1 - Introduction to Bank Lending and Debt Securities (1, 2, 3, 4, 9 & 17)
Raising Finance – An Overview
Key Players
Borrowers
✓ Governments (sovereign debt) (may be short-term to fulfil policies/targets or long-term to fund projects
etc)
✓ Local Authorities (typically to invest in infrastructure)
✓ Individuals
✓ Companies
✓ Others (partnerships, sole traders, supranational organisations (e.g. World Bank), educational institutions)
Lenders
✓ Banks and institutional lenders (known as funds). Both are intermediaries (lend money raised from
others)
Commercial banks → Raise money by attracting deposits and then lend money to individuals,
companies and governments who need it
→ Intermediaries; move money to where it is required and provide basic
banking services
→ As long as they lend prudently, there is a relatively low risk and lucrative
business
→ N.B. universal banks – combined retail, wholesale and investment bank
services in one institution but now there are attempts to force banks to
separate their businesses (ring-fencing) (Vickers Report). This ‘ring fencing’
of the retail banking business was adopted by the HM Treasury White
Paper. Meanwhile, the US authorities similarly restrict banks from making
certain speculative investments under the ‘Volcker Rule’.
Investment banks → Sell advice and underwrite securities issued
→ Trade and speculate on bonds, shares and complex financial instruments
→ Huge reward, but risk of a large loss
Central banks → All countries with developed economies have a central bank (functions
vary across jurisdictions). BoE was set up as a private bank in 1694 and was
nationalised under the Bank of England Act 1946.
→ Main function of the Bank of England is to act as the government’s banker
(holds its main account and borrows on its behalf, and advise on monetary
policy, to issue bank notes, to regulate the money markets by lending or
borrowing and to set interest rates)
→ Also helps other banks with short-term liquidity issues as a lender of a last
resort, for long-term liquidity issues, advice will be given
→ Also is indelibly linked with UK bank supervision.
Finance Solicitor
✓ Structure the deal (if particularly complex)
✓ Draft and negotiate loan documentation
o Be aware of current market practice as this will dictate the terms that most banks are likely to accept
✓ Most city firms will split a large finance department into: a) general banking b) capital markets and
securitisation c) project finance d) asset finance and maybe e) derivatives/regulatory
1
, Financing a Company
Broadly 4 methods by which a company may raise finance.
→ Issuing shares in return for capital investment (equity finance, not debt)
→ The more shares that are issued, the more this dilutes profits per share
→ If voting shares are issued, control is diluted as shares are issued
→ There is no absolute obligation to give shareholders dividends
→ Unless you are a public company, it can be difficult to find subscribers for new
Share capital allotment of shares
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(Equity) → Funds are non-returnable (except on winding-up), so the company is able to
commit the monies in long-term investments
→ Cannot really raise small amounts on a regular basis (can with loan facilities)
→ Company can borrow money at a relatively fixed cost and use it to make greater
profits for its shareholders (gearing and leverage)
→ Profits of the company are kept to provide working capital and funding
→ Thus, the profits are not distributed to SH as dividends (but where there is a surplus
Retained profits
it will be distributed to the SH’s as a return on their investment in shares)
2 (Neither)
→ These are shown in the Profit/Loss Reserve section of the balance sheet
→ Timing and amount of profits is unpredictable so may not be helpful
→ Borrowing by way of a loan (usually known as a ‘loan facility’) can provide a
company with a flexible and ‘reliable’ source of funds.
→ Includes overdraft, (provides an instant source of variable borrowing, helping a
company with cash flow), term loan (lump sum borrowed for a period of time) and
Loan facilities revolving credit facility (below)
3 → Can borrow in a choice of currencies
(Debt)
→ Can be good for temporary-cash flow issues (raise small amounts on regular basis)
→ Can be good to fund a specific project (long-term loan)
→ However, company must pay interest (fixed or floating)
→ Must be PUBLIC company to issue bonds to public – s755 CA
→ A company issuing a series of instruments (i.e. a form of certificate) to investors in
acknowledgement of an amount of capital it has borrowed from them (these
instruments are known as ‘debt securities’).
→ The most common forms of capital markets debt security involve the issuer
agreeing to repay the borrowed capital on a specified date (on ‘maturity’) and to
pay interest on the borrowed capital in the meantime.
→ These act as an IOU (DEBT SECURITY – borrowing – security is the instrument)
Capital market issued to investors (used by large companies)
4 instruments → Investors (gives money) and issuer (receives money)
(Debt) → Such security includes bonds, notes, certificates of deposit, loan stock, commercial
paper
→ Interest is payable in addition to the capital lump sum on maturity (specific date)
→ They can be sold on secondary markets too; company pays interest to whoever is
the current owner of the debt; original investor is therefore able to recover some
before maturity date (subsequent investor then gets the remaining interest
payments and receives the borrowed capital on maturity)
2
, Factors Influencing a Company’s Choice of Financing – loan versus debt securities
Bank Loan
HARD TO GET LOAN ABOVE £500M, even if syndicated loan (likely banks won’t want such a concentration of risk)
Advantages Disadvantages
✓ Confidentiality: Unlike with a bond issue, a loan Security (generally): In contrast to a bond issue,
agreement can be kept confidential between the you will almost certainly need substantial security.
parties involved (confidentiality clause). Borrower Note: It is not uncommon that banks will take fixed
not exposed to market rumours and allows them to charges over what they can and floating charges
handle its affairs more discretely. Listed bond over everything else that is left.
issues will almost inevitably require publicity.
