IB Capital Markets Questions Flashcards
What is the difference between a bond and a leveraged loan?
Leveraged loan
- A loan is a private transaction between a borrower and a lender.
- A single bank or a small syndicate of banks or institutional investors
Interest cost is often LIBOR plus a spread, =
- The loan is often secured by collateral
with strict covenants, while the repayment of principal can happen over time or as a bullet payment at the end
- Given the collateral, earlier principal repayments, and covenants, loans are less risky and carry lower interest rates than bonds.
Bond
- Must be registered with the SEC and are public transactions.
- Bonds are issued to institutional investors and traded freely on the secondary bond market, leading to a broader investor base.
- Bonds are usually priced at a fixed rate with semi-annual payments, have longer terms than loans, and have a balloon payment at maturity.
- Since bonds come with less restrictive covenants and are usually unsecured,
they’re riskier for investors and therefore command higher interest rates than loans
What is the difference between investment-grade and speculative-grade debt?
Investment-Grade Debt: Investment-grade debt (often called high-grade debt) has a credit rating above BBB/Baa. This category of debt is issued by companies with a strong credit profile. Investment-grade debt
is considered safe, given the low risk of default.
Speculative-Grade Debt: Speculative-grade debt has a credit rating below BB/Ba. These types of debt are issued by more leveraged companies with a riskier credit profile. Given this increased risk of default and bankruptcy, the interest rates on these riskier debts will be significantly higher to compensate investors for taking on the additional risk.
What does it mean when a debt tranche is denoted as 1st lien or 2nd lien?
A lien is a legal mechanism that grants the lienholder the right to claim or take possession of specific property as security for an outstanding debt or obligation. It ensures that the creditor (one who has given something to someone else) has a legal interest in the debtor’s property until the debt is paid or the obligation is fulfilled……
Lien is defined as the seniority and the priority of payment to a debt holder relative to the other tranches. A lien is a legal claim against the assets of a borrowing company (i.e., used as collateral) and the right to seize
those assets first in forced liquidation/bankruptcy scenarios.
1st Lien Debt: The highest seniority, fully secured by the company’s assets and has the first claim to collateral in a liquidation/bankruptcy scenario (e.g., revolver, term loans).
2nd Lien Debt: Right below 1st lien loans sits 2nd lien where compensation is provided only if there’s collateral value remaining once 1st lien lenders are repaid in full. These debt types are riskier and more expensive for borrowers (e.g., high-yield bonds, mezzanine financing).
Tell me about the different classifications of term loans.
Term Loan A (TLA):
Lenders: Syndicated to banks (often alongside a revolving credit facility).
Amortization: High, straight-line amortization (equal payments over the loan term).
Tenure: Shorter (~5 years).
Use Case: Common in less leveraged transactions due to stricter covenants and faster repayment.
Term Loan B/C/D (Institutional Term Loans):
Lenders: Syndicated to non-bank institutional investors (hedge funds, CLOs, insurance companies).
Amortization: Minimal (“bullet payment” at maturity), with nominal annual amortization.
Tenure: Longer (7-10 years).
Use Case: Preferred in LBOs for flexible covenants, lower amortization, and longer maturities.
Note: “B/C/D” denotes investor base (not seniority). Terms become more flexible with later letters (e.g., Term Loan D vs. B).
Key Differences:
Covenants: TLAs have stricter covenants; TL B/C/Ds are “covenant-lite.”
Repayment Pressure: TLAs require steady cash flow for amortization; TL B/C/Ds prioritize terminal cash flow for bullet payments.
Risk Profile: TL B/C/Ds are riskier for lenders (longer terms, bullet payments) but cheaper for borrowers.
What is the difference between a secured and unsecured loan?
Secured Loans: If a debt instrument is secured, that means the debt is backed by collateral. The assets of the borrower were pledged as collateral to get favorable financing terms. If the company were to go
bankrupt, the lenders have a legal claim on the pledged collateral. Leveraged loans are secured by collateral and are the safest security class for a lender. Most term loans and revolvers in the leveraged loan
market are syndicated to institutional investors such as hedge funds, CLOs, and mutual funds.
Unsecured Loans: For unsecured loans, pension funds, mutual funds, insurance companies, hedge funds, and some banks are typically willing to invest in this relatively riskier type of debt for the higher yield.
