1. Short-term marketable securities

The term bond (see previous chapter) is used to refer to marketable securities with maturity of over one year, but firms can also issue shorter-term instruments. Commercial paper refers to negotiable debt securities issued on the money market by large (and now medium-sized) companies for periods ranging from one day to one year. In practice, the average maturity of commercial paper is very short, between one and three months. Issuers can also launch paper denominated in foreign currency. Two markets of similar size are active on the European level:

• The ECP (European commercial paper) market is based in London and is not regulated.
• The French TCN (titres de créances négociables), on which French but also other European corporates issue. This market is regulated and under the supervision of French market authorities, and offers better secured and more flexible transactions (spot and overnight delivery).

Short-term European paper (STEP) is a label adopted in 2006 that has homogenised the documentation for the issue of short-term paper.

Obtaining at least a short-term credit rating for a commercial paper issue is optional but implicitly recommended, since companies are required to indicate whether they have called on a specialised rating agency and, if so, must disclose the rating given. Moreover, any issuer can ask a bank for a commitment to provide financing should the market situation make it impossible to renew the note. These backup lines came into their own at the end of 2008, when the commercial paper market virtually closed for several weeks following the bankruptcy of Lehman Brothers. Companies have to have such lines if they want their commercial paper issues to get an investment grade rating. Certain credit rating agencies, for example, will only keep their short-term rating of outstanding commercial paper at A1+ if 70% of the paper is covered by a backup line.

In addition to costing less than an overdraft, commercial paper gives the company some autonomy vis-à-vis its bankers. It is very flexible in terms of maturity and rates, but less so in terms of issue amounts.

Regardless of their country of origin, companies can issue American commercial paper. Such issues are governed by Regulation 144A defining the terms and conditions of securities issues by foreign companies in the US (see Chapter 26).

2. Long-term marketable securities

These include two types. The first is bonds, which we have seen in the previous chapter; they are listed and potentially subscribed to by international investors. The second usually takes the form of bonds that are subscribed to through a private placement by a limited number of institutional investors (insurers, asset managers, pension funds) of a specific country.

There is a market for such products in the US, where there is a specific regulation for such issues, but also in Germany (Schuldschein) and in Belgium (mostly to individual investors). Under the name of Euro PP, private placements have emerged mainly in France since 2012.

Private placements have become a real alternative for the financing of large (BASF, Rolls-Royce) or mid-sized (Bonduelle, Copenhagen Airport) or even smaller (Microwaves) groups. The transaction usually consists in the issue of a bond (sometimes a loan) in dollars or euros with a fixed rate. These financings generally have a long maturity (seven to 15 years, with the bulk of the issue with a six- to seven-year maturity). Most investors keep their investment until maturity (buy and hold). As there is no liquidity constraint, the issues (or each tranche within an issue) can be of reduced size (compared to a standard bond issue).

They are appealing for groups that are willing to diversify their financing sources and have access to long-term financing without the need for a rating. The documentation can include some stringent covenants, and investors in such products may show much less flexibility than banks when it comes to renegotiation.

The increasing constraints on bank solvency have led to reduced loan offerings, in particular outside the domestic market. Financings outside the banking circuit have therefore developed (shadow banking), and the increasing success of private placements is just an illustration thereof.

1. Types of business loans

Overdrafts on current accounts are the corporate treasurer’s means of adjusting to temporary cash shortages but, given their high interest charges, they should not be used too frequently or for too long. Small enterprises can only obtain overdrafts against collateral, making the overdraft more of a secured loan.

Commercial loans are short-term loans that are easy to set up and therefore very popular.

The bank provides the funds for the period specified by the two parties. The interest rate is the bank’s refinancing rate plus a margin negotiated between the two parties. It generally ranges from 0.10% to 1.50% per year depending on the borrower’s creditworthiness, since there are no other guarantees.

