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.
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:
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.
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.
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:
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.
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.
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.
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.
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.
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.