18073516 Economic Basis of Syndicated Lending Wild

8/8/2019 18073516 Economic Basis of Syndicated Lending Wild

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The Economic Basis of SyndicatedLending

William Wild B.Com LLB (Qld) LLM (Deakin)

submitted in ful lment of the requirements

of the degree of

Doctor of Philosophy

The School of Economics and Finance

Queensland University of Technology

Brisbane, Australia

2004


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Keywords

Syndicated Loan

Lending

Commercial Bank

Loan Pricing

Underwriting

Arranger

Borrower

Participant

Credit Risk

Capital Charge

Credit Exposure Limits

Final Hold

Relationship Banking

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Abstract

This work undertakes the rst comprehensive theoretical assessment of syndicated

loans. It is shown that syndicated and bilateral (single lender) loans should be good sub-

stitutes in meeting a borrowers nancing requirements, but that syndicated loans are

more complex and impose additional risks to the parties in the way they are arranged.

The existing explantions of loan syndication - that they are hybrids of private bank

loans and public debt instruments, that syndication is a portfolio management tool,

and that loans are syndicated where they are too large to be provided bilaterally - are

unable to substantially explain both the nature of syndicated loans and practice in the

loan markets. A rigorous new explanation is developed, which shows that syndication

reduces the rate of lending costs, so that the return to the loan originator is greater,

and the borrowers cost of nancing is lower, where a loan is syndicated rather than

provided bilaterally. This explanation is shown to hold in competitive loan markets

and to be consistent with the observation that syndicated loans are generally larger

than other loans. Incidental to this new explanation, new expressions of the return to

a bank from providing a loan on a bilateral basis and from originating a syndicated

loan are also developed. New algorithms are also developed for determining the distri-

bution of the commitments from syndicate participants and thus the originators nal

hold, the amount it must lend itself, where the loan is underwritten. This provides,for the rst time, a rigorous basis for assessing the expected return, and the risk, for

the originator of a given syndicated loan. Finally, empirical testing nds that a banks

observed lending history is signi cant to its decision to participate in a new syndicated

loan but that predictions of participation, which are fundamental inputs into the nal

hold algorithms, based on this information have relatively little power. It follows that

there is competitive advantage to loan originators that have access to other, private

information on potential participants lending intentions.

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Contents

Keywords i

Abstract ii

Declaration vi

1 Overview 1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.2 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2 Use of Syndicated Loans 9

2.1 Snapshot of Syndicated Loan Usage . . . . . . . . . . . . . . . . . . . . 9

2.2 Short History of Syndicated Loans . . . . . . . . . . . . . . . . . . . . . 142.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

3 Structure of Syndicated Loans 21

3.1 Syndication Terms and Conditions . . . . . . . . . . . . . . . . . . . . . 22

3.2 Arrangement of Syndicated Loans . . . . . . . . . . . . . . . . . . . . . 26

3.3 Syndication Risk, Best E ff orts and Underwriting . . . . . . . . . . . . . 28

3.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

4 Returns from Syndicated Lending 35

4.1 Loan Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

4.1.1 Loan Availability and Utilization . . . . . . . . . . . . . . . . . . 38

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4.1.2 Net Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

4.1.3 Credit Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4.1.4 Opportunity Cost . . . . . . . . . . . . . . . . . . . . . . . . . . 49

4.1.5 Other Major Income and Costs . . . . . . . . . . . . . . . . . . . 51

4.1.6 Return from a Bilateral Loan . . . . . . . . . . . . . . . . . . . . 52

4.2 Syndicated Loan Return . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

4.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

5 Why Are Loans Syndicated? 57

5.1 Syndicated Loans as Hybrid Debt Securities . . . . . . . . . . . . . . . . 59

5.1.1 Preference Ranking of Debt Financing Alternatives . . . . . . . . 61

5.1.2 Syndication as Disintermediation . . . . . . . . . . . . . . . . . . 635.1.3 HLT Syndicated Loans . . . . . . . . . . . . . . . . . . . . . . . . 68

5.1.4 Empirical Findings . . . . . . . . . . . . . . . . . . . . . . . . . . 69

5.2 Active Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . 72

5.3 Loan Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

5.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

6 Syndication and the Costs of Lending 79

6.1 Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 806.2 Capital Charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

6.3 Opportunity Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

6.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

7 New Loan Syndication Model and Hypothesis 93

7.1 Marginal Return from Syndication . . . . . . . . . . . . . . . . . . . . . 96

7.2 Effi cient Loan Originator . . . . . . . . . . . . . . . . . . . . . . . . . . 101

7.3 Loan Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1057.4 Risk, Return and Sharing of Marginal Return with the Borrower . . . . 108

7.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

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Appendix 7.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

Appendix 7.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

8 Final Hold 115

8.1 Overview of Final Hold . . . . . . . . . . . . . . . . . . . . . . . . . . . 1168.1.1 Industry Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

8.1.2 Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

8.2 Final Hold Algorithms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

8.2.1 Algebraic Method . . . . . . . . . . . . . . . . . . . . . . . . . . 123

8.2.2 Numerical Method . . . . . . . . . . . . . . . . . . . . . . . . . . 123

8.3 Distribution of Final Hold . . . . . . . . . . . . . . . . . . . . . . . . . . 124

8.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Appendix 8.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

Appendix 8.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

9 Syndicated Loan Participation 137

9.1 Loan Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

9.2 Theoretical Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

9.2.1 Classic Relationship Banking Hypothesis . . . . . . . . . . . . . 141

9.2.2 Extended Relationship Banking Hypothesis . . . . . . . . . . . . 144

9.2.3 Overall Activity Hypothesis . . . . . . . . . . . . . . . . . . . . . 146

9.3 Variables and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

9.4 Econometric Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

9.5 Testing, Results and Interpretation . . . . . . . . . . . . . . . . . . . . . 161

9.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

10 Summation 173

Bibliography 178

Index 187

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DECLARATION

The work contained in this thesis has not been previously submitted for a degree

or diploma at any other higher education institution. To the best of my knowledge

and belief, the thesis contains no material previously published or written by another

person except where due reference is made.

Signed:

Date:

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Chapter 1

Overview

1.1 IntroductionA syndicated loan is broadly de ned as a loan facility that is provided by two or more

lenders, the syndicate , on common terms. Each lender who participates in the syndicate,

usually called a participant , makes a commitment to provide a given proportion of the

total loan amount and has a right to receive the same share of all payments from the

borrower. For the convenience of the parties all the facility cash ows1, as well as ows

of information between the borrower and participants, are passed through a designated

facility agent . Nevertheless, the fundamental right of each participant to receive itsshare of the agreed payments, as scheduled, is always protected.

It might be suggested, therefore, that syndicated loans are just an obscure variation

of the commonplace bilateral - single lender - commercial bank loan facility; and there

are relatively few works that consider syndicated loans speci cally. Yet syndicated

loans have been described as a major component of todays nancial landscape, a

powerful third arm of the capital markets and one of the workhorses of the inter-

national capital markets (Jones, Lang and Nigro, 2000; Garrity, 2000; Eichengreen

and Mody, 1998). This rhetoric is supported by the statistics. In the year 2000 there

1 Facility cash ows include loan advances, repayments, fees and interest.

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were over US$2.2 trillion 2 equivalent of new syndicated loans executed worldwide, rep-

resenting compound growth in excess of 10% annually over the previous decade (Esty

and Megginson, 2000). The leading arranger of syndicated loans has completed over

US$300 billion in new transactions in a single year, over 3,000 banks participate as

lenders in loan syndicates globally, and syndication of one individual loan generated

commitments from participants of over Euro70 billion during syndication 3.