How are leveraged loans usually priced?
Leveraged loans are usually priced off LIBOR plus a spread. In addition, loans often include a LIBOR floor, so an
example would be a pricing of “LIBOR + 3%” (300 basis points) with a LIBOR floor of 2%, so the interest rate can never dip below 5%.
What does LIBOR stand for?
“London Interbank Offered Rate,” representing the global standard benchmark used to set lending rates. LIBOR is the rate at which banks lend amongst each other.
For lenders of debt instruments with
floating rates, the debt pricing will be based on LIBOR, the standard interest rate.
However, LIBOR is expected to fade away in use as UK regulators have voiced a desire for LIBOR to be phased out by the end of 2021.
What is SOFR, the expected replacement of LIBOR?
Coming up on the horizon and expected to replace LIBOR eventually, the Secured Overnight Funding Rate (SOFR) is a measure of the borrowing costs of cash collateralized by Treasury securities. Said another way, the
SOFR is a Repo-based funding rate of the observed transactions overnight.
In terms of debt terminology, what does the coupon rate mean?
The coupon rate simply refers to the annual interest rate (“pricing”) paid on a debt obligation. The interest
expense is based on the outstanding principal amount and is modeled as a percentage of the beginning and
ending balance of the relevant debt tranche. In terms of payment dates, senior bank debt pays interest each
quarter, whereas most bonds pay interest on a semi-annual basis.
What is a debt tranche
The “debt portfolio” concept highlights how issuers use tranching as a strategic tool to structure their debt offerings in a way that maximizes capital inflow while balancing investor preferences. It’s not just about raising funds—it’s about doing so efficiently by tailoring the debt structure to meet market demand.
How does the coupon on a bond differ from the yield?
The coupon represents the annual interest rate paid based on the notional principal of the bond (par value), while the yield is the annual return on the bond, including the coupon payment adjusted for the premium or discount of the purchase price when held to maturity. One difference is coupons are fixed for the bond’s term, whereas
yields move with the markets.
Fixed elements:
Coupon rate
Par value (principal)
Maturity date
Coupon pmt amount
Variable elements:
Bond prices (IR, credit risk, supply/demand)
Current yield (coupon/bond price)
YTM (changes as the bond’s price move)
Coupon Rate (Floating-Rate Bonds), coupon adjusts periodically based on a benchmark rate (e.g., SOFR) plus a margin. Payments rise or fall with market rates
Nominal principal (par value) is fixed, but inflation erodes its real purchasing power over time
Secondary market dynamics: investors buying/selling bonds before maturity are exposed to price volatility and reinvestment risk
What does it mean when a bond is trading at a discount, par, or premium?
Discount: Price < 100, Yield is Greater than Coupon
Par: Price = 100, Yield is Equal to Coupon
Premium: Price > 100, Yield Less Than Coupon
What is the difference between a fixed and floating interest rate?
Fixed Interest Rate: A fixed interest rate means the interest expense to be paid is the same regardless of changes to the lending environment. A fixed interest rate is more common for riskier types of debt, such as
high-yield bonds and mezzanine financing.
Floating Interest Rate: A floating interest rate is tied to LIBOR plus a specified spread (i.e., LIBOR + 2-4%). This pricing type is seen more often for senior debt tranches (e.g., term loans, revolvers).
When would an investor prefer fixed rates over floating rates (and vice versa)?
If interest rates are expected to fall in the near-term future, investors would prefer fixed rates. However, if interest rates are expected to increase, investors would prefer floating rates.
What are some different debt amortization schedules?
Refers to the amount of principal the borrower must repay annually. Compliance with this payment schedule is mandatory and not optional for the borrower.
Types of Debt Amortization Schedules:
Bullet Maturity: The entire loan payment is due at the end of the loan’s lifespan
Straight-Line Amortization: Principal payments must be repaid in equal installments until maturity.
Minimum Amortization: Entails lesser amounts of annual payments (e.g., ~5-10% per year) – therefore, the entire principal will not have been paid off at maturity.
What is a callable bond and how does it benefit the issuer or borrower?
Can be redeemed by the issuer prior to its maturity, with the decision being at the issuer’s discretion. A callable bond enables the issuing company to pay off the debt earlier if they have more free cash
flow remaining in the period and can refinance at lower interest rates.
