Understand your risk positioning to secure the best investment terms

In today’s market, most lenders agree that the market is overbought. When the market turns, credit investors like banks will seek to get better compensation for their risk. Now is the time to identify your risk positioning and to secure the best borrowing terms.

Public credit ratings and bank internal credit ratings can both affect corporate credit terms. Understanding the bank’s perspective and your options for obtaining a credit facility will ensure accurate financial decisions.

The banks’ perspective on crossover grade corporations

It is important for companies to understand the structure of the syndicated loan market, specifically from a bank’s point of view.

Within the market are both investment grade and non-investment grade corporations. In the middle are crossover corporations, those of low investment grade or high non-investment grade credit quality.

Crossover corporations are an attractive market for banks, although banks prefer high non-investment grade corporations. This is because low investment grade borrowers get investment grade terms, which have fewer protections for banks, so a one-notch downgrade leaves the banks at higher risk. In contrast, high non-investment grade companies usually have tighter protections for the banks, so a one-notch downgrade is not as significant in terms of risk profile for the bank.

Two lending opportunities are particularly attractive to the banks: structural or legal seniority. It is possible or even likely, based on the bank’s position in the capital structure or its loan documentation, for a bank to structure an investment grade facility from a non-investment grade issuer. Whether the facility is publicly rated or not, this structural seniority for the banks should drive them to view their risk more favorably and drive tighter pricing on the facility. Be aware, though – some banks do not give appropriate benefit to structure and collateral when evaluating their risk, resulting in mispricing.

Ensuring that a bank’s internal rating is accurate is a key factor in the bank calculating their return appropriately. Banks that don’t rate you and your credit facility properly will either overcharge you for the facility or continually request additional business to cover their shortfall.

There’s a discrepancy between the banks’ and rating agencies’ perspective on ratings

Importantly, banks and external credit agencies such as Moody’s or Standard & Poor’s (S&P) often assess the same company differently. Your bank may consider you as a crossover or investment grade company, while a rating agency may view your company as a non-investment grade risk. This frequently happens with small and mid-size enterprises (SMEs) (size is a key factor for the agencies), privately owned businesses (no access to equity capital markets), or simply with companies offering above-average profitability to their banks. One key difference is that banks usually have a more intimate relationship with senior management than the agencies or bond investors. Other factors like amortization schedules and shorter-term tenors can drive significant differences in the rating of each tranche of a company’s debt structure.

Understanding in detail the implications of those factors is critical to understanding how investors will engage with you and effectively assessing the implications of various structures on your cost of capital. You must understand how all the pieces fit together and impact each other in order to determine the right structure to minimize your cost of capital.

Benefits of a secured credit facility for non-investment grade companies

Often, banks will ask for security from a non-investment grade company, which potentially lowers the loss they would experience in the event of the company’s default (i.e., loss given default, or LGD). For non-investment grade companies, a secured credit facility can be rated much higher than the underlying corporate credit rating. For non-investment grade companies in the BB or B range, understanding the impact of that collateral on both the rating of the bank facility and the rating of other debt is vitally important.

Credit ratings for small and large companies

While a secured credit facility will often have a higher rating than the corporate credit rating, there is an important caveat. Sometimes there is a large gap between how banks and rating agencies perceive the corporate credit rating and the security package enhancement. That said, there may be a benefit in not publishing a rating from a rating agency. For example, if you are a small company with good credit, rating agencies will view you poorly simply due to your size. In this case, you are likely better off not getting an external rating.

Large companies with bigger needs will face more market pressure to obtain a rating. Bank loans sold to collateralized loan obligation (CLO) investors generally require a rating. A rating can also be valuable if there is a wide gap in the credit risk assessment among the banks themselves, which often happens when the credit story is not straightforward.

Improve credit by acknowledging bank conflict of interest

Many companies today rely on banks to advise on and structure a credit facility. Banks are viewed as independent advisors, but this is not accurate.

With inherent conflicts of interest, banks are unable to provide truly unbiased advice. This doesn’t mean that banks or bankers are bad, just that they have many factors to consider when giving you advice, not all of which are best for you. The bank must protect its own balance sheet. If the deal will be syndicated, they must make sure that it is easy to sell. If your transaction will be sold to investors, they may have large investors driving the terms of the deal at your expense. Just read about the United Natural Foods lawsuit, and you’ll get a sense of all the potential pitfalls. Good bankers will acknowledge the conflicts and tell you that you must evaluate their proposals on your own.

Some companies self-syndicate their credit facilities. Others hire independent advisors to help them evaluate the options or even run the process while still naming a bank as syndication agent.

In any case, listen to your bankers, but make sure to understand your credit standing and the terms you can expect from lenders.

Take control of the process and challenge your banks. The optimal strategy is to evaluate potential lenders one by one, understanding from each what they are willing to provide and at what rates. In doing so, you can evaluate the true “market” for your credit and get the best possible deal.

Need help renewing your credit facility? We’re ready to answer your questions. Get in touch with one of our debt advisory specialists today.

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