Professional Documents
Culture Documents
1
Overview of Deal Structuring and
Monitoring
Introduction
A credit assessment provides the lender with a prospective view of the borrowers probability
of default (PD), loss given default (LGD) and exposure at default (EAD). A positive credit
assessment indicates a favorable outlook of the PD and LGD. This means that the lender can
expect to be repaid or serviced on time.
However, that favorable outlook does not always become a reality. Unexpected events can
occur that change the risk profile of the client. Lenders manage uncertainty by mitigating risk
with deal structures and dynamic internal monitoring.
This lesson discusses four key concepts:
Good deal structuring and monitoring do not make bad deals an acceptable risk. Good risk
analysis, and the assessment that the borrower can service debt from operational cash flow,
are the foundation of deal structuring and monitoring. The lender must be satisfied that the
transaction meets acceptable risk criteria on a judgment of the future. The deal structure and
monitoring are then required to mitigate the risk that the lenders initial view of the future
may change.
WHAT COMPONENTS FORM A DEAL STRUCTURE
A deal structure is a unique mix of different components, often negotiated on a case-by- case
basis.
The deal structure always includes three key items:
Tenor
The tenor reflects the duration of the asset being financed.
Repayment schedule
The schedule aligns with the projected cash flow.
Pricing
Pricing reflects market conditions. It is a key determinant in the risk-adjusted return to
the lender.
PD and LGD have not changed in the period between negotiation and drawdown
(because of external or internal client events).
Some deal structure components are designed solely to prevent LGD and EAD from
increasing during the tenor of the exposure. The most common components for this purpose
are:
Collateral
Collateral provides a security interest in critical assets and cash flows (discussed in
detail in the next lesson).
Guarantees
Guarantees provide the lender with an unsecured claim on the guarantor (discussed in
detail in the next lesson).
Assignment of contracts
This provides the lender with a legal assignment (pledge) of a clients commercial
contract. In some legal jurisdictions (subject to notice of the assignment to the
contract counterparty), this gives the debt provider the right to oblige the contract
counterparty to fulfill their obligations under the contract.
Other components of the deal structure either provide an EWS of deteriorating PD or prevent
an increase in LGD. Some components provide joint protection. The most common of these
components include:
Covenants
Covenants provide an EWS of deteriorating business and financial risk, or prevent
subordination and dilution (discussed in detail in later lessons).
Transactional control
Using trade finance and cash management products, transaction control provides an
EWS of a problem with transaction flows, or protects LGD by controlling the assets,
cash flows and contracts on one or more transactions.
Information undertakings
These provide the lender with the right to access information required to monitor PD
and LGD on an ongoing basis.
Design phase
Negotiation phase
Design Phase
The design phase establishes several important elements:
Which legal counterparties will provide collateral or guarantees? For example, which
credit bases can be indirectly included in the deal structure by taking covenants on a
consolidated basis?
Time based review ranging from quarterly to annually, depending on risk levels
Warning signals are identified too late. There is usually a time lag between when a
problem occurs in business operations and when it is reflected in the financial data.
There is also a time gap between the reporting date and when the lender receives the
financial information. Depending on the type of business and market practice, the
delay could be as short as a few months or years. For example, a business dependant
on an order book will not reflect immediately a declining order book in declining
sales.
In a typical situation of this example, the order book declines in quarter 3 or 4, but the
annual sales at the end of quarter 4 still show growth because they reflect quarters 1
and 2 of the order book. The decline in the order book does not show up until the next
years order book.
Late warning signals on deteriorating business and financial risk delay the lender
taking action against the potentially larger increase in structure risk. However, other
stakeholders may be taking action to improve their debt priority position.
Bank account monitoring is effective only when the client is not multi banked, and the
majority of the clients transactions are routed through the bank.
Include internal triggers to measure the variance between reality and expected
outlook (where possible).
This sets a clear standard at the start of the exposure that if the internal trigger is
broken, a change in risk profile is likely.
In practice, internal triggers should be set on the business operations. Issues like delays in
events or changes in market prices can easily be measured. For example, a credit decision
may include an internal monitoring trigger around the delay of completion of a new plant by
more than one month, or perhaps an increase in raw material costs of over 10%. In both of
these examples, if the trigger is broken this will strongly indicate that future profits and cash
flow will be less than expected, with a potential negative impact on PD.
In many cases, however, it is difficult to measure the expected outlook in a non-financial way.
The necessary information may not be available. In such cases, the credit approval would
normally indicate the areas of the business operations that relationship management should
discuss during regular client contacts.
Historical financial data generally provides a late warning signal. However, internal triggers
can easily be set to identify when a potential change in risk profile has occurred. If the lender
is relying on projections, it should be clear how much variance will be allowed before a full
review takes place. For example, the internal trigger could be a 10% negative variance with
the projections. Similarly, if the expected outlook of the lender is that historic good
performance will continue, an internal trigger could be set on historic financial trends. For
example, the internal trigger may be set to identify a decline in historic profit margins by
more than a percentage that would trigger a review.
Setting exact internal triggers on structure risk can also be difficult. In general, however, any
unexpected increase in guarantees, debt or collateral given to other lenders should trigger an
immediate review.
