Background
One of the key parts of an investment bank is the ability to lend money to borrowers to facilitate their business activities, be it to acquire a new asset, a new company or just to have cash on its balance sheet.[1]
When lending money, banks need to be sure that they will be able to recover that money (plus interest and fees) and in doing so, they look at how “creditworthy” the borrower is, i.e. can they repay the money they have been lent. Larger companies might seem more creditworthy given their size, but that may not actually be the case. If the company’s balance sheet does not paint an optimistic picture, how and why would any bank be comfortable in lending money to any business with less than perfect financials? To protect against this risk, these loans are usually made on the basis that the borrower is willing to grant security in favour of the lender, making the lending “secured”.
[1] Just to note, when we refer to "balance sheet" - this is a key metric that is used by bankers to determine the financial health of the borrower. This is a snapshot of the financial health of the company as it depicts its assets (cash and other 'positive' items), liabilities (debts/money it owes) and capital. Bankers use this (as well as financial modelling - a tool which in essence is a way of predicting a future balance sheet) to be able to make an assessment as to whether they will be able to pay their debts.
But what is security?
In the context of a financing, security is a form of “credit support” that is usually given by the borrower to help a lender get comfortable with lending to it. It is essentially a legal right in an asset that is granted to the lender to secure repayment of the loan as ultimately, if the borrower does not repay, the lending banks will be able to enforce on the security. The classic example is a household mortgage – a bank will lend you money to buy a house, but until the loan is paid off, they take security over the house and if you fail to repay, they will take possession of the house, i.e. enforce on their security to help recover any losses they may suffer.
Secured lending
There are a variety of ways to classify secured lending, but broadly speaking, and for the purposes of this article it can be split into two types: asset-backed lending and cash-flow backed lending.
Asset-backed lending – a loan where the borrower grants security over an asset that is either tangible (e.g. aircraft, ship or real estate) or intangible (e.g. shares or account receivables). In other words, the banks would be lending against a single asset or a group of assets with the amount of the loan linked to the value of the particular asset.
What does this mean in practice?
The lender and its advisors would need to conduct the appropriate financial and legal due diligence to understand:
(i)the way that asset generates and retains its value;
(ii)how that asset and its value can be transferred to the lender (or more likely, to a third party) in the event of default by the borrower and the lender enforces its security; and
(iii)within the legal documentation, ensure there are sufficient obligations on the borrower to maintain the value of the asset, be it by ongoing obligations of maintenance or a requirement to insure the asset.
What are the types of assets that could be used as security?
The way to structure the loan and the wider transaction as a whole depends on the asset that security is granted over. As such, law firms typically have specialised teams to advise on different types of assets, such as:
(i) fixed assets (e.g. aircrafts, trains or ships);
- MUFG Bank acquired the entire $6.3 billion aviation finance portfolio from DVB Bank SE
(ii) real estate (e.g. residential or commercial estates);
- Global Mutual’s Intu SGS received lending which was secured against its entire portfolio of shopping centres, including the Victoria Centre
(iii) trade credits and account receivables from export or supply contracts
- Avianca, the largest airline in Columbia and one of the oldest airlines in the world, entered into an export credit backed financing for more than 70 Airbus aircrafts
(iv) liquid assets (e.g. pools of shares and liquid loans); and
(v) intellectual property.
The type of asset will also have implications as to the documentation put in place by lawyers, the various legal formality requirements around ensuring there is valid security as well as the overall value ascribed to such asset by the lender in ensuring they have sufficient comfort in the security provided.
Cash-flow backed lending – where the lender’s decision to lend is not based on the value of a single fixed asset but rather the borrower’s ability to generate cash. This lending is particularly used where the borrower does not have many high-value assets to provide security over or otherwise, in the case of a strong borrower, does not want to provide such security and instead asks the banks to lend off the basis of the businesses’ ability to generate cash.
What does this mean in practice?
The lender would analyse the projected cash flow of the borrower and the credibility of its business as these are the main factors in providing comfort in lending. Business plans and balance sheets would be extensively reviewed by the various deal, credit and risk teams within a bank. Ultimately, the lender needs to be confident in the borrower’s ability to repay the debt.