From the investor’s perspective, a callable bond gives more optionality to the issuer, so the debt holders are compensated with higher interest rates (compared to non-callable bonds).
When would the prepayment optionality of certain debt tranches be unattractive to lenders?
If the borrower pays more principal off early, the annual interest payments (inflows to the lender) in the future are reduced since interest is based on the beginning and ending balance of the debt outstanding.
A bond has a call protection clause of NC/2. What does this mean?
NC/2 means the bond has call protection for two years. Once this two-year period has passed, the borrower can repay the debt along with the prepayment penalty fee.
How it works:
- HYBs will have call protection clauses that last two or three years (denoted as NC/2 and NC/3)
- Some are often NC/L, which means the bond is not callable for the term’s entire duration.
Once a bond becomes callable, the borrower may repay some (or all) of the debt balance and pay less interest. The caveat is that the prepayment penalties could offset those savings on interest – thus, HYB’s classification as an expensive financing source.
What is a revolving credit facility and what purpose does it serve to the borrower?
It’s not like a one-time loan; instead, it’s always available (within limits) to address short-term financial gaps. However, excessive use of a revolver can lead to accumulating interest and financial strain over time
The revolver refers to a company’s revolving line of credit drawn down when the
free cash flow being generated is insufficient.
The revolver acts as a “corporate
credit card” for urgent situations. The borrower typically draws from the revolver
to meet its short-term working capital requirements after an unexpected,
temporary shortage in liquidity. Ideally, the lender doesn’t want the revolver fully
drawn frequently as it signals a deterioration in cash flows.
(The revolver provides the
borrower with the optionality to
drawdown, repay, and reborrow on an “as-needed” basis.)
What is the undrawn commitment fee associated with revolvers?
A revolver typically comes with a small < 1% fee, which is an annual fee paid out to the lender. The borrower is charged an annual fee on the unused amounts, called the undrawn commitment fee.
What is the difference between an asset-based loan and a cash flow revolver?
The maximum amount that can be drawn from an ABL revolver is based on the company’s liquid assets. Thus, the amount is tied to borrowing-base lending formulas to limit borrowing to a certain percentage of the collateral – most often inventory and accounts receivable (e.g., 80% of A/R + 65% of Inventory)
VS
The maximum amount that can be borrowed for cash flow revolvers is tied to the borrower’s historical and
projected cash flow generation. Therefore, covenants are more restrictive due to the uncertainty around future
cash flows. Unlike physical assets such as inventory, a company’s future cash flows cannot be pledged as
collateral or seized in bankruptcy, hence its less favorable terms.
Why do revolvers normally not have a leverage test?
Revolvers will only have an interest coverage ratio test (e.g., > 2.0x EBITDA/Cash Interest) and have the simplest covenant structure relative to other tranches of debt. This is because the revolver has the highest priority in the capital structure and has a priority claim to the borrower’s assets.
Therefore, the lender that provided the revolving credit line is unconcerned if the borrower raises additional
debt, since this means the company has more cash available (on which the revolver has the first claim). In the
scenario that the borrower undergoes bankruptcy, the revolver will almost certainly be made whole.
What is unitranche debt and its benefits?
Definition: Hybrid Structure: Combines senior and subordinated debt into a single tranche with a blended interest rate (between senior and subordinated rates).
Single Lender: Typically provided by non-bank institutional lenders (e.g., private credit funds), streamlining negotiations.
Simplified Process: Single set of loan documents and covenants (vs. separate agreements for senior/subordinated debt).
Faster closing due to reduced coordination between lenders.
Cost Efficiency: Blended interest rate often lower than layered senior/subordinated debt structures.
Flexibility: Customizable terms (e.g., repayment schedules, covenants) tailored to borrower needs.
Reduced Complexity: Avoids inter-creditor disputes common in traditional multi-tranche deals.
Use Cases:
Middle-market companies prioritizing speed and simplicity over marginal cost savings.
Acquisitions or growth initiatives requiring streamlined financing.
Trade-Off:
Blended rate may be slightly higher than pure senior debt but offsets this with administrative ease.
What is the difference between a bond’s coupon rate and the bond’s current yield?
The coupon rate (“nominal yield”) represents a bond’s annual coupon divided by its face (par) value. The current yield on a bond equals the bond’s coupon payment divided by the bond’s price.
