Companies rarely have sufficient cash on hand for a significant acquisition. Bank debt can fund an acquisition that’s later paid down with cash flow. More typically, companies need some permanent debt in the form of bond offerings, while very large transactions may require preferred common or preferred equity issuance to preserve good credit. Here’s a brief overview of bank debt from the perspective of an investment banker.
Characteristics of Bank Debt
As the most senior form of financing, bank debt tends also to be the cheapest. It tends to have short maturity timelines, and borrowers are expected to pay down the debt. An amortization schedule is staggered instead of requiring an end bullet payment, allowing principal to steadily decrease.
Because banks are risk averse, they demand the most security on their debt. They will have the first claim on posted collateral, and will be the first to be paid should the business go bankrupt or be liquidated. Banks insist on strict legal covenants to prevent companies from taking on higher risk than the lender is comfortable with.
Types of Bank Debt
There are two general options for bank dept:
- Revolvers, like credit cards, are loans that are drawn upon and paid down. They are charged at the highest interest rate as long as they are drawn. These revolvers can be helpful for companies that engage in frequent M&A.
- Term loans are one time loans drawn once or gradually. Once payments begin, they cannot be redrawn. In most cases, these loans involve a lump sum that is gradually repaid.
Considerations for Bank Debt
Bank debt is cheap and does not increase share count. Interest payments are tax-deductible. It’s also more flexible in terms of sizing and paydowns. Unlike bonds, which are a more permanent source of capital for the issuer, banks seek to get debt off their books as quickly as possible. Thus there are no prepayment penalties, allowing borrowers to quickly rid themselves of debt. And while bonds require a certain level of demand, revolvers allow companies to draw as little as they need.
Bank loans aren’t without liabilities, however. Bank loans are more restrictive and short-term. So companies cannot undertake actions that would restrict their ability to meet bank loan requirements. This debt is also normally at a variable rate, so sudden interest rises can increase expenses. Companies that prefer fixed rate debt can hedge out their interest rate risk via an interest rate swap, but this strategy is only effective for debt intended to last for a known period.
Other Forms of Bank Debt: Bridge Loans
Bridge loans are an alternative to traditional bank debt meant to serve as a bridge to another type of financing. For instance, when a transaction is about to close and a company has not yet raised equity or bonds, it may use a bridge loan to pay the seller. In this regard, many transactions meet their conditions precedent by initially securing financing from a bank.
Banks prefer bridge loans because they are short and carry many fees. If bond or equity offerings fail, bridge loans contain provisions for a higher interest rate if the loan remains outstanding.
Companies can have narrow to wide syndicates for providing funding. On one end, a corporation may embark on a two-sided bilateral transaction. But on the other side, companies can undertake club deals. These are medium-sized loans involving three to five banks. The terms may not be as favorable and the price may not be as low, but the funding can be much higher. For even more financing, companies may choose global syndicated loans. This typically involves an administrative agent, and can require significant planning and negotiation.