While there are comprehensive guides to syndicated lending practice (see Rhodes,

2000), this work outlines the rst general economic theory of syndicated loans, develop-

ing a rigorous model that shows why certain loans should be syndicated and methods

for assessing the trade-o ff between risk and return for the banks that originate them.

The question of why loans are syndicated is raised not only by the fact that syn-

dicated loans are so widely used, but by the fact that it is not immediately obviousthat they favour any of the parties to them. While they are a form of commercial bank

loan it is also clear that they are more complex, and potentially more di ffi cult and

costly for borrowers to arrange and manage, than the bilateral form of loan. For their

part, it is not clear why banks should desire to share the loans they originate, and the

potentially lucrative lending relationship that goes with them, with other lenders, their

competitors, by syndicating them.

It is certainly not possible to ascribe motives to all institutions that participate in

the syndicated loan markets, and without doubt some syndicated loans are undertaken

for reasons that may not be rational on a purely economic basis. Furthermore each

syndicated loan is unique in its circumstances, and the product is used for a large

variety of purposes and for a diverse range of borrowers. This work therefore develops,

based on the nature of commercial banks and their operating environment, a general

economic model and explanation for the use of syndicated loans that shows why certain

loans should , under reasonable assumptions, be syndicated by bank loan originators who

2 There are a number of syndicated loan databases that vary in their methodologies and so generatediff erent statistics. The value of $2.2 trillion in new syndicated loans in 2000 is the minimum amountrecorded by the major databases.

3 See Chapter 2 for more information.

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seek to maximize their returns and for borrowers who wish to minimize their costs of

borrowing. It is demonstrated that this model and explanation are compatible with,

and able to signi cantly explain, observed practice in the syndicated loan markets. This

work also describes and considers the popular alternative explanations for syndication.

These are not strictly economically based and, it is observed, leave signi cant aspects

of observed syndicated loan market practice unexplained.

The new explanation can be summarized as follows. Given reasonable assumptions,

a loan with given pricing will generate greater expected return to the bank that origi-

nates it where it is syndicated rather than provided on a bilateral basis. The incentive

for both parties to select the syndicated loan comes from the originator sharing this

expected marginal return from syndication with the borrower by reducing the pricing,

and thus all-in costs of the loan to it, to below that of the alternative bilateral loan.The model demonstrates the existence of this expected marginal return to the origi-

nator under realistic conditions, including that the originator is equally as e ffi cient as

the syndicated loan participants in providing loan commitments; vital to explaining

syndication in competitive loan markets. It also demonstrates a positive relationship

between expected marginal return from syndication and loan size which is consistent

with the observation that larger loans are more likely to be syndicated. It also explains

the advantage of syndication where the loan is fully underwritten.

At the heart of the model are new, general expressions of the return to a bank from

lending on a bilateral basis and its extension into an expression of the return from

originating an underwritten syndicated loan. The former is developed by comparing

and contrasting loans with their major alternative, bonds issued in the capital markets,

and so provides important insight into the unique nature of loans that enables them

to provide nancing of a kind that cannot be provided by other debt instruments.

The expected marginal return from syndication demonstrated by the model is due to

syndication reducing the rates of the lenders major costs of providing the loan facility,which are major elements in the expressions of loan return; namely credit, capital and

opportunity costs.

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The expression of syndicated loan return is more speci cally an expression of the

expected return from syndication, re ecting the fact that syndication of a loan intro-

duces a new risk, and thus additional uncertainty in return, that is not present if the

loan is provided on a bilateral basis. Called syndication risk , it is the uncertainty as

to which institutions will participate in the loan syndicate and the amount each will

commit. In competitive loan markets the bank that originates a syndicated loan is

usually required to accept syndication risk by underwriting the borrowers desired loan

amount, in which case it faces uncertainty in the residual amount it must lend itself,

called its nal hold . So an important contribution of the model, and the further work

on its interpretation, is to make explicit the relationship between its return and the

acceptance of syndication risk by the syndicated loan originator.

This work is then extended to the development of new algorithms for determiningthe probability distribution of an originators nal hold in a given syndicated loan. The

new syndication model shows that the return to the originator is sensitive to its realized

nal hold amount, and so these algorithms provide the basic tools for quantifying the

distribution of return, and thus the expected return and the risk, from originating a

syndicated loan on given terms. Two alternative methods are proposed, an e ffi cient

algebraic method and a conceptually simpler numerical approach. These new tools are

also used to investigate the general form of the distribution of nal hold, which is found

to be a truncated normal distribution, with greater risk to the loan originator in the

direction of higher nal hold.

The nal important contribution of this work is in considering the question of

whether an institutions observed lending history has any power to predict its partici-

pation in syndicated loans, and this is empirically investigated. This is an important

question because it is the decisions of potential participants to participate that deter-

mine the originators nal hold in any given syndicated loan. It is found that, while

statistically signi cant, such information has relatively limited power to explain the de-cision to participate. This suggests that there is a competitive advantage for originators

who invest in acquiring additional private information.

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1.2 Structure

The body of this work is structured as follows. Chapter 2 brie y describes the use

of the modern form of syndicated loan; not just the bare transaction volume, but

the type and location of borrowers and lenders, and the nancing purposes to whichthey are applied. A short history traces the modern form of syndicated loan from the

euromarkets in the 1970s through to the integrated global markets of today, and notes

their central place in some of the major nancial market events of the time. The use

of syndicated loans is described rst, even before the nature of the instrument itself,

because it is their widespread use by such a diverse array of borrowers and for such a

range of nancing purposes that provides a fundamental motivation for this work.

Chapter 3 then begins to focus on the syndicated loan speci cally. The generic

syndicated loan agreement is considered, and is shown to be a standard commercial

bank loan agreement onto which has been overlaid terms governing the additional

relationships between the parties. Next the process by which syndicated loans are

arranged, including the major tasks of the originator and its obligations to the other

parties, is outlined.

Chapter 4 undertakes the rst major analytical work, generating a new expression

of the return to the institution that originates a syndicated loan. As well as being

an important result in its own right, providing a tractable return model and a clearexposition of the unique nature of commercial bank loans, this is the basis of the new

model and explanation for syndication that is developed in subsequent chapters.

The following chapter, Chapter 5, introduces the fundamental question in this eld:

Why are loans syndicated? The most popular existing explanations are each described

and considered. These are that syndicated loans are a hybrid of public debt securities

and private bank loans, that syndication is a loan portfolio management tool akin

to secondary loan sales, and that syndication of a loan is a means of avoiding the

constraints of banks credit exposure limits. It is observed, however, that some of

the major assumptions underlying these explanations are not consistent with, nor are

they able to adequately explain, some important aspects of observed practice in the

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syndicated loan markets. This means that there is a place for an alternative hypothesis

that both is and can do so.

The next chapter, Chapter 6, begins to set out the basis for a new hypothesis.

The eff ect of syndication on the three major costs of lending, identi ed in the new

expressions of return developed earlier, is considered. It is shown that, again with

reasonable assumptions, syndication of a loan reduces the rates of credit loss provision,

capital charge and opportunity cost for the loan originator compared with the provision

of the loan on a bilateral basis.

Chapter 7 then develops the new model of loan syndication that shows exactly how

this lower rate of lending costs can translate in a lower overall cost of nancing for the

borrower, compared with the alternative bilateral loan, in realistic market conditions.

The model is then expanded and analysed to show how this is the case even whereparticipants are equally as e ffi cient as the originator in providing loan commitments,

a pre-requisite for the existence of syndicated loans in competitive loan markets. A

positive relationship between loan size and marginal expected return from syndication,

which should more highly motivate the syndication of larger loans, is then demonstrated

to ow from this economic structure. Finally, it is shown that the originators return

from a syndicated loan is sensitive to its nal hold. While this does not a ff ect the

validity of the new hypothesis it does mean that the amount by which the originator

can reduce the pricing on a syndicated loan below that of the alternative bilateral loan

will be sensitive to the distribution of nal hold and its own risk tolerance. As such

it makes explicit the relationship between syndication risk and the loan originators

return.

