restrict the lender’s right to assign or transfer. If it is necessary for the loan to be syndicated (e.g. because of its size) the documentation would, ordinarily, expressly permit the lenders to sell their share of the loan in the secondary market. If this is unacceptable to the company then it can seek to negotiate suitable restrictions to the rights of the syndicate to transfer. This may require payment of additional fees by the company in order to persuade lenders to become syndicate members.
Term loans and revolving loans (see this page) are often treated differently from a transferability perspective. This is because in a term loan, once it is drawn down (utilised) in full, the borrower is not at risk of the lenders refusing, or being unable, to advance further funds. As drawdowns (utilisations) may take place at any time over the life of a revolving facility, borrowers are often more concerned as to the identity of the lenders in these facilities. Many financial institutions are only willing to enter syndicated loans if they are entitled to receive a front-end fee for participating and then, to minimise capital adequacy requirements, quickly sell their portion of the loan. If the initial sale and subsequent transferability under a syndicated loan are restricted then the loan is referred to as a “club loan”.
Some companies prefer to negotiate a series of bilateral loans rather than enter into an ad hoc collection of bilateral and syndicated loans. A company may do so on the basis of a standard form loan agreement prepared by the company itself. Banks may be prepared to accept this on the basis that each bank will be in a similar position to any other bank as if they had participated in a syndicated loan. A company may prefer this arrangement since it can more easily replace particular banks with other banks as it sees fit and may be able to negotiate better financial terms as individual facilities fall for renewal. The conformity of the documentation also enables the company to monitor its compliance with the terms of its loans more easily.
In a term loan, the lender (or lenders, if the loan is syndicated) commits to lend the company a specified amount of money for a period of time from the date of drawdown (utilisation) to the end of the agreement, although as discussed below, repayment will usually be in instalments. Most term loans have a short availability period for the disbursement of funds, often three months. If a longer availability period is required, for example where the proceeds are to be used to fund payment of various instalments of a building contract, (and sometimes even for short availability periods) the lender(s) may insist on receiving a fee by way of commitment commission for keeping the facility on standby.
A term loan is often drawn down (utilised) in one amount but there may be provision for it to be utilised in a number of smaller advances. This will enable the company to spread interest payments and, in a multicurrency loan, will enable it to have different amounts outstanding in different currencies. Prepayment of the loan may or may not be permitted (it usually is) but, in any event, any monies repaid will not be available to be utilised again.
In a revolving loan, the company has the right to draw down specified amounts throughout the course of the agreement but will be required to repay these at the end of short specified periods. This requirement is sometimes managed by the use of rollover provisions, which allow the company to rollover amounts borrowed for further interest periods. It may redraw any amount repaid so long as the total principal amount outstanding at any time does not exceed the amount of the facility. A commitment commission will be charged on the unutilised part of the facility. Which of these two options is preferable depends on the purpose to which the funds will be put. A term loan is used to finance the longer-term needs of a company such as the purchase of plant or machinery. Because of the length of time for which a term loan is being made, a lender will usually insist on the loan being repaid in instalments during its life.
This gives the lender a check on the company’s continued financial soundness by observing whether there is difficulty in obtaining any of the scheduled repayments from the company. The company will usually be expected to fund the repayments from the generation of profits during this period. If this is not possible (e.g. where the company is using the money to develop an office block and will receive no income stream until the building is completed) it may be able to negotiate the right to repay the loan in one instalment (a “bullet repayment”) or with the repayments weighted towards the later scheduled payments (“balloon repayments”).
A revolving loan is used where the funding requirements of the company are more variable. For example, if a company is expanding and needs working capital during this period and it is believed that the period of growth will exceed one year, a term loan would be inappropriate since the day-to-day capital needs will vary. A variant of the revolving loan is the revolving standby credit facility, a particular type of which is known as a swingline facility. A standby credit facility is a committed facility that is used in tandem with another cheaper source of finance such as a commercial paper programme. It is intended that the cheaper source of finance will be used in preference to the standby credit. However, if at any time it becomes impracticable for the company to utilise the cheaper source of funds then it may draw under the standby credit. A swingline facility is generally regarded as a standby credit facility that is available for same-day drawing with a short maturity, usually no more than seven or ten days.
Rating agencies will usually insist on such facilities before rating a commercial paper programme. The fact that under most normal circumstances the standby credit will not be used leads to a variation in the fee structure of the agreement. The up-front fees are kept to a minimum (since otherwise it would be uneconomic for the company) but a utilisation fee may be added which imposes additional fees on the borrowing costs if the company over-utilises the facility. It is also important for the company to ensure that the utilisation provisions are not too restrictive so that the standby credit can be utilised when required (i.e. at the time that there is a problem which prevents the use of the other source of finance) and that the funds are made available on short notice – in the case of a swingline facility, on the day requested. Some agreements provide for both term and revolving loans giving a very flexible arrangement. Many variations exist in relation to both term and revolving loans. One such variation is an evergreen facility, which will include provisions for its automatic extension, subject to service of a notice by the company requesting an extension (usually not less than 30 days prior to the expiry of the facility) and the lender not objecting.