For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate, a current yield of 6.7% ($6/90).
While the coupon rate is always the same, the current yield fluctuates based on the
market price of a bond.
What is the difference between current yield and yield to maturity?
Current yield on a bond equals the bond’s coupon payment divided by the bond’s price
(not the true yield of a bond as it doesn’t capture any yield associated with
principal recovery nor it assume the reinvestment of coupon payments.)
YTM is the internal rate of return of a bond. YTM considers coupon payments, principal recovery, assumes reinvestment at the same rate (an iterative process), and time to maturity.
(Every coupon payment is reinvested at the same rate as the YTM.
The reinvested coupons grow over time, contributing to the total return.)
Could you define fixed income and name a few examples?
Provide their investors with a stream of fixed periodic interest payments and then the
return of principal at the end of its term.
The fixed amount of interest is paid in the form of coupon payments, usually semi-annually.
While all bonds technically fall under fixed income, fixed income usually refers to low-
return, low-risk bonds (as opposed to mezzanine financing and HYBs).
Examples include treasury notes,
treasury bonds, treasury bills, municipal bonds, money markets, and certificates of deposits (CDs).
What does the money market refer to and what is the typical maturity range?
The money market refers to the purchase and sale of large quantities of short-term bonds and other debt instruments overnight.
The maximum maturity of these short-term bonds is 397 days (~13 months), and the
investors are usually risk-averse with limited risk appetite.
What are the two main classifications of money market accounts?
- Government Money Market Funds: T-Bills, Discos (Agency Discount Notes, Reverse Repo)
- Prime Money Market Funds: Short-Term Bonds, Commercial Paper, Certificates of Deposits
What is a municipal bond and what is the one distinct benefit it has for investors?
A municipal bond is a debt instrument issued by a state, municipality, or county to finance its capital expenditures needs, including construction needs, road developments, parks, highways, and other public
projects. “Munis” could be viewed as loans that investors make to local governments – and for doing so, these bonds are exempt from federal taxes and most state/local taxes.
What is the difference between coupon bonds and discount bonds?
Unlike coupon bonds, zero-coupon bonds (discount bonds) make no payments between issuance and maturity and are priced at a discount to their face value.
What is the difference between Macaulay duration and modified duration?
Macaulay duration is the weighted average timing of the present value of all the cash flows, typically denoted in years.
The modified duration indicates the percentage change in a fixed income
instrument’s price given a 1% interest rate change – by making a slight adjustment to Macaulay’s duration to reflect the price movement given a change in yield.
For example, a 10-year bond with a modified duration of 8 would lose 8% in price (say from par or $100 to $92) if the yield increased from 1% to 2%.
What is the relationship between duration and the coupon?
The duration of any coupon-bearing bond will be less than its years to maturity, as there are coupon payments between now and maturity.
Lower Coupon → Longer Duration: The lower the coupon, the longer the duration is and closer the duration is to maturity. The impact of each coupon payment to shorten the payment is reduced.
Higher Coupon → Shorter Duration: The higher the coupon, the shorter the duration. Each coupon payment has a higher cash flow, which shortens the duration.
What is convexity used to measure?
Convexity is a measure of the relationship between the price of a bond and its yield.
High convexity portfolio would be more sensitive to interest rate fluctuations.
What are the three types of covenants found in lending agreements?
Affirmative Covenants: These covenants require that the obligor (borrower) of the debt to perform certain specific tasks. Examples of affirmative covenants are meeting financial reporting requirements, paying taxes, being insured, maintaining licenses/permits, and legal compliance.
Negative Covenants: These covenants restrict the obligor of the debt to refrain from certain specific tasks such as issuing dividends, raising debt, acquiring another company, or pledging assets as collateral.
Financial Covenants: For financial covenants, there are two types: 1) maintenance and 2) incurrence covenants. Maintenance covenants are usually included in credit agreements (bank loans), while
incurrence covenants are included in indentures (bonds).
What is the purpose of covenants in debt financing?
Covenants are contractual agreements between lenders and borrowers meant to protect the interests of the lending parties. Failure to comply with these covenants or breaching a covenant can cause the borrower to be placed into default, allowing lenders to seize the borrower’s assets. Debt-holders desire assurance of the full receipt of their due payments with a high level of certainty and restricting the borrower into making only risk-averse decisions and maintaining healthy credit statistics decreases the risk of not being paid back.