As the distribution of nal hold should be a vital element of the decision to syndicate

a loan, or the terms on which it might be done, Chapter 8 considers how nal hold is,

and should be, estimated. It begins by describing current industry practice, which is

characterized as qualitative and based on expert judgement. It then goes on to assess asmall number of academic works that identify, empirically, features of syndicated loans

that they contend are signi cant to the level of nal hold. It is observed, however,

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that these works do not account for the fact that loan originators ration participation

in syndicated loans in an attempt to achieve pre-speci ed nal hold targets. The

major contribution of the chapter is the development of new nal hold algorithms for

generating the distribution of nal hold that, among other things, do capture this

rationing e ff ect. The fundamental parameters of these algorithms are the participation

probabilities, parameters that quantify the probability that any potential lender will

join the loan syndicate and the amount it will commit. The new algorithms o ff er two

alternative methods for transforming the participation probabilities into a distribution

of nal hold; an e ffi cient algebraic method and a numerical simulation method. The

general form of the distribution of nal hold is also described.

The nal substantive chapter, Chapter 9, addresses the question of whether prior

public information as to an institutions lending history has any power to predict itsdecision to participate in a syndicated loan, and implicitly its participation probability.

Three separate hypotheses are proposed to explain why this information might be

signi cant. These draw on classic relationship banking theory and actual banking

industry practice. A suitable empirical model is developed and then data drawn from

one of the leading commercial syndicated loan databases, of the type used by syndicated

loan practitioners, is recompiled to generate a suitable sample. This is tested using a

binary probit technique and the anticipated result found that, while an institutions

observable lending history is signi cant, it has relatively limited power to predict its

decision to participate in a new syndicated loan. Further analysis draws the conclusion

that participants in syndicated loans fall into two main groups; relationship banks who

are captured relatively well by the empirical model and transactional banks who are

not and who, it is observed, comprise a signi cant proportion of all syndicated loan

participants.

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Chapter 2

Use of Syndicated Loans

The signi cance of syndicated loans is demonstrated in this chapter. Section 1 outlines

the geographical distribution of syndicated loans, identi es the major borrowers and

arrangers, and provides examples of the diverse nancing requirements that syndicated

loans are able to meet. Section 2 provides a brief history of the modern form of syndi-

cated loans, describing how they have diversi ed from an important, albeit relatively

specialized, source of sovereign nance in the 1960s and 1970s, to become a vital source

of capital for all aspects of the global economy.

2.1 Snapshot of Syndicated Loan Usage

There were approximately US$1.9 trillion equivalent in new syndicated loans completed

globally in 2003 (Thomson Financial, 2004). This represents a small fall from the peak

in the year 2000, but it is consistent with the change in general economic conditions

over that time and does not represent any decline in the relative use of the product.

The broad geographic distribution of syndicated lending for the year 2003 is shown in

Table 2.1.

Over fty percent of new syndicated loans are completed in North America, whichre ects the relative size of the US economy and the sophistication of the commercial

banking sector in that country. Yet while the European syndicated loan market is less

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Region US$ billion

North America 1,010Europe, Middle-East, Africa 642

Latin America 21Asia-Paci c 197Total 1,870

Table 2.1: New Syndicated Loans by Region, 2003. Source: Euromoney.

than two-thirds of the size of its US equivalent, it has been the location of some of

the largest single private nancings in history. In 2000, for example, France Telecom

raised a syndicated loan to nance its acquisition of mobile telephone company Orange.

The banks invited to join that loan syndicate committed, between them, a staggering

Euro71 billion, which was scaled-back to the borrowers required loan amount of Euro30

billion (International Financing Review).

The Asia-Paci c accounts for just over ten percent of global syndicated loan volume,

but this belies the fact that the dominant source of capital for Asian economies 1 was and

remains commercial banks, particularly non-Asian commercial banks, provided mainly

through syndicated loans (Eichengreen and Mody, 1998). While the Asian crisis of

1997-98 has been relatively well documented, what has been generally overlooked in

the literature is that it was a banking crisis as well as a currency crisis, caused bythe fragmentation and shrinkage of the commercial bank market for Asian risk (Wild,

1998). This is demonstrated in Table 2.2 which shows the changes in syndicated lending

in the region from the second quarter of 1997, the last full quarter before the onset of

the crisis, to the third quarter of 1998, when the crisis had taken full e ff ect across the

region.

Borrowers under syndicated loan facilities now cover the entire spectrum of commer-

cial and nancial entities, from sovereigns to corporations to special purpose nancing

vehicles. The volume of syndicated loans completed by some borrowers is very sub-

1 Excluding Japan and China.

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Asian Syndicated Loans (excluding Japan) 2nd Qtr 1997 3rd Qtr 1998

Volume of new syndicated loans (US$ million) 13,584 3,466Number of new syndicated loans 193 38

Average annualized interest margin and fees 0.94% p.a. 1.33% p.a.Number of participants in new syndicated loans 326 128Number of participants by nationality 37 24

Table 2.2: Asian Syndicated Loans and the Asian Crisis. Source: Loanware.

stantial. In the 25 years to 1999, AT&T entered into syndicated loan facilities in the

total amount of $128 billion. Table 2.3 shows the top 30 syndicated loan borrowers for

the 25 years up to 1999 (Hurn, 1999).

In the United States alone, $242 billion in new syndicated loan facilities were com-

pleted for investment-grade borrowers 2 in just three months in the second quarter of

2004 (Loan Pricing Corporation, 2004). As well as being a direct source of short and

medium-term capital 3, syndicated loans have also developed an indispensable role in

enabling investment-grade rms to utilize the attractive short-term commercial paper

(CP) 4 markets as a source of core debt funding. Firms reliant on CP for anything

other than very short-term funding requirements leave themselves open to the risk that

disruption to the capital markets may leave them unable to re nance outstanding CP

when it comes due.The solution is to put in place syndicated standby loan facilities that may be drawn

to fund the repayment of CP in adverse circumstances. In fact the credit major ratings

agencies require the commitment of such liquidity as a precondition to the investment-

grade credit rating rms needed to access the CP markets (Hahn, 1998). This use for

syndicated loans has developed to the point where Duran (2001) observed that, out

of $2.1 trillion in US domestic syndicated loan facilities available in 2001, only $769

2 Investment grade rms are those with a credit rating of BBB or above from Standard & Poors or theequivalent rating from another recognized agency. An investment grade credit rating is a preconditionfor debt issuance in most parts of the public capital markets.

3 Syndicated loans for investment-grade borrowers typically have a maximum maturity of 5 years.4 Commercial paper has short maturities, at most one year, and more typically 30 days.

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Rank Borrower US$ million

1 AT&T 128,7692 General Motors 93,5393 DaimlerChrysler 90,5154 Philip Morris 76,8245 Morgan Stanley DW 52,6356 ARCO 45,5067 RJ Reynolds 44,1688 Sears Roebuck 44,0709 Viacom International 42,67610 Hanson Trust 42,515

11 ITT 39,39612 IBM 38,94613 MCI WorldCom 37,11014 Time Warner 36,88215 BP 33,07416 American Home Products 32,77517 Kingdom of Spain 32,20618 Xerox 31,48819 HCA 31,00420 Canada 30,87521 Dai-Ichi Kangyo Bank 30,159

22 Deere 29,79523 Westinghouse Electric 29,57024 Fuji Bank 29,07125 News Corp 28,52726 Texaco 28,28727 American General 27,46528 Walt Disney 27,10929 Kingdom of Sweden 26,94230 Olivetti 25,455

Table 2.3: Top 30 Syndicated Loan Borrower by Volume of Transactions, 1974 - 1999.Source: International Financing Review 25th Anniversary Issue.

