Chapter 14

Understanding Financial Contracts

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Financial Contracts

Financial contracts are written between lenders and borrowers

Non-traded financial contracts are tailor-made to fit the characteristics of the borrower

Publicly traded financial contracts are more standard and suitable to meet the needs of large number of inverstors

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Financial Contracts

Contracting matters because: Determines how instruments/securities

are originated Determines restrictive covenants Determines terms of contract

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Why Business Needs Financing

Businesses need funds for a variety of reasons

Finance permanent assets such as plant and equipment

Finance the acquisition of another business

Finance working capital—inventory or accounts receivable

Payroll

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How Business Obtains Financing

Financing Small Businesses Small firms—assets less than $10 million Vast majority are privately owned with ownership

concentrated in a single family Profitable firms may have sufficient capital to be

self-financing Generally do not need external financing beyond

trade credit—delayed payment offered by suppliers

Banks are most likely source of external financing

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Financing Small Businesses

Characteristics: Provide funds via a short-term loan or line of

credit (L/C) for either working capital or purchase of plant and equipment Short-term loan—negotiated contract with short

maturity Line of Credit

Bank extends a credit for specified period of time The borrowing firm can draw down funds against L/C Credit Rationing—insures borrower has access to funds

even if bank would prefer to curtail new loans When financing capital assets the maturity of the loan

is typically less than life span of the asset

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Financing Small Business

Origination Mechanism Locate a bank that meets your needs,

usually through a referral (bank’s accountant)

The bank’s loan officer conducts a complete credit analysis. Which involves: Review borrower’s financial statements Visit the place of business Assesses the managerial

strengths/weaknesses of borrower Provides an opportunity to develop a one-on-

one relationship

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Origination Mechanism

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Financing Small Business

Origination Mechanism Credit Analysis

Obtain additional information about the firm Obtain credit report on the firm and borrower Address any concerns with the borrower

Loan Approval Small loan approved by a loan officer Larger loans are approved by more senior officers Above a certain amount must get approval from

loan committee Borrower and bank negotiate terms of

the loan

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Financing Small Businesses

Unique features of a small business loan

During application period and after the loan is granted, a personal relationship between bank and borrower is developed

Banks offer a wide menu of options to borrower Loans have shorted maturity (rarely exceeds 5

years) Loans are often collateralized, which means

Pledging of assets against the loan Owner may pledge personal assets as collateral Secured lender—bank has the right to petition the

bankruptcy court to sell the asset pledged as collateral to satisfy the loan

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Financing Small Businesses

Unique features of a small business loan

Loan can be guaranteed by the owner Borrower is personally liable for any unpaid balance Lender may require a personal financial statement of the

borrower

Loan may contain restrictive covenants Covenant—promises that the company makes to the

bank regarding their future actions and strategies The bank may require an audited financial statement to

verify the convents have not been broken More restrictive covenants are linked to actions indicating

the company has become riskier If violated, bank may demand immediate payment of loan Possible for the borrower to renegotiate the terms of the

loan to reflect higher risk

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Financing Midsize BusinessesCharacteristics:

Assets between $10 million and $150 million Large enough to no longer be bank-

dependent for external debt financing, but not large enough to issue traded debt in the public bond market

Some are likely to be publicly owned—issue equity traded in the over-the-counter market

Can either be owner managed or managed by someone other than the owner

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Financing Midsize Businesses

Characteristics For short-term debt, principally rely on

commercial banks Depending on size of debt and bank, can use

either local or non-local banks Typically have covenants placed on the loan and

may pledge collateral For long-term debt, commercial bank may

combines an line of credit with intermediate-term loan known as Revolving Line of Credit

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Financing Midsize BusinessesLong Term Debt Financing

Through non-bank institutions Mezzanine debt funds provide loans to smaller

midsize companies Through Private Placement Market

Generally a bond issue in excess of $10 million Bonds do not have to be registered with the

SEC Avoids public disclosure of information Sold only to financial institutions and high net

worth investors with sophisticated knowledge of investment

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Private Placement Market

Characteristics: Generally not resold by original investor for at

least two years Have covenants that are generally less

restrictive than when borrowing from a bank Terms will be renegotiated one or more times

during the life span of the loan if the company wishes to embark on a new strategy

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Private Placement Market

Origination Issued through agents, commercial banks or

investment banks who structure the contract and market the issue

Due diligence: the agent handling the private placement evaluates the firm’s management, financial condition, and business capabilities

Based on due diligence, the placement issue will receive a formal credit rating which measures the perceived risk from a rating agency (such as NAIC)

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Private placement origination.

