Syndication
A syndicated loan is
often part of a wider financing strategy. These are big corporate loans
provided to a corporate by the consortium of banks or institutional investors. Many
companies use syndicated loans alongside bilateral agreements and a bond
issuance program to maximize their ability to raise funds effectively and
cheaply.
The loans are beneficial
to banks, it helps in:
·
Diversifying their
lending portfolio
·
Establish cross border
relationships with institutional clients and customers
·
Reduce risk of high
exposure to a counterparty
·
Sharing the
responsibility and cost with other lenders
Benefits to customers / counterparty
There are different
reasons why a corporate might want to arrange a syndicated loan. Common reasons
include:
·
To meet the working
capital financing.
·
To fund an expected merger
and acquisition program
·
To fund a new big size
project, such as building a new production facility.
·
To provide back stop
facilities for other forms of financing, such as a commercial paper program.
In addition, the
company would need to be able to provide the details on the usage of funds and
how it will be meeting their business and operations strategy. Company would
also need to provide the repayment plan for the mentioned fund obligations.
Syndication process:
Appointing arranger bank(s)
First step in
syndicated loans process is to appoint one or more lead arranger banks for
corporate loans. The role of lead arranger involves facilitation and leading
the group of investors for major financing.
The selection of a
lead lender is based on a number of factors, including the proposed terms and conditions
of the facility, the willingness of the lender to hold a designated amount of
the loan after the syndication, the reputation and experience of the potential
lead lender, and the ability of the lead lender to execute and support other
types of capital markets products for the company.
Two issues need to be
considered:
Club deal
This is essentially the same as a syndicated
loan, with the same terms and conditions applying to all banks. They are mainly
used by private equity groups to provide capital for acquisition of a target
that is larger than the acquiring capacity of a single party. These deals allow
private equity firms to compete for acquisition targets that were once only
available to large acquirers.
These syndication usually covers a smaller
amount up to $150 or $200 million. The main difference with syndication is that
these loans are equally divided among the lead agent and other members. Similarly
the fees and interest are also equally shared among the agent and participant
banks.
However, there could also be added complexities
on who would lead the acquisition, which party will take over the role of
administrative agent, who will be overlooking the financial stability of the corporate
and even the seller would need to negotiate with a number of different parties
in the club rather than just one buyer.
Geographical spread
Lead arranger has to
ensure that they have coverage in the markets where the parties willing to participate
in a loan are located.
Multinational
companies may want to invite banks in all their countries of operation to come
into a syndication. It is important that the arranging bank(s) has presence in those
countries and is aware of the investors business who are likely to be
interested. This is generally referred to as distribution capability.
Loan
Structure
After the lead
bank/arranger gets appointed, next step is to structure the loan. This will
depend on the purpose for which the company wants the loan, the
creditworthiness of the borrower and the size of the required loan.
Term and repayment
First step to furnish
the corporate’s loan requirement is determining the tenor of the loan. The
decision varies according to the purpose of the loan and when the company
expects to draw down the funds.
For example, if the
funds are required to finance a particular project, the term should match the
duration of that project (perhaps with an extension option if there is any
delay). However, if the company views the syndication as contingency financing
(to be used either when needed or when relatively cheap), the term should be
determined within the overall context of the company’s financing strategy.
In effect, there are
two alternatives, although a loan can be structured with both elements within
it. The elements are:
1.
Term Loan aka Repayment on maturity.
These type of loans
are drawn down in full and should be repaid on the maturity at the end of the
term. This can be varied, by allowing companies either to draw down the funds
in tranches or to repay in installments over the life of the loan.
These loans are
·
Similar to Mortgage
loans
·
More structured – Only
one Initial borrowing
·
Repayment schedule –
due in installments/scheduled payments
·
Are drawn for a
specific purpose – like to fund a new project
·
Payments to borrower
will reduce the commitment made to borrower
·
The funds cannot be
re-borrowed
2.
Revolving loan.
These type of loans
are similar to credit card facility and are mainly used to fund the working
capital requirements. Under the terms of a revolving loan, the company may be
required to repay the loan in full at pre-determined points throughout the term
of the loan. Once repayment has been achieved, the terms allow the company to
draw down additional finance.
The key point is to
ensure that an appropriate repayment profile is agreed. The purpose of this
type of loan is to fund the working capital needs of a corporate and as such it
emphasize the short-term nature of the funding and impose discipline on the
liquidity management process.