Commercial loans can be made in foreign currencies either because the company needs foreign currencies or because the lending rates are more attractive.

Alternatively, the firm can put in place a revolving credit facility (RCF), which is a confirmed short-term or mid-term credit line. When the line is put in place, the firm will not have debt on its balance sheet, but it will have the capacity to draw on the credit line when it needs it. On the undrawn amount, the corporate will only pay a commitment fee. In addition to the spread, a utilisation fee will be added depending on the percentage of credit drawn.

If the firm has to finance a specific investment, it will put in place a term loan that will be less flexible than the RCF. Usually the borrower has the capacity to reimburse by anticipation, but will not be allowed to re-borrow any of the repaid amounts.

A bridge loan is put in place to finance an investment quickly. A bridge loan can be reimbursed in the short term after a long-term financing has been put in place (long-term loan, equity issue, disposal of a subsidiary, etc.). This type of loan is costly, as it presents a significant risk for the lender. Its development is highly dependent on the activity of the mergers and acquisitions market.

Syndicated loans are typically set up for facilities exceeding €50m which a single bank does not want to take on alone. The lead bank (or banks, depending on the amounts involved), known as the mandated lead arranger, will arrange the line and commit to undertake the full amount of the credit. It will then syndicate part of the loan to some five to 20 banks, which will each lend part of the amount. The mandated lead arranger will receive an arrangement (or coordination) and underwriting fee and the other banks a lower participation fee.

Firm underwriting by one firm will allow the company to maintain maximum confidentiality with regard to the transaction, which could be crucial, for example in the case of the acquisition of a listed company. This can be achieved by having only one arranging bank that will bear the whole credit risk until the transaction becomes public (it can then syndicate the loan).

When the loan is put in place with the house banks of the firm with no further syndication of the loan, we use the term club deal.

Extending this concept leads us to the master credit agreement, which is a confirmed credit line between several banks offering a group (and by extension its subsidiaries) a raft of credit facilities ranging from overdrafts, commercial credit lines, backup lines, foreign currency advances or guarantees for commercial paper issues (see above). These master agreements take the form of a contract and give rise to an engagement commission on all credits authorised, in addition to the contractual remuneration of each line drawn down. Large groups use such master agreements as multi-currency and multi-company backup lines and umbrella lines, and secure financing from their usual banks according to market conditions. Smaller companies sometimes obtain similar financing from their banks. Engagement commissions are usually paid on these credit lines.

Master agreements take into account the borrower’s organisation chart by organising and regulating its subsidiaries’ access to the credit lines. At the local level, the business relationship between the company’s representatives and the bank’s branches may be based on the credit conditions set up at group level. Subsidiaries in other countries can draw on the same lines at the same conditions. Centralising credit facilities in this manner offers a number of advantages by:

• pooling cash between subsidiaries in different countries to minimise cash balance differentials;
• harmonising the financing costs of subsidiaries or divisions;
• centralising administrative and negotiating costs to achieve real economies of structure.

Master agreements are based on a network of underlying guarantees between the subsidiaries party to the agreement and the parent company. In particular, the parent company must provide a letter of credit for each subsidiary.

2. Features of the loan documentation

The loan documentation sets out:

• the amount, maturity and purpose of the loan (i.e. the use of funds);
• the way the amount will be cashed in by the firm (one single payment, upon request by the firm, etc.);
• the interest rate, fixed or more often floating, periodicity of interest payments, rules for the computation of interest, fees to be paid;
• the reimbursement or amortisation features;
• the potential early repayment options;
• the potential guarantees, pledges;
• the covenants.

