Collateral Chains, Cash Restraints And Waterfall Buckets! Are You A Business Prisoner Of Loans?

A commercial lender has many ways to restrain the borrower. Business movement can be hindered with restrictions in the loan agreement. The lender can get intrusive rights over the collateral and business operations. Here are some of the biggest lender controls on a borrower and some suggestions for preserving your business operating freedom.

The Collateral Shackle: Lenders want to have as much security as possible for a loan because it reduces their repayment risk. Borrowers are too eager to give up loan collateral out of ignorance or ambivalence. Lenders often require security beyond the asset being financed and sometimes require cash deposits as additional collateral. What is the appropriate risk adjusted rate of return for the lender if they have cash or near cash collateral securing the loan? Closer to Zero %?

Limit the pledged collateral to the asset being financed especially if it generates sufficient cash flow to cover debt service. Avoid cross-collateral arrangements where an unrelated asset is pledged as security. If you default on the loan you may lose both assets. Watch for spreader clauses that automatically capture new borrower property as it is acquired. Negotiate specific collateral release provisions if you need to sell or otherwise remove the debt on part of the security during the loan term.

The Reserves Straight Jacket: Loan reserves are an especially insidious way lenders control borrowers. Reserves for capital improvements, operating expenditures, insurance and taxes are common in many loans. The borrower is forced to go through time consuming requests for the release of reserve funds for reimbursement of costs already paid. This creates an additional cash requirement that may be difficult to source. The lender sometimes requires the reserves to be on deposit at their bank which increases fee and interest income. The reserve deposits are hard cash that is additional security for the loan. Try to eliminate reserve requirements whenever possible. Negotiate the right to receive interest on your reserve deposits. Capital market conditions, lender competition, sponsor quality and the loan collateral all determine what reserves and funding levels are required.

Cash Management Cuffs: A lender fastens metal bracelets through the control of cash into and out of the borrower. Cash management provisions give the lender an additional source of security. A typical cash management agreement may have multiple levels in the sweep account structure, defined cash waterfall buckets and triggers for even more borrower restrictions. Be aware of any cash trap trigger events and make sure you have sufficient cushion before these would come into play. Negotiate the use of your existing cash management account structure to avoid opening new deposit accounts which cost your company time and money. Limit restrictions on borrower distributions of cash whenever possible.

Prepayment Prison: The lender looks for a guaranteed yield on its investment in your loan. A prepayment causes the lender to redeploy its cash into new loans which may have a lower yield depending on market conditions. The prepayment penalty creates a disincentive for the borrower to pay off the loan early. Penalties come in several popular flavors including a yield maintenance premium and defeasance.

Yield maintenance is a predefined formula in the fixed rate loan agreement which uses the current bond market yields to discount the remaining loan payments in the term. If current market interest rates are lower than your loan interest rate then the yield maintenance premium will be positive. If market rates are higher than your loan interest rate then the formula returns a zero premium. However, the lender usually writes a second test with a fixed percentage of the outstanding loan balance so it ends up with a premium in its pocket anyway. Floating rate loans can have spread maintenance premiums and both types of loans can have prepayment lock out periods where any prepayment is prohibited.

Commercial mortgage backed securities (CMBS) typically use a defeasance calculation which allows for replacement collateral in the form of notes and bonds to be purchased and pledged. The future payments from the securities closely match the future loan payments to make the lender or investors whole. Experienced capital markets advisory firms are available to assist with a defeasance transaction.

Avoid the biggest restrictions found in many commercial loans. You want to operate your business with minimal interference from the lender. Make sure you hire an experienced attorney for your loan transaction team with the goal of preserving your business operating freedom.