BPP LPC – Debt Finance Exam Notes
PART 1 – Overview of Banking Transactions & Syndication
Debt Finance = Investors provide capital for a limited period in return for periodic interest payments.
à Understand the commercial reality for both sides and negotiate the documentation accordingly.
Everything depends on the parties’ relative bargaining position.
The Banking System
- The ‘real’ debt providers: Individuals and companies deposit money with banks either through
savings or current accounts. Banks use this money for lending.
- Banks act as a conduit for lending. Banks may also borrow from other banks that have surplus
deposits available. Lending and borrowing between banks occurs on the ‘interbank market’.
- LIBOR: The rate at which banks are prepared to lend to others in the interbank market is
known as an ‘interbank offered rate’. Rate in London = London Interbank Offered Rate/LIBOR.
o Rate of LIBOR will affect amount of interest a borrower will have to pay on a loan.
o A particular bank’s LIBOR will depend on factors e.g. credit rating of the bank,
currency of the loan, length of the loan and liquidity of the interbank market.
Regulation of Banks
- Authorisation and Supervision: Financial Conduct Authority (FCA).
- Capital Adequacy:
o Capital adequacy rules require banks to maintain a sufficient proportion of capital,
compared to the amount lent by the bank, to protect depositors in the event that the
loans are not repaid.
o Capital adequacy rules affect the relationship between banks and borrowers because
the requirement to maintain capital represents a cost to the bank.
o If sufficient capital not available, bank will either have to raise further capital (by
issuing shares) or transfer some existing loans off its balance sheet to make the loan.
Key Business Issues for Banks
1. Relationship
o Borrowers are a bank’s customers and, like any other business, a bank needs to keep
its customers happy if it wants to sell further products to them in the future. The bank
will aim to become the borrower’s ‘relationship bank’, to which the borrower will turn
first when it is in need of loans or other financial products.
2. Risk
o Banks need to ensure that they are protected against credit risk i.e. the risk that the
borrower will not repay the loan.
i. Perform detailed due diligence on borrower before agreeing to the loan.
ii. Well-drafted loan agreement.
o Risk is correlated with return. A bank may be willing to make a high-risk loan, but will
expect higher interest to compensate it for taking this risk.
3. Recourse
o Bank’s claim on certain assets for repayment of loan – need sufficient security.
o Borrower’s may seek to limit the assets to which the bank has recourse.
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, 4. Profit: Cost-plus loans
o Cost of the loan is the bank’s cost of borrowing the money.
o If the bank is only using deposits made by its customers, then this cost is the amount
the bank will pay out on those deposits (interest payable to depositors).
o If borrowing on the interbank market, cost of funds is LIBOR. Difficulty is that LIBOR
fluctuates during the life of a loan. As a result, many loans are priced on a cost-plus
basis, where the interest rate is calculated as the sum of LIBOR plus certain of the
bank’s other costs in making the loan available (known as mandatory costs), together
with a sum representing the bank’s profit (known as the margin).
o Mandatory costs = low level costs associated with regulatory funding requirements.
o The margin attached to a loan will represent the risk to the bank of making the loan
and is, in effect, the bank’s profit. Margin protection provisions.
Lender/Borrower Tension
- Lender’s perspective:
o Lending money always carries the inherent risk of a borrower not being able to repay
the loan.
o Bank’s concern is to ensure document provisions are sufficiently water-tight.
o Due diligence.
o Internal credit assessment of the borrower to determine the level of interest and fees
charged. Type of facility, rigidity of the undertakings, financial covenants and
representations etc. will also be determined by this internal credit assessment of the
borrower.
o à The higher the risk, the higher the fees and interest will be and the more onerous
the provisions in the documentation.
o Banks are taking a credit risk on the borrower; such risk is assessed on the assumption
that this particular borrower undertakes a particular kind of business with particular
assets. Therefore, banks want a borrower to remain roughly the same entity with the
same assets throughout the loan period. Control through loan agreement restrictions.
§ Loan agreement will expressly state the purpose of the loan and will restrict
the borrower from using the money for any other purpose.
§ Agreement will restrict any change in the nature of the borrower or its assets
and is generally likely to prohibit any significant disposal of assets.
§ Agreement will prevent the borrower from creating any security so no other
interested party will take priority over or compete with the bank’s claim
against the borrower’s assets.
- Borrower’s Perspective:
o Wants the cheapest available funds from a lender while retaining flexibility and
longevity.
