What is debt finance?
Debt finance is money that a company borrows from banks or other financial institutions and which it must at some point pay back, usually with interest.
It is one of the two main types of corporate financing available. The other is equity finance, that is, money that a company raises through issuing shares. To find out more about this topic, see The Gateway guide to equity finance in our next issue.
Why does a company choose to use debt finance?
There are many reasons why a company might choose to use debt finance, including:
- To smooth over an irregular cashflow. For example, an ice cream company with costs throughout the year might borrow money every January to pay staff and equipment expenses and pay it back after the summer when it has collected the majority of its annual revenues.
- To purchase another company without using its own funds. For example, private equity funds generally use a much greater proportion of borrowed money than fund money to acquire their targets because doing so is more tax efficient and provides them with a greater return on the fund money they invest. For more on why most corporate acquisitions are funded largely by debt, look out for The Gateway guide to mergers and acquisitions in an issue later this term.
- To invest in an asset needed by the business. For example, an airline might want to finance the purchase of new planes. This type of debt finance is known as asset finance.
- To fund a construction project, using expected revenues from the completed facility to enable it to be granted the loan, which is known as project finance.
- As a temporary measure before it puts in place some form of equity financing. This kind of financing is known as bridge finance.
- To refinance an existing loan, either because its current financing is due to be repaid, or because it is able to obtain better terms by switching to a different lender or to a different type of debt finance.
How is a company's level of debt finance indicated?
The "gearing" of a company indicates how much debt it has in relation to its equity capital, that is, the amount of money invested in the company by its shareholders. Gearing is normally expressed as a percentage, or sometimes as a ratio.
For example, a company with a gearing of 60% (or 0.6 : 1) has debt which is equivalent to 60% of its equity capital. Whether a company's gearing is considered prudent depends on the industry in which the business operates and on the economic climate but, as a general rule, a gearing of 15% or below would be considered cautious, while anything over 100% would be seen as excessively risky.
What kinds of debt finance are available?
There are two main types of debt finance available to a company: loans and bonds.
A loan is a sum of money lent by a bank or a group of banks to a company. A corporate loan is often also known as a "facility".
There are a variety of different types of loan available to a corporate borrower. The most straightforward kind is a "term loan" which must be repaid after a set period of time, that is, the loan's "term". Term loans are sometimes divided into senior and junior sections or "tranches", with holders of senior debt enjoying greater protection of the money they've invested, but in return for lower interest rates than those offered on more risky junior debt. Some common types of junior debt include "mezzanine" and "second-lien" tranches.
A revolving loan (or a "revolver") is akin to an overdraft. When banks agree to grant a revolving loan to a company, they agree that, for a certain period of time, they will allow the company to draw from a fund of a set amount whenever the company needs extra resources. Withdrawals under the revolving loan, unlike other types of corporate loan, can be repaid and then redrawn, although there may be limits on the number of withdrawals that can be made. It's important to remember, however, that while it's useful to think of a revolver as an overdraft, these loans are usually not technically overdrafts because lenders cannot demand at any point that their money is repaid, as they can with overdrafts.
A "swingline" is a loan which lenders may offer to a borrower as an emergency facility by which it can have access to large sums of money at short notice but for a limited period of time. Swinglines are typically used to pay back money borrowed through bond issues when a company is unable immediately to "rollover", that is, reborrow, these funds by issuing new bonds.
Usually a loan agreement between a company and a bank or banks will offer the borrower a combination of these different types of loan.
A bond can be thought of as an IOU note issued by a company. When it issues bonds, a company effectively splits the debt finance it requires into a large number of small sums and, by issuing the bonds for sale on the financial markets, borrows these small sums from the range of banks and financial institutions who purchase the bonds. Bonds are also known as "paper" or "notes". Companies who borrow money by issuing bonds are normally known as "issuers".
As with loans, there is a wide variety of bonds available to a company. "Commercial paper" or "shorts" are bonds which must be repaid a short period of time after being issued, usually under a year. An "MTN", that is, medium term note, is a bond which usually must be repaid within a few years of issue. "Long bonds", as the name suggests, have a longer repayment period, which can be as much as 30 years. Finally, "perpetuals" are bonds with no repayment date, which can therefore be seen as akin to equity finance.