What are maintenance covenants and provide some examples?
The objective of maintenance covenants is to ensure the borrower maintains sufficient profitability and cash flows to service debt payments. Compliance with maintenance covenants is tested each quarter.
Examples of Maintenance Covenants:
Total Debt/EBITDA must remain below 5.0x
Debt/Equity must never exceed 2.5x
Interest Coverage Ratio cannot fall below 3.0x
These parameters will change depending on the prevailing market conditions and be industry specific.
What are incurrence covenants and give some examples?
The purpose of incurrence covenants is to prevent the borrower from taking specific actions that could put the lender’s payback at risk. Compliance with incurrence covenants is tested when taking a specific action (e.g.,
new debt issuance, dividends, acquisition)
Examples of Incurrence Covenants:
- Restricted from making acquisitions or divesting one of its business segments (or major assets)
- Prevented from raising additional debt, especially if it has higher seniority than the covenant holder
- Cannot distribute dividends to equity shareholders without the approval of the lenders
What is one key difference between maintenance and incurrence covenants?
Maintenance covenants are subject to periodic tests, typically completed at the end of each quarter. The borrower must routinely prove its compliance with its maintenance covenants to avoid default.
Incurrence covenants are tested only once a certain action or event “triggers” it.
Leveraged loans have become increasingly “covenant-lite,” what does this entail?
Definition: Covenant-Lite Loans: Secured 1st lien loans with less restrictive covenants, primarily incurrence covenants rather than traditional maintenance covenants.
Characteristics:
Compliance Tests:
- Triggered only by specific borrower actions (e.g., raising additional debt, issuing dividends).
- Unlike maintenance covenants, they are not tested periodically (e.g., quarterly financial ratios).
Borrower Flexibility: Provides borrowers with greater operational freedom and reduced risk of covenant breaches.
Reason for Trend:
Competitive Pressure: Large banks have adopted covenant-lite structures to compete with institutional lenders like private credit funds, which offer more borrower-friendly terms.
Implications:
For Borrowers: Easier to manage and less restrictive financing terms.
For Lenders: Higher risk exposure due to reduced oversight and weaker protections in case of financial distress.
What are subordinated notes?
Characterized by longer tenors (duration) and higher-interest rates that compensate investors for undertaking more risk. This layer of debt enables the borrower to increase leverage beyond what risk-averse
institutional banks will provide. While subordinate notes have a higher cost of capital relative to bank debt and
don’t allow prepayments, these notes come with less restrictive covenants.
What are the characteristics of mezzanine financing?
Mezzanine financing refers to the layer of financing that lies in between traditional debt and common equity. This category is the lowest form of debt in the capital structure and includes preferred stock, convertible debt, bonds coupled with warrants. All mezzanine debt is unsecured and will be of smaller magnitude relative to the
other parts of the capital structure.
The debt terms involved in mezzanine financing are highly negotiated, flexible, and tailored to meet the specific needs of both parties. The interest rates are the highest compared to other less risky tranches and debt, with the option for interest to be paid-in-cash or payment-in-kind (PIK). Also, the conversion feature that some of these securities carry provides the holder with the optionality to partake in the upside potential of the equity (and create dilution for common shareholders).
What are bridge loans?
Bridge loans provide interim financing should the required debt commitments not be available by the closing of the deal (i.e., the borrower could not secure a firm commitment letter from lenders). Investment banks that can do so will provide this type of bridge loan commitment to prevent a transaction from stalling and give assurance that sufficient funding will be available to close the deal.
What is staple financing and which type of lender provides it?
Definition:
Staple financing is a pre-arranged debt package provided by the sell-side investment bank to potential buyers in an acquisition.
The financing details are “stapled” to the back of the acquisition term sheet, offering buyers a clear financing option.
Key Features:
Typically arranged by large, institutionalized investment banks (e.g., J.P. Morgan, Goldman Sachs).
Includes terms such as loan principal, interest rates, fees, and covenants.
Buyers can either use the staple financing or negotiate alternative terms with other lenders.
Benefits:
For Sellers:
Increases competition by ensuring all bidders have access to financing.
Expedites the sale process and can drive up the sale price through more aggressive bidding.
For Buyers:
Simplifies financing by providing a ready-made package.
