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Corporate Finance: SGS 8: Loan Finance INDEX OF ABBREVIATIONS
- RIE - Recognised Investment Exchange
- IPO - Initial Public Offering
- PR - Prospectus Rules
- LR - Listing Rules
- DTR - Disclosure Guidance and Transparency Rules
- LP - Listing Principles
- PLP - Premium Listing Principles
- FSMA 2000 - Financial Services and Markets Act 2000
- RAO - Financial Services and Markets Act 2000 Regulated Activities Order 2001
- FPO - Financial Services and Markets Act 2000 Financial Promotions Order 2005
- MAR - Market Abuse Regulations
- CJA - Criminal Justice Act 2002
- FSA - Financial Services Act 2012
- UK CGC - UK Corporate Governance Code
- RCF - Revolving Credit Facility
- LSE - London Stock Exchange
- AIM - Alternative Investment Market
- FCA - Financial Conduct Authority
- MAC - Material Adverse Change
- EoD - Event of Default OVERVIEW OF BANKING SYSTEM
- Individuals - Deposit money with banks through savings/current accounts - banks use money deposited with them to lend to other individuals/companies and invest in securities.
- Banks - Act as conduit for lending - take money deposited with them and lend it to other individuals/companies and/or invest in securities.
- Interbank Market - Banks seeking to provide loans but which lack sufficient funds to make the loan may borrow money from other banks with surplus deposits in order to fund provision of loan to the 3rd party.
- London Interbank Offered Rate (LIBOR) - Rate at which banks in London are prepared to lend to each other - determines amount of interest a bank will pay on amounts it borrows from other banks.
- LIBOR rate can affect rate of interest paid by borrower (i.e. individual/company) as bank will seek to pass on cost of interbank loan to its own customers.
- Interest periods in loan agreement between bank/borrower mirrors those applicable to bank's own interbank loan so that bank immediately able to pass on changes in interest payable on interbank loan to its borrower's.
- Business Relationships - Bank will seek to maintain relationships with key customers in order to enhance bank's ability to sell products to such borrowers in future + increase chances of becoming that customer's 'relationship bank' (bank to which borrower first turns when requiring loans/financial products).
- Importance of customer to the bank + extent of bank's desire to preserve relationship with that customer will influence what action bank takes in respect of that customer (e.g. how bank deals with occurrence of event of default under loan agreement).
- Credit Risk - Lending bank takes risk that borrower will not be able to satisfy interest/capital repayment obligations
- banks seek to mitigate against credit risk by: (a) conducting due diligence on potential borrower before agreeing to make the loan (including source of funds borrower will use to make capital/interest repayments); (b) drafting loan agreement to include provisions which will increase likelihood that bank will be able to recover sums due to it before borrower becomes insolvent (e.g. events of default + security + guarantees); and (c) demanding higher rate of interest (i.e. greater returns for bank) as condition of entering into higher risk loans.
- 'Recourse' - Bank's claim on certain assets in order to ensure repayment of loan - bank must ensure it has recourse to sufficient assets to enable it to recover amount lent to borrower (i.e. security over assets of borrower).
- Lending to Corporate Group - Subsidiary company may operate business of group + generate revenue + own productive assets whilst holding company merely holds shares in subsidiaries + does not conduct business on its own account.
- Bank lending to non-business operating holding company must determine, in course of due diligence, how holding company will acquire funds to repay loan (e.g. via dividends paid to it by revenue generating subsidiaries) +
location/ownership of assets over which it may take security + may demand guarantees from subsidiaries.
- Bank Profits - Amount by which price of financial products provided by banks exceeds cost to bank of providing those products.
- LIBOR Rate Fluctuations - Rate of interest payable on an interbank loan as determined by LIBOR may fluctuate during life-time of loan - increase in rate of interest payable by bank on its interbank loan may wipe-out bank's profits on loans made at fixed rate of interest where cost of interbank borrowing to fund that loan exceeds amount recovered by way of interest from the borrower. 1
- 'Cost-Plus' Loans - Used by banks to mitigate against risk of increases in LIBOR - interest rate on loans made by banks to customers is variable and is calculated as sum of LIBOR + bank's other costs (mandatory costs) +
bank's profit (margin) - interest rate payable by the customer will vary as LIBOR/mandatory costs fluctuate but bank's margin will remain fixed in order to generate consistent revenue stream for lending bank.
