1. Should loans be backed up by assets or not?

The main aim of lenders is to ensure that the firm will pay the interest and reimburse the loan. One of the most secure ways of guaranteeing reimbursement is to use one of the company’s assets as a form of collateral. This results in heavy restrictions on the company (impossible to sell the asset), but could enable it to bring down its cost of financing and to find more financing than in the overall financing of the firm. Accordingly, we distinguish between:

• Loans to companies, guaranteed solely by the borrowing company’s ability to generate future free cash flows and by its current financial solidity.
• Asset-backed loans, which are loans backed by a specific asset, the material existence of which constitutes both the basis and the collateral. Pawning is probably the most important and the oldest example of asset-backed loans. Generally, the maximum amount of the loan is equal to the value of the collateral provided by the borrower. In most cases, it is inferior to it, since the disposal of the asset at its booked amount is always uncertain.

The principle of asset-backed loans is sometimes criticised as it runs contrary to financial logic, which holds that financing should feed cash flows, the result of all of the firm’s operating and investment decisions, without being linked to a specific transaction. This means that the difference between loans to companies and asset-backed loans is sometimes unclear. A loan to a company may be backed by a pledge on an asset, which only guarantees a small portion of the loan. An old asset that generates cash flows with little risk can be used as collateral to finance a new development.

The financial manager will highlight the guarantees provided in order to isolate them and obtain cheaper financing. But let’s not deceive ourselves. In a world in equilibrium, if backing a loan with an asset makes it possible to reduce the cost of financing, there is a risk that the corollary could be an increase in the cost of other financings which do not have this guarantee, and will, accordingly, be more risky.

Pushing the logic of asset-backed financing to the extreme, we get project finance (see Chapter 21). This is financing that is backed by a whole project. This technique makes it possible to isolate the different economic risks. As these risks are perceived differently by investors depending on their respective resources and preferences, the sum of the components of the financing may be less expensive than the financing of the whole.

2. Obtaining financing from banks or on the financial market

This is a theoretical choice for the small company which, in general, only has access to bank or similar financing, most often guaranteed (leasing, discounting, factoring). Nevertheless, given Basel III (and soon Basel IV) and changing banking regulations, the share of market financing in the debt of medium- and large-sized eurozone companies is tending to increase and is getting a bit closer to the situation in the US. Additionally, medium-sized companies are seeing the development of the securitisation of receivables and especially private debt placements: private placements in the US (see Chapter 21), Schuldschein (see Chapter 21) and now euro private placements.

Bank loans (or more generally private loans) follow a negotiation and intermediation logic, which runs contrary to the market logic of bond financing or financing using commercial paper.¹ Bond loans and commercial paper enable the company to seek financing from financial investors directly, without going through the “screen” that is created by the balance sheet of a financial institution.

The main differences between these two major categories of financing are cost, volumes, term and management flexibility.

• The costs relating to bank loans and to bonds are by nature very different. Readers may believe that the bank’s intermediation cost is the only difference. In reality, the interest rate on a bank loan does not generally correspond to the real cost of financing the company. Under pressure from competitors, banks may introduce commercial strategies in order to get close to certain clients, offering loans on very attractive terms that are not linked to the counterparty risk. Their hope is that they will make money by selling the company other products (cash flow management, foreign exchange transactions, management of employee benefits, M&A mandates, etc.), which is called the “side business”.

It also means that investors have to be continually informed of the company’s results and prospects and generally (though not always) requires that the company or issue in question be rated (see Chapters 20 and 25), which means additional costs. The interest rate at which the market is prepared to buy the company’s bonds, given its appreciation of the risk, is the real cost of financing the company.

In both cases an intermediation fee or flat fee must be added to the cost of interest rates. Such fees are paid on signature of the loan agreement.