The process of internal dynamic monitoring can be difficult. Lenders need to allocate
resources to the monitoring effort for risks that are not sufficiently mitigated by the deal
structure.
Competitive market conditions often lead to internal dynamic monitoring being the lenders
most effective mitigation to identify change in the expected outlook and increased risk levels.
The trade-off for the lender is between receiving internal monitoring warning signals that are
too early, with limited negotiation power, versus receiving warnings from the deal structure
too late, with stronger negotiation power:
Internal triggers may provide early warning signals. However, if they are not legally
enforceable, the lender relies on the clients cooperation to resolve the problem.
A deal structure may provide a late warning signal. However, the covenant breach is
legally enforceable, giving the lender more negotiating power to resolve matters if the
client is not cooperative.
o
What are the negotiating options or key issues for each of the selected deal
structure components?
Several items are necessary for negotiation:
Financial strength
Negotiate and agree the deal structure components with the client.
Once disbursement of funds has taken place, the lender takes several important
steps:
Dynamically monitor the client and the facility structure to spot signs
of a deterioration in the risk profile.
Take action upon a deterioration of the risk profile, which can lead to a
breach of internal monitoring parameters or covenants.
Tenor
Does the funding tenor match the asset being financed?
Repayment schedule
Does the schedule align with projected cash flow?
Pricing
Is pricing in line with market conditions, and does it provide an acceptable return to
the lender?
Type of business
Collateral is an unlikely option for a borrower that only raises unsecured debt, for
example. A lack of trade finance transactions does not allow transactional control.
Evidence of increased risk is needed for the borrower to agree to additional deal
structure components.
Negotiating power
The stronger the lenders position, the more likely the borrower is to agree to a DS
that imposes more control on the business. On the other hand, the weaker the lenders
position, the more likely a borrower is to resist a DS that imposes more control on the
business.
When planning for negotiations with the client, follow the two steps outlined below:
Create a range of options for each deal structure component likely to be used. For
example, if collateral applies, the strong option is security over all assets; the weak
option is a minimum of security over fixed assets.
Design internal triggers that can be included in an IMP to compensate if the optimal
structure cannot be negotiated. For example, a lender may wish to negotiate a Debt
EBITDA covenant of 3.5, but may have to agree to a level of 4 because of the clients
negotiating power. The underlying credit may still be good. However, this makes the
DS weaker, which can be compensated by including an internal trigger of 3.5. If this
trigger is broken, it becomes an EWS leading to a review of the credit when the Debt
EBITDA ratio reaches 3.5, before the covenant is breached at 4.
During the negotiations, it is in the lenders interest to make sure that the borrower
understands why the lender needs the deal structure. This helps ease the natural resistance of
the client to give away any future control of the business, reducing flexibility in the future.
After the negotiations, check that the documentation accurately reflects the critical deal
structure components. Then, design an IMP that compensates the weaknesses in the DS.
When the client asks for the funds, the lender must ensure that all conditions precedent have
been met. After the drawdown, the lender needs to control the risk of changes in the expected
outlook. The lender does this by monitoring the clients compliance with the information
requirements, checking that covenants remain as per the loan agreement and checking that all
internal triggers and key factors are included in the IMP.
An effective deal structure and internal monitoring plan protects the lender from the negative
impact of future events. The deal structure should provide two key services:
What are the key business and financial factors affecting PD for which an EWS is
required in the DS or IMP?
Does the proposed repayment schedule match the projected cash flow?
Is the anticipated pricing at market level, and does it give the lender an adequate
return?
What type of deal structure components are most suitable for the type of business and
transaction?
Which deal structure components are in current loan agreements with the client?
What are the range of negotiation options for each of the deal structure components
that the client is likely to accept?
To what extent does the agreed DS provide an early warning sign of a deteriorating
PD (business and financial factors)?
Do the triggers in the IMP compensate for the shortcomings in the EWS provided in
the DS?
Does the DS control the critical assets or cash flows, and does it prevent
subordination or dilution?
Before Drawdown
After Drawdown
How does reality compare with the expected outlook at the time of credit approval?
Knowledge Check
Question 1
Which statement about effective deal structuring is most accurate?
An effective deal structure should protect the lender from the negative impact of future events
by providing an early warning signal of an increase in the expected PD, caused by a
deterioration in business and financial risk or natural mitigation. It should also offer
protection against increasing LGD by preventing an increase in structure risk or mitigation
through increased subordination and dilution.
Question 2
Which phase of deal structure implementation seeks to establish who, what, why and key
issues?
Negotiating phase
Design phase
Drawdown phase
Monitoring phase
In the design phase, it is important to establish who should be included in the deal structure,
why the lender needs the structure, what range of possible deal structure components could
be used and which negotiating options or key issues are required for each of the selected deal
structure components.
Question 3
Generally, what does not determine the level of a clients negotiation power with a lender?
The level of the clients negotiation power is determined by financial strength, terms and
conditions in existing or past credit agreements, local market practice and the intensity of
competition between debt providers.
Question 4
In the final phase of deal structure implementation, what should be done prior to the
disbursement of funds?
