Feeling A-LOAN?

It is common for businesses to borrow capital to fund short-term operations (or cashflow deficiencies) or to fuel long-term growth plans. This e-brief focusses on forms of loans and/or facilities one may encounter when opting for debt as capital (“debt capital”). The reasons for which debt capital is being acquired will usually inform the type of agreement concluded. Debt is oftentimes the preferred means of accessing capital because, in most cases:

1. ownership remains unaffected (notwithstanding any collateral to secure the loan in the event of default); 
2. the interest payments on the debt are tax-deductible, so long as the interest on the debt capital is incurred in the production of taxable income (reducing overall tax liability);
3. there is typically predictable repayment schedules associated with debt financing which makes it easier to predict and manage cashflow; 
4. the cost of the capital is traditionally lower than in other instances of capital raising (i.e., equity capital) as the lenders generally take on less risk as compared to equity investors. For example, in the event of insolvency proceedings, debt holders are paid before equity investors; and 
5. there is no dilution of earnings as there are no new shares being issued. This is particularly relevant when maintaining the value of the shares and appeasing existing shareholders.

Below we highlight prevailing forms of debt capital arrangements and the context within which each is typically used, together with notable aspects of each to be aware of.

A. Short-Term Loans (“STLs”)

STLs are typically utilised for immediate and/or short-term financial requirements of a business. Depending on the risk profile of a business (i.e., the cashflow history together with its asset base), the respective lender’s propensity for risk, and the maturity date and value of the STL, STLs may or may not require security. Within the context of securitised STLs, a lender may require a commercial guarantee, general notarial bond and/or special notarial bond over movable assets or pledges and cessions of specific rights of the borrower in favour of the lender. The repayment or maturity periods of these STLs are generally between one or two financial year periods, with interest being fixed or variable for the maturity period. 

However, STLs, which are unsecured, usually incur significantly higher interest rates compared to longer form loans and/or facilities. It is also not uncommon for lenders to limit the amount of debt borrowers take out with them, which may be insufficient for an entity’s larger financial needs. There are usually prescribed fees and penalties contained in STLs which may include prepayment penalties (subject to the National Credit Act restrictions where applicable), origination fees (effectively an amount expressed as a percentage of the STL value) and late payment fees. 

B. Overdrafts (“OVDs”)

OVDs are facilities provided by lenders and allow the borrower to drawdown amounts in excess of the amount the borrower holds to its credit, up to a prescribed limit. OVDs, like STLs, are typically utilised by businesses for their monthly operations and/or short-term financing needs. OVDs are known to be a common arrangement for purposes of financing small and medium sized entities and are specifically crucial for businesses with fluctuating finance requirements, or unexpected expenditure. OVDs can be unauthorised or authorised. For the latter, these are pre-agreed and will be offered at lower rates as opposed to unauthorised OVDs. Practically speaking, authorised OVDs are preferred because unauthorised OVDs will incur charges for the unauthorised use thereof. Where an OVD is considered larger than usual, the lender may also require security (examples might include a pledge and cession of the borrower’s shares and/or book debts and all related rights thereto, commercial guarantees being granted in favour of the lender or the borrower entering into general notarial bonds and/or special notarial bonds in respect of specific movable assets in favour of the lender) before authorisation, which is typically connected with the lender and borrower’s level of risk. 

OVDs are provided at a cost to the business, and this comprises, amongst others, annual arrangement or maintenance fees, plus interest on the overdrawn amount at the end of each day. There are also other costs associated with OVDs, such as non-utilisation fees, which will depend on the size of the facility and the lender arranging the OVD. Arrangement fees are those administrative charges payable to the lender for purposes of reserving the funds and to cover all opening costs. In addition, OVDs also come with maintenance fees which are charged monthly. The interest payable at the end of each day will vary depending on the risk of the business defaulting, with these rates being variable based on a “margin over prime rate” or other reference rates. A higher interest rate will usually be charged for utilising the unauthorised facility. 