Who provides the money?
A company will sometimes borrow money from one lender only, which is known as a bilateral agreement. However, the financing needs of many companies are usually too great for any one bank or financial institution to take on. A company will therefore usually borrow from a group of different lenders at once, known as a syndicate. The way in which companies do this works differently for loans and bonds.
The vast majority of parties involved in making syndicated loans are banks. Within a syndicate of banks, different banks will be allocated various roles, which vary from deal to deal. The "arranger" will be responsible for getting other banks to agree to lend to the borrower, assisted by the "bookrunners" (the list of banks involved in the deal is known as the "book"). The "documentation agent" is responsible for working with lawyers to produce the loan documentation. The "facility agent" (sometimes known as an "administration agent") deals with the administration of the loan once it has been made, for example, paying interest to the lenders and co-ordinating the way in which decisions about the loan are reached by the syndicate.
Bonds may be purchased by banks, but are also often purchased by other investors such as pension funds, insurance companies or even individuals. Because the pool of investors is much wider, there is not the same ongoing relationship between an issuer and bondholders as there is between a borrower and a loan syndicate. However, there are some similarities. A bond issue will be run by a "lead manager" who forms an initial syndicate of banks who "underwrite" the bond issue, that is, agree to be the first purchasers of all the bonds issued. The issuer's "fiscal agent" will be responsible for paying interest under the bonds to the bondholders and eventually, repaying the principal, that is, the money loaned to the issuer by the bondholders.
Why do banks and financial institutions choose to lend to borrowers and to purchase bonds?
Most loans and bonds pay interest. In the case of a loan, interest can be fixed or floating. A floating rate is a set percentage above an externally set variable rate which in the case of loans in the London market is normally LIBOR (the "London Interbank Offer Rate", which is based on the rates at which banks are lending to each other in London). Interest on a bond is known as its "coupon", which can also be fixed or floating.
However, banks and financial institutions make their most significant income from the fees they charge for their involvement in setting up and administrating these forms of financing for their clients.
How are lenders protected?
Lenders may choose to protect their money when they make a loan by taking "security", that is making the loan subject to getting rights over the borrower's assets. Protection of lenders could also take the form of guarantees by other parties, perhaps the borrower's parent company, that the loan will be repaid.
Bonds are typically unsecured, although occasionally offer some form of security to investors.
Do the original lenders hold on to the debt?
Banks and other institutional lenders do not always keep loans made and bonds purchased until the date on which repayment is due. Bonds and loans are viewed as assets which can be traded. Such transactions between lenders are collectively known as the "secondary market" (the "primary market" is the initial making of loans or issuance of bonds).
There are a number of reasons why a bank or other investor might choose to sell debt or bonds on the secondary market, for example: to reclaim the capital in order to make other investments; to dispose of risky investments; or to make a profit by selling debt products for more than it paid for them.
Some useful terms
Amortisation: Repayment of a debt in a number of separate installments.
Basis point: One hundredth of one percentage point - the unit in which interest rates on loans and bonds are usually expressed.
Bullet repayment: Repayment of a debt in a single instalment.
Credit rating: A grade given to a borrower or a debt product by a credit rating agency based on its opinion of the risk of lending to the borrower or investing in the product.
Drawdown: The transfer of loan money to the borrower.
Gilt: A UK government bond - perceived in the market as a safe but low-return investment.
High-yield bond/junk bond: A bond with a below investment grade credit rating, which therefore usually offers a high rate of interest.
Investment grade: Collective term for the higher credit ratings; a rating below investment grade signifies that the credit rating agency is not confident that debt will be repaid.
Maturity date: The date on which a debt is repayable.
MTN programme: A system by which an issuer is able to issue an ongoing series of MTNs on similar terms.
Waterfall: The mechanism used to determine the order in which a company's creditors are repaid.
Yield: The interest income a creditor gets from a bond, usually calculated by dividing the bond's coupon by its current market price - so a fall in yield paradoxically represents a rise in desirability, and vice versa.