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billion (37.5%) had actually been drawn as advances in that year. Investment-grade

rated rms are not the only entities to bene t from syndicated liquidity facilities. For

example the high-pro le hedge fund Long Term Capital Management, famous both for

the lack of transparency of its operations and its eventual collapse, was supported by

a US$900 million syndicated standby loan facility (Shirre ff , 2004).

Syndicated loans are also major sources of funds for such diverse applications as

sovereign balance of payments nancing, construction nance, trade nance and bridg-

ing nance. A very important application is as a source of limited recourse project

nance. At the peak in 1997 there were US$102 billion of new syndicated project -

nance loans completed globally, and syndicated loans have historically accounted for

more than 90% of total project nance debt (Esty and Megginson, 2000). While vital to

the economic development of emerging economies, this nancing structure also becameintegral to infrastructure development in developed countries. The Eurotunnel project,

for example, was initially nanced through a $13 billion syndicated loan provided by

220 diff erent nancial institutions (Grant, 1997).

One of the fastest growing, and by far highest pro le, applications of syndicated

loans is in highly leveraged transactions (HLTs) 5, particularly in the United States but

increasingly in Europe. This is not a new use for the product, however, and one of the

signature transaction of the 1980s, the acquisition of RJR Nabisco by Wall-street buy-

out rm KKR, was funded by a $13.5 billion syndicated loan (Miller, 2002). By 1998

the annual volume of leveraged syndicated loans had grown to $256 billion (Miller,

2004). What has garnered so much recent attention about this form of syndicated

loan is the increasing participation of non-bank institutional investors as syndicate

lenders, with over 144 funds investing regularly in HLTs by 2001, representing almost

40% of the participants commitments in these loans (Garrity, 2000). Nevertheless

the global syndicated loan market remains one dominated by commercial banks. Non-

bank institutional investors participate exclusively in HLT syndicated loans, which still

5 HLTs are de ned by the large proportions of debt in their borrowers capital structures and theconsequently high levels of credit risk they represent. They are typically used to nance mergers andacquisitions.

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comprise a relatively small proportion of total syndicated loan volume. Over 3,000

banks joined syndicated Eurocurrency loans, just one class of syndicated loans, during

the 1980s (Chowdry, 1991) and a similar number still participate in syndicated loans

throughout the world today.

Syndicated loans are also signi cant to a smaller group of commercial banks for

another reason. These are the banks that originate and arrange them. The leading

arrangers of syndicated loans represent most of the worlds largest nancial institutions,

and the arrangement of syndicated loans is a signi cant business line in its own right.

The two leading arrangers in 2000, JP Morgan and Bank of America, arranged new

syndicated loans in a cumulative amount of over US$600 billion equivalent in that year

alone. Even the 50th ranked arranger in that year completed new syndicated loans

in excess of $5bn equivalent. And in the late 1990s, for example, it was reported thatChase Manhattan Banks 6 "syndicated nance business is now grossing close to US$2bn

a year in fees." (Hurn, 1999). Table 2.4 lists the top syndicated loan arrangers in 2000.

2.2 Short History of Syndicated Loans

The modern form of syndicated loan was noted in the late 1960s in the eurocurrency

market, and they are referred to in the early literature as international or eurocurrency

syndicated loans. A number of authors have traced the development of the eurocur-

rency syndicated loan market through the 1970s and early 1980s, with the signi cant

statistic being the growth of transaction volume from US$4 billion equivalent in 1970

to US$100.9 billion at its peak in 1981 (Goodman, 1980; Allen, 1990; Chowdry, 1991;

Clark, Levasseur and Rousseau, 1993).

The Eurocurrency market developed in the 1950s when communist bloc countries,

concerned that their US dollar deposits in the United States might be frozen for po-

litical reasons, transferred them to European banks outside of US government control

(Skerman and Barrett, 1989). Not only were these banks outside the control of the US

6 Chase is now part of the JP Morgan group.

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Rank Institution Nationality # loans US$ million

1 Bank of America USA 1,465 299,5762 JP Morgan USA 977 305,2023 Citibank/SSB USA 799 225,7394 BancOne USA 442 81,6175 FleetBoston USA 437 44,9296 Deutsche Bank Germany 400 87,9947 ABN-AMRO Netherlands 365 76,3818 Barclays UK 351 115,7829 Mizuho FG Japan 330 70,73110 First Union USA 298 34,65511 BNP Paribas France 212 41,42712 Societe Generale France 210 41,42413 Commerzbank Germany 203 32,92114 Scotiabank Canada 188 27,08315 Credit Suisse First Boston Switzerland/USA 182 51,70816 Credit Lyonnais France 176 21,23217 Westdeutsche Landesbank Germany 171 26,31718 Bank of Tokyo Mitsubishi Japan 166 32,13019 Dresdner KB Germany 154 30,37920 HSBC Hong Kong/UK 152 46,43321 Royal Bank of Scotland UK 148 31,79822 ING Barings Belgium 124 15,51723 CIBC Canada 120 17,66124 Bank of New York USA 116 25,96825 Toronto Dominion Canada 113 24,549

Table 2.4: Leading arrangers of syndicated loans, 2000. Source: Loanware.

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government as far as depositors were concerned, they were also outside the control of

domestic banking regulators which limited prudential oversight and, without the costs

of strict regulation, increased their competitiveness in providing nancing. US banks

soon set up o ff shore branches to compete in what were now described as the euro-

markets, a term which in time came to mean all markets for currencies traded outside

their domestic jurisdiction. The alternative, domestic markets, are those within the

domestic jurisdiction of the parties and under the direct supervision of prudential and

other nancial regulators.

Today the globalisation of capital ows and the competition amongst countries for

international capital, which is re ected in increasing nancial liberalization, has greatly

reduced the practical distinctions between domestic and o ff shore nancial transactions.

Furthermore, the increasing global reach of banking regulators has generally meantreduced bene ts for banks in lending from o ff shore as opposed to domestic jurisdictions.

This is, however, a relatively recent development and even as recently as the mid-

1990s these markets were to a greater or lesser extent separate; which explains a clear

distinction between the two implicit in the early literature on syndicated loans.

While the United States has always been the major domestic syndication market,

the historical distinction between euro- and domestic syndications was not limited to

that country. For example, Australian borrowers have only since the late 1990s been

entering into loans with syndicates comprising domestic and o ff shore participants to-

gether. This was when the rst round of changes to the regulations on interest withhold-

ing tax made it practical for Australian borrowers to source loans directly from o ff shore

lenders 7. Prior to this Australian borrowers who wished to raise loans from o ff shore

lenders generally did so through specially created o ff shore nancing subsidiaries.

What provided the major impetus for the development and growth of the eurocur-

rency syndicated loan market was the massive transfer of wealth to OPEC from non-

OPEC countries in the 1970s, re ected in the current account de cits that were run

7 Interest withholding tax is deducted at source by a resident borrower on interest paid to a non-resident lender.

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by oil-importing nations. The syndication market stepped in as a conduit by which

eurocurrency deposits from OPEC countries were re-channelled to non-OPEC coun-

tries in the form of loans. This was actively encouraged by governments for political

reasons, and so quickly did this form of nancing develop that the syndicated loan

market provided more than 85 percent of the medium and long-term funds for devel-

oping economies and 98 percent for centrally planned economies between 1973 to 1979

(Goodman, 1980). Given the signi cance of the product to the international nancial

system at that time it seems odd to now describe the original eurocurrency syndicated

loan market as limited, but in the context of the market today it certainly was. In 1970

only ten borrowers accounted for over 80 percent of the market and never in the next

10 years did the top 10 account for less than 50 percent (Goodman, 1980). Sovereign

borrowers dominated the market, usually to nance balance of payments de cits or fordevelopment projects.