Even where an authorised OVD is agreed upon, the lender may charge unauthorised borrowing charges (unpaid fees and utilisation fees) where the authorised OVD is exceeded in each period. Whilst in practice these charges are mostly capped by the lender to reduce a business’ exposure, the over-utilisation charges tend to add up. In the case of larger OVDs, the cost of borrowing may be reduced where the OVD is secured as the lender’s risk is mitigated by the security provided. In most cases, the borrower will be required to securitise its business assets, guarantee the OVD amount, or be requested to source third-party guarantees or security for this purpose. The same applies where covenants (effectively financial and/or operational boundaries agreed upon by the borrower, to ensure that the risk of default is lowered – and can include a mixture of “affirmative” covenants requiring specific actions, such as adhering to financial ratios, and “negative” covenants which restrict activities that the borrower may engage in pursuant to the facility, such as incurring additional debt) or other information is required by the lender as a condition to providing the OVD and continued access to the debt capital. Typical covenants might involve current management accounts and/or cashflow projections being requested from the borrower on a regular basis, which compliance will be for the business’ expense.

C. Revolving Credit Facilities (“RCFs”)

RCFs are lines of credit and allow the borrower to withdraw, repay, and redraw funds up to a certain limit. These provide businesses with ongoing access to capital, distinguishing RCFs from STLs and OVDs. Under RCFs the entire amount can be drawn down at any time, and variable interest is charged on the withdrawn amount. Traditionally, RCFs require minimum monthly repayments and may be open-ended or for a set term. RCFs are particularly convenient as, once arranged, there is no need to reapply for access to the funds. In addition, interest is only payable on the amount borrowed, and not on the entire credit limit. 

Whilst RCFs provide easy access to pre-agreed limits, the interest costs will tend to mount where the balance owing is not paid timeously. As with the other debt capital arrangements, costs are also associated with RCFs, and these include annual arrangement fees, drawdown fees, and ancillary charges for making the credit line available. 

D. Syndicated Facility Agreements (“SFAs”)

SFAs involve multiple lenders providing loan facilities to a borrower and are typically arranged in connection with large-scale projects or significant forecasted financing needs. For example, it is common that international development lenders will syndicate these arrangements for a borrower’s ear-marked expansion or development needs, in line with the lenders’ development mandates. SFAs usually require arrangers, a book-runner for the syndicate, an agent (acting on behalf of the syndicate) and different classes of lenders (senior, mezzanine and junior/equity lenders). The agent in these instances is responsible for representing the lenders’ collective interests throughout the term of the SFA, including its enforcement and any security rights established under the SFA. Owing to distinct lending commitments owed by each lender separately under SFAs, the liability of each lender will typically be several and not joint and several. Depending on the class of lender, the right to repayment of the specific facility being made available by each is tiered, in order of priority. 

Whilst distinct to the other debt capital arrangements, SFAs will house similar terms. Interest for example can be fixed or variable and will be linked to a benchmark rate determined by the lenders. Repayments of the respective loan facilities is usually periodic and controlled by the agent on behalf of the syndicate. A lending syndicate prefer these arrangements because risk is shared amongst the syndicate, which theoretically reduces the exposure of each lender. Whilst a borrower will reap the rewards of the expertise provided from multiple financial bodies under the SFA, there will be higher costs involved because of the complexity linked to the arranging and management of the repayment schedules, security enforcement and the differences in cross-border practicalities. A syndicate of lenders (through a lead arranger) will instruct a lead counsel, which will then engage its local counterparts for purposes of negotiating and agreeing on an SFA’s terms. A borrower in these instances will likely require representation on many levels, especially where cross-guarantees (which must comply with the Companies Act requirements for financial assistance) and/or other securities are required for purposes of securitising the SFA. For example, SFAs which are drafted to protect the lenders’ interests will contain many condition precedents (“CPs”) that appear non-negotiable, however, the context may not necessitate some of the CPs’ applicability and these will be flagged and negotiated by counsel for the borrower.

Hence, representation by a team of professionals accustomed with SFA terms and their arrangement is advisable to ensure efficient and fair dispensations.