How, And When, To Position Loans Like Equity

Improving Loan Sales

We have witnessed some banks position their senior secured loans as quasi-equity financing.  This plays well to borrowers who are looking for long-term banking relationships, and it has helped these innovative banks secure quality clients, increase relationship lifetime value and drive core deposits.  In this blog, we will outline how these banks structure these credits and how they position these loans for maximum effect.

Debt versus Equity

There are numerous differences between debt and equity. However, there are a few features that community banks can modify for senior secured loans that can make debt financing appear more like equity.  Below is a list comparing the most important features of debt versus equity.

Using Debt and Equity For Capital Financing

 

The banks that can offer their senior secured loans as quasi-equity have been able to structure financing to eliminate some of the drawbacks of debt and accentuate some of the benefits of debt.  This strategy alters the features that are outlined above in the blue boxes. 

 

Senior Debt Structure

 

The first important feature of the quasi-equity loan product is to extend the maturity of the commitment.  Extending maturities to 20 or even 30 years are not easy for some banks, but consider that the product is offered only to the best credit customers.  The credit fundamentals must support the term structure.  The following are the fundamentals that community banks consider when extending loan commitments to 15, 20, 25 or 30 years:

 

  1. Strong and predictable long-term borrower cash flows.  The structure is reserved for “A” and “B” credits where default rates are expected to be significantly below average. 
  2. The structure must make sense from the outset of the loan.  That usually reflects modest LTVs in the range of 50% to 70%. 
  3. Interest rate risk should be mitigated to protect both the bank and the borrower.  We have seen various solutions, but many banks contract out interest rate risk protection with third-party vendors that can offer seamless solutions without derivatives for the lender or the borrower.
  4. These loans are all amortizing and therefore the concern that loan exposure is too great when visibility of cash flow is lowest (five to 10 years out) is mitigated by the mortgage-style amortization that reduces exposure quicker after year five than in the first few years of the credit.  Below is a graph showing the LTV over time on a 25-year amortizing loan.  In the first few years the LTV declines slowly, but in year ten the initial 65% LTV is only 47% and in year 15 that LTV is 35%.  With the correct initial LTV and amortization structure, these loans allow for commitments out to 20 or even 30 years.

 

Loan To Value Comparison

 

The second important feature of the quasi-equity loan product is to give the bank and the borrower (if both agree) the option to retain financing in the event of a change in circumstances.  For decades community banks have emphasized relationship banking over transactional business - and for good reasons.  To cement and grow a relationship, the commitment between borrower and lender must be longer and deeper.  However, commercial accounts are always in flux, with changes in borrower composition, alterations to business models, and changes in borrowing needs.  To achieve quasi-equity flexibility, a loan should be structured to offer the following flexibility (all subject to the lender's unilateral approval):

  1. Substitute affiliated borrowers for tax or business purposes.
  2. Permit additional debt, subject to covenants, the proven ability to repay and collateral priority.
  3. Permit extension of the term, subject to covenants and pricing that reflects the then prevailing rate.
  4. Bifurcation of the loan to various affiliated borrowers.

 

If the borrower is high credit quality and a relationship account, then the above features make sense.  These features also serve to extend the lifetime value of the relationship while still providing the bank with the ability to review the credit in the future and the option to call the loan if the credit is no longer suitable.  However, too many banks spend energy trying to get borrowers to accept shorter loans so that credit can be re-evaluated.  For the average borrower, this is sound, but the strategy leads to transactional business and competition at every renewal. 

The third important feature of the quasi-equity loan product is to sever the connection between the loan and the specific collateral.  The quasi-equity loan permits borrowers to substitute collateral for the same loan through the commitment term as long as the collateral is acceptable to the lender.  This appears to be more of a radical change for the banking industry, but it is sound from a credit and marketing perspective. 

Consider that most borrowers view the collateral securing the loan (typically real estate) as inventory that is bought, sold and substituted.  If banks make the buying, selling or substitution of collateral a call feature of the loan, then the loan becomes a transaction (instead of a relationship), the lifetime value of the customer decreases, and competition for the customer increases – all negative outcomes.  Instead of collapsing the loan when collateral is sold or changed, the loan can continue with substituted collateral that is acceptable to the lender in the future.  This feature also allows the borrower to bifurcate the security arrangement and allow the loan to be secured by multiple properties.

How does the quasi-equity loan lead to better deposits?  Banks are all looking for customers with multiple cross-sell opportunities.  When a borrower has a two or three-year committed loan, excess cash is typically used to pay down debt because the remaining commitment term is short and the value of retaining the debt is low.  However, when a borrower has a committed loan term of ten, 15 or 20 years with the options and features described above, the value to the borrower of retaining the credit is high, and excess cash is not best deployed to retire the debt but may be available to the bank as cheaper deposits. 

Conclusion

When changes in rate, changes in business circumstances or changes in collateral require the repayment of a loan and renegotiation, the customer interaction becomes transactional.  By modifying some of the key features of traditional credit products, community banks can position a loan as quasi-equity financing and in the process solidify a relationship, increase lifetime value, and gain more deposits.  This strategy is effective for the best customers, but those are the ones that community banks want to source and retain.