SCL 1 Intro to Structuring Commercial Loans

Question 1

Four keys to loan structure

Answer 1

1) understand the bank’s goals
2) understanding of the client’s goals
3) Accurately identify the sources of repayment available to the client as well as the related risks of those sources.
4) choose loan elements that respond appropriately to the first three keys

Question 2

1) What’s the primary bank’s goal in structuring a loan?

Answer 2

To protect and preserve the primary repayment sources

Question 3

1) Others goals in structuring a loan

Answer 3

• make secondary and possibly tertiary sources of repayment available
• establish controls that ensure that the bank is alerted when repayment risks increase
• controls that allow the bank to bring the borrower back to the table
• establish an understanding between the bank and the borrower of expected financial behavior and outcomes.
• But the bottom line, the most important concept here, is that all of these goals serve to mitigate the identified repayment risks.

Question 4

2) Most common client goals include:

Answer 4

• financing a need or a project
• having the flexibility to run their business as needed and desired
• knowing exactly where they stand with the bank
• preserving business and personal resources for future needs

*Above all else, clients’ goals revolve around obtaining and retaining access to the capital they need.

Question 5

The bank’s and the client’s goals can be aligned by understanding that the borrower needs some flexibility and access to capital sources. So how can the bank meet this need while also staying true to its own needs?

Answer 5

1) you should construct loan elements that respond to the specific risks identified
2) impose the appropriate controls
3) require support as needed to mitigate risks, but not just as a blanket policy

Question 6

3) Number of possible repayment sources

Answer 6

• revenue that consistently exceeds expenses
• changes in the balance sheet refer to the cash impact from more efficiently managing the cash cycle
• liquidation of assets involves the sale or liquidation of a fixed or other non-current asset
• a refinance, which represents additional borrowing, is also a possible repayment source
• companies can use an injection of equity as a repayment source

Question 7

Capital Structure

Answer 7

• the combination of a company’s liability and equity accounts.
• In other words, it’s the right-hand side of a company’s balance sheet.

Question 8

4) Loan elements include:

Answer 8

• Covenants

- Restrictions

Question 9

When packaging the loan, it’s important that the loan elements:

Answer 9

• complement the goals of the bank,
  and the client
• identify the sources to be used in the repayment of the loan
• mitigate the risks posed to those repayment sources.

Question 10

SOURCES OF CAPITAL: BS SOURCES

Answer 10

• Certain changes in the balance sheet can lead to sources of capital
• A/P: By maximizing trade credit, more cash is preserved for the servicing and repayment of bank debt
• Accrued expenses: Paying payroll and other bills more slowly can preserve cash for other uses

Question 11

SOURCES OF CAPITAL: DEBT

Various types of debt that can be counted as a source of capital:

Answer 11

1) Senior revolving debt
2) Short-term revolving credits
3) Seasonal loans
4) discretionary line
5) Bullet revolvers
6) revolver/term credit loan
7) Senior term debt
8) Subordinated debt
9) owner’s/stockholders’ subordinated debt
10) Sellers’ subordinated debt,

Question 12

Senior revolving debt

Answer 12

• line of credit that allows the borrower to borrow and repay at will. In bankruptcy, this debt will be paid in full before any other indebtedness

Question 13

Short-term revolving credits (ie. seasonal lines or other lines for busines purposes)

Answer 13

• have maturities of one year or less
• only covenants are maturity and financial reporting
• Other covenants are usually not considered necessary due to the short-term nature of the bank’s exposure.

Question 14

Seasonal loans

Answer 14

• generally required to be paid out to zero or paid down to some agreed upon level in order to demonstrate that the loan is being used for seasonal purposes.

Question 15

Discretionary line

Answer 15

• Such loans are uncommitted and no regulatory reserves

- sometimes referred to as guidance lines

Question 16

Senior revolving loan types

Answer 16

1) Bullet revolvers
2) Revolver/term credit

• used for long-term, greater than one year, corporate needs. Such loans are sometimes referred to as revolvers.