Check the clients compliance with covenants as per the facility agreement
Prior to disbursement of funds (in full or in stages), the lender needs to make sure that all risk
control measures are in place, particularly that all conditions precedent (CPs) are completed
prior to any drawdown (partial or full), a dynamic internal monitoring is in place to enhance
loose structures and check that covenants are being complied with to ensure no unexpected
deterioration in PD has already taken place.
Question 5
What can lenders use to compensate for weakness in traditional internal monitoring systems?
Time based review, ranging from quarterly to annually depending on risk levels
Set internal triggers with specific focus on business operations to provide early
warning systems
The more a lender controls critical assets and cash flows, the lower the exposure to
subordination or dilution risk, and the more power the lender has in negotiations with
other parties. This is enhanced when the legal system allows efficient and quick
enforcement.
Collateral prevents the borrower from raising cash from asset disposals without the
lenders agreement.
Depending on the asset type, collateral can provide an eventual repayment source.
This is determined by the correlation between the value drivers of the collateral and
the business operations. The less the value of the asset relies on the success of the
business, the more substantial the amount to be collected from the sale proceeds of
collateral. For example, if the value of a general warehouse is driven by the local
property market, specialized inventory for a manufacturer will have little value if the
business fails.
Guarantees reduce LGD by including another legal counterparty in the deal structure.
Guarantees give the lender an unsecured claim to the guarantors assets. This can be
improved by taking collateral from the guarantor to convert an unsecured guarantee to a
secured guarantee.
Collateral and guarantees do not make a marginal loan a good loan. Generally, a loan that
cannot be repaid from cash generated from normal operations, should not be made, regardless
of the quality or amount of the collateral.
Even if the loan is fully secured by a savings instrument, the deal should not proceed if the
borrower can never repay the debt and the primary repayment source is collateral or a
guarantee. Such a loan would increase reputation risk for the lender and in some countries,
could lead to legal action against the lender as funds loaned irresponsibly.
Learn more about the rules for Collateral and Guarantees
Collateral
Dealing with collateral generally requires that some basic rules are observed:
1. Collateral must be specifically identified and designated.
2. Collateral value must be properly and independently appraised.
3. Title to the proposed collateral must be investigated to ensure that a clear title can be
obtained.
4. Lenders must achieve a first position, unless upper management makes an exception.
Approval for an exception is usually required, regardless of the loan amount.
5. Collateral must be properly documented. For example, the lender and the borrower
must sign documents (principally, a collateral agreement) giving the lender a formal
interest in the collateral.
6. Collateral interests in assets must be perfected properly and in a timely manner.
Usually, the lender files formal documentation with government authorities, within
the required time limits, to provide public notification of its appropriate position or
rights to the collateral.
7. Collateral must be monitored throughout the term of the loan being secured to help
ensure that it is locatable, insured and in good condition.
8. When it is applicable for a lender to establish loan-to-value (LTV) ratio for a
particular type of collateral, the collateral must hold its value sufficiently to ensure
that the prescribed LTV ratio is maintained throughout the term of the loan.
Guarantees
Dealing with guarantees generally requires that some basic rules are observed:
o
The guarantors should have the legal capacity to enter into a guarantee. With
some legal entities, such as limited companies and government agencies, this
power can be removed.
The amount, and conditions under which the guarantee can be called should be
clear. Ideally, the lender is seeking a guarantee that is payable on first demand.
An institutions loan policy establishes acceptable types and guidelines for collateral
and guarantees. Commonly-acceptable collateral types include:
o
Inventory (stock)
Intangible assets
Single-family residence
Savings instruments
Inventory (Stock)
It can be important for the lender to control inventory. However, the value can be
highly questionable in a stress scenario. Inventory may realize some value only if it
can be easily tracked, insurable, readily marketable as is and is not susceptible to
radical market changes or prior claims from suppliers. However, if it consists of many
items in different stages of production, or if the goods are not easily marketable in
their present state, inventory value is dependent on the borrower remaining a going
concern. Under these conditions, inventory control is the main benefit of the collateral
to the lender, in the stress scenario.
Intangible Assets
These assets are usually of a highly specialized nature, such as intellectual property,
patents or quotas. In general, their value depends on the business continuing as a
going concern. Therefore, lenders take intangible assets as collateral for control
purposes, rather than for their minimal forced sale value. The legal perfection of the
collateral can be complex. It may not even be possible in emerging legal systems.
On a few occasions, there can be a recognized market in intangible assets such as
trade quotas. In these exceptional circumstances, there may be value in the stress
scenario.
Savings Instruments
A savings instrument can be the sole collateral on a loan if it meets certain
requirements:
1. The amount of the instrument is in the same currency as the loan, and greater
than or equal to the principal balance of the loan plus accrued interest.
2. The term of the instrument is greater than or equal to the term of the loan.
Otherwise, the borrower agrees in writing that an instrument with a shorter
term will be rolled over as many times as necessary to keep the loan
completely secured throughout its term.
3. The name of the savings instrument and the name on the loan are identical.
Ideally, the savings instruments should be deposited with the lender, who will also
control withdrawals. The liquid nature of the security does not, as previously
mentioned, reduce the lenders responsibility to ensure than the loan can be repaid
from the projected cash flow.