• The amount of loans offered by banks is perfectly adapted to a company’s requirements, as long as they can be drawn as and when the company needs them. On the other hand, the financial markets impose heavy restrictions on borrowers in terms of volumes. A debt security is hard to list unless it has sufficient liquidity for investors, who want to be able to buy it and then sell it easily if necessary. The necessary minimum is often €5m. This means that SMEs cannot really issue “small” amounts of ²debt, which is a serious restriction that considerably limits their access to the market for listed debt securities. The liquidity of a €5m bond will be poor on the secondary market, preventing large funds and institutional investors from financing SMEs. Private investors and some specialised funds will be the main holders of such bonds. This moves away from a market logic, but remains in a disintermediation logic.
• The bond market generally offers financings over a longer period than those offered by the bank market. Bank loans rarely have a maturity of over five years, while it is possible for companies to issue bonds over 12 years, or even longer, especially in dollars or in pounds sterling. Additionally, bonds have a longer duration because they are practically all reimbursed at the end of the loan term (bullet repayment) and not in instalments like most bank loans.
• While bank loans can normally be obtained relatively quickly, preparations to tap the debt market can take weeks if the issuer is a first-time issuer, and there is no guarantee of success. The need to provide investors with information explains the length and difficulty of the process. So it’s not a good idea to launch a bond issue during a major strategic operation (takeover, restructuring, etc.) because there is the risk of not being able to place the bonds on a market that has become wary as a result of the upheaval taking place at the company. Moreover, the unpredictable nature of the market sometimes results in major uncertainty in terms of the success of the debt issue. It’s also ill-advised to issue debt during periods of tension on the financial markets. However, most of the time, groups with a good rating (investment grade) can issue amounts of several hundreds of millions of euros in a few hours on the markets.

The principle of bilateral banking arrangements naturally offers a greater availability of funds. Similarly, for commercial reasons, banking terms can be renegotiated if the company’s situation deteriorates. This is extremely complicated and costly for listed debt securities, which are held by a multitude of investors who will all have to be invited to a general meeting where they will have to approve these changes by a given majority.

Additionally, bank loans are generally more restrictive in terms of restrictions on the borrower. In particular, they impose compliance with covenants (Section 39.2), while documentation relating to bond loans is substantially less complex and standardised.

On the other hand, a bank loan offers additional flexibility by allowing borrowers to defer drawing down funds, i.e. to defer the moment when the funds are made available and when interest starts to accrue. Borrowers then pay a commitment fee. This is not possible for a bond loan as the funds are paid to the issuer immediately after the close of the issue. Private debt placements offer a certain amount of flexibility in this regard.

The treasurer of a group may choose to tap the bond market, even if the cost is higher, so as to avoid falling into the hands of banks and to retain flexibility.

3. Choosing a maturity

The choice of a maturity depends on how liquid the company is (see Chapter 12).

Naturally, the treasurer will base decisions on the forecast cash flow budgets. Let us assume that he is certain he will have to invest €10m during the year under way and that the company’s cash flows will only be positive from the third year. In this case, it would be worth looking for financing where no capital has to be reimbursed during the first two years; for example, a bank loan with deferred repayment or a five-year bullet bond.

The treasurer will look at these issues separately by drawing up a financing plan with different maturities. Once this has been done, he can carry out arbitrages between short-, medium- and long-term financing, taking advantage of specific opportunities on one of the types of loans.

The treasurer will first rely on the least expensive resources for the most foreseeable portion of his financing requirements. He will then adapt the level of credit on the basis of loans obtained the most quickly (credit line, revolving loan, overdraft), as new information comes in. When major funds have to be allocated without being anticipated in advance, the treasurer will rely on immediately available resources, then gradually replace them with less expensive or more structured resources (maturity, guarantees, etc.).

4. Choosing a currency for debt

As we’ll see in Chapter 50, taking out debt in a foreign currency can turn out to be a good way for the company to reduce its exposure to the foreign exchange risk. Accordingly, the treasurer of a group operating on an international scale should add the foreign currency dimension to his financing plans. But taking out debt in a foreign currency when most of the company’s business is in the eurozone on the pretext that interest rates are lower than in the eurozone is a serious mistake! It is speculating that the difference in interest rates will not be set off, or even worse, by a depreciation of the euro against this foreign currency between now and the loan’s maturity. It’s taking a very big foreign exchange risk for a very small interest rate saving, it’s playing against economic theory and it is certainly not the type of activity that shareholders signed up to finance when they invested in the company.

5. Choosing between a fixed rate and a floating rate

The choice between a fixed and a floating rate is a lot more complex than it seems.

Firstly, you should remember that it is quite different from the choice of a maturity. Medium- and long-term loans can be taken out at a floating rate. This is generally the case for bank loans indexed to a short rate like the 1.3- or 6-month Euribor, regardless of their maturity. Additionally, through swaps (see Chapter 50), the financial markets offer a simple way of moving from fixed to floating rates and the other way around.

In order to make the best choice, the financial director has to focus on other criteria – minimising costs, reducing risk, optimising value and following the siren’s call of his expectations.

Studies show that for the past 30 years, companies that took out debt on the basis of short rates (so at floating rates) were winners in terms of costs. Nevertheless, generally, taking out debt at a fixed rate is seen as playing it safe, as the company knows today what its expense on the income statement will be for the years to come. But this is forgetting that when interest rates fall (generally during periods of crisis), the value of the debt at a fixed rate will increase, thus reducing the value of equity, even if effectively there is no impact on the income statement. In this case, accounting that does not record the opportunity costs on the income statement does not shine any light on the decision made.

