Loan workouts are voluntary agreements to restructure a company’s finances. The principal aim of such transactions is to improve a company’s ability to service its debt.
At its core, this requires one or more of the following:
- A reduction in the nominal or present value of the company’s debts.
- An extension of the period over which its debts are serviced.
- The provision of new finance.
- The appropriate restructuring of the business of the enterprise.
A loan workout may be formally defined as: An out-of-court agreement between the stakeholders of a company on a mutually acceptable course of action, with the aim of rescuing an enterprise with a commercially viable future. Loan workouts are entered into voluntarily by all the participants affected by their terms, without being compelled to do so by a court. There is also a distinction between the company (or the legal entity) and its business undertakings. The focus of a loan workout is on the latter. In certain circumstances, a business may be viable, whereas the company which owns it, may not be. In such circumstances, a loan workout may focus on the commercially viable parts of an enterprise (provided they are a relatively significant element of the group), whereas other parts may be subject to statutory insolvency procedures.
A typical loan workout involves three stages:
- The calling of a moratorium to achieve stability.
- A restructuring of the company’s business and finances.
- A refinancing once the business has been turned around, or the implementation of other exit strategies by the company’s lenders.
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Statutory frameworks can be broadly categorised into those that are ‘creditor-friendly’
or ‘debtor-friendly’. In a strict creditor-friendly insolvency regime, the control over all the assets and businesses of a company is taken away from its management and shareholders upon entering into formal procedures. Responsibility for managing and realising the assets passes to a trustee or administrator, who does so on behalf of all, or the secured, creditors. Also, the country’s priority rules are followed strictly when proceeds are distributed among creditors. Countries with English law tradition, such as England, Ireland, Malaysia and Australia, are considered as having strongly pro-creditor insolvency regimes.
Scandinavian countries and those with German law traditions also have creditor-friendly regimes, although less so than the first group. Insolvency under debtor-friendly regimes tends to encourage some form of debt
forgiveness or forbearance as part of the financial restructuring. Also, the company is generally allowed to continue operating, either in the hands of its existing management, or a trustee. The creditors have a relatively passive role in the restructuring process. Debtor-friendly insolvency procedures are found in the United States, France and, to a lesser extent, in parts of Central and South America. The lenders’ influence over the outcome of statutory insolvency proceedings is considerably weaker in debtor-friendly regimes.
Some countries without a corporate tradition, such as Islamic jurisdictions, tend to be neutral in this area.
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Statutory insolvency frameworks provide the rules and mechanisms for the realisation and distribution among stakeholders of the assets of insolvent companies. If the value of a company as a going concern is greater than if it were to be liquidated, such frameworks also enable the preservation of the enterprise of the company so that, if appropriate, it can be rehabilitated. If necessary, this can be under a different ownership. Also, the procedures provide for changes in control once insolvency is established or expected. Statutory insolvency frameworks aimed at the recovery of assets from a non-viable business are prevalent in all countries around the world, although they vary considerably in their effectiveness. They generally provide for a trustee or other official appointed by a court (or other body empowered by legislation) to realise the assets of an enterprise and distribute them to the various stakeholders of the company in accordance with priority rules. In many jurisdictions, they also provide for the prevention of preferential treatment of a party or interest group in the period leading up to a financial crisis.
Insolvency procedures aimed at rehabilitation are also common, providing for the stabilisation and, usually, sale of the business to new owners, under the supervision of a specialist appointed under the provisions of a statute.
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There is normally considerable uncertainty and instability surrounding a company experiencing financial difficulties. This makes an accurate assessment of its position and prospects difficult. Reaching agreement on a course of action becomes problematic.
Insolvency legislation is aimed at overcoming such problems. The key challenge for policy-makers in this area is to design a legal and regulatory framework that meets two key objectives:
- To identify and rescue those companies that can and should be rehabilitated.
- To liquidate efficiently those companies that do not have a viable future.
In reality, various shortcomings associated with statutory frameworks, highlighted later in this chapter, create difficulties in meeting these objectives. Rescuing commercially viable companies within a statutory framework can be particularly difficult. Failure of such companies causes unnecessary losses among their stakeholders and for the economy as a whole.
Many of the drawbacks of rescuing companies within a statutory framework can be avoided if a company’s stakeholders, and in particular its creditors (who are usually the interest group most affected) can assess a company’s commercial viability and agree a financial restructuring without recourse to the courts. Loan workouts, which are essentially financial restructurings agreed in an out-of-court process, can therefore be
an effective tool for corporate rescues.
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While there are a few differences, the structures for conventional small business loan transactions are similar to those of the unguaranteed portions of SBA 7(a) loans. One distinction is the excess spread available. Note, for 7(a) transactions, excess spread from the entire loan is available with only the unguaranteed portion being securitized, where for conventional business loans the entire loan is in the transaction.
Conventional small business loans are also made to “qualifying borrowers,” whereas the eligibility requirement of SBA loans is for borrowers that cannot obtain this financing. Therefore, the quality of conventional small business loans is generally better than SBA loans.