2. The insurance policy must be read and understood in its own light. Further, it
must be clear that the insurer, the insured, the beneficiary and the lender all
interpret the terms of the policy the same way.
3. The beneficiary must join in the assignment of the policy to the lending
institution.
4. Both the insured and the beneficiary must sign a separate contract setting forth
the lender's rights.
5. Payment of premiums on time should be monitored.
6. In many countries, an acknowledgement is required from the insurance
company.
Guarantees can be given by most legal entities, including individuals, partnerships
and limited companies. There are two commonly acceptable types of guarantee:
o
Limited or unlimited
For a limited guarantee, the amount is capped; whereas an unlimited guarantee
depends on the amount of lenders exposure plus interest, at the time of
default.
Secured or unsecured
This depends on whether or not the lender has collateral from the guarantor.
Collateral and guarantees are generally taken to lower expected loss. Much of the
enhancement depends on the control and the cushion maintained between the value of
the collateral or guarantee and the loan amount.
The valuations should be addressed to the lending institutions and done in consideration of
the specific loan being requested by the borrower. If a lender relies on a valuation addressed
to another party, in most legal jurisdictions, the lender will not have any redress against the
valuer in case of negligence.
In many countries, market value is interpreted as being on a willing buyer/willing seller
basis. The asset being valued is advertised for sale for a number of months. Clearly these
conditions would not apply in the event of a forced sale when the collateral is realized. The
difference between forced value and "market value" can be considerable. In addition, a
lender can become liable to many extra costs (e.g., security, maintenance, repairs, etc.) during
the process of realizing collateral. This should be kept in mind when the collateral valuation
is based on market price.
The value of a guarantee is primarily determined by the financial strength of the guarantor
and the lenders assessment of their continuing ability to repay the borrower's debt during the
term of exposure.
Structure risk on the guarantee claim is also relevant for two reasons:
The weaker the guarantor is, the greater the risk of subordination and dilution. This is
especially true if the guarantee is unsecured, and the guarantor has issued other
guarantees and given collateral to other parties.
Lenders have specific policies that determine coverage rates on different types of
collateral, and what overall loan-to-value ratios should be. The coverage rate is
described as the percent of the collateral value. It determines the maximum exposure
that a lender is willing to take.
is smaller. The value of the remaining collateral may just as easily reduce in value after an
erratic increase. Obtaining additional collateral from a client is more difficult than releasing
existing collateral.
When relying on an LTV, the lender must be clear on two key issues:
Does the regularity of monitoring the LTV match the potential volatility in the asset
value?
Examples of LTV ratios are listed in the table below. Next to the LTV ratio is an explanation
of the maintenance usually required to ensure the LTV is not being eroded. These standards
are set by institutions to protect the lender from undue risk. They also reflect the ease with
which the collateral can be realized in the local legal system. Exceptions to these rules
typically require approval by upper management, regardless of the loan amount.
You should check your institutions LTV policy to ensure that you are abiding by the rules
governing your performance.
Note: The LTV ratios quoted below are illustrative only. The lender needs to make an
assessment depending on local market conditions, quality of the asset and the probability of
default of the borrower. The potential collateral maintenance outlines a range of possibilities.
The amount of resources the lender decides to spend on this will depend on the level of risk
and the importance of the collateral to the lender.
Collateral
Type
Collateral Value
LTV Ratio
Potential Collateral
Maintenance
Industry type is
also a factor.
Mobile
Equipment and
Heavy Trucks
Used: 75%
Amortizing: Visual
inspection at least
annually by the loan
officer
Non-amortizing: Annual
appraisal by an industry
expert
Amortizing: Visual
inspection at least
annually by the loan
officer
Non-amortizing: Annual
appraisal by an industry
expert
New: 100% of
dealer price
Location, usage and
Used (less than 3
general condition of the
years old): 80%
vehicle reviewed at least
of listed value
Used: Red Book loan value
annually by the loan
officer
Used (3 years or
older): 70% of
listed value
Reviewed at least
Cash Surrender 100% of confirmed insurance
quarterly by the loan
Value of Life company value, minus prior
90%
officer, including update
Insurance
charges
on premium payments
Reviewed at least
Savings
90% (assuming
100% of the face amount
annually by the loan
Investments
same currency)
officer
Reviewed regularly by
the loan officer,
Range from 0%
Shares
Market value
depending on market
to 70%
volatility and the level of
the LTV
Reviewed regularly by
Up to 90% of
The realizable value from sale of
the loan officer,
value, depending
Bonds
government and semi-government
depending on market
on credit rating
securities
volatility and the level of
and liquidity
the LTV
Commercial
Lower of cost or appraisal value 70%
Reviewed when the loan
Real Estate and
is being considered,
Construction
usually by an
Light Trucks
and
Automobiles
independent valuer
Single Family
Lower of cost or valuation value 80%
Residence
For construction
projects, regular visits
by professional advisers
or engineers is required
Reviewed when the loan
is being considered,
usually by an
independent valuer
If the lender does not take collateral, the deal structure must prevent other
stakeholders from taking collateral. Otherwise, the lender will be subordinated.
Check that the risk analysis demonstrates that the loan can be serviced or repaid from
future cash flows.
