Thursday, 29 September 2011

Anatomy of a convert - why not get a loan from the bank?

If a company needs money, it can always go to the bank and ask for a loan.  This is certainly something most companies do, so it is interesting to ask why companies don't just exclusively take out bank loans.  The answer is because the familiar terms and conditions of company loans are not ideal for companies.

Loans can often be variable rate - this allows the bank to cheaply remain neutral to moves in interest rates - they're passing that interest rate or reinvestment risk on to your company, which will need to manage that risk.  At certain times in the business cycle, that risk can be quite substantial.  Regular interest payments could increase by 10%, 25%, 50%, 100% even, on a dramatic upswing from a very low interest rate.  Of course, that could work in your favour if rates are already high and you have a project whose projected return on capital is higher than the high interest rate, and you expect rates to decrease over the following period.

Also, from a cash flow and accounting point of view, having this variable outgoing on your balance sheet can make it hard to maintain that signal of financial stability your chief financial officer would like to present to the world of potential investors in your company.

One talks of the capital markets as the place where companies try to get equity financing, but it is important to realise that your company needs to be of a sufficiently large size to play in the capital markets.  So smaller companies simply may not have this option open to them in a way and on a scale which makes economic sense - investment banking fees have never at any time been called cheap.  They're left to negotiate local deals with local banks.  Those banks operate in a less rarefied environment, perhaps have less of a capacity to make forecasts of your company's true growth prospects over the medium-to-long term (by which I mean over a 5 year repayment horizon).  In other words, your local bank in all likelihood can't afford to make corporate credit assessments beyond this five year horizon.  Result?  The loans they make tend to fall into this maturity horizon.  Bond maturities can be on the twelve year, fifty year, hundred year horizon.  This kind of stability allows corporate finance people to plan with more stable cash-flows and fewer trips to the bank manage to arrange shorter-term loans.

Local banks tend to be in more of a position of power with respect to a local medium sized company and their loan terms surely reflect this.  Often standard business loan contracts have what is known as an early payment premium, which just means that it'll cost you if you are thinking of over-paying on your loan - i.e. giving your bank more money back than was agreed on the primary repayment schedule of the original loan.

Also, a company often has each loan with a single lending institution - its local bank.  Raising debt on the debt markets means in effect there are as many different lenders as there distinct holders of bond or convertible bond certificates out there in the world.  This diversification of the investor base is sometimes considered desirable for the management team of the company, on the assumption that it is less likely that a tiny number of hugely important stakeholders will attempt to bully the management team into modifying their decisions to be more in line with what the debt owners want to see happen.  Still this does happen, especially when the company comes close to bankruptcy.

Banks often will want senior management in the company to offer some kind of personal guarantee on the loan.  With a bond, all the senior managers are in effect personally indemnified in the case of the company subsequently failing to meet its payments.  Nice for them.

It has to be said that loans provide a large proportion of how companies get their hands on capital for projects.  The debt markets provide the next largest fraction, and finally the equity markets provide the third fraction, so I've kind of introduced them in reverse order of importance.

For all of the above reasons, sometimes companies which are large enough will prefer sometimes to get  their capital from the bond markets instead of asking their bank for yet another loan.  And so-called 'straight' corporate bonds are the subject of the next posting.