In terms of security, the lender would be most interested in being secured against shares in the borrower and their group, rather than the collection of assets that makes up the business. This is because the true value of the borrower would be with its shares rather than any fixed asset. With regards to this share security, the banks take comfort from a so-called Single Point of Enforcement which is share security over a single point, which, if enforced upon, would enable the lender to take control of the whole group and in turn be able to sell this group to recover hopefully all but at least some of its lent moneys.
Just to note: nothing restricts the lender from asking for additional security to be provided over individual assets (such as contracts, real estate and bank accounts) depending on the scope and structure of the particular transaction, but this will form part of the commercial negotiation between the bank and the borrower, given there are costs and administrative burden to putting security in place.
As you can imagine, these types of transactions can become very complex and may involve layers of financing where some are secured by assets and others by cash flows, including the use of “opco/propco” structures but deal structuring is beyond the scope of this article. In the meantime, let’s look at examples of cash-flow backed lending in the context of leveraged finance.
What is Leveraged finance?
This is a form of lending usually offered by banks whereby the borrower wants to fund a merger or acquisition through a highly levered, i.e. lots of debt, transaction where they put in 35% or 40% equity (often in the form of cash) and borrow the remaining 65 or 60% of the purchase price from a bank. Given the amount of debt on the balance sheet of the borrowing company, they will need to generate a lot of cash to be able to repay these loans, so there will be a lot of diligence focused on the cash generation abilities of the business.
- Spanish telecom giants Orange SA and MasMovil Group recently announced that they have received a leveraged debt financing package of up to $6.6bn to fund its merger valued at $19bn, creating the largest telecommunications operator in the country
Whilst the above example focuses on loans, companies may also receive financing by the issuance of secured bonds.
- The International Design Group, an Italian company managed by The Carlyle Group and Investindustrial issued €470m of senior notes, secured against 100% of the share capital of the company to fund its acquisition of YDesign Group, a leading e-commerce US lighting business.
At a law firm, the teams who provide the legal advice around bonds (often referred to as DCM or Capital Markets) and loans (often called Banking, or Leveraged Finance) are very different teams – not least because in the context of leveraged finance bond issuances these are often NY law governed compared to English law governed loans. In an investment bank, however, there is not this split based on debt, but instead often on product and industry type given the importance of credit analysis and confidence in the cash generative nature of the business being lent to.
Enforcement of security – when things don’t go as planned
Security documents typically contain detailed provisions to provide enforcement remedies, which are generally effective as a matter of contract between the lender and the borrower, however, there are also overriding principles of law which govern security.
In the event of default in repayment or corporate failure, i.e. insolvency of the borrower, the secured lender can enforce its security in accordance with the security document(s) or in accordance with law (both common law and statute).
Amongst a number of contractual remedies, there are four principal ways to enforce security which are recognised by law:
(i) foreclosure – a court ordered remedy which allows the secured party to take outright title to the secured property in discharge of the debt;
(ii) possession – take possession of any secured asset for the sole purpose of repayment of the debt;
(iii) power of sale – a statutory power, which may also be included as a contractual remedy, to sell the secured asset pursuant to the Law of Property Act 1925; and
(iv) receivership – appoint a receiver to take control of the secured asset, collect any generated income or sell the secured asset on behalf of the secured party.
o Case study – Intu Trafford Centre
In 2017, the Canada Pension Plan Investment Board (CPPIB) provided retail giant Intu a £250m facility secured against the Trafford Centre and the shares in the property holding company. The Trafford Centre is one of the largest shopping centres in the UK, which recorded over 30m visitors a year and was valuated at £1.7bn in 2019. However, Intu failed to uphold its repayment obligations after struggling financially for years before entering into administration in the wake of the Covid-19 pandemic in 2020. CPPIB consequently exercised its right as a secured creditor and placed the shopping centre into receivership where a sale was attempted, but no viable bids were received by the administrators as the bids did not exceed half of the valuation made in 2019. CPPIB took possession of the Trafford Centre shortly after.
Written by Yukit Tang & Michael Poolton
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