Be clear about which of the borrowers assets and cash flows are included in, or
excluded from, the collateral pool.
Assess the subordination or dilution risk on the assets and cash flows outside the
collateral pool. In particular, determine what collateral other stakeholders have, and
whether the deal structure includes covenants preventing the borrower from giving
collateral or disposing of assets.
Determine the quality of any collateral valuation on which the lender is relying. In particular,
consider several key issues:
What were the lenders instructions and the quality of the valuer?
What is the time scale required to realize the valuation? For example, in some
developing legal systems, it can take more than five years to complete all legal
proceedings to realize a mortgage over property.
Check that the collateral has been legally perfected. (Note: If there is more than one legal
jurisdiction, the process will be complex.) In particular, consider some specific legal issues:
All legal documents and local registrations should have been completed in the
required time frame.
Make sure that monitoring procedures are in place to check regularly the insurance, physical
control and condition of the secured assets. This includes personal visits, review of
maintenance records or site visits by professional advisors.
Guarantees
Guarantees are an important deal structure component because they add another legal
counterparty to the deal structure. Therefore, you should carefully consider several issues
regarding guarantees:
Establish the financial strength of the guarantor, and assess the impact of a guarantee
claim on the leverage and debt service capacity of the guarantor.
Confirm with legal experts that the guarantee is enforceable. This is especially
difficult in many legal jurisdictions where the guarantor does not receive a
commercial benefit, or is in a different country than the beneficiary of the guarantee.
Be clear about what conditions are required for the guarantee to be called.
Assess the subordination and dilution risk on the guarantee claim. In particular,
determine whether the guarantor has issued other guarantees or given collateral to
other parties.
Check that monitoring procedures are in place to monitor the final health of the
guarantor. Regularly notify the guarantor that the guarantee is still in force.
Consider all the above in light of your institutions policies. Follow the basic collateral and
guarantee rules and related procedures of your institution. Make sure that collateral and
guarantees are reliable deal structure components that will protect from increasing LGD in
the stress scenario.
Collateral is an important deal structure component that protects against the risk of increasing
LGD, especially in situations where the PD is deteriorating or is uncertain because of poor
quality information. Collateral can help in several ways:
It increases the negotiating power of the lender with other stakeholders and with the
borrower in a stress scenario. This is especially helpful if the stakeholders do not react
positively and with cooperation when the business faces problems and cash flow is
under pressure.
It prevents important assets from being sold and the cash being diverted away from
repaying the lender. This should not occur without the lenders permission, even if
intended to meet a deficit in the cash flow.
It realizes an eventual repayment source, depending on the value and liquidity of the
asset in a stress scenario and the maturity of the legal system. Assets whose value is
closely linked to the success of the business (e.g., intangible assets and inventory) are
likely to have little value in a stress scenario. Other assets whose value is determined
by market forces independent of the business (e.g., shares or property commodities)
are more likely to hold their value if the business is in a downturn. However, that may
not be the case when the economy or industry sector as a whole is in a downturn.
Guarantees spread the risk for the lender. This is because the PD of both the borrower and
guarantor need to deteriorate before repayment is at risk. When the guarantee is also secured,
it gives the lender additional protection against increasing LGD from the guarantor.
Has a good risk analysis been completed? Is it clear that the collateral is an
enhancement to the credit and not the reason for the credit?
What are the businesss critical assets, cash flows and contracts?
o
What protection does the deal structure have to prevent unsecured assets from
being given as collateral to third parties in the future?
Has proper documentation been completed to give the lender a formal collateral
interest in the assets?
Have acknowledgements been received from relevant parties, such as debtors and
insurance companies?
How will you monitor the collateral over the life of the loan to ensure it is locatable,
continues to be insured, meets agreed LTV ratios and is in good condition?
Are there any prior charges or claims on the collateral that would prevent you from
taking a first position?
What were the instructions to the valuer? Is the valuation addressed to the lender? Is it
based on a forced sale value or market value?
What would be the impact of a guarantee claim on the debt service capacity and
leverage of the guarantor?
Is the guarantee easily legally enforceable? Under what conditions can the guarantee
be called?
If the guarantee is unsecured, has the guarantor given collateral to other parties that
would subordinate an unsecured guarantee claim?
Knowledge Check
Question 1
The collaterals enhancement to the loan depends mainly on its value, as well as on the
cushion between its value and which factor?
Advance ratio
Appraised value
Loan amount
Collateral is generally taken to lower the probability of a loan loss. A great deal of the
enhancement provided by collateral on a loan is dependent upon the value of the collateral
and the difference between that value and the amount of the loan. The greater the cushion, the
greater the likelihood that the assets liquidated will cover unpaid principal and interest on the
loan
Question 2
Collateral on a loan can enhance the credit so that a marginal loan becomes a good loan.
True
False
Collateral does not make a marginal loan a good loan, and should not be considered a primary
source of repayment.
Question 3
Which type of collateral is normally considered acceptable for a loan to a business?
Restricted shares
Loans to shareholders
Some acceptable collateral types include accounts receivable (trade debtors), inventory
(stock), machinery and equipment, commercial real estate, single-family residence, shares
and bonds, and savings instruments.
