Chapter 14 Understanding Financial Contracts

14-2  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

14-3 Financial Contracts Contracting matters because:  Determines how instruments/securities are originated  Determines restrictive covenants  Determines terms of contract

14-4 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

14-5 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

14-6 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

14-7 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

14-8 Origination Mechanism

14-9 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

14-10 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

14-11 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

14-12 Financing Midsize Businesses Characteristics:  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

14-13 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

14-14 Financing Midsize Businesses Long 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

14-15 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

14-16 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)

14-17 Private placement origination.

14-18  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

14-19 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

14-20 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

14-21 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

14-22 Securities underwriting.

14-23 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

14-24 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

14-25 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

14-26 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

14-27 Credit market comparison

14-28 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

14-29 Asymmetric Information and Financial Contracting Adverse 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

14-30 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

14-31 Economics of Financial Contracting Small 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

14-32 Economics of Financial Contracting Large 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

14-33 Economics of Financial Contracting Midsize 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