Banks include a certain number of covenants in the loan agreements, chiefly regarding accounting ratios, financial decisions and share ownership. These covenants fall into four main categories:

• Positive or affirmative covenants are agreements to comply with certain capital structure or earnings ratios, to adopt a given legal structure or even to restructure.
• Negative covenants can limit the dividend payout, prevent the company from pledging certain assets to third parties (negative pledges) or from taking out new loans or engaging in certain equity transactions, such as share buy-backs.
• Pari passu clauses are covenants whereby the borrower agrees that the lender will benefit from any additional guarantees it may give on future credits.
• Cross default clauses specify that if the company defaults on another loan, the loan which has a cross default clause will become payable even if there is no breach of covenant or default of payment on this loan.

The agreement can also include a clause allowing banks to cancel the contract in the event of a material adverse change (MAC). The execution of such clauses (as well as “market disruption” clauses) is very complex from a legal point of view, but also from a commercial point of view.

Standardised legal documentation for syndicated loans has developed in Europe, led by the Loan Market Association (LMA) in London.

There is clear cyclicality on the loan market. After a period of high liquidity (2004–2007) marked by very favourable borrowing terms (both in terms of legal documentation and spreads), banks drastically tightened the terms and conditions of their loans after 2008 due to the weakening of their loan portfolios and the reduced market liquidity. Since 2013, lending conditions have become increasingly borrower-friendly and in 2017 they came close to those observed in 2007.

1. Discounting

There are several short-term financing techniques that bridge the cash flow gap between invoicing and collection and are backed by the corresponding trade receivable. They are the counterpart to trade credit (inter-company credit), which is widely used in some countries (Continental Europe).

Discounting is a financing transaction whereby a company remits an unexpired commercial bill of exchange to the bank in return for an advance of the amount of the bill, less interest and fees.

The discounting bank becomes the owner of the bill and, ordinarily, is repaid when it presents the bill to its customer’s customer for payment. If, at maturity, the bill remains unpaid, then the bank turns to the company, which assumes the bankruptcy risk of its customer (such discounting is called discounting with recourse).

In principle, a company uses discounting to obtain financing based on the credit it extends to its own customers, which may be better known to the banking system than the company is. In this way, the company may be able to obtain better financing rates.

In discounting, the bank does not finance the company itself, but only certain receivables in its portfolio, i.e. the bills of exchange. For the bank, the risk is bound by a double guarantee: the credit quality of its customer backed by that of the issuer of the bill of exchange.

Under most accounting principles (including IFRS and US GAAP), discounted bills are reintegrated into accounts receivable and the bank advances are reported as debt.

For this reason, banks now also offer non-recourse discounting, which is a straight sale of customer receivables, under which the bank has no recourse to its customer if the bill remains unpaid at maturity. This technique allows the company to remove the receivables from its balance sheet and from its off-balance-sheet commitments and contingencies.

2. Factoring

Factoring is a credit transaction whereby a company holding an outstanding trade bill transfers it to its bank or a specialised financial institution in exchange for the payment of the bill, less interest and commissions. Factoring companies or factors specialise in buying a given portion of a company’s trade receivables at a discount to the face value. The factoring company then collects the invoice payment directly from the debtors.

Factoring actually may include one or several of the following services to the firm:

• a financing with an attractive interest rate;
• the externalisation of receivables recovery;
• an insurance against unpaid bills;
• an off-balance-sheet financing.

Factoring is like discounting with additional services!

Banks increasingly offer non-recourse discounting services, which consist of an outright purchase of the trade receivables without recourse in the event of default. This technique removes contingent liabilities from the bank’s on- and off-balance-sheet accounts.

A factoring contract mentions:

• The scope of the contract (nature of the product, geography, type of debtors).
• The share of invoices available for financing (typically the bank will retain 8% to 15% of the invoices to cover the risk of unpaid invoices or litigation).
• The cap on financing and its features.
• The financing fee charged for the early availability of funds and that evolves in line with a money market index (EONIA of 3-month Euribor in Europe) plus a spread of up to 2.5%.
• The factoring fee that pays for the services and guarantee provided by the factor; this is computed as a percentage of invoices sold (between 0.2% and 2%). Its level depends on certain factors such as the nature and risk of clients, the statistics of unpaid invoices, the geographical spread of invoices, the average DSO (days sales outstanding), the number of customers and invoices and the average amount of invoices.
• Whether the contract allows for possible recourse to the company or not (if so, the firm will have a debt towards the factor after a certain period).