Question 4
A guarantee is an agreement by a third party to repay a loan if the borrower fails to do so.
True
False
A guarantee is an agreement with a third party to repay a loan if the borrower fails to do so.
Question 5
A characteristic of a limited guarantee is that a specific amount is stated in the legal
agreement supporting the guarantee
True
False
Guarantees reduce LGD by including another legal counterparty in the deal structure. They
give the lender an unsecured claim to the guarantors assets. This can be improved by taking
collateral from the guarantor to convert an unsecured guarantee to a secured guarantee.
Question 7
Generally speaking, how should you proceed if a loan cannot be repaid from cash generated
from normal operations?
Generally, a loan that cannot be repaid from cash generated from normal operations should
not be made, regardless of the quality or amount of collateral.
Question 8
What collateral type represents normal sales made and recorded, but not yet collected in
cash?
Accounts receivable
Inventory
Savings instruments
Intangible assets
Accounts receivables are normal sales made and recorded, but not yet collected in cash.
These accounts are expected to be liquid and not subject to dispute or performance risk. In
taking these fairly liquid assets as collateral, lenders frequently subtract all non-eligible
receivables. Non-eligible receivables are commonly defined as receivables over 30-60 days
old, related party receivables and receivables in dispute or with set off.
Question 9
What collateral type can generally have a higher LTV?
Accounts receivable
Inventory
Savings instruments
Intangible assets
For details, refer to the table in the Collateral section, specifically the row: Light Trucks and
Automobiles.
Question 10
What collateral type generally requires at least quarterly review?
Accounts receivable
Mobile equipment
Machinery
For details, refer to the table in the Collateral section, specifically the row: Accounts
Receivables (Trade Debtors).
2016 Moody's Analytics
Event Covenants
Event covenants trigger default on the occurrence or non-occurrence of a critical
event, usually of high importance to the business operations. Examples include loss of
a license or failure to complete a contract on time.
Restrictive Covenants
Restrictive covenants prevent actions from being taken that would increase risk for
the lender. Examples include no payment of dividends or no further debt and
limitations on capital expenditure clauses.
Non-financial Covenants
Non-financial covenants are designed to control the risk without setting financial
parameters. Examples include a negative pledge triggering default if collateral is
given, or a cross default, which occurs if the borrower defaults with a third party.
Financial Covenants
Financial covenants trigger default when financial ratios based on the balance sheet,
income statements or cash flow are not met.
Information Undertakings
Information undertakings traditionally require the client to provide financial
information on a regular and timely basis during the tenor of the credit exposure or at
the specific request of the lender. Information requirements can be made effective and
dynamic by linking the required information to the clients business and the lenders
monitoring plan. Default is triggered if the information is not given upon request or
within the agreed time frame.
In general, the stronger the borrower, the fewer and less stringent the loan covenants will be
in the deal structure.
A strong, low-risk borrower may agree to a covenant lite deal structure requiring regular
financial information (semi-annual or annual) and an understanding not to give collateral to
third parties. That means that the lender needs to rely mainly on dynamic internal monitoring,
rather than the deal structure, to identify a change in risk profile
A high-risk borrower, on the other hand, may need to provide a variety of strong covenants
and very regular information (monthly or quarterly) on the business operations and financial
budgets and reports.
A high-quality covenant structure does not guarantee repayment. A lender's analysis of the
expected outlook should show that the debt can be serviced or repaid on time. Covenants, if
effective, provide additional protection in two areas:
If the expected outlook is not being achieved, covenants provide an early warning
sign (EWS).
Covenants give the lender more time to discuss corrective action with the client, and prevent
other stakeholders from improving their debt priority position. There is no guarantee,
however, that at the time of covenant breach cash flow will be available to repay the debt.
Lenders need to consider a seven-step approach when designing and assessing the
effectiveness of covenants:
Step 1. Identify the critical risk factors.
A good deal structure is based on high-quality risk analysis. To select which covenants are
most appropriate, the lender needs to identify and prioritize two types of factors:
This provides a benchmark for the lender to assess to what extent the covenants selected will
provide an EWS, and protect against structure risk.
Step 2. Determine who the covenants will apply to.
Covenants may apply to the legal counterparty (borrower or guarantor) or the credit base
(groups or shareholders) or both. This needs to be clearly specified. There is a difference in
the protection, depending on whom the covenant is set. For example, if a cross default
covenant is set on the borrower, and another member of the group goes into default, the
lender cannot take action because a covenant breach has not occurred. However, if the cross
default clause is taken on a group basis, the lender has the power to call default because a
covenant has been breached.
Step 3. Assess the definitions of the covenants.
In a stress scenario, the borrower may delay breaching the covenants as long as possible. One
potential escape route is a vague or imprecise definition of the covenant. For example, if a
maximum debt clause defines debt as only bank borrowing, the borrower can raise debt from
other parties such as leasing companies or bonds. This makes the maximum debt clause
ineffective.
Developed loan markets have a standard market definition of covenants that has been agreed
to by market participants such as the Loan Market Association (LMA) and the Loan
Syndications and Trading Association (LSTA). This provides a benchmark and represents the
compromise negotiated between representatives of lenders and borrowers. From the lenders
perspective, however, these definitions could be tighter, especially in a high-risk situation like
a problem loan. Unless the lender has strong negotiating power, the shortcomings in the
market definitions need to be compensated by internal monitoring.
