One tool at the lender’s disposal when working with a complex credit is to create incentives that reward positive performance in the company. Most lenders do not realize this, but any lender who sets up a revolving line of credit tied to a borrowing base has set up a loan that rewards good performance and punishes bad performance. If a line is tied to receivables, perhaps you allow the company to borrow 75% of any receivable that is under 90 days old, but you exclude receivables that are over 90 days old. In this case, as long as the company is collecting their receivables at a reasonable pace, they are rewarded with a larger amount of money they can borrow on the line. If their receivables begin to get rather old in the tooth, their borrowing ability on that line is cut off.
Rewarding positive covenant trends can also extend further than the limitations on a borrowing base tied line. These can also be structured in such a way as to increase or decrease the interest rate, given changes in the performance of the company. This can be tied to a ratio or a combination of ratios that the lender finds most useful in judging the company’s performance. A company performing well indicates a less risky credit and should require less cost in time, loan loss allocation, and energy to manage, rather than a company that is barely making its debt coverage requirements.
Consider the following covenant, “The interest rate shall be determined on a quarterly basis in accordance with a matrix on the borrower’s leverage, current ratio, and minimum debt service coverage ratio as described in the pricing grid below:
Max Leverage Ratio Min Debt Service Min Current Ratio Loan Rate at Coverage Ratio LIBOR +bps <=0.50 > 2.00 >1.75 250
> 0.50 ≤ 0.625 >1.60 ≤ 2.00 >1.30 ≤ 1.75 275
>0.625 ≤ 0.75 >1.30 ≤ 1.60 >1.10 ≤ 1.30 325
>0.75 ≤1.30 ≤1.10 350
In this example, the income statement and balance sheet are reviewed quarterly and three ratios are tested. The result of those ratios determines the interest margin above LIBOR for that loan for the next quarter. Here, you are rewarding lower leverage, higher debt service and a higher current ratio and are punishing higher company leverage, lower DSCR and a lower current ratio with a higher loan interest rate.
The question arises as to what will be done if you have three different loan rate results from the readings of these ratios at one time? This needs to be determined by your loan structure and defined in the note and loan agreement. It is easier to concentrate on flexible margin pricing on a smaller number of variables than a larger group of indicators.
Another variation of performance pricing may deal with a specific action that you want the borrower to complete. I once had a loan that we decided to increase the interest rate in six months if easement issues of the property were not properly corrected. The borrower could continue to enjoy a lower interest rate, provided he fixed the problems with the collateral.
Rewarding positive covenant trends with risk-adjusted pricing can be done on as many factors as there are different ratios and methods to measure company performance. However, these must be set up in a thoughtful manner, to help control behavior you do not want to see and encourage performance you want the company to do.