The main purpose of a firm’s financial policy is to support the execution of its strategic goals. The goals that are derived from this are:
- To secure the availability of funds to prevent the firm from having liquidity problems and to enable execution of the strategic goals.
- To maintain a certain flexibility to be able to react to unexpected circumstances, to facilitate changes in the firm’s strategy, and to seize new opportunities.
- To realise competitive financing costs by maintaining competition between suppliers of finance and by optimising the capital structure.
For a long time, the emphasis in finance was on visible costs: margins and fees. Due to the excessive supply of credit, the availability of finance was not an issue for managers. Consequently, they were hardly inclined to pay additional costs in order to increase the availability of funds. However, the world has changed dramatically and credit has become a scarce, uncertain commodity.
Availability of Finance
As part of financial policy, the following measures could be taken to ensure the continued availability of financing:
- Maintaining a sufficient amount of buffer capital: investments and acquisitions initially have to be financed with more equity or mezzanine capital. In case of disappointing developments, measures have to be taken immediately to restore the balance sheet (i.e. intervene in the operations and/or cut dividends).
- Timely refinancing: existing finance should be refinanced at least one year before maturity.
- Adjusting finance for future financing needs: which part of future needs can already be secured with committed facilities.
- Sufficient headroom in covenants that also make sense: covenants must not be broken because of incidental or external factors (i.e. currency effects), but only because of structural problems within the business.
- Diversification of financing sources: consider asset (backed) finance or access to the capital markets.
- Maturity: focus predominantly on long maturities and a balanced redemption schedule.
The forward start facility (FSF) is an instrument that can help in the realisation of some of the above-mentioned measures in times of uncertain availability of financing: timely refinancing, taking future needs into account and extending maturity.
What is a Forward Start Facility?
Financing can be provided on an individual basis by banks (bilateral loans), or by a consortium of banks (a club deal or a syndicated facility).
In case of a bilateral loan, the company could request the bank to extend the maturity. If the bank and the company can agree on the terms for this extension, a simple amendment letter reflecting the extension and other adjustments will suffice.
In case of a syndicated facility, the company would need to make the same request to the consortium of banks. Achieving the same result, will, however, be more difficult to realise, as the group of banks has to agree on a unanimous basis. The response from the banks may differ, resulting in a difficult bargaining position for the company: some banks may agree to the request, but in return for stricter credit terms; others may not agree at all and it takes just one bank to frustrate the extension of maturity.
An FSF offers a solution for this potential stalemate. With an FSF, part of the consortium of banks will provide a separate facility with the sole purpose of providing financing to repay the existing facility at maturity. The key feature of an FSF is that it can only be drawn on maturity of the existing facility and not earlier.
The lenders that participate in an FSF will commit to an amount at least equal to their present exposure/commitment under the existing facility. In return for this commitment, the FSF lenders receive ‘top-up’ payments consisting of fees (top-up fees, loyalty fees which are similar to commitment fees – albeit that they are not called that because the availability of the FSF facility only occurs in the future – as discussed below). The fee is expressed as a percentage of their commitment, and is meant to bring the margin in line with current pricing in the market.
FSFs are not new. They are the equivalent of back-stop facilities used in bond financing (i.e. facilities that kick in when the bonds become payable). However, due to the abundance of liquidity the past few years, there was little interest in committing in advance or obtaining commitment in advance to refinancing facilities.
FSFs in their current form (and purpose) are fairly new. So far FSFs have commonly been used for unsecured loans to investment grade borrowers. The first Dutch transaction took place mid-2009. Although the documentation for FSFs does not deviate substantially from standard loan documentation, there is no standard wording publicly available yet. However, there is broad agreement on the key terms and these are discussed below.
Borrower and Lender Benefits
An FSF is a useful tool to refinance/extend the existing facility in times when the availability of financing is uncertain at best. Under an FSF, a borrower can continue to do business with its willing bankers, while ignoring the banks that are unable to commit against fair terms. In addition to the extension of the existing facility against market level conditions, a borrower could also view the negotiation of an FSF as a selection process for its relationship with the banks.
The FSF lenders receive additional payments on the amounts of their commitments (the top-up payments). This allows the FSF to bring the pricing on their existing commitments in line with market pricing. If properly drafted, the FSF does not lead to a double exposure for regulated lenders. There are no extra solvency requirements.
It also gives FSF lenders the opportunity to increase their share of lending to the borrower (especially since FSFs are not really attractive to non-bank lenders such as money market funds (MMFs), collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs). In addition, banks could use the FSF to improve their relationship with the borrower in favour of the lenders that do not participate.