It is, however, difficult for a heavily indebted company, or a company operating in a cyclical sector, to take the risk of interest rates rising, which would increase its costs. For such companies, a fixed rate is a form of insurance policy.

In the end, the financial director’s expectations of rising or falling interest rates will obviously have a major influence on his choice. Under the cover of good management, he becomes a speculator, taking out debt at a floating rate when he thinks that interest rates are going to fall and at a fixed rate when he finds that current interest rates are very low. This is speculation, because if he’s wrong, the company will suffer the consequences, which include a rise in the future cost of financing and an opportunity loss on the cost of its present debt.

Bank loan agreements contain covenants which set out the obligation to hedge part of the interest rate risk when the company takes out debt at a floating rate. In this case, the cost of hedging must be added to the real cost of the loan. The interest rate risk is theoretically described in the notes to the accounts of the company, and its hedging policy must also be set out.

The result of these considerations is often an arbitrary proportion (50-50, 2/3-1/3) of fixed and floating rates.

6. Defining the seniority of repayments

A creditor that has rights either in terms of access to the collateral on the debt or priority in terms of repayment of the principal and of interest has debt which is frequently called senior debt. A creditor that has no guarantee is called a chirographic creditor. It is also possible to introduce, legally or contractually, “less advantaged” creditors than chirographic creditors. Such creditors are known as subordinated creditors. If the company is liquidated, they will be reimbursed after the senior creditors and also after the chirographic creditors, but before the shareholders.

Of course, in exchange for accepting additional risk, subordinated creditors will demand a higher interest rate than the other creditors, who run less of a risk, and especially the holders of senior debt.

In an LBO (see Chapter 46), subordination is the central thread and the debt is structured like a multi-layered wedding cake.

Within the same debt category (subordinated debt, chirographic debt), it is important that the legal features are similar (the notion of pari passu).

1. Clauses over corporate investment and production policies

The purpose of such covenants is chiefly to protect debtholders against the possibility that the firm will substitute more risky assets for the existing ones or will simply reduce the total assets. Any investment in other companies, mergers, absorption or asset disposals are either restricted or subject to approval by the debtholders.

In some cases, inventories, client receivables, the securities of certain subsidiaries or the equipment the issue served to finance are given as collateral (pledge). Some covenants restrict the granting of certain assets as collateral for future debt (negative pledge).

2. Clauses over net debt and subsequent debt issues

Any unforeseen, subsequent issue of equal or higher-ranking debt reduces value for existing debtholders; yet it would not be in the interests of either the current bondholders or the shareholders to rule out any further debt issues. To protect themselves against a reduction in the value of their claims, debtholders can impose limits on the amount of net debt and the nature of the new debt issued based on certain ratios:

When these ratios exceed the predefined threshold, the debt immediately falls due.

It can also become payable when the ratios exceed these thresholds because of deteriorating corporate results rather than new borrowings.

In practice, these are chiefly rendez-vous clauses that force the company to arrange a restructuring plan with its creditors to contain the risk to the latter, which increases with the financial distress of the company. In addition, waivers (i.e. the fact that banks may allow the borrower not to respect covenants) may be granted against a specific increase in rates or a waiver fee, thereby increasing the remuneration of the lender (as the borrower has become more risky).

Alternatively, or jointly, the spread on the loan can be moved up or down to reflect the variation in risk borne by lenders.

3. Clauses over dividend payments

These covenants are designed to avoid the massive dividend distributions financed by increases in debt or asset disposals that make the lenders poorer and which we discussed in Chapter 34. For example, they can link dividend distribution to a minimum level of equity during the life of the debt. Similarly, they can restrict or rule out the distribution of reserves or share buy-backs.

As it is difficult to impose this clause on large groups, it often takes the form of a covenant limiting the debt level, which produces the same result.

4. Clauses concerning control over the borrower

In the event of a change of control at the borrower, the lenders may reserve the right to request that the amounts owed to them be repaid. Their goal is to be in a position to negotiate should this change in shareholders result in an increase in the risk on their loans, so that they can re-evaluate the terms, or, if necessary, pull out completely.

Covenants are often the bugbear of the financial director as they are sources for reducing room for future manoeuvre. There are some very solid groups that, on principle, refuse to agree to covenants. Others do not have this luxury and they negotiate them reluctantly with lenders, hoping they will never have the humiliation of having to announce that they have been unable to comply with them.