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Navigating the Complex World of Revolving Loans: Key Considerations for Lenders and Borrowers

Revolving loans are a crucial financing tool for businesses with fluctuating cash needs, providing flexibility and access to funds when needed. However, the intricacies of these facilities can be challenging to navigate for both lenders and borrowers. In this article, we will delve into the key aspects of revolving loans, discussing their structure, types, and the various issues that arise in the context of syndicated and bilateral deals.

Understanding the Basics of Revolving Credit

At its core, a revolving loan allows a borrower to borrow, repay, and re-borrow funds up to a predetermined limit. This distinguishes revolving credit from term loans, which are one-time borrowings that amortize according to a set schedule. Revolving loans are particularly useful for businesses with seasonal cash needs or those requiring working capital to fund inventory purchases or supply chain management.

Borrowers benefit from revolving credit by only paying interest on the amount borrowed, providing cash flow flexibility. This is especially advantageous for businesses with cyclical cash needs, such as those in the manufacturing or retail sectors. Professional firms, like law firms and accounting firms, also frequently utilize revolving credit facilities to manage their cash flow during periods of partner distributions.

Lenders generate revenue from revolving loans through interest charged on outstanding balances and unused line fees. The unused line fee compensates the lender for committing funds even when they are not being actively utilized by the borrower.

Revolving Loan Structure and Key Features

Revolving loans are subject to maximum borrowing amounts, which include the commitment amount (the overall maximum that can be borrowed) and the borrowing base. The borrowing base is a means of limiting and structuring the amount a borrower can borrow based on the value of its assets, with the lender setting advance rates for different asset classes. Accounts receivable typically receive the highest advance rates, followed by inventory, with certain categories subject to caps.

Credit availability is determined by the lesser of the commitment amount or the borrowing base at a given time. In situations where the outstanding amount exceeds the credit availability, known as an over-advance, the borrower is usually required to immediately pay down the excess.

Revolving loans often have shorter maturities compared to term loans, and when the same lender provides both, they are typically structured to be co-terminus. Interest payments are usually synchronized for administrative convenience.

Sub-limits are another common feature in revolving credit facilities, which are specific limitations on types of borrowing within the overall commitment. For example, a sub-limit may be placed on the amount of letters of credit that can be issued under the facility. When a letter of credit is issued, it reduces the available credit by the same amount, as the lender has essentially committed those funds.

Eligibility criteria play a crucial role in determining the assets that can be included in the borrowing base. These criteria typically include factors such as the borrower's ownership of the asset, the lender's first priority lien, the absence of disputes or offsets, concentration limits, and the general collectability of the asset. Lenders often seek to include a provision allowing them to determine eligibility in their sole discretion, which can be a heavily negotiated point.

Types of Revolving Loans

Working capital and leverage loans are the most common types of revolving loans. Leverage loans, also known as cash flow loans, involve the borrower maintaining certain financial covenants that drive pricing. These loans are often used for acquisitions or dividend recapitalizations and are among the most complex and heavily negotiated revolving facilities.

Construction loans are another type of revolving loan, often used for projects such as office buildings or residential subdivisions. These loans are tied to the borrower meeting certain milestones, which has proven challenging in recent years due to supply chain disruptions.

Capital call credit facilities have seen significant growth in recent years, with loans made to private equity or venture capital funds secured by the uncalled capital commitments of the fund's investors. This area of lending has expanded to include loans against the funds' portfolio investments, with the lender having the ability to foreclose on those investments in the event of default. The capital call credit facility market has experienced exponential growth, with the number of lenders and the size of the market expanding significantly in recent years.

Term loans are another type of facility often paired with revolving loans. These loans are typically structured with scheduled amortization payments and a larger bullet payment due at maturity. One key consideration with term loans is the need to ensure that there will be sufficient liquidity in the market to refinance the bullet payment when it comes due.

Syndicated vs. Bilateral Deals

Revolving loans can be structured as either syndicated or bilateral deals. Bilateral loans involve a single lender bearing all the risk and are often relationship-driven. The benefits of bilateral loans include streamlined decision-making and ease of administration, as there is only one lender to coordinate with for waivers, consents, or amendments.

Syndicated deals involve multiple lenders, led by an administrative agent who is responsible for disseminating information and coordinating with the lending group. Syndicated facilities can range from club deals (a small group of lenders) to large syndications involving dozens of lenders. The challenges of syndicated deals include managing divergent lender interests, increased administrative burden, and higher legal costs due to the complexity of negotiating and documenting the facility.

In syndicated deals, the use of swing line facilities can help streamline the borrowing process and reduce administrative burdens. A swing line is essentially a mini-revolving facility within the larger syndicated facility, allowing the borrower to borrow and repay funds on a short-term basis without involving the entire lending group. The swing line lender (usually the administrative agent) advances the funds and then periodically settles with the other lenders. This structure helps to minimize the frequency of fundings and repayments for the syndicate members.

Defaulting Lenders and Remedies

In syndicated revolving loans, the failure of a lender to fund its committed portion can create significant issues for the borrower and the other lenders. The credit agreement typically provides remedies for dealing with defaulting lenders, such as interest penalties, exclusion from voting rights, and the ability for the borrower to remove or replace the defaulting lender.