Large groups sometimes suggest that their suppliers put in place a reverse factoring line, whereby the supplier will get early payment of the invoice through a bank. The logic is the same as factoring, except that it is provided by the client.

3. Leases

In a lease contract the firm (lessee) commits itself to making fixed payments (usually monthly or semi-annually) to the owner of the asset (lessor) for the right to use the asset. These payments are either fully or partially tax-deductible, depending on how the lease is categorised for accounting purposes. The lessor is either the asset’s manufacturer or an independent leasing company.

If the firm fails to make fixed payments, it normally results in the loss of the asset and even bankruptcy, although the claim of the lessor is normally subordinated to other lenders.

The lease contract may take a number of different forms, but is normally categorised as either an operating or a financial lease.

For operating leases, the term of the lease contract is shorter than the economic life of the asset. Consequently, the present value of lease payments is normally lower than the market value of the asset. At the end of the contract the asset reverts back to the lessor, who can either offer to sell it to the lessee or lease it again to somebody else. In an operating lease, the lessee generally has the right to cancel the lease and return the asset to the lessor. Thus, the lessee bears little or no risk if the asset becomes obsolete.

A financial (or capital) lease normally lasts for the entire economic life of the asset. The present value of fixed payments tends to cover the market value of the asset. At the end of the contract, the lease can be renewed at a reduced rate or the lessee can buy the asset at a favourable price. This contract cannot be cancelled by the lessee.

From an accounting point of view, leasing an asset rather than buying it substitutes lease payments as a tax deduction for the payments that the firm would have claimed if it had owned the asset – depreciation and interest expenses on debt (Chapter 7).

According to IFRS principles:

• Finance leases are those that transfer substantially all risks and rewards to the lessee.
• Lessees should capitalise a finance lease at the lower of the fair value and the present value of the minimum lease payments.
• Rental payments should be split into (i) a reduction of liability and (ii) a finance charge designed to decrease in line with the liability.
• Lessees should calculate depreciation on leased assets using useful life, unless there is no reasonable certainty of eventual ownership. In the latter case, the shorter of useful life and lease term should be used.
• Lessees should expense operating lease payments.

There are different reasons a firm can prefer leasing.

1. The firm may not have the borrowing capacity to purchase an asset.
2. Operating leases provide a source of off-balance-sheet financing for heavily leveraged firms. However, this opportunity does not reduce the firm’s financial risk. Lenders are, in fact, careful in considering the cash flow effects of lease payments.
3. The firm may want to avoid bond covenants.

4. Sale and lease back

Sale and lease back is a procedure by which a company that owns a factory, an office block, a machine, etc. sells it to a leasing company or a real-estate company, which immediately places it at the company’s disposal through an ordinary rental agreement or an equipment or real-estate leasing agreement, depending on the nature of the asset sold.

In consolidated financial statements, assets rented through leasing appear on the asset side of the balance sheet while the corresponding financing appears on the liabilities side. On the other hand, if the sale makes it possible to transfer the risk from the owner to the buyer, then the assets and the debt no longer appear on the balance sheet.¹

These transactions are described further in Chapter 51.

5. Bonds and guarantees and export credit

Bonds and guarantees are not credit lines as the bank does not provide the funds unless the firm defaults (in which case the bank will pay instead of the firm). They are off-balance-sheet commitments.

For the firm, a bank guarantee generally allows it to defer payment or not to provide a down payment (rents, customer advance payment).

Performance bonds are issued by a bank to guarantee the proper performance of a contract (construction, etc.) within a certain timeframe. They are used in the real-estate sector or for capital goods (construction of factories or power plants).