The infatuation of the syndicated loan market with sovereign borrowers continued

through the 1970s and early 1980s with increasing, as it turned out, recklessness. The

accepted wisdom that countries could not go bankrupt was shown to be, for all practical

purposes, false when in 1981 Poland deferred payment on part of its debt. It was

followed in 1982 by Mexico and shortly thereafter by Brazil, Yugoslavia, Chile and

Nigeria. Although there was sovereign lending activity recorded up until 1985, almost

all represented forced re nancing of defaulted sovereign debt (Clark, Levasseur and

Rousseau, 1993). Figure 2.1 illustrates the dramatic rise and fall of the eurocurrency

syndicated loan market over the period 1970 to 1985.

While the common perception is that domestic loan syndication markets developed

after the collapse in sovereign syndications required lenders to look for alternative

sources of business, they certainly existed well before then, at least in the United States.

As early as 1977 the Federal Reserve, the Federal Deposit Insurance Corporation and

the Offi ce of the Comptroller of Currency felt it necessary to establish the SharedNational Credit (SNC) program for monitoring the credit quality of large US syndicated

loans extended by banks monitored by those agencies (Federal Reserve Bank of San

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Francisco, 2001).

0

20

40

60

80

100

120

1 9 7

0

1 9 7

1

1 9 7

2

1 9 7

3

1 9 7

4

1 9 7

5

1 9 7

6

1 9 7

7

1 9 7

8

1 9 7

9

1 9 8

0

1 9 8

1

1 9 8

2

1 9 8

3

1 9 8

4

1 9 8

5

U S $ b i l l i o n

Figure 2.1: Annual eurocurrency syndicated loan volume 1970-85.

Source: Clark, Levasseur and Rousseau, 1993.

It is true, however, that it was the latter half of the 1980s that saw the dramatic

resurgence of the syndicated loan in domestic form. In 1987, even as some were pre-

dicting the demise of the syndicated loan following the sovereign debt crisis, it wasaccelerating into a new phase on the back of a vital corporate sector and domestic, as

opposed to o ff shore, liquidity. The huge demand for corporate nancing during this

period is well-documented, with many classes of nancial instrument experiencing sub-

stantial growth to meet it. Bond and equity markets, and the new high-yield (also

called junk) bond markets, grew dramatically. It was this growth in disintermediation ,

where investors "loaned" directly to rms through the capital markets without the in-

termediation of banks, that fuelled new predictions of the syndicated loans decline (see

Norton, 1997). Yet syndicated loans continued to develop as a vital source of capital

and it is signi cant that the RJR Nabisco deal mentioned previously, the signature

transaction of the period, was funded through a syndicated loan. The growth in do-

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mestic syndicated loans in the US during this period was mirrored in other countries

as well. Elsewhere it was the trend to privatization and private nancing of public

works, together with increased corporate activity, that shifted demand for nancing

from public to private entities.

0

500

1000

1500

2000

2500

1 9 8 6

1 9 8 7

1 9 8 8

1 9 8 9

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

U S $ b i l l i o n

Figure 2.2. Annual global new syndicated loan volume, 1986-2003.

Source: LoanConnect.

As the 1980s closed it became clear that the syndicated loan markets were not

immune to the e ff ects of overheated economies, unsuitable nancing structures and

poor credit control that characterized bank lending in this period. The consequent

capitalization problems su ff ered by many of the worlds leading banks translated into

a signi cant drop in the volume of syndicated loans completed. By now, however,

the syndicated loan had proved itself as an indispensable part of the global nancial

infrastructure. It rebounded and continued to develop during the 1990s, building up

the signi cant transaction volume (see Figure 2.2) and broad scope of nancing that

have already been noted as characterizing the product today. In just the United States

alone the Shared National Credit program now reviews in excess of 10,000 separate

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domestic syndicated loans annually, each in an amount of greater than US$20 million

(Duran, 2001).

2.3 Conclusion

The growth in syndicated lending has been dramatic since the modern form arose in

the late 1960s. It has paralleled the development of the global economy and it is

not unreasonable to suggest that the syndicated loan was actually one of the driving

forces behind the mobilization of global capital in the last 30 years. This contention is

supported by the work in the Chapter 4 where it is shown that it is their combination of

exibility and nancing capacity that enables syndicated loans to provide nancing of

a type that is not available in the public capital markets, but which is vital to the sort

of transactions that underpinned the development of the global economy that exists

today.

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Chapter 3

Structure of Syndicated Loans

In this chapter the structure of syndicated loans is described, with two aspects addressed

in particular. The rst is the syndicated loan agreement itself, and more speci cally

the major terms and conditions that distinguish the syndicated loan agreement from

the generic bilateral loan agreement. These are shown to relate almost exclusively to

the nature of each participants rights against, and obligations to, the borrower and

the other syndicate participants. As such it is reasonable to conclude that, from the

borrowers perspective, there should be relatively little di ff erence between a bilateral

and syndicated loan in meeting its nancing requirements in normal circumstances.

The second aspect to be addressed is the process by which a syndicated loan isarranged; that is, brought from initial mandate through to execution of the syndicated

loan agreement. It is shown that it is in the way they are arranged, and the risks

this poses for the parties, that syndicated loans di ff er most signi cantly from bilateral

loans. The process itself is described and shown to be more complex, time consuming

and costly for the parties than a bilateral loan. The most signi cant di ff erence, however,

is the introduction of syndication risk, arising from uncertainty as to which institutions

will participate in the loan and the amount they will commit. Syndication risk is

allocated either to the borrower or the loan originator, and the manner in which this

is done and the consequences for the parties is described.

The chapter is structured as follows. Section 1 addresses the syndication-speci c

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terms of the syndicated loan agreement. Section 2 then describes the process by which

syndicated loans are arranged. Section 3 concludes the chapter by considering the

nature and consequences of syndication risk.

3.1 Syndication Terms and Conditions

The major di ff erence between an executed syndicated and bilateral loan agreement is

the addition, to the former, of syndication speci c terms and conditions to govern the

additional relationships between the parties. In this section a number of standard pro-

visions from syndicated loan agreements are cited and considered. These are drawn

from the Asia Paci c Loan Market Associations (APLMA) documentation precedents

released to the author in June 2003. They re ect the consensus of all the major players

in the international loan market active in the region. They are also consistent with

market practice in the European loan markets, represented by the Loan Market Asso-

ciation in London. Before commencing it must also be noted that, for this section only,

the term lender is used to describe a participant, re ecting the language used in the

APLMA documentation.

That syndicated loans are a type of loan facility is made clear in the foundation

provision of any syndicated loan agreement. The provision in the APLMA documentary

precedent is typical.

Subject to the terms of this Agreement, the Lenders make available to

the Borrower a loan facility in an aggregate amount equal to the Total

Commitments.

What is signi cant about this provision is that it de nes the aggregate loan amount

as being equal to what are called the total commitments , which are in turn de ned as

the sum of the commitments of each of the syndicate lenders. This is, notwithstanding

the single set of syndicated loan documentation, suggestive of the retention of individual

rights by each lender. This supposition is con rmed by three further provisions that

set out the speci c nature of the relationships and explicitly provide that a syndicated

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loan is, at heart, a composite of separate legal relationships between the borrower and

each individual lender.

Lenders Rights and Obligations

(a) The obligations of each Lender are several. Failure by a Lender to perform its

obligations does not a ff ect the rights of any other party. No party is responsible

for the obligations of another party.