Question 17

Bullet revolvers

Answer 17

• most commonly requested by larger corporations who need the liquidity of a general purpose line of credit, but want the loan to show as long-term debt on the balance sheets
• Because the loans have maturities longer than one year, it is customary to include financial covenants to monitor performance.

Question 18

Revolver/term credit loan

Answer 18

• revolving credit which converts to a term loan with predetermined payments on a stated conversion date.
• typically do not have a final term longer than seven years
• commonly used in acquisition transactions where the cash flow immediately following the acquisition is either uncertain. Once the acquisition has stabilized, the loan may term out.

Question 19

Senior term debt

Answer 19

• Unlike revolving debt, senior term debt has a life attached to it, meaning that it needs to be paid off after a predetermined amount of time.
• In the event of bankruptcy, senior term debt must be paid off before any indebtedness

Question 20

Subordinated debt

Answer 20

• often referred to as mezzanine debt
• Gets paid after senior debt gets paid
• Higher interest rate

Question 21

Sellers’ subordinated debt,

Answer 21

• essentially an IOU in which the seller takes back a note that is subordinated to the senior lender debt.

Question 22

Owner’s/stockholders’ subordinated debt

Answer 22

• cash injected into the business by the owner as a loan, and not as equity.

Question 23

OTHER SOURCES OF CAPITAL

Answer 23

Stocks

Question 24

Matching Concepts in Structuring

Answer 24

• Matching the value of the collateral to the loan amount serves to protect the bank
• Match the term of the loan to the useful life of the asset being financed by the loan
• Match availability of cash to the repayment schedule, to create a realistic opportunity for the borrower to successfully meet the repayment schedule.
• Match the covenants of the loan agreement with the business drivers specific to that company (ie. key “covenant” used to control this business driver could be the requirement that each lawyer or doctor provide a personal guaranty of the debt)
• Match the sources of cash to the tenor or length of the loan

Question 25

Four Loan Types

Answer 25

1) Seasonal loan
2) Permanent working capital (PWC)
3) Bridge loan
4) Term loan

Question 26

Seasonal loan

Answer 26

• designed to finance the seasonal working capital needs of a borrower, such as a ski and snowboard rental company.
• Often will have a cleanup or clean-down period
• Collateral is usually the company’s receivables and inventory.

Question 27

Permanent working capital or PWC

Answer 27

• finance a layer of working capital that never goes away and should be regarded as forming part of the long-term capital structure of the company

Question 28

Bridge loan

Answer 28

• provides temporary financing to bridge a gap until a specific event occurs that repays the loan. Often that event will be the sale of an asset, property, or business.
• typically interest only loan
• mature within one year
• collateral is typically the asset being financed.
• key risk is failure of the event to occur

Question 29

Term loans

Answer 29

• typically used to finance the purchase of noncurrent assets. For example, a company might acquire a thirty-year term loan in order to purchase a piece of property or equipment.
• collateral is usually the long-term asset the customer is financing
• P&I payments

Question 30

Ways to finance permanent working capital needs

Answer 30

1) Term loan
- regular amort, terms not exceeding 5 years
- include receivables and inventory as collateral
- Covenants: restrict use of proceeds, restricting other borrowings, minimum interest or DSCR or max debt to equity ratio

2) Revolving line of credit
- include receivables and inventory as collateral
- 1 to 3 years maturity
- Covenants: Borrowing base formula,
- Reporting frequency for the borrowing base with monthly reporting, quarterly reporting, or reporting at the time of every borrowing
- The bank would also enforce the ability to change eligible collateral at the bank’s decision, restrictions on use of proceeds, restrictions on other borrowings, minimum interest or debt service coverage ratio, and maximum debt-to-equity ratio.

3) Asset based loan
4) Obtain new equity

Question 31

Parowan Support offers technical support to a number of customer service industries. Parowan recently doubled its client load, requiring it to double not only its workforce but also the hardware and software it uses to serve its clients. The bank required Parowan Support to provide a borrowing base for its two-year loan. What type of loan does Parowan Support have?