- Lender-Borrower Relations: Lender's Perspective - Bank takes credit risk whenever it makes it a loan + takes measures to minimise credit risk based on assumption that borrower will remain virtually the same entity with same assets throughout duration of loan and bank will attempt to draft loan agreement to provide it with power to ensure that this remains the case (e.g. change of control + change of business + substantial transaction clauses + undertakings +
financial covenants etc.).
- Lender-Borrower Relations: Borrower's Perspective - Borrower seeks to obtain loan finance at cheapest possible rate with maximum degree of flexibility/least amount of lender interference or control over the borrower.
- Bargaining Positions - Relative bargaining strengths of parties will vary according to state of lending market - lenders in stronger position where borrowers are seeking funds (higher fees/interest rates + more restrictive covenants in loan agreement) BUT borrowers in stronger position where banks are keen to lend money (lower fees/interest rates +
less restrictive covenants in loan agreement). TYPES OF LOAN FACILITY (1) Overdraft
- Characteristics - Overdraft allows borrower to borrow money by 'overdrawing' on balance of their account up to a specified sum + interest charged on daily overdrawn balance of the account.
- Borrower can repay, in whole/part, the balance of the overdraft and then draw on it again up to the specified amount.
- Overdrafts usually an UNCOMMITTED FACILITY where bank NOT obliged to continue lending under terms of contract and retains discretion as to whether/not to advance funds to borrower.
- Overdraft usually granted on bank's STANDARD TERMS + CONDITIONS which are NOT negotiated between the parties + requires very little formal documentation with a FACILITY DOCUMENT being the only document produced in majority of cases.
- Accounting for Overdrafts - Overdraft is legally REPAYABLE ON DEMAND so bank does NOT have to wait for an event of default/breach of overdraft agreement/prescribed period of time before demanding repayment of overdraft means overdraft listed as CURRENT LIABILITY on borrowing company's balance sheet.
- Function - Overdraft used as short-term measure to assist cash flow by providing reserve of readily available funds to meet any shortfalls in borrowing company's working capital.
- Known as 'WORKING CAPITAL FACILITY' due to use as means of ensuring that borrowing company has funds available to allow it to continue to operate its business even where it is facing a lack of working capital/cash flow issues. (2) Term Loan
- Characteristics - Term loan involves lender providing fixed amount of funds to borrower over a fixed period of time with funds advanced repayable by the end of the fixed term in accordance with agreed repayment timetable as set out in loan agreement.
- COMMITTED FACILITY whereby bank obliged by terms of loan agreement to advance funds with no discretion as to whether/not to lend and repayments of capital prior to final repayment date are final and cannot be redrawn by borrower.
- Borrower charged interest on amount of funds advanced throughout duration of loan.
- Repayments - Schedule of repayments set out in loan agreement + can be structured in different ways: (a) Amortisation - Repayment of regular amounts at fixed regular intervals throughout term of loan. (b) Balloon Repayment - Repayment over several instalments throughout term of loan but with a final larger repayment at the end of the loan term. (c) Bullet Repayment - Repayment of whole of capital sum borrowed in 1 or 2 instalments at the end of the loan term.
- Function - Term loan most appropriate where borrower requires specific sum of money in connection with specified event and seeks to use loan to provide the capital required in the short-term, whilst using a prospective regular source of income/revenue to repay the loan over the medium/long-term (e.g. property purchase/acquisition of another company/expansion of business). (3) Revolving Credit Facility (RCF)
- Revolving Credit Facility (RCF) - Commitment by a bank to lend to borrower on a recurring basis, over a defined period on pre-determined terms so that a specific amount of money is available to borrower over a specific period (e.g. 3-5 years).
- Allows borrower to draw down and repay tranches of money (up to specified amount) as/when it chooses during the loan period with no fixed amount of money advanced to the borrower at outset of loan and no pre-established timetable for repayment of the loan.
2 - Characteristics - Loan monies made available by lender for set AVAILABILITY PERIOD (duration of the RCF) and within that period the borrower elects when to borrow individual loans of a size determined by the borrower (up to specified de minimis/de maximus limits) for an INTEREST PERIOD (usually 1-6 months).
