Key considerations for renewing your revolving credit facility
As a treasurer or CFO, you know when your revolving credit facility matures. You likely regularly think about or talk to your banks about ways to ensure a smooth renewal. But what’s the best way to be prepared, and what are the key considerations ahead of the renegotiation? The answer begins with understanding several key aspects that will help you optimize the facility.
Know your bank credit rating
We were recently at AFP 2019, where we hosted an educational session on acquisition financing. The audience consisted of more than 200 senior treasury professionals, corporate treasurers and CFOs, who we polled with several questions. The first was, “Do you know how your banks rate you internally?”
The answer was overwhelming: 57 percent of the audience didn’t know what rating their banks assigned to them during the credit review process (i.e., how the bank rates them internally). This is a problem: if you don’t know your bank ratings, you will not be in a position to start your negotiations on a level playing field! Indeed, banks use a company’s credit rating to determine virtually everything about the relationship, including the acceptable amount of exposure, the required pricing of the facility, the covenants they will require in the documentation and the flexibility they will allow in the baskets.
Your rating is at the heart of your bank’s business case. Your banks will talk about the ‘market’ for your credit, which starts with your rating. Your upfront fee, commitment fee, drawn margin, arranger fee, and others will all be based, at least in part, on your rating. These fees, plus the ancillary business the banks would like to do with you, have to compensate the bank for the risk they are taking by providing this facility. The worse your rating (as perceived by the bank), the more capital the bank will have to use and the more business they will require to earn an appropriate return. You can use RAROC (risk-adjusted return on capital) or one of the myriad other return models to better assess this complex equilibrium.
If you have external credit ratings, you may think your banks rate you the same, but this is not true! Each bank will make its own assessment of the risk. Commercial banks’ ratings are often more generous than the rating agencies’ as their expected loss in case of default is lower than bond investors’ (shorter average maturity, additional revenues from bank services, offsets, etc.).
Understanding how your banks rate you will help you understand how well they know your business and, therefore, how likely they are to demand additional business or even be there when you need them. We have seen more than six notches of difference in rating between the way different banks view the same company’s credit risk. This drives a significant difference in how the banks perceive their return on the relationship.
Key consideration: While many credit facilities reference external credit ratings in the pricing grid/documentation, you need to determine what is right for your company and your needs, given your strategic plan. The first obvious point is that the rating agencies will charge a few basis points (bps) on the whole facility amount if you include a rating based margin grid. More importantly, your external ratings may prove more difficult to manage than say a debt/EBITDA margin grid or covenant, and you will likely end up paying more over time for a ratings-based facility.
Understand your business profile and needs for the next five years
Once you know your credit rating, assess your business’s needs, including growth plans, liquidity needs and potential downside scenarios. We often see companies renew credit facilities by just taking their old documents, making any changes required by the banks for new laws, etc. and then going to market. Don’t make this mistake! Even if you think not much has changed since the last time you renewed, you need to take the time to model the next five years and ensure that your facility supports that plan. Even if you are doing an amend and extend, make sure the amended deal fits your needs!
If you believe your business will experience significant changes in the medium term, first carefully consider the timing of your process. Should you launch the process as soon as possible to secure significant short-term needs, or delay it somewhat to capitalize on a meaningful improvement of your credit profile?
Be sure to assess the size of each of your baskets and the level and flexibility of each of your covenants. You should take a deep dive into the size of your requirements, the liquidity you need to support your business, and the flexibility you need in the terms and conditions to support the expected volatility of your business. Is your company acquisitive? If so, how much ‘dry powder’ do you need to fund potential acquisitions? Is it worth paying for that dry powder now, or can you wait and rely on the market to provide it at reasonable rates and terms when the need arises?
Failure to consider the possibilities and incorporate the flexibility you need in your documentation will likely cause you to overpay, either now or in the future. You can always make amendments, but it is expensive and requires consensus from your bank group. In addition to the fees you may need to pay for an amendment, you may find yourself trying to get it done when your company is in a weaker position and/or the market is in worse shape. Proper contingency planning can pay for itself many times over!
Finally, consider market, legal and other risk factors. What currencies do you need or might you need to borrow? Might you get better overall pricing and receptivity by tranching the deal to allow banks to participate only in currencies where they have funding advantage? Do you need a swingline? What benchmark rates do you need to provide for in the documentation, especially given the coming Libor transition? How do you provide the most flexibility to manage the transition without requiring amendment fees in the future? Note: While SOFR looks like the preferred rate to replace Libor in the U.S., it may disadvantage smaller banks, giving the moneycenter banks even more leverage over you. In short, figure out how you want to manage risk and the banks or lenders that understand your business and, therefore, can help you manage your risk more efficiently.
Craft your lenders’ group
Now that you know your needs at a very granular level determine which banks across the globe can fulfill them. Research and identify the best banks suited to provide the services you need. Have significant operations in Europe or Asia? A U.S. bank may not be the best provider in the region. Significant leasing needs? Ensure you have banks in the group that like the leasing business.
Take meetings with potential new banks, even if you don’t think you need them now. We can’t tell you how many times we have seen clients that thought they had a great relationship with a bank, only to have the bank decline to participate in a refinancing. Consider whether your current banks have enough appetite to support your financing needs. How many banks do you want in your group to provide an appropriate balance between having enough credit available and having too many “mouths to feed”?
A final factor to consider, especially for leveraged companies
Credit is available from a much broader range of participants than just banks. Ensure that you consider all the potential providers and weigh the plusses and minuses of using non-traditional lenders to enhance and diversify your sources of funding.
There are a lot of things that go into renewing your credit facility. The key is to start early, be proactive and be thorough in your analysis. Do not just take what your lead banks tell you for granted. Challenge their assumptions, drive what you need, and look for the best banks to provide it.
While your banks will certainly give you “advice,” they have many other factors to consider (including their own balance sheets and credit constraints) and may not have your best interests in mind.