However, as seen during the banking crisis of 2023, the traditional defaulting lender provisions may not always function as intended, particularly when dealing with lenders subject to regulatory intervention or insolvency proceedings. In these situations, the automatic stay provisions of bankruptcy law or other regulatory actions may prevent the borrower and other lenders from exercising their contractual remedies, leading to a period of uncertainty and potential disruption to the credit facility.

Collateral and Priority Issues

When multiple lenders are involved, either within the same facility or through separate revolving and term loan facilities, the allocation of collateral and priority rights becomes a critical issue. Split collateral arrangements are often used to align the interests of the revolving and term lenders, with the revolving lender typically receiving a first priority lien on current assets (accounts receivable, inventory) and the term lender receiving a first priority lien on long-term assets (real estate, intellectual property).

Intercreditor agreements play a vital role in these situations, governing the rights and remedies of the various lender classes. For example, the revolving lender may negotiate for access to the term lender's collateral for a specified period post-default to facilitate the orderly liquidation of current assets. Control provisions are also heavily negotiated, with the revolving lender often having the right to control the decision-making process early in a workout scenario, shifting to the term lender after a predetermined period.

Lenders must also be aware of the risk of collateral leakage, where borrowers use creative structures to move assets outside of the lenders' security interests. Recent high-profile cases have highlighted the need for robust protections against these tactics, such as the inclusion of anti-assignment provisions and restrictions on investments in unrestricted subsidiaries.

Pitfalls and Best Practices in Revolving Loan Documentation

Proper documentation is essential for ensuring that revolving loans function as intended and that the rights and obligations of all parties are clearly defined. Some key pitfalls to avoid include:

1. Inconsistencies in borrowing mechanics: Lenders should ensure that the notice periods, funding timelines, and interest rate provisions in the credit agreement are achievable and consistent with their operational capabilities. Failure to properly align these provisions can lead to funding delays and administrative challenges.

2. Inadequate borrowing base reporting: Borrowers should be required to provide regular, detailed reporting on the assets included in the borrowing base, with appropriate mechanisms for lenders to verify this information. Insufficient reporting can hinder the lenders' ability to monitor collateral and manage risk.

3. Unclear or overly broad permitted use of proceeds: The credit agreement should clearly specify the permitted uses of loan proceeds and any applicable restrictions. Overly broad or ambiguous language can lead to disputes and potentially allow the borrower to use funds for unintended purposes.

To mitigate these risks, lenders and their counsel should:

1. Conduct thorough due diligence on the borrower's business, assets, and financing needs to ensure that the loan structure and documentation are appropriately tailored.

2. Engage in a collaborative drafting process with the borrower and its counsel, focusing on clarity, consistency, and operational feasibility.

3. Incorporate robust reporting and monitoring requirements, with clear mechanisms for lenders to access and verify borrower information.

4. Stay abreast of market developments and trends in loan documentation, including emerging lender protections and borrower-friendly provisions.

The Role of Legal Counsel in Revolving Loan Transactions

Given the complexity of revolving loan transactions, the role of experienced legal counsel is critical for both lenders and borrowers. For lenders, counsel can assist in structuring the facility, drafting and negotiating the loan documents, and advising on the various legal and regulatory considerations involved. This includes ensuring that the lender's rights and remedies are properly documented and enforceable and that the loan structure complies with applicable laws and regulations.

For borrowers, legal counsel can help to negotiate favorable terms and protect the borrower's interests throughout the transaction. This may involve pushing back on overly restrictive covenants, ensuring that the borrower has sufficient operational flexibility, and advising on the potential risks and implications of the loan structure.

In syndicated deals, legal counsel plays a crucial role in coordinating the various lenders and ensuring that their rights and obligations are properly aligned. This includes drafting and negotiating the intercreditor agreement, advising on voting and control provisions, and facilitating the resolution of any disputes or conflicts among the lenders.

Conclusion

Revolving loans are a powerful tool for businesses seeking flexible financing solutions, but the complexity of these facilities requires careful consideration and negotiation by both lenders and borrowers. Understanding the various structural elements, types of revolving loans, and the dynamics of syndicated and bilateral deals is essential for successfully navigating this area of finance.

Lenders must be attentive to the risks posed by defaulting lenders, particularly in syndicated deals, and work to structure their facilities to mitigate these risks to the extent possible. The allocation of collateral and priority rights is another critical consideration, requiring thoughtful negotiation of intercreditor agreements to balance the interests of revolving and term lenders.

For borrowers, understanding the implications of the various structural elements and covenants in their revolving loans is crucial for ensuring that the facility meets their needs and does not unduly restrict their operations. Careful attention must also be paid to the dynamics of syndicated deals, as the presence of multiple lenders can create challenges in obtaining waivers, consents, or amendments.

As the legal and financial landscape continues to evolve, it is essential for both lenders and borrowers to stay informed of developments in the revolving loan market and to work with experienced counsel to structure and negotiate these complex facilities. By doing so, they can unlock the benefits of revolving loans while minimizing the risks and challenges associated with these powerful financing tools.