(b) The rights of each Lender are separate and independent, and any debt arising shall

be a separate and independent debt.

(c) A party may, except as otherwise stated, separately enforce its rights.

The retention of individual rights by lenders has important consequences for the

borrower under a syndicated loan. It means that the nancial capacity of each lender

is important, as each is solely responsible for providing a given proportion of the bor-

rowers loan requirement. This di ff ers from the oating rate loan product in the capital

markets, under which the initial subscribers are jointly responsible for providing the

funds to the issuer. Obviously the separation of each lenders rights and obligations is in

their interests when it comes to the enforcement of the borrowers obligations. A strict

segregation would, however, make day-to-day utilization of the facility by the borrowermore diffi cult than an equivalent bilateral loan. So there are a number of subsequent

provisions which act to modify this basic position. These allow the borrower the con-

venience of utilizing the loan as a single facility, at least in normal circumstances. The

clearest example is that certain decisions of the lenders are made by a majority of the

syndicate which is binding on all of them. In fact syndicated loans are usually struc-

tured so that all decisions are by majority lenders except for those that are speci cally

excluded. Those excluded relate to changes to the fundamental terms of the loan such

as the amount of each lenders own commitment, the interest margin on the loan and

the timing and amount of scheduled repayments.

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The mechanics of syndicated loan utilization are relatively straightforward and need

not be excessively complicated here. Each lender is required to provide a share of all

loan advances, and receives a share of all payments from the borrower, according to

the proportion of the total loan commitments that it provides.

Dennis and Mullineaux (2000) propose that the structure of syndicated loans might

create agency con icts of two major kinds. The rst they categorize as an adverse

selection problem, in that the institution that originates a syndicated loan might have

more information about the risks of the borrower and the loan than the other par-

ticipants. It may have an incentive not to disclose adverse information to potential

participants. The second they categorize as a moral hazard problem. They assume

that the originator continues to monitor the loan and borrower on behalf of the other

participants, but has less incentive to be rigorous in this task as it is not taking all of the risk of the loan.

Clearly action of this kind by the originator (in its role as arranger of the syndicated

loan) might expose it to legal sanction, and so rms undertaking this role are very aware

of the potential or perceived con icts and take steps to eliminate them. There are two

main ways this is done. The rst is that written information provided to the potential

lenders prior to signing of the loan facility is always deemed to have been provided

by the borrower, and the arranger disclaims all liability for it. Arrangers also take

potential legal liability into account when discussing the facility with potential lenders

during syndication. These aspects of the syndication process are considered in more

detail in the next section. What is important and relevant for this section is the second

way; that arrangers explicitly contract out of any informational relationship with the

lenders. That the following provisions represent a new standard for syndicated loan

documentation seems to limit the relevance of adverse selection issue as an issue in this

context.

(a) ... the Arranger has no obligations of any kind to any other Party under

or in connection with any Finance Document.

(b) Nothing in this Agreement constitutes the Agent or the Arranger as a

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trustee or duciary of any other person.

(c) ... each Lender con rms to the Agent and Arranger that it has been, and

will continue to be, solely responsible for making its own independent ap-

praisal and investigation of all risks arising under or in connection with anyFinance Document including but not limited to: ... the nancial condition,

status and nature of each member of the (borrower) Group.

Along the same lines are provisions granting certain of the lenders rights and re-

sponsibilities to a designated facility agent. This role is created by the loan agreement

and is one that is not found in other forms of loan. It means that ongoing management

of the loan is undertaken by a dedicated and independent entity whose legal obligations

are to the members of the lending syndicate as a whole. Agents are highly protectiveof their legal position and so there are also provisions which strictly limit their liability

for actions they take on behalf of lenders. While it is common for the agent to also be

the same bank that originates, arranges and participates in the loan, there are almost

always strict legal rewalls between the di ff erent parts of the bank that act as agent and

undertake these other roles. This all suggests that the moral hazard problem proposed

by Dennis and Mullineaux is far less signi cant in syndicated loans than in other forms

of loan participations or loan sales.

Apart from setting out the legal relationships, the agency provisions of a syndicated

loan agreement also describe the mechanical tasks of managing the facility and ulti-

mately give the borrower the convenience of having to deal only with one party, the

agent, rather than each of the syndicate lenders on an ongoing basis. For example,

a notice given to the agent in proper form by the borrower is deemed to have been

given to all syndicate lenders. And one of the agents major tasks is the receipt and

disbursement of payments, both the funding of loan advances by the lenders and their

repayment, together with interest and fees, by the borrower. Again the receipt by theagent of suffi cient funds is taken as satisfying the borrowers payment obligations.

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3.2 Arrangement of Syndicated Loans

The formal appointment by the borrower of an institution or group of institutions to

arrange a syndicated loan is called a mandate . The mandate obliges the arranger 1

(also called the agent 2 or lead bank in the United States) to provide the borrowerwith an executable syndicated loan on the terms agreed. In pursuance of this, the

arranger has two major tasks, which can be conveniently described as syndication and

documentation .

At the time the mandate is agreed, the borrower and arranger are the only parties

with binding legal commitments in relation to the loan; there are at this time no legal

commitments by any other institutions to participate as lenders. An important task of

the arranger is therefore securing these commitments from participants, and this is un-

dertaken in a process known as syndication. Syndication usually commences with the

arranger nalising, sometimes in consultation with the borrower, a list of institutions

to be invited to participate in the loan. Syndication is then launched by the arranger

when it issues formal invitation letters to each of the selected institutions. An invited

institution may respond within a de ned time period by agreeing to participate with

a particular commitment amount. The invitation and the acceptances are strictly be-

tween the arranger and the participant; at no time prior to execution of the syndicated

loan agreement does the participant have any direct legal relationship with the bor-rower. This does not, however, absolve the borrower of responsibility for information

given during this time.

It is very common for the arranger to provide an information memorandum together

with the invitation. This document is usually produced by the arranger and includes

information on the proposed loan and the borrower which is designed to help the

potential lender in its assessment of the lending opportunity. Information memoranda

1 In this work the term "originator" is used to describe the bank that proposes a loan, whethersyndicated or bilateral, to meet a borrowers nancing requirement. If the borrower chooses a syndicatedloan, then the originator takes up the role of arranger.

2 The role of the "agent" as arranger must be distinguished from that of the facility agent describedin the previous section.

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vary in detail and complexity depending on the nature of the borrower and the loan,

but in every case the arranger insists that the borrower take full responsibility for its

contents and disclaims any responsibility for itself. The provision of information often

goes beyond simply providing an information memorandum. It is also common for

the borrower and arranger to present information directly, in what is usually called a

roadshow , to potential participants. And even after the roadshow, potential participants

often seek clari cation or additional information. Management of this information ow

is another part of the arrangers role.

A very important feature of syndication is that the arranger almost always o ff ers

participants a fee, called the participation fee , as an incentive to participate. The

participation fee is typically a at fee expressed as a percentage of the participants nal

commitment amount. It is paid from the arrangers own account, and so the arrangeris free to set or vary the rate of participation fee after mandate without a ff ecting the

cost of the loan to the borrower.