Buyer’s credit or export credit is used to finance export contracts of goods and/or services between an exporter and the buyer importing the goods/services. The banks granting the buyer’s credit undertake to provide the borrower with the funds needed to pay the supplier directly according to the terms specified by the contract.

The borrower, in turn, gives the bank an irrevocable mandate to pay the funds only to the supplier. The agreement stipulates the interest rates, duration and repayment conditions of the loan, and any bank fees or penalties that may arise if the borrower fails to meet its obligations.

The credit agreement also specifies that the transaction is purely financial, since the borrower must repay the funds notwithstanding any disputes that may arise in the course of its business with the exporter. The advantages to the supplier are:

• insurance against payment default;
• the cost of the credit is not deducted from the contract while the risk level remains acceptable to the bank;
• the portion of the contract that must be paid upon maturity is not on the balance sheet.

Moreover, in most cases the first payments can be made before completion of the contract. There is thus less need to resort to cash or pre-financing loans. And lastly, if the sale is denominated in a foreign currency there is no need to worry about hedging the foreign exchange risk while the borrower makes his repayments.

Certain types of buyer’s credit can also be used to finance major projects and thus resemble project financing, which we will discuss shortly.

6. Securitisation

Securitisation was initially used by credit institutions looking to refinance part of their assets; in other words, to convert customer loans into negotiable securities.

Securitisation works as follows: a bank first selects mortgages or consumer loans, trade payables or unsecured loans such as credit card receivables, based on the quality of the collateral they offer or their level of risk. To reduce risk, the loans are then grouped into an SPV (special purpose vehicle) so as to pool risks and take advantage of the law of large numbers. The SPV buys the loans and finances itself by issuing securities to outside investors: equity, mezzanine debt, subordinated debt, senior debt, commercial paper, etc., so as to offer different risk–return profiles to investors. Usually the vehicle is kept alive and “refilled” progressively by banks with new loans when old loans mature. A new entity, such as a debt securitisation fund, receives the flow of interest and principal payments emanating from the loans it bought from the banks (or non-bank companies). The fund uses the proceeds to cover its obligations on the securities it has issued.

To boost the rating of the securities, the SPV buys more loans than the volume of securities to be issued, the excess serving as enhancement. Alternatively, the SPV can take out an insurance policy with an insurance company. The SPV might also obtain a short-term line of credit to ensure the payment of interest in the event of a temporary interruption in the flow of interest and principal payments.

Most of the time, the securitisation vehicle subcontracts administration of the fund and recovery to one service provider and cash management to another. More complicated structures, often based on swaps (see Chapter 49), can also be used when the SPV does not need to reproduce the exact cash flows of the original loans. Instead, cash flows can be reorganised to satisfy the requirements of the various investors involved: no income stream, steady income stream, increasing income stream, etc.

Once isolated, certain assets are of higher quality than the balance sheet as a whole, thus allowing the company to finance them at preferential rates. That said, the cost of these arrangements is higher than that of straight debt, especially for a high-quality borrower with an attractive cost of debt. Hence, they are hard to put in place for less than €50m, except if the platform is syndicated between several firms.

For example, ArcelorMittal securitises its account receivables and Avis its rental fleet, while Glencore does the same thing with its lead, nickel, zinc, copper and aluminium inventories.

The subprime crisis of 2008 has badly hurt securitisation of banks’ assets due to a fear of finding subprime loans or debts of highly leveraged LBOs among the securitised assets. For industrial groups, the securitisation market is still open provided the SPV structure is crystal clear and its assets are of undisputed quality.

7. Project financing

Bankers’ imaginations know no bounds when creating specialised bank financing packages that combine funding with accounting, tax, legal or financial advantages. Sometimes lenders take the global risk of the group in the form of subordinated debts (see Chapter 24). In other cases they may only be taking the risk of one project of the group, which, most of the time, is isolated into a separate entity.