Step 4. Link the covenants to projections.
Financial covenants should provide a corridor of financial parameters within which the
business should perform. The lender relies on projections. Therefore, the covenants should be
set at a level that allows for an agreed variance from managements projections. For example,
a variance of 10% to 20% could be set, depending on the level of optimism in the projections
and the level of risk.
If projections are not a critical part of the lending decision, the financial covenants should be
based on historical financial performance.
Step 5. Determine when the covenants will be triggered (or bite).
One role of covenants is to provide an EWS. This includes an assessment of the financial
condition of the business when the covenant is breached. Will the business still be able to
generate some cash flow for partial repayment? Or are the covenants set so loosely that they
have no bite until the business is in a very serious position. If that is the case, the lender
needs to rely on internal monitoring to meet the shortfall in protection from the deal structure.
The effectiveness of covenants can vary. Financial covenants are commonly listed in order
from most effective to least effective:
For example, a lender wanting to control the level of debt has a potential range of options in
terms of effectiveness:
Restrictive or event:
No more or maximum level of debt clause covenants
Cash flow:
Debt service capacity covenants
Income statement:
Interest coverage or Debt or EBITDA covenants
Balance Sheet:
Leverage covenants, based on debt or total liabilities figures from the balance sheet
The weaker the option agreed to, the more reliance is placed on internal monitoring to
provide an EWS. Otherwise, the client and the lender have limited options to take corrective
action.
Step 6. Identify actions to take when a covenant is breached.
The lender should assess all available options when the covenants are triggered and
repayment is no longer likely to follow the original plan. Options available to the lender and
client may include:
Above all, given that the situation is uncertain, the lender needs to be in a strong negotiating
position with third parties and with the client, if agreement for remedial action is not likely. A
strong negotiating position is possible only under certain conditions:
Therefore, the effectiveness of covenants in the deal structure is questionable where the local
legal environment does not allow covenant breaches to be easily enforced, or if the deal
structure provides little protection against structure risk.
Step 7. Examine the quality of compliance.
The covenant structure sets out the negotiated expected outlook with the client. It is critical
for the lender to know as soon as possible when the client is not compliant with the deal
structure. This means that the negotiated outlook has changed. If the covenants are loose, or
the compliance requirements from the client are weak, the covenant package is ineffective.
There are critical issues to consider in terms of compliance:
How detailed are the compliance statements required by the deal structure? Do they
provide enough detail to allow the lender to substantiate the compliance statements
made by the client?
How stringent are the lenders internal controls to ensure that compliance statements
are received on time and in the required format?
Can internal monitoring systems compensate effectively for compliance and deal
structure weaknesses?
Is the cost to the lender of the compliance and monitoring justified, when compared to
the pricing of the loan?
This seven-step approach should be applied in line with the internal policy of the lender. Most
financial institutions have policies on the type of covenants to be included in deal structures
for different types of loans. They also set guidelines on definition issues.
The approach not only helps assess the effectiveness of individual covenants, but also the
combined package of covenants. Some covenants in the deal structure may be strong enough
to compensate for weaker covenants.
The lenders assessment of the effectiveness of the whole covenant package is determined by
how well the stronger covenants compensate, or fail to compensate, for the inadequacies of
the weaker covenants.
Financial strength
Applying the seven-step approach requires you completion of several detailed actions. Each
action is described below according to each step.
Step 1. Identify the critical risk factors.
Use the Credit Risk Grid discussed in previous lessons, to prioritize the existing business,
financial and structure factors. Create a range of covenants to protect and control the potential
negative impact of these factors on future PD and LGD. The various covenants available
include event, restrictive, non-financial, financial and information undertakings.
Step 2. Determine who the covenants will apply to.
Draw a group legal structure organizational chart. Decide which other legal counterparties
and credit bases, in addition to the borrower, should be covered by the covenants. Other legal
counterparties will most likely include guarantors. Other credit bases will most likely include
other group companies and shareholders. Then decide on the mix of unconsolidated or
standalone covenants and consolidated or group covenants.
Step 3. Assess the definitions of the covenants.
For financial covenants, examine the most recent financial statements. Look for critical
accounting policies and potential issues of creative accounting, such as misuse of asset
revaluation and capitalization of costs.
Check that the covenant definitions do not allow the client to use creative accounting as an
escape route to avoid covenant breach. Look for ambiguous definitions that can be used to
gain an advantage.
Non-financial covenants can also use weak definitions as an escape route. Look for weak
definitions such as the two examples listed below:
High thresholds
For example, cross default only triggers when a debt of a very large size goes into
default.
Exceptions
For example, a negative pledge covenant may restrict a borrower in the airline
industry from providing collateral from all assets except aircraft, which in reality
accounts for 70% of total assets.
Once you have forecast the approximate situation, assess whether the business will be in a
strong enough position to take remedial action. If not, you may need to set earlier warning
signals from internal monitoring.
Step 6. Identify actions to take when a covenants is breached.