The average loan balance for conventional business loans for the most part will be higher than the SBA due to a lack of SBA limits on loan size. Also recall that SBA loans are typically floaters indexed to the prime rate. Conventional loans tend to be indexed to three-month LIBOR because the investment community prefers LIBOR floating rate bonds. Indexing the underlying collateral to the same index mitigates basis risk. SBA transactions have basis risk; however, the rating agencies take this into consideration when specifying levels of credit enhancement for deals.
Large portions of conventional loans are secured by first liens on real commercial property. Transactions will often consist of pools of loans backed almost completely by real estate collateral. When the loan is not backed by real estate, losses on defaulted loans will typically be higher due to the lack of real estate collateral, which is generally an appreciating asset, versus collateral such as equipment, which is a depreciating asset.
Prepayment penalties for conventional loans tend to be more severe than the SBA. Penalties are set by the lender and will likely start at 5% and step down one percentage point per year for the first five years following disbursements.
SBA transactions are generally more geographically diverse than conventional transactions. Forty-eight states could be represented in an SBA transaction where conventional transactions may contain only eight with around 70% of loan concentration in one state. Small business performance is negatively affected by downturns in economic cycles; the geographic diversity of SBA transactions lessens some of this risk.
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Grace
Following graduation or withdrawal from school, Stafford, and Perkins borrowers are granted a period before the repayment of their loan begins. During the grace period, the government continues to pay the interest for subsidized and Perkins loans. For unsubsidized Stafford loans, the interest is still the responsibility of the student, who may request a shorter grace period to avoid additional accrual of interest. Grace periods for Stafford and Perkins loans are typically six and nine months, respectively.
Deferral
A deferral is a postponement of the loan repayment and acts similarly to the grace period. Interest accrues and the government pays it for subsidized and Perkins loans. However, for unsubsidized loans, the borrower is required to pay the interest or have it capitalized. Following are some circumstances in which students may receive deferment:
- Enrollment in postsecondary school at least half time.
- Economic hardship.
- Inability to find full-time employment.
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The loan size varies from $1 million to, more recently, greater than $1.5 billion. Smaller loans allow for greater diversification and less credit risk, yet they are more difficult to analyze. Large-loan deals are typically purchased by buy-and-hold accounts, such as insurance companies and pension funds with real estate expertise, and often are preferred by these “real estate-savvy investors” as it is economical to spend the time analyzing the property.
Smaller loan deals (conduit) are more liquid and are typically purchased by total-return, mark-to-market investors that, lacking real estate experience, are more apt to rely on diversification and the rating agencies’ analysis and judgment.
Fusion deals, presently the most common type of CMBS deal, are “lumpy” conduit deals. Generally, a fusion deal has a few large loans that are typically shadow-rated investment-grade loans that are combined with a diverse pool of conduit loans. They grew in popularity after 9/11, which shut down the single-asset and large-loan type CMBS deals due to concerns that the risk of a terrorist act against one large property was too great. As a result, these large loans were split up and portions placed into various CMBS, thereby creating fusion deals. Much focus is placed on the top 10 and top 20 loans in any given deal as these can have a substantial influence on performance.
Concentration is important because it is sometimes difficult for the rating agencies to predict commercial loan defaults. The rating agencies use measures to score loan concentration and, accordingly, require more or less credit enhancement. For example, Moody’s uses the Herfindahl index to determine the effective number of loans within a pool. A pool of 100 loans that had a Herfindahl index of 65 indicates that the pool has an effective diversity of 65 loans.
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Greater complexity in loan workouts is a result of increased diversity, both in the participants involved in financing companies and in the nature of financial claims. Traditional bilateral banking relationships are being replaced by more transaction-based financing arrangements, including the direct access to investors in the capital markets. As a result, when corporate distress occurs, there is a very wide range of institutions that become involved in support operations. Potentially conflicting objectives from a wide spectrum of financiers, including venture capitalists, credit insurers, institutional and retail bondholders and vulture funds, can be difficult to reconcile. At the same time, the complexity of companies’ legal structures and financial management activities results in a loss of transparency. Considerable effort is required to unravel financing arrangements if such companies encounter difficulties. The process of determining the prioritisation and negotiating strengths of the different claims on a company’s assets is hampered, causing uncertainty among the participants.
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The U.S. real estate crisis attracts more circles. Even at the beginning of January, experts expected that between 50 to 100 billion U.S. dollars by banks concerned must be depreciated. In addition to the 50 billion U.S. dollars, which has already been written off.
Now reports that the U.S. credit rating agency S & P with the message word that further loans with a volume of over 500 billion should be examined. In the worst case, this loan volume fully depreciated. The experts from S & P, however, assume that this sum of “only” nearly 265 billion U.S. dollars must be depreciated.
Through this message is likely many investors have become clear that the U.S. real estate crisis, which led to a worldwide credit crunch seems to mutate, long ausgestanden is not. Only when all the banks its portfolio of securities and loans examined, re-assessed and thus endangered by a failure of papers have depreciated, this crisis can be ended. Until the true size of the necessary write-offs are not known, the credit crisis persist. Yet, not all value losses in the books of the banks has been updated.
German investors have therefore been the coming weeks to further adjust fluctuating stock exchanges.
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