These loans are:
·
Similar to a credit
card
·
Facilitate daily
transactions
·
Full commitment by
bank expires only on maturity date of the facility provided to borrower
·
Used for ongoing cash
management
·
Flexible line of
credit
Fees and pricing
There are essentially
five elements to the fees payable on a syndicated loan. These are:
1. Margin
The lenders will
charge a margin also called spread over an agreed market benchmark. In Europe, the
loans are usually agreed on one of the interbank rates in the money market,
either LIBOR or Euribor plus some spread over it. The size of the margin will
depend on the creditworthiness of the borrower usually represented by the
credit rating provided to corporate by S&P and Moody’s. The spread will normally
range from less than 50 basis points for the highest quality investment grade
borrowers to 300 basis points for the riskier leveraged buy-outs. The margin/spread
may change over the course of the loan, if the terms and conditions allow, to
represent, for example, a change in credit rating.
2. Commitment fee
A commitment fee is
charged by borrowers when a loan is not fully drawn. This is charged on the
undrawn portion of the loan and is usually spread over the same benchmark rate
as the margin. It will usually be between a quarter and a half of the drawn
margin.
3. Utilization fee
In some cases, banks
may be able to charge a small additional fee if a high proportion of the loan
is drawn. This applies to investment grade loans and reflects the fact that
banks may have to set aside additional capital to meet capital adequacy rules.
For example, this may be an additional 10 basis points if over half of the loan
is drawn.
4. Arrangement fee
The appointed lead
arranger or banks will normally receive a fee for the syndication process once the
whole process of arranging the participants and loan disbursement has been
successfully completed. This will be determined by the size of the syndication
and the associated credit risk. In some cases, other lenders will receive an
upfront fee (of only a few basis points) for participation in the syndicate.
Again, this will depend on their commitment and the risk of the credit. The
payment of these fees will depend on the nature of the relationship the bank
has with the borrower. In some cases, the arrangers or lenders will waive their
fees as part of the overall relationship.
5. Legal fees
Finally, companies
will have to meet the costs of their legal advisors. The fee is normally paid
for drafting the credit agreements and also for maintaining the financial
statement ratios for the corporate.
Underwriting
Both parties will have
to agree whether the arranger will underwrite the loan or not.
If the loan is
underwritten, the borrower will receive the full amount of the loan,
irrespective of whether the arranger has successfully syndicated the deal. If
the arranger fails, then the underwriting bank or institution has to advance the
balance of the underwritten loan.
If the loan is to be
underwritten, the arranger will usually try to involve other banks as
underwriters as part of the syndication process. Loans which are designed to
raise a certain level of funds, perhaps to finance an acquisition, are more
likely to be underwritten.
If a loan is not
underwritten, it is said to be arranged on a ‘best efforts’ basis. This means
the arrangers do not have to meet any shortfall in any unsuccessful syndication
and the borrower will receive the reduced amount. ‘Best efforts’ deals are more
likely when they are arranged on behalf of investment grade companies looking
for back-up financing (where the total sum arranged is not vital).
Action by arranging bank
Once the lead arranger
bank(s) has been appointed, it will start the process to arrange the loan
participants to sell the syndication to other banks. The number of banks
required will depend on the level of cash required to be raised and the
individual banks’ appetites for involvement.
First tier syndicate
The arranger will
usually start by approaching the other members of the company’s core banking
group. Where a company does not have a core banking group (if it is company
being spun off another), this is more complex.
Extending the
syndicate
Depending on the
interest from the core banking group and the amount needed to be raised, the
arranger may look to extend the syndicate to a broader base of banks. By
definition, these are not the members of the core banking group. Banks joining
the wider syndication may have a variety of objectives. They may see
participation as the first step towards joining the company’s core banking
group. Alternatively, they may be keen to diversify their portfolio of
investments by lending to a a completely new sector/industry. Their main
interest is to reduce the research cost.
Closing a deal
Once a sufficient
number of banks have joined the deal, the arranger will close the syndication.
At this stage, documentation is important as these loans are traded in the OTC
markets. It is important that all participants agree to the same terms and
conditions. This can take some time to negotiate. Once all parties are
comfortable, the deal will be signed.