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Private Placement Market

Origination The terms of the contract are negotiated to be

attractive to investors—interest rate, maturity, covenants, and any special features

Offering memorandum and Term sheet containing information of the firm and the contract terms are sent to prospective investors

Once the issue is placed, the investors do their own due diligence which verifies the original information

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Financing Large Businesses

Characteristics Firms with assets in excess of $150 million Becomes cost effective to enter the

public bond market These bond issues are liquid assets that

are traded in the secondary market Therefore, can be issued at a lower yield

than a non-traded instrument

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Financing Large Businesses

Cost of Issuing Public Bond Distribution cost: costs to sell to a wider range of

investors Registration cost: costs associated with

registering the bond with the SEC Underwriting cost: costs of issuing and marketing

a public issue

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Securities Underwriting

Underwriting Process: Issuer selects an underwriter, generally an

investment bank, to assist in issuing and marketing the bond

Underwriters actively market their services to companies large enough to issue in the public market

Underwriter does due diligence on the issuer and then issues the following items

Registration Statement Offering (preliminary) prospectus

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Securities underwriting.

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Securities Underwriting

Registration Statement conforms to specific disclosure requirements blessed by the underwriter, the accountants,

and issuing firm’s attorneys The registration statement is approved by the

SEC and can now be distributed It is difficult to incorporate highly restrictive

covenants in publicly traded bonds

Offering (preliminary) prospectus Contains all relevant factual information about

the firm and its financing

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Role of Underwriter

Underwriting syndicate is formed by the managing underwriter to share responsibility for distribution the issue and the underwriting risk

Underwriting risk occurs when the underwriters make a firm commitment to sell the bonds at an agreed price (implied interest rate)

If bonds sell below this price, underwriter takes a loss

Underwriting Spread—hope to sell bonds at a higher offering price, above the commitment price

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Financing Large Businesses

Shelf Registration Permits the issuer of a public bond to register

a dollar capacity with the SEC Draw down on this capacity at any time This avoids additional registration

requirements Permits issuers to respond instantaneously to

changing market conditions

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Financing Large Businesses

Summary Large companies with good credit ratings

tend to rely on the commercial paper market for short-term financing

Some very large businesses also issue medium-term notes, which are like commercial paper, except maturities range from one year to five years

Also issue equities, through underwriters, which is another form of external long-term financing

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Credit market comparison

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Economics of Financial Contracting

transactions costs helps explain why firms of different size rely on different financial contracts to raise funds

However, to fully understand the differences must rely on the concept of asymmetric information—buyers and sellers are not equally informed about the quality of the product

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Asymmetric Information and Financial ContractingAdverse Selection

Caused by asymmetric information before a transaction is consummated

Bank loan officer cannot easily tell the difference between high and low quality borrowers

Part of the loan officer’s job is to use credit analysis to uncover relevant information

Asymmetry of information is particularly acute for small firms since there is little publicly available information

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Asymmetric Information and Financial Contracting

Moral Hazard Occurs after the loan is made Loan contract may give the firm the

incentive to pursue actions that take advantage of the lender If the firm does very well, the owner does not

pay more to the issuer of the bank loan If the firm does poorly, the owner’s liability is

limited to the terms of the loan Therefore, owners disproportionately share in

the upside of increased risk, while lenders disproportionately share in the downside

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Economics of Financial ContractingSmall firms

External reputations are difficult to establish Most activities are beyond the public’s scrutiny Need proxies to demonstrate they are low risk and

committed to not shifting their risk profiles Outside collateral or personal guarantees: This puts owner’s

wealth at risk Inside collateral: This allows bank files a lien against

collateral Loan covenants: This prevent risk shifting by explicitly

constraining borrower behavior No long-term debt contracts:

There is too much flexibility in small business operation incentives to shift risk is very high

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Economics of Financial ContractingLarge firms Relatively easy to observe and any risk shifting is

easily detected for following reasons: Labor contracts are often public knowledge Supplier relationships are often well known Marketing success or failure is well documented No incentive to switch to high risk activities: the firm’s

desire to maintain their reputation Therefore, public markets for stocks and bonds will

generally reflect true riskiness of investment strategies.

This riskiness in turn determines prices and yields of the stocks and bonds issued by large firms

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Economics of Financial ContractingMidsize Companies

Their information problems lie between small and large size companies

More visible publicly than small, Less transparent than large companies

At the origination stage, financial intermediary Needs to address adverse selection problems Design a tailor-made contract

May have access to long-term debt in the private placement market