Answer 31

Permanent working capital loan - Banks often require a borrowing base when financing a permanent working capital loan. This helps mitigate the risk that the borrower might not have the ability to generate cash flow over the long term.

Question 32

Red Butte Pumping needs to add two well servicing units to its fleet. The loan is set to mature in seven years with Red Butte making regular payments of principal and interest until then. The bank is holding the rigs as collateral. What type of loan does Red Butte Pumping have?

Answer 32

Term loan - A term loan generally matures within three to ten years, depending on the life of the asset being financed, and features regular payments of principal and interest, with the expectation of full repayment at the end of the term.

Question 33

Tiki’s Hawaiian Ice Shack wants to take advantage of supplier discounts while it still can, and it also needs to double its number of employees for the summer rush. What type of loan does Tiki’s have?

Answer 33

Seasonal loan - seasonal loan typically matures within one year, and features a cleanup or clean-down period. The key risk to the seasonal loan is that the bank must finance the carry-over inventory because the season doesn’t happen as expected.

Question 34

Center Equipment Suppliers is finalizing a sale of several excavators. In order to meet its capital requirements while waiting for this infusion of cash, what type of loan would best suit Center Equipment Suppliers?

Answer 34

Bridge loan - The bridge loan is typically an interest-only loan that matures within one year or less, and is designed to literally bridge a gap until a specific event occurs that repays the loan.

Question 35

Loan covenant

Answer 35

• legally enforceable promise or restriction in a loan agreement

Question 36

Covenants exist for one basic reason

Answer 36

To provide protection for the bank while enabling success for the borrower

Question 37

Loan covenants can be broken up into four categories and serve a variety of purposes

Answer 37

1) Covenants should identify key risk points in the borrower’s operating profile. For example, in order to protect the net worth of the borrower, the bank might impose covenants that restrict the sale of certain assets
2) Covenants should provide timely warning signs.
3) Covenants also bring the borrower back to the table.
4) Covenants establish expectations for both the bank and the borrower - you should only include covenants that you expect to enforce. Including covenants that can’t—or won’t—be enforced only invites confusion, negotiating lapses, and inconsistencies, especially when the banker attempts to enforce other covenants in the agreement.

Question 38

Affirmative covenants

Answer 38

Outline actions that the borrower is obligated to perform. For example, a covenant might require the borrower to maintain its financial records in a specific location where they will be available for inspection by the bank.

Question 39

Negative covenant

Answer 39

Any covenant that defines actions that the borrower is obligated not to perform. For example, a covenant might impose limitations on incurring new indebtedness, leases, or certain investments.

Question 40

Financial covenants

Answer 40

Guidelines, laid out in the loan agreement, that require the borrower to adhere to set financial limits in their operations. For example, a financial covenant might state that the borrower may not allow specific balance sheet items or ratios to fall below or go over an agreed upon limit.

Question 41

Nonfinancial covenants

Answer 41

Guidelines, as written in the loan agreement, which require the borrower to meet certain nonfinancial requirements, such as maintaining the proper business insurance.

Question 42

Goals/Objectives of Covenants

Answer 42

• Ensure full disclosure of information
• Protect net worth
• Protect cash flow,
• Protect asset quality,
• Control growth
• Maintain key management,
• Assure legitimacy
• Serve to earn a profit for the bank

Question 43

Let’s assume that Sunshine Bank gives a loan to MedicCal, a distributor of medical supplies, so it can build a brand-new warehouse for inventory storage. Sunshine Bank includes the Condition of Assets covenant in the loan. Consider the covenant shown onscreen. How, if at all, does this covenant protect the bank?

Answer 43

This covenant does serve to protect the bank. By prohibiting the borrower from selling its property, or allowing it to fall into a state of disrepair, this covenant serves to protect the bank by
ensuring the value of its designated collateral
and by requiring the borrower to communicate any and all changes in the status of its property.

Question 44

Maintaining minimum levels of cash flow can be achieved by using these financial covenants

Answer 44

• interest coverage
• minimum fixed charge coverage—including all debt service and lease payments
• debt service coverage.