Assess the relative importance of the covenant structure in relation to the other deal structure
components. Establish to what extent the deal structure includes flexibility and control:
Do you have control over critical assets, cash flows and contracts? Control provides
strong negotiating power over an uncooperative client, and avoids being subordinated
to other stakeholders. Without control over key assets and cash flows, you have little
influence with an uncooperative client, or with other stakeholders who likely have a
superior debt priority position in claiming funds from the business.
Covenants are a critical part of deal structure design and negotiations. The client
wants to retain control over the business and may regard strong covenants as placing
unacceptable limitations on that control.
Covenants are an essential part of monitoring against the most likely outlook.
Covenants are a major tool for the lender in managing unexpected changes in the risk
profile.
Create options and suggest alternatives that may be more acceptable to the client,
while still retaining some protection.
Assess the effectiveness of the covenant package, and how it combines with other
deal structure components and internal monitoring to provide an EWS of increased
risk, and protection from subordination and dilution.
Have the borrower risk profile or market conditions changed significantly (positively
or negatively)? If yes, should you or the client seek different terms from the existing
covenant package?
Does your competitive position allow you to seek a tighter covenant package? Or
does it force you to rely on other deal structure components or internal monitoring to
provide the protection needed?
What type of covenants will give the best protection against the most important
business, financial and structure factors? Is the ideal covenant type event, restrictive,
non-financial, financial or information undertakings?
What is the most realistic range of covenants to aim for in line with your current
negotiating power, internal policies and market conditions?
Are the covenants most applicable to the borrower, guarantor, group, shareholders or
other legal counterparties and credit bases?
Are there standard local market definitions? It is possible to tighten the definition? Is
reliance placed on internal monitoring to compensate for the limitations of covenants?
Are standard lender definitions available in the institution that can be used uniformly?
What are the critical accounting policies in the clients financial statements? Does the
definition of financial terms in the financial covenants prevent these polices from
being manipulated to avoid a covenant breach?
If not, will the financial covenants be monitored internally at a tighter level than in the
documentation, to provide an earlier warning signal?
If there are no projections, do the financial covenant levels give an EWS of variance
from historic performance, or should they be monitored at a tighter level?
Will there be enough cash flow to at least pay for interest, to prevent debt from
increasing further?
Will the capital and leverage of the business sufficiently allow time for remedial
work?
Does the deal structure provide alternative independent sources of repayment such as
guarantees or equity injections?
What would be the scope of the business to conserve cash by delaying capital
expenditures, or by reducing costs and working capital requirements?
What control would you have of the key assets and cash flows, compared to other
current and future stakeholders?
How easy would it be to legally enforce default, should the client not be cooperative,
or if unreasonable behavior is threatened by a third party?
Are the compliance reports from the client frequent enough for the level of risk?
Do you have the right to call for additional information on a regular basis?
Is it clear internally who is responsible for monitoring the compliance, and how alerts
for non-compliance will be generated?
Summary
What is the overall strength of protection from the whole covenant package?
Has it been integrated into the deal structure and internal monitoring to provide the
best possible EWS, and protection from structure in the current market conditions?
Knowledge Check
Question 1
Limitations on capital expenditure clauses are an example of which type of covenant?
Event
Restrictive
Non-financial
Financial
Restrictive covenants prevent actions that would increase risk for the lender. Examples of
restrictive covenants include clauses such as no more debt and limitations on capital
expenditures.
Question 2
A negative pledge would be classified as what type of covenant?
Event
Restrictive
Non-financial
Financial
Non-financial covenants are designed to control risk without setting financial parameters.
Examples include a negative pledge triggering default, if collateral is given, and cross default,
if the borrower defaults with a third party.
Question 3
If a company fails to complete a contract on time, what type of covenant would most likely
be in default?
Event
Restrictive
Non-financial
Financial
If a company fails to complete a contract on time, what type of covenant would most likely
be in default?
Event/Restrictive
Cash Flow
Income Statement
Balance Sheet
In terms of effectiveness, the order of financial covenants, from most effective to least
effective, is generally restrictive or event based covenants, cash flow covenants, income
statement covenants and balance sheet
Question 5
Adopting the seven-step approach to design and assess the effectiveness of covenants benefits
the lender. Which is not a benefit of this approach?
Creates options and suggests alternatives that may be more acceptable to the client,
and still offer the lender some protection
Assesses the effectiveness of the covenant package, and how this combines with other
deal structure components and internal monitoring, to provide an EWS of inreased
risk and protection from subordination and dilution
Guarantees that the lender will not be subject to credit losses, if the borrower defaults
on principal or interest repayment
Adopting the seven-step approach provides the lender with various choices for flexibility and
control:
Create options and suggest alternatives that may be more acceptable to the client, and
still offer the lender some protection.
Assess the effectiveness of the covenant package, and how this combines with other
deal structure components and internal monitoring, to provide an EWS of increased
risk and protection from subordination and dilution.
Question 6
The existence of covenants on a loan can enhance the credit so that a marginal loan becomes
good.
True
False
Covenants do not make a marginal loan good and should not be considered as a secondary
source of repayment. They do not guarantee that at the time of covenant breach, cash or cash
flow will be available to repay the debt.
2016 Moody's Analytics