Saves time, allowing buyers to focus on due diligence and bid preparation.
Potential Drawbacks:
Conflict of Interest: The sell-side bank serves both the seller (as an advisor) and the buyer (as a financier), raising ethical concerns.
Not Mandatory: Buyers are not obligated to use the staple financing and may seek better terms elsewhere.
Use Cases:
Common in mergers and acquisitions to streamline bidding and ensure competitive offers.
Particularly useful when buyers may struggle to secure independent financing quickly.
What is a firm commitment letter?
Once a financial sponsor or a strategic buyer has met with the target’s management team and has proceeded with submitting an LOI, the next step is to get a firm commitment letter from its lender(s). This is done to gain
credibility as a buyer, as the most credible bids are the ones with financing commitments prepared with the
initial debt terms outlined.
How does a highly confident letter differ from a firm commitment lender?
From both the buyer and seller perspective, committed financing is preferred as the lending bank is practically guaranteed to fund it upon closing. Alternatively, highly confident letters mean the lender believes it can raise the amount of capital required, but they’ll not commit to it (and not backstop it with their balance sheet).
Other than covenants, what provisions can be included to protect lender interests?
These provisions collectively safeguard lender interests by mitigating risks and ensuring repayment viability even in adverse scenarios.
Material Adverse Effect (MAE) Clauses:
Lenders can withdraw their commitment if a significant adverse event occurs that raises doubts about the borrower’s ability to repay.
Commonly included in commitment letters to protect lenders from unexpected risks.
Security Agreements:
Provide lenders with a security interest in collateral, ensuring they can seize and sell assets if the borrower defaults.
Collateral can include tangible assets (e.g., property, equipment) or intangible assets (e.g., patents, receivables).
Guarantees:
A third party (e.g., parent company or key executives) agrees to repay the loan if the borrower defaults, adding an extra layer of protection.
Default Provisions:
Specify conditions under which the lender can declare a default, such as nonpayment, covenant breaches, or inaccuracies in borrower representations.
Include remedies like accelerating loan repayment or foreclosing on collateral.
Yield Protection Provisions:
Protect lenders from increased costs due to changes in laws or taxes (e.g., gross-up clauses for withholding taxes).
Include breakage costs for prepaying loans early, ensuring lenders are compensated for potential losses.
Closing Conditionality:
Lenders may include conditions precedent to closing, such as satisfactory due diligence or third-party approvals, ensuring they lend only under favorable circumstances.
Indemnities:
Borrowers indemnify lenders for transaction-related costs (e.g., legal fees) and liabilities arising from the loan agreement.
What is commercial paper and which types of companies issue them?
Commercial paper is issued by large corporations with high credit ratings as short-term borrowing to finance
their working capital needs. The typical commercial paper term is ~270 days, and the debt is issued at a discount (i.e., zero-coupon bond) as an unsecured promissory note. The minor concern associated with commercial paper is that they’re unsecured, meaning they’re not backed by any collateral. Therefore, only large corporations issue this type of debt as they have strong credit ratings.
Besides market risk, name some other risks that bond investors face?
Default Risk: Default risk means the borrower’s creditworthiness has decreased from deteriorating financial performance, and most often, it coincides with a downgrade from a credit agency. The higher the credit rating, the lower the probability of default.
Liquidity Risk: Next, liquidity risk refers to when the ability of the bond to be exchanged has unexpectedly decreased. This means that the number of potential buyers in the market has diminished (e.g., changing lending conditions, unexpected company-specific circumstances).
Event Risk: Finally, event risk pertains to specific events such as M&A or legal investigations that could change the risk of holding a particular bond. For example, if the SEC announces they have started an investigation into a company for fraud, this would have an immediate negative effect on all stakeholders.
Tell me about the debt lender and equity investor “story disconnect.”
In the best case scenario, lenders
receive all interest payments and repayment of debt principal, whereas equity owners theoretically have unlimited upside.
This disconnect between debt lenders and equity investors is due to lenders being
“backward-looking” and focused on how the company has performed historically.
Additional:
Particular attention is paid to signs of cyclicality in the borrower’s performance and
how it was affected by the latest recession. This is because debt lenders are more
concerned with the downside case. After all, even if the company performs well, the
lenders don’t get to participate in the upside alongside the equity investors.