Administrative Agent
The company will need
to appoint a bank to act as administrative agent. Normally the function is
taken over by the lead arranger. The administrative agent has two main roles:
1. It administers the collection of interest payments from the
borrower and distributes them to the lenders. This can be a complex issue as
the amounts outstanding can vary over the term of the loan as funds are drawn
down and repaid.
2. It administers any interim draw-down notices. Under the terms of
a revolving credit, the borrower is entitled to call for a draw-down of funds
at any time. In order to access these funds, all the participants in the
syndication need to provide funds. Ensuring all participants meet their
obligations is a key determinant of the success of the syndicated loan.
Secondary Trading
Once the syndication
has been closed, investors are able to trade part or all of their investment in
the secondary market. In most cases, there is a clause in the documentation
which permits this. Most transfers are made "by novation", in which
case the new lender becomes a ‘lender of record’. In these circumstances, the
new lender simply replaces the original lender. The original terms and
conditions apply, with only the bank receiving the interest payments changing.
In these circumstances, the original investors will often simply be looking to
make a fee on the trade of the loan. A small number of loans do not permit
secondary trading or transferability.
Documentation
The Loan Market
Association was formed in 1996 with the aim of fostering a secondary market in
European syndicated loans. Since then, the OTC loans secondary market has
developed relatively quickly. The LMA has standardized the documentations
required, at the heart of which is recommended form for primary documents.
Importance for lenders
The secondary market
is an important factor for lenders. Lenders know that they can manage their
exposure to a borrower by selling on part or all of their participation in a
syndicated deal. There are three key aspects to this:
1. The prospective lender is not committed to the credit for the
term of the loan. Under a revolving credit, lenders often have the option of
withdrawing from the loan after 364 days (depending on the structure of the
loan itself). However, under a term loan, the ability to trade participation in
the facility means the lender is not committed to the borrower until maturity.
2. The lender can manage its exposure to individual credits as part
of the management of its counterparty portfolio. To participate in the
syndication, a potential lender may be asked to advance a higher sum than it
would like. Alternatively, a lender may want to extend credit to another
borrower in the same industry sector although it has reached its limit in that
sector. The ability to trade part of the loan in the secondary market allows
the lender to manage its own portfolio of investments according to its overall
credit policy.
3. It offers investors the ability to recoup losses in the event
that a loan becomes ‘distressed’. Banks can sell such loans to other investors
at a significant mark down from face value. The investors in the ‘distressed’
loans are attracted by the additional returns offered in the event of full
repayment.
The key factor in all
cases is that the bank’s ability to sell loans in the secondary market reduces
the counterparty risk associated with the decision to participate in the
syndication. As a result, the secondary market enhances liquidity in the
syndicated market.
Importance for borrowers
From the corporate
borrower’s perspective, the development of the secondary market has enhanced
liquidity in the primary market and, arguably, has brought down margins for all
borrowers. This is because of the reduction in risk assumed by the original
lenders.
Some corporate
borrowers are still concerned about transferability of their loans. For the
reasons outlined above, companies need to accept that transferability has been
an important factor in the growth of the syndicated loan market. However, there
are two valid areas of concern:
1. Relationship management.
Transfer-ability makes
it much more difficult for the corporate treasurer to evaluate a bank’s
commitment to the company. Although a core relationship bank may commit to a
syndication, the company may not know whether the bank has sold any of its loan
in the secondary market. As a result, it makes it more difficult to know the
true level of commitment over time to the company. Therefore it becomes very
hard for the company to measure the level of ancillary business it awards on
the basis of the banks providing credit.
2. Renewing a facility.
Allied to this, any
attempt to renew a syndicated facility on the basis of a commitment made in the
original syndication can be complicated. Treasurers, or their arranging banks,
may be surprised that some banks do not want to participate in a second
syndication when the time comes to renew. This may make the renewal process
more complicated, although other factors such as the market conditions and the
nature of the credit will also be important.
Funding Flexibility
One of the major
reasons corporates like syndicated loans is that they represent an alternative
source of funding, providing them with additional flexibility. However, to
achieve that flexibility, the company must take care to structure the loan
appropriately. This requires careful thought about how the syndication fits within
the company’s financing structure. This then needs to be communicated to the
arranging bank(s) so that they understand the company’s objectives. Care needs
to be taken to ensure documentation is appropriate. We will examine this next
month.