The arrangers second task, documentation, refers to the preparation of the syndi-

cated loan agreement and related legal documents. The major element of the mandate

between arranger and borrower is a term sheet , which is a summary of the major terms

and conditions of the proposed loan. This mandated term sheet is reproduced in the

invitation letter to potential participants. Clearly these summaries of proposed terms

and conditions need to be turned into completed legal loan documents for ultimate

execution by the parties. The arranger retains legal counsel - the lenders counsel - to

act for it and on behalf of the other participants that subsequently commit to join the

loan. It is usual for the lenders counsel, rather than the borrowers counsel, to produce

a rst draft of the loan documents based on the term sheet. The documentation process

then continues simultaneously with the syndication process. The arranger and borrower

negotiate and reach agreement over the form of the loan documentation, which they

usually try to conclude prior to the completion of syndication. The participants whohave committed to the loan are then given an opportunity to review the documentation

and possibly request changes prior to execution. Arrangers, in their mandate letters,

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and participants, in their acceptances, inevitably condition their commitments to the

loan on their satisfaction with the nal form of documentation. They are not obliged

to execute a syndicated loan agreement in a form with which they do not agree.

An exception to the usual process occurs in the case of what is called a bought

deal , under which the loan is structured as a syndicated loan but is executed by the

borrower and the arranger, as sole lender, prior to the completion of syndication. After

the subsequent completion of syndication, the new syndicate participants join the loan

by way of an assignment of their commitment amount from the arranger. In this case

participants must accept the form of loan documentation as already agreed between it

and the borrower without opportunity for input. Bought deals are generally used in

circumstances where, for some reason, it is impractical, impossible or undesirable to

complete the syndication process prior to execution of loan documentation. A goodexample is where the loan is to fund a hostile acquisition. The borrower, as potential

acquirer, usually requires funding to be available at the moment the bid is launched. As

syndication is a public process, con dentiality requirements would certainly preclude

the underwriter undertaking syndication until after this time.

In this work a distinction is also made between syndicated loans and what are called

club loans , even though the two forms of loan in executed form are identical. The

diff erence comes from the way in which they are arranged. Club loans are arranged,

jointly, by those institutions that will comprise the nal lending syndicate. There is no

general syndication of a club loan.

3.3 Syndication Risk, Best E ff orts and Underwriting

Looming over all of the arranging process is the presence of syndication risk . This

describes the uncertainty, at the time the borrower selects a syndicated loan and the

mandate is entered into, as to which institutions will participate in the loan and the

amount each will commit. Where the mandate provides for syndication risk to lie

with the borrower, it is described as a best e ff orts mandate. The arranger undertakes

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to use its best e ff orts to secure commitments from participants su ffi cient to meet the

borrowers desired loan amount 3. In this case syndication risk manifests in uncertainty

in the total loan amount. Usually, the arranger agrees as part of a best e ff orts mandate

to commit some amount to the loan itself (Fight, 2000). The greater the amount of

the arrangers own commitment, the less that needs to be secured from other lenders

and, all else being equal, the less the syndication risk to the borrower. Competition

between institutions for arranging mandates tends to ensure that the arranger usually

commits a not insigni cant amount.

An alternative is for syndication risk to be accepted wholly by the arranger. It can

do so by unconditionally underwriting the syndicated loan (and the arranger that does

so is now described as the underwriter ). In its simplest terms, underwriting is an oblig-

ation to lend, as a member of the syndicate, the di ff erence between the total amountcommitted by other participants and an underwritten loan amount. More speci cally,

the underwriter underwrites not just the total amount of the syndicated loan, but the

loan in that amount and with terms and conditions in accordance with those in the

term sheet agreed in the mandate letter. Where the loan is unconditionally underwrit-

ten, syndication risk manifests entirely in uncertainty in the amount the underwriter

must commit to the loan itself. This amount is called its nal hold 4.

Underwriting commitments are rarely unconditional, however, and there are a num-

ber of conditions which underwriters impose to allocate some syndication risk back to

the borrower. Where this is the case syndication risk manifests itself in di ff erent ways

3 The arranger is not otherwise responsible for the outcome of syndication, although an unfavourableoutcome certainly re ects poorly on its credibility and ability as an arranger. It may also have adverseconsequences for the relationship with the borrower and it is not unheard of for an arranger to increaseits own commitment amount to make up a shortfall, notwithstanding that it is not legally obliged todo so.

4 It is necessary to address some confusion in terminology. The term underwriting is used in thiswork in the very speci c sense described above. However the term is commonly used, particularly inthe United States, to describe the provision of loan commitment by a bank, whether on a bilateral

basis or as participant in a syndicated loan. And the term "underwriting standards" describes thelevel of credit risk a lender is accepting in providing a loan, and does not relate in any way to whatwe call syndication risk. Most confusingly, underwriting standards are often discussed by US nancialregulators speci cally in relation to syndicated loans. But there, however, the term is accepted asdescribing the credit risk of the loan, and the relevance of syndicated loans is simply that such a largeproportion of loans made in the US are syndicated.

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depending on the occurrence of events after the award of the mandate. If an event oc-

curs which breaches an underwriting condition, then the underwriter can withdraw and

the borrower faces uncertainty in the loan amount. If the underwriting conditions are

not breached, then the underwriter must meet its obligations and faces uncertainty in

its nal hold amount. There are four major underwriting conditions; material adverse

change , clear market , commitment expiry and market ex .

The rst provides that the underwriting commitment is conditional on there being

no material adverse change in the nancial condition or business of the borrower, or

in the international capital markets, which would a ff ect the successful syndication of

the loan. Usually referred to as the MAC , this condition applies from the date of

the underwriting mandate until completion of syndication. While protection of the

underwriter by a MAC is a feature of all normal syndications, it is necessarily givenup where it provides a bought deal. In that case the loan is executed and fully funded

by the underwriter prior to syndication and so the underwriting commitment cannot

be subsequently revoked. The possible consequences of this were demonstrated in a

bought syndicated loan provided to Sunbeam by Bank of America and First Union

Bank. Disclosures, subsequent to the funding of the loan by the underwriters but prior

to syndication, that the borrower had breached accounting standards meant that the

underwriters were unable to syndicate successfully and were forced to provide most of

the loan themselves (Eavis and Kinsella, 2000).

The second major condition prescribes that the borrower must provide a clear mar-

ket for the underwritten transaction, usually de ned to mean that no other loan or se-

curities issue for the borrower or associated company has been launched or is expected

to be launched into syndication and which would thus compete with the underwritten

loan in the market. The third standard condition is that the underwriting commitment

will expire if the loan is not executed within a de ned time period. The fourth under-

writing condition is usually described as market ex. An example of the wording of this provision, from one of the leading law rms in this area, Millbank & Tweed, is as

follows:

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accept oversubscription.

Often, however, the borrower may not desire to increase the loan amount or the

lenders may not approve. The practice in this case is to scale-back the commitments

of both the participants and the target nal hold of the underwriter, so that each

participant executes the loan with a commitment amount which is some fraction of its

preferred amount. The amount in which each participant executes the loan is called

its allocated or allotted commitment amount. Invitation letters always specify that the

underwriter can allocate commitments at its sole discretion, but in practice scale-back

is almost always done on a pro-rata basis, so that each participant is scaled-back by

an amount proportional to the amount by which the loan is oversubscribed. In this

way each participant is treated equally. An underwriter that maintained its own nal

hold at target level while scaling-back the other participants would risk damage to itsreputation in the market, and this is su ffi ciently important that it almost never occurs.

This section has described the simplest case of a single underwriter who underwrites

the borrowers entire desired loan amount. There are, however, variations on this in

practice. Relatively rare is partial underwriting, where the underwritten amount is

less than the borrowers desired loan amount, with the di ff erence arranged on a best-

eff orts basis only. More common is the practice of joint underwriting, where two or

more institutions team up to underwrite the entire loan amount. The reasons that

institutions may be forced to team up to underwrite the loan are explored in Section

5.3, but can be simply explained as resulting from institutions being constrained in the

maximum amount they can underwrite or a desire to reduce their own level of under-

writing risk. The joint underwriting obligations are usually several, which means that

each institution is responsible only for its own underwritten amount. In syndication,

commitments from participants are usually applied to reduce each underwriters com-

mitment on a pro-rata basis according to the amount of its underwriting (noting that

it is not necessary for each to underwrite the same amount).At this point it is appropriate to refer to the work of Francois and Missonier-Piera

(2004). They speci cally consider the case where a group of banks is observed to

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the facilities. This is a signi cant conclusion because it means that borrowers should

view syndicated and bilateral loans as substitutes in terms of meeting their funding

needs.