✓ Speed: A loan agreement can be made quicker Costs - Higher interest rates: Interest rates are
than a bond issue if necessary (particularly an likely to be much more rigid and higher
overdraft). So, if company urgently needs money, (particularly if high risk). Tends to be more costly to
loan more effective. Can take around 6 weeks. reflect that bank has own cost of funds and wants
✓ Don’t have to draw down straight away – e.g. if to make a margin. Lower in a bond issue due to the
dependent on an acquisition, can wait until certain much wider base of potential investors meaning
it will go ahead. less risk for individual investors compared to a loan.
✓ Obtainable: A loan is in many ways easier to get. It More onerous terms: A loan agreement will
is not subject to market fluctuation and less generally impose very onerous terms on the
dependent on your reputation in the market and borrower and try to cover for every eventuality to
liquidity of the market (these are more likely to avoid the bank losing any money. These terms
reflect interest payments). A convincing business could limit a business’ activities and thus adversely
plan likely to get you a loan if risk is deemed affect its future prospects.
acceptable (but will pay interest according to risk)
✓ Flexibility: loan agreement offers a lot of flexibility Control / covenants: The bank will have a
with regard to the individual terms. You can agree: substantial amount of control over how you
▪ Repayment (e.g. amortisation; bullet; balloon) manage and conduct the company as a result of all
▪ Instalment size and overall amount borrowed the covenants they will impose (e.g. financial
▪ Interest covenants, information covenants (supply certain
▪ Type of facility – which type would be best on info to bank), events of default (like material
the facts (could have term loan + RCF) adverse change)).
✓ Option to pay back early (for a penalty) and
thereby save on the interest payments.
✓ Chance for renegotiation: A major advantage is Disclosure: As part of the DD, banks will require
that you are often dealing with 1 party (the very extensive disclosure from the borrower and
arranger). 1 party will be a fairly sophisticated party impose strict information covenants on it to
who knows the market and will be willing to listen provide the bank regularly with information.
to what you have to say. This gives you more scope
to reason with that party if you are in breach.
✓ Relationships: KEY - you build a relationship with Need for a guarantor: Loan agreements will
the bank over a period of time which can be generally require a party to guarantee in case the
important also with a view for future borrowing. A borrower defaults. This is another onerous term
good relationship can benefit the borrower if imposed on the borrower that can make loan
renegotiation of the terms of the loan is required. arrangements less attractive.
✓ Credit Rating – No credit rating for a loan. Smaller investor base compared to debt securities.
However, bank will do Due Diligence to investigate
company and security where credit rating will be
considered. Interest payments and fees will vary
according to the risk assessment from the DD.
✓ Able to take out a loan in multiple currencies
3
, Bond Issue (debt securities) – only for public companies!
Debt securities = companies issuing BONDS on the capital market for investors to buy. Investment will have a
maturity date and investor will have a right to receive an interest payment (coupon) or investment may be issued
at a ‘discount’ to its face value on redemption at maturity. Investor does not take any equity in the issuer.
NOT WORTH IF < £100M (as it is only cost effective (profitable) to the bank if the bond is above this amount).
Advantages Disadvantages
✓ Lower interest rates and regulatory costs: Interest Not confidential: A bond issue will be public
rates are more flexible under a Bond Issue. The because they are listed on public markets –
reason for this is that there is smaller risk attachedrequires prospectus and details of what the
to the investment for investors (take a smaller slice borrower plans to do with money.
of the risk) and wider pool of potential investors Note: This may expose the company to market
✓ AND more liquid and tradeable market so no need rumours (e.g. this company is in need of money, so
to keep investment until maturity something is not going well). This in turn can affect
✓ AND with direct lending bonds, the investors can the share price and spook exiting creditors (who
miss out the ‘middle-man’ (bank) so costs reduced may start considering finding events of default in
order to claim their money back)
✓ Less onerous undertakings and terms: The terms Risk that money will not be raised: A bond issue is
under a bond are considerably less onerous and the in many ways subject to your reputation in the
issuer has much more bargaining power in market, investors’ interest and other factors that
dictating terms. E.g. grace periods tend to be more generally cannot be influenced by the issuing party.
generous. The issue can be underwritten, but this will cost a
Note: You DO NOT want sensitive default triggers fee, and underwriters may try and get out of it.
in a bond issue. Huge problem if required finance not raised.
✓ No security (generally): Bonds are commonly not Lack of flexibility: Get an upfront payment of
secured as it raises issues with dealing on the money from the issue (cannot draw down at
secondary market. However, can link a particular different stages). Once issued, only in exceptional
security to a bond issue. circumstances can you redeem bonds early.
Generally, must pay interest payments until
maturity and then bullet payment on maturity date.
✓ Disclosure: Disclosure requirements are minimal Bond holders: It is almost impossible to reason
and limited to information that is ALREADY with all individual bond holders who often will be
available in the public domain. regular (unsophisticated) private investors who
bought the bonds in the secondary markets (if you
even know who your bond holders are as there is
no requirement to register)
✓ Broader investor base: A public bond issue brings a High up-front costs: The up-front costs of arranging
remarkable exposure which cannot be matched by a bond issue, particularly if first time, will be
a bank. Whenever you need serious money, bond significantly higher than just negotiating a loan
issues are the way to go (e.g. £500m upwards) (issuing prospectus, acquiring credit rating for bond
✓ Could deal with just one trustee rather than and borrower, marketing the issue, disclosure,
multiple bond holders listing the bonds, legal fees to ensure regulatory
✓ Due to the deeper and wider pool of investors, compliance). Also = higher admin burden.
there is easier access to cash hence investors are Need to be for about £100m for the higher costs of
happy to accept lower interest rates a bond issue to cost the borrower less than the
higher interest rates of a loan.
✓ No control / fewer covenants: Bond holders give Time: It takes substantially longer to arrange a
you the money and wait for repayment. They do bond issue than it takes to arrange a loan. Can take
NOT obtain any form of control over the company.
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