- à COMPROMISE POSITION.
‘Finance Documents’ – Loan agreement, any security documents and certain other ancillary
documents.
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,Types of Facility
1/ Overdraft
Characteristics:
- The overdraft permits the borrower to borrow up to a specified limit and interest is charged
on the daily overdrawn balance.
- The borrower can repay the loan or part of it and then redraw the money – up to the specified
limit.
- It is normally an ‘uncommitted’ facility – i.e. the bank is not committed by any contract to
continue lending the money and may decide to withdraw the facility at any time and for any
reason.
- An overdraft is usually granted on the bank’s standard terms and conditions and there is little
room for negotiation of these.
- Any overdrawn amount is legally repayable on demand. This means a bank needs no reason,
and does not have to wait for a breach of the overdraft agreement by the borrower, to require
repayment of an on-demand facility.
- Little formal documentation is required – often merely a ‘facility’ letter.
Function:
- An overdraft is a tool to assist cash flow i.e. to keep the business liquid.
- It provides a reserve of easily accessible money to meet any shortfalls in working capital. An
overdraft is sometimes known as a working capital facility.
- Whilst most companies will have access to an overdraft facility, it is not intended to be a core
source of funding but rather a means of dealing with short-term funding requirements.
2/ Term Loan
Characteristics:
- A term loan provides a fixed sum over a fixed period.
- The borrowed amount may be fully drawn down in one lump sum or in several ‘tranches’.
- It is usually a ‘committed’ facility i.e. the bank is bound (subject to the terms of the loan
agreement) to lend the money and can only demand repayment before the agreed repayment
date if there is a breach of the loan agreement.
- It is repayable by the end of the term (according to an agreed repayment schedule set out in
the loan agreement).
- Any prepayments are usually final (i.e. they cannot be redrawn by the borrower).
- Repayments can be restructured in a variety of ways including:
o Amortisation – repayment of amounts at regular intervals.
o Balloon repayment – repayment is in several instalments where the final payment is
bigger than the rest
o Bullet repayment – repayment in one instalment at the end of the term.
Function:
- A term loan is most suitable where the borrower needs a specific sum of money for a medium
to long term period i.e. for the purchase of property, acquisition of a company, starting-up
costs.
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, 3/ Revolving Credit Facility (RCF)
Characteristics:
- This is a commitment by a lender to lend on a recurring basis on predefined terms.
- The bank makes a specific amount of capital available over a specific period, typically 3-5
years.
- Unlike a term loan, the RCF allows a borrower to draw down and repay amounts of capital
almost as it chooses during the availability period, subject to the terms of the loan agreement.
- There are limitations to such drawing down and repayment to ease the administrative burden
on the lender:
o The capital is made available for a set availability period (e.g. 5 years) and, within that
period, individual loans (subject to a minimum size e.g. £500,000) are borrowed for
an ‘interest period’ (generally 1, 2, 3 or 6 months at a time) and repaid at the end of
that interest period.
o Typically, a loan agreement would specify that a borrower can have no more than a
certain amount of loans outstanding at any one time.
o The borrower usually has to give a number of days’ notice to draw down.
- à Although the RCF may be available for 5 years, individual draw-downs are short-term in
nature.
- It is usually a committed facility so, provided there is no default, the bank is bound to lend the
money and cannot demand early repayment.
- The RCF will cease to be available and any outstanding drawings will be repayable in full at
the end of the Availability Period.
- The RCF allows a borrower to draw down loans only when it needs the capital and only for the
period it needs the capital, thereby keeping interest costs to a minimum.
- The bank will charge a fee called a ‘commitment fee’, which is a percentage of the undrawn
amounts of the facility from time to time. A bank charges a commitment fee because it has to
put aside a certain amount of loan capital based on the total committed facility available to
the borrower in order to comply with the capital adequacy rules.
- Each time funds are drawn, the borrower is deemed to repeat certain representations which
it originally gave to the lender in the loan agreement.
Function:
- RCFs are often used for working capital (i.e. to provide liquidity for a company’s day to day
operations). An RCF combines the flexibility of an overdraft facility (allowing the borrower to
withdraw capital only when it is required) and certainty of a term loan (an RCF is usually a
committed facility).
- A syndicated RCF can be very large in size.
- The borrower can draw down when the money is needed and pay it back when it is not,
thereby saving interest.
- The documentation, timing and negotiation required for an RCF will be very similar to that of
a term loan.
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