- Borrower drawing down a loan under an RCF must repay the loan by the end of the interest period UNLESS the loan is rolled over for another interest period.
- Total amount outstanding on an RCF will vary as capital repaid + new loans drawn down.
- Different interest periods can run concurrently where borrower has drawn down different portions of RCF funds at different times with different interest periods.
- COMMITTED FACILITY pursuant to which bank required to advance funds requested by borrower provided borrower has not defaulted on previous loan repayments + total amount drawn down at any time during Availability Period does not exceed specified maximum under terms of RCF agreement.
- RCF can be secured/unsecured depending on level of credit risk for lender.
- RCF ceases to be available and any outstanding capital/interest must be repaid at end of Availability Period.
- Advantages for Borrowers - RCF reduces costs + enhances flexibility for borrower who is able to draw down loans only when it requires capital (i.e. suitable for borrowers who are not able to predict with certainty when they will require access to capital + how much capital they will require) and can repay such loans at will within interest period +
can roll over an existing loan into a new interest period.
- Repeating Representations - Each time loan drawn down under RCF, borrower deemed to repeat representations given to lender in loan agreement.
- Borrower must ensure that it is capable of repeating representations before each loan drawn down under RCF otherwise borrower risks giving false representation to lender - may amount to an event of default under terms of loan agreement. (4) Bilateral Lending and Syndicated Lending
- Bilateral Loan - Contract between borrower and SINGLE LENDER (2-party agreement) where single lender acts as borrower's sole source of debt finance.
- Syndicated Lending - Contract between borrower and 2/MORE LENDERS (multi-party agreement) where multiple lenders agree to collectively lend money to borrower on same terms pursuant to overriding syndicated loan agreement - used to fund larger transactions/projects where individual lenders would lack sufficient capital to act as the sole lender OR lenders wish to decrease their share of risk/extent of exposure to individual borrower by only contributing a proportion of the loan monies required by the borrower. COMMON FEATURES OF LENDING (1) Due Diligence
- Due Diligence - Fact-finding exercise enabling lender to assess credit risk it will incur by lending to particular borrower - greater the credit risk identified in course of due diligence, the greater the need for bank to obtain security +
larger fees/interest rates/margin bank will charge to compensate for the increased risk.
- Bank may refuse to enter loan agreement if credit risk identified in course of due diligence cannot be adequately mitigated by provisions in loan/security agreement.
- Format/Extent of Due Diligence - No standard/industry-wide due diligence procedure - due diligence will vary from bank-to-bank and according to circumstances of each transaction, including: (a) size/type (committed/uncommitted) of loan; (b) whether is/is capable of being secured and/or guaranteed; (c) whether borrower is known to the bank and has previously borrowed from the bank; (d) type/financial position of the prospective borrower; and (e) whether the loan is part of a larger series of dealings between the bank and the prospective borrower.
- Initial Offer - Bank relationship manager compiles basic package with borrower, including basic terms of loan agreement such as amount to be advanced + term + repayment dates + main covenants to be given by the borrower.
- Credit Department/Committee - Analyse all credit requests submitted to bank + reviews bank's overall lending and possess ultimate decision-making power in relation to whether/not the bank lends funds to borrower on proposed terms.
- Decision taken after consideration of circumstances/terms of proposed loan + assessment of bank's overall exposure + bank's internal rules/limits/lending policies + results of due diligence on prospective borrower.
- Committee may approve/amend/reject lending proposal made by bank's relationship manager.
- Legal Due Diligence - Conducted by bank's solicitors after term sheet agreed to ensure that there are no restrictions on borrowing company's ability to borrow money/grant securities/provide guarantees in its constitution OR that any limitations/restrictions placed on such abilities (e.g. shareholder approval) complied with.
- Further due diligence may be required where bank taking security over assets of borrowing company (e.g. review of business assets over which security may be taken + borrower's ability to grant security + report on title where security taken over borrower's property). (2) Term Sheet
3 - Term Sheet - Document setting out principal terms of loan agreement - usually drafted by lender's solicitors and reviewed by borrower's solicitors with any proposed amendments negotiated between parties prior to approval of final version term sheet.