The major di ff erences between the two forms of loan are found in the way they are

arranged; that is, brought from initial mandate to execution. The process of arranging

syndicated loans, as well as being more complex, introduces a major element of risk to

the parties that is not present in the arrangement of bilateral loans. This is syndication

risk, which derives from the uncertainty in the amounts that will be committed to the

loan by the participants. The allocation of syndication risk between the syndicated

loan originator and borrower is a major factor in the decision to select a syndicated

loan. In particular, it impacts on the return to the originator and the way in which it

does so is a major subject of the next chapter.

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(EVA) models in which the required return to the investors who provide the capital

with which an investment is funded is treated as a cost of that investment. The mix of

the rms debt and equity capital which is assumed to fund each individual loan in this

model is determined by the incremental risk of the loan to the banks portfolio and an

objective of maintaining this overall portfolio risk at a given level. This treatment of

risk and capital is the same as that in the RAROC (Risk-Adjusted Return on Capital)

models which are being increasingly adopted by banks. The di ff erence between EVA

and RAROC models, however, is that the latter does not treat the return on capital as

a cost, instead generating an internal rate of return measure which is then compared

with the investors required return on capital. EVA models, by contrast, generate a

direct measure of the value by which the rm is increased due to undertaking the new

investment.It should be noted here that the expressions of return developed in this chapter

have one non-traditional element. They include not just the contractual revenue and

direct costs of meeting the contractual obligations, which are usually accepted as the

major elements of return, but also the opportunity cost of the return from alternative

investments that must be foregone, which is not. To this extent, therefore, the ex-

pressions di ff er from the traditional EVA model as the measure generated is not the

value added to the rm per se, but rather the marginal value added to the rm over

that of alternative investments. Opportunity cost is important in the context of this

work because it is a signi cant element of the new model and explanation for the use

of syndicated loans that is one of its major subjects.

The chapter is structured as follows. Section 1 undertakes a comprehensive analysis

of loans generally, comparing them to bonds, and develops the expression of return

from providing a bilateral loan. Section 2 then compares the economics of bilateral

with syndicated loans, concluding with the complete new expression of return to the

originator of a syndicated loan.

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4.1 Loan Returns

In this section loans are compared with their major nancing alternative, bonds issued

in the public capital markets. Bonds are well-understood, as much because of their

relative simplicity as their usage. The major theme of this section is that loans aremore complex than bonds, but it is because of this complexity that they are able to

meet a range of nancing requirements that are beyond the scope of other debt capital

markets instruments. Ultimately, the di ff erences between bonds and loans ow from

diff erences in the nature of their providers.

Bonds are structured on the assumption that they are xed debt claims purchased

by capital markets investors with surplus funds. In terms of elementary nance theory

investment in a bond is a mechanism for deferring consumption. By contrast loans are

structured on the assumption that they are provided by commercial banks. Banks are

not assumed to lend surplus funds. Instead they are the classic nancial intermediaries

that raise the funds they lend by selling xed debt claims, traditionally by accepting

deposits from investors or by drawing on surplus liquidity in the interbank market.

Today there is a large and growing universe of nance providers, with all manner of

funds and non-bank nancial institutions blurring the distinction between investor and

lender that drove the historical development of the distinct bond and loan products.

This periodically incites commentators to forecast the demise of commercial banks andtheir staple product, loans, in the face of increasing disintermediation in the capital

markets. Yet the loan in traditional form continues to go from strength to strength, as

the statistics on syndicated loans attest. It is true that there is a retreat of the loan

product from areas where the nancing requirement can be more e ffi ciently met in the

capital markets, most notably for core debt funding of investment-grade corporates.

This is more than o ff set, however, by the use of loans to enable transactions that would

otherwise be impossible using capital markets funding (Fuchs, 2004). There is also an

increasing use of loans and capital markets instruments as complements rather than

substitutes. The classic example is the complementary use of commercial paper and

standby loan commitments, described in Chapter 2.

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So what is it about a loan, structured on the assumption that it is provided by a

true nancial intermediary, which distinguishes it in its capacity to meet a rms debt

nancing requirements? Foremost is in the way in which the funds are available to and

utilized by the borrower.

4.1.1 Loan Availability and Utilization

A bond issue is a series of identical debt claims that are initially sold by the rm to

investors, and the purchase price paid by the initial investors generates the required

funding to the issuer. The issuing rm will, therefore, receive its funding in one lump

sum on the payment date of the bonds. After issuance the bonds may be freely traded

so that, when they mature and the debt becomes due, the issuer pays out to the parties

that hold the bonds at that time. Prepayment prior to the maturity date is not allowed

or, if it is allowed, the issuer must compensate the then bondholders for the opportunity

cost of the cash ows they will forego over the remaining original life of the bond. This

is necessary because the bondholders will have purchased the bonds, and determined

the price for them, in expectation that their cash ows will be received as scheduled.

When a loan is executed and becomes binding on the parties it does not create

an immediate debt claim. Instead a loan gives the borrower the right, subject to

conditions, to require the lender to make cash advances to it upon request. So loans

are more accurately described as loan facilities that set out the conditions on which

the borrower may draw advances and the terms of those advances. This is possible

because the lender does not raise its funding for an advance until it is required; it

does not have surplus funds sitting idle on which it requires an immediate return. In

the academic literature a distinction is often made between what are called spot loans

and loan commitments (Saunders and Lange, 1996). Loan commitments are those loan

facilities where the borrowers options to draw and repay advances exist throughout

the life of the facility, provided only that the total of advances outstanding do not

exceed the maximum facility amount. Where it is expected that the borrower will

utilize a loan commitment regularly it is usually described as a revolving loan facility .

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Standby facilities , such as those backing commercial paper programmes or for credit

enhancement, are also loan commitments but are usually expected to be drawn only in

speci c, rare circumstances.

There are equivalents to loan commitments in the capital markets, namely commer-

cial paper (CP) and medium term note (MTN) programmes. Under these programmes

an issuer may, from time to time at its option, o ff er to sell CP or notes to a tender panel

of institutions who will bid to purchase them for trading or on-sale to investors. There

is, however, no obligation on the tender panellists to do so and even should they wish to

purchase paper or notes, the price at which they are issued depends on the price o ff ered

by tender panellists at the time of the request. This lack of obligation, and thus lack

of certainty of funding for the borrower, is a very important di ff erence between these

programmes and loan commitments. Under a loan commitment the lender is obligedto provide the advances upon request, at the pricing and on the terms agreed at the

time the facility is entered into.

While a loan commitment allows the borrower to request and maintain advances

throughout the often lengthy life of the facility, each individual advance is actually

repayable within a relatively short period; 1, 3 or 6 months being usual. These periods

are called funding periods or interest periods . Loan commitments are structured in this

way because of the underlying assumption that lenders are intermediaries that raise

short-term funding to meet loan advances. The typical 1,3 or 6 month advance periods

are the most common periods for banks to raise funding in the deposit or interbank

markets, but longer or shorter periods may be agreed between borrower and lender.

If it wishes to keep the funds from an advance outstanding beyond the term of the

current funding period the borrower simply redraws the advance for a further period

and the lender matches this by re nancing its own funding for the same period. It is

important to note that advances cannot be prepaid during a funding per

Documents

18073516 Economic Basis of Syndicated Lending Wild