The FSF need not necessarily be for the full amount of the existing facility. The borrower may not need to have the full amount refinanced/extended. This may constitute a risk for the FSF lenders (some residual refinancing risk would continue to exist), but the FSF can be drafted in a manner so as to allow it to be increased over time. If not all existing lenders participate from the outset, they would be allowed to join later (and that may be attractive, given the top-up payments). The FSF could also be open to other new lenders.
No double exposure
If properly drafted, the FSF lenders should not have double exposure (i.e. for both the FSF and the existing facility). As capital requirements may differ per jurisdiction, this needs to be checked by each FSF lender individually (to prevent additional capital/solvency costs).
The FSF lenders receive top-up payments that effectively increase the interest margin payable under the existing facility. These payments are usually called top-up payments or loyalty fees. The idea is to bring the margin in line with current market pricing.
As FSF lenders extend their loans or provide new commitments, they will want to receive an up-front fee (i.e. the regular up-front or participation fee paid for new money). If the FSF facility is intended to be increased allowing subsequently lenders to joint the FSF, the borrower may also agree to pay ‘early bird’ fees to the initial FSF lenders. If the FSF lenders have unfunded commitments under the existing facility, they may also require that the level of commitment fee for those commitments to be topped-up, in line with the increased margin they receive through the top-up fees.
The FSF is only available on the date the existing facility matures.
The sole purpose of the FSF is to refinance (a specific part or tranche of) the existing facility (thereby effectively increasing the maturity of the existing facility).
The FSF will be reduced to the extent that the existing facility is prepaid or cancelled. The borrower is should be permitted to voluntarily cancel the FSF (e.g. if financing becomes cheaper towards the maturity of the existing facility or if the borrower generates sufficient cash to repay the existing facility without using the FSF).
The FSF will usually include a clause that means that changes the terms of the existing facility will also require changes in the FSF. This may not always be achievable in practice, though (see no-conflict below).
The FSF as Part of Total Financing
Non-conflict with existing facility
The FSF will (as an undrawn facility) coexist side by side with the existing facility until the latter matures. The documentation of the FSF should be in line with the documentation of the existing facility, or, at least, the documentation of the FSF should not conflict with the existing facility. This limits the possibility of FSF lenders to require additional or deviating terms as compared to the existing facility (and therefore, the scope of negotiations, which may be an additional benefit to borrowers).
FSFs have commonly been used only for unsecured loans to investment grade borrowers. If the existing facility is secured, partial refinancing through an FSF can be rather challenging if the FSF needs to share in the (existing) security. It will probably require that intercreditor agreements and security documents allow for changes without requiring unanimity. For this reason, FSFs are difficult to implement to refinance leveraged or secured financings.
If a FSF is applied in leveraged financing, additional complexity arises. The FSF needs to be integrated in the existing framework (and may require that the FSF is incorporated in the existing documentation). The leveraged financing documentation will need to allow for structural amendments (such as incorporating the FSF) without unanimous consent of the senior lenders – it would require that the majority of lenders become FSF lender or have no objection to the FSF being entered into. If the intercreditor arrangements protect the junior (mezzanine) lenders against additional debt, the FSF can only be incorporated if the junior lenders consent or the FSF fits within the headroom for extra senior debt allowed under the intercreditor agreement (normally 10% of existing debt and therefore not likely to be the case without junior lenders consent).
An FSF for bonds poses some logistical difficulties because it requires separate agreements with individual bondholders. Therefore, a bond FSF will most likely be in the form of an exchange offer on terms equivalent to an FSF. If this is done well in advance, it will reduce refinancing risks and give the borrower (the issuer) the opportunity to negotiate better terms than just prior to the maturity of the existing bonds.
With the current uncertainty in the financial markets, the emphasis of the financial policy has moved to the availability of financing in the long run, instead of on pricing alone. Borrowers are now willing to pay in order to secure the continued availability of financing in the longer term.
FSFs can play a role in securing the continued availability of financing by extending the maturity of the existing facility through a separate facility. The most important benefit of the FSF is the fact that it enables borrowers to do business with banks that are willing and able to provide financing. For the FSF lenders, the most important benefit is that they can receive a margin that is in line with current market pricing, without a double solvency requirement.
FSFs in their current form and purpose have mostly been used for investment grade borrowers in unsecured facilities. Even though more complex, expectations are that FSFs will be used in secured facilities and, possibly, even in leveraged finance.
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