Thus, the continued generation of the borrower’s cash flows to satisfy debt
obligations is of the utmost highest importance to debt investors.
When a company is raising capital, why is the lender’s case usually less optimistic than the projections shown to raise interest from equity investors?
While they must show that the company can meet the debt obligations to be approved for financing, there’s no rational reason for a sponsor to stretch its assumptions beyond this.
A distinction when dealing with lenders is that there’s little incentive to show aggressive assumptions. Thus, lender case forecasts are lower than the base case for the debt covenants to be set off a lower base.
Debt covenants are usually based on this metric of EBITDA – thus, the EBITDA provided to lenders is the starting point. A higher EBITDA as the starting point means a higher EBITDA level is required to abide by the
covenants. Then, future covenants will be based on quarterly projections of this initial EBITDA.
Therefore, the borrower should desire a sufficient “cushion” to operate where, even if its EBITDA were to drop in an economic downturn, the covenant would still not be breached.
What does refinancing risk involve?
Refinancing (a process through which a company can reorganize its financial obligations by replacing or restructuring existing debts) risk is the concern that a borrower cannot refinance its debt obligations at the same (or similar)
rate as before.
For example, the credit rating of the company may have been demoted, and lenders are no longer willing to refinance at the same rates.
From the perspective of an investor, what is the interest rate risk in reference to?
Interest rate risk becomes a consideration for bonds with longer maturities. For instance, the market rates constantly change, and the lending environment could turn more favorable (interest rates could decrease).
If an investor is locked into a long-term bond, they’ll face more interest rate risk due to the longer maturities. Therefore, the investor would demand a higher yield to compensate for the additional risk taken on by agreeing to a long-term arrangement.
Prepayment risk (often called reinvestment risk) is the risk that a lender takes on when allowing the borrower to pre-maturely paydown a particular debt. For example, if a borrower has pre-paid their loan and the lender has received the initial principal back – the lender must search for a new borrower.
However, there’s the risk that the credit market has become less favorable to lenders, and the lender may not
achieve the same yield as before. For this reason, many lenders will not allow the optionality for prepayment, or if they do, they’ll attach prepayment penalties as compensation for taking on the risk of having to reinvest at the current market rates (which could be significantly lower).
Define this process of Prepayment risk (or reinvestment risk)
- What Happens When the Borrower Pays Down the Principal Early?
When a borrower pre-pays their loan, the lender receives the principal amount back earlier than anticipated. This disrupts the lender’s original plan for earning interest over the life of the loan. Loans are typically structured to provide lenders with steady interest income over time, so early repayment cuts short that stream of income. - Why Does the Lender Need Another Borrower?
Once the original borrower repays their loan early, the lender now has cash (the returned principal) that they need to reinvest to continue earning returns. However:
Finding a new borrower to lend money to isn’t always immediate or guaranteed.
The terms for new loans may not be as favorable as the original loan, especially if market interest rates have dropped since the initial loan was issued. - The Risk for Lenders
If interest rates have decreased, the lender might only be able to issue new loans at lower rates, reducing their potential income compared to what they were earning on the original loan.
If they cannot find a suitable borrower quickly, the cash returned from prepayment may sit idle and not generate any income.
This is why prepayment risk is significant for lenders—they face uncertainty about reinvesting returned principal at an equivalent or better rate of return.
In mezzanine financing, what is an “equity kicker”?
Is often issued as a “deal sweetener” for new debt issuances. Through the inclusion of an
equity kicker, mezzanine investors can often increase returns by an extra 100-200 basis points. In return, the cost of financing can be brought down to allow the borrowing company to secure better terms.
“Equity Kicker” Types
Warrants: Warrants function similar to employee stock options such that the mezzanine investors have the option to exercise their options and turn them into common stock if profitable. This usually amounts to 1-2% of the total equity of the borrower.
Co-invest: Mezzanine investors may seek the right to co-invest* equity alongside the controlling shareholder, such as the financial sponsor in the case of funding an LBO.
Conversion Feature: If the debt or preferred stock is structured as convertible, the investor has the option to…
1) participate in the common equity’s upside
or
2) continue to receive interest or dividends.
(*a minority investment made by the co-investor into a company. The investment is made alongside a financial sponsor. An example of a co-investor includes institutional investors such as an insurance company, pension fund, or endowment.)