- Legal Status - Term sheet generally NOT LEGALLY BINDING EXCEPT in respect of confidentiality provisions +
provisions relating to costs BUT requires EXPRESS STATEMENT where such provisions are intended to be legally binding.
- Negotiation of Term Sheet - Borrower will want a detailed term sheet so that issues can be agreed before the loan agreement entered into BUT lender will generally want a less detailed term sheet and seek to negotiate the terms of the transaction as a whole and incorporate such terms into the loan agreement.
- Function of Term Sheet - 4 main functions of term sheet: (1) provide overview of deal before parties begin drafting the loan agreement; (2) provide an initial summary of the fundamental terms of the loan facility; (3) used alongside information memorandum in syndicated transactions to encourage potential members of syndicate to participate as a syndicate lender; and (4) assist solicitors in estimating fees they will charge parties for working on the transaction.
- Content of Term Sheet - Term will generally include following provisions: (1) Details of Deal - Date + parties + guarantors (if any) + amount/duration of loan. (2) Capital/Interest Payments - Provisions for repayment/prepayment of capital and payment of interest including schedule of repayments + rules on voluntary prepayments + mandatory prepayment requirements in occurrence of specified events + terms of interest payments. (3) Deal Specific Provisions - Bespoke provisions specifically tailored to the individual loan agreement (e.g. conditions precedent/representations/warranties/undertakings/events of default) with other provisions incorporated by reference to 'other provisions usually included in this type of facility' - list of bespoke provisions should be NON-EXHAUSTIVE to allow for inclusion of further specific provisions in final loan agreement. (4) Confidentiality Undertaking - Written undertaking by bank to treat all information about borrower acquired in course of due diligence process as confidential - must be EXPRESSLY STATED that confidentiality undertakings are LEGALLY BINDING. (5) Costs/Fees - Borrower may be obliged to pay bank's fees + a bank cancellation fee in event of loan facility not being entered into after term sheet agreed - must be EXPRESSLY STATED that provisions regarding costs/fees are LEGALLY BINDING. (6) Boilerplate Clauses - Standard terms which appear in all loan agreement to govern relationship between the parties + enforcement of loan agreement (e.g. fees + notices + force majeure clauses + governing law/jurisdiction clauses + exclusion of 3rd party rights etc.). (3) Drafting the Loan Agreement
- Bank's Objective - Lender will want borrower to remain roughly the same entity conducting the same type of business with same assets throughout loan term as this is what the bank's due diligence/assessment of credit risk is based on - achieved through restrictions on borrower in loan agreement including: (a) statement of purpose of loan + prohibition on use of loan monies for any other purpose; (b) restriction on change in nature of borrower and disposals of significant assets by the borrower; and (c) prohibition on borrower creating further securities in respect of assets over which the lender has been granted security.
- Borrower's Objective - Borrower will seek to retain maximum degree of flexibility/freedom including: (a) widest possible purpose clause to allow for flexibility in application of the loan monies; (b) freedom to change its business + dispose of its assets; and (c) ability to grant further securities over its assets in order to allow it to offer such securities when seeking to obtain loans in future.
- Negotiating Loan Agreement - Generally drafted by lender's lawyers and reviewed by borrower's lawyers UNLESS borrower in particularly strong bargaining position and makes drafting of loan agreement by its own lawyers a condition of contracting with particular lender.
- Commercial deal agreed between the parties recorded in the term sheet which is used as basis for negotiation of the final loan agreement + where loan agreement relates to refinancing of pre-existing loan, existing loan agreement should be used as basis of terms of the new agreement.
- Loan Market Association (LMA) Standard Forms - LMA produces range of standard form loan facility agreements for different types of borrowers/deals which can then be amended to suit particular transaction/parties - aim to create certainty regarding terms generally included in common types of loan agreements and reduce time/cost of negotiating loan agreements.
- Legal Effect of Loan Agreement - Loan agreement is a contract so requires OFFER + ACCEPTANCE +
CONSIDERATION + INTENTION TO CREATE LEGAL RELATIONS in order to be legally binding (may also be subject to conditions precedent). STRUCTURE OF LOAN AGREEMENT
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