What is Loan Structure?
Loan structure is the terms of a loan with respect to the various aspects the make up a loan, including the maturity or tenor, repayment, and risk.
The loan structure is arrived at by taking into consideration several factors, such as the purpose, the timeline, and the risk profile of the borrower. In the following sections, we will discuss different structures that exist based on the above factors.
Different repayment structures vary based on how repayments are organized. Some common structures are listed below:
Amortized loan: An amortized loan is fully repaid by the end of its tenor in equal payments that include both the principal and interest.
Balloon loan: A balloon loan is similar to an amortized loan, except there is a large payment at the end of the loan’s tenor. The size of the balloon payment effects the size of the equal payments, which include both principal and interest.
Bullet loan: A bullet loan is similar to a balloon loan, except the equal payments are comprised of interest only, and the principal is paid at the end as a balloon payment. The structure is most commonly used in bonds, which make equal coupon payments and pay the face value at maturity.
Callable/Puttable: Some loans come with a prepayment option, which means that the borrower can repay the loan earlier than maturity. It is a callable loan. A borrower may want to take advantage of lower interest rates and refinance the loan. The most common example is mortgages. A puttable loan is an exact opposite, where the lender can demand an earlier repayment. It helps the lender pursue higher returns when interest rates are rising by freeing cash from lower rate loans.
Convertible: Convertible loans can be converted into equity of the borrowing business at the option of the lender. They specify two terms, the conversion ratio and the conversion price, which define the number of shares and the price at which they will be issued to the debtholders.
Floaters: Floaters are loans with varying coupon rates that match the prevailing interest rate in the market. Hence, the repayments from floaters vary with the change in interest rates. The rate on the loans varies with respect to a benchmark and is quoted as a spread to the benchmark. For example, a common benchmark is LIBOR, so the rate on a floater will be quoted as LIBOR + 2%, where the spread is 2%.
Loan structure is also based on the tenor of the loan. Short-term loans can assume very different structures compared to medium- or long-term loans.
The loans need to be repaid in less than one year. They are typically used for working capital requirements and can have a tenor from one month up to a year.
A revolving loan is a service that a lender provides, where the borrower can borrow any amount up to a maximum for a short period of time. The amount available for borrowing depends on previous borrowing and repayment. Such loans are typically used to meet funding shortfalls in the short-term.
Factoring is a type of secured short-term debt. It allows a business to borrow money against its receivables. The business is allowed to borrow a fraction of its receivables and transfer its receivables to the lender. The lender then collects the full amount of the receivables from the concerned parties.
Medium and long-term debt offer more traditional payment structures. A medium-term loan is for tenors between one and five years, while long-term loans come with tenors greater than five years. The different structures within long-term debt arise from the differences in the risk level of the loan.
The risk of a loan is primarily captured by the interest rate on the loan, but a change in loan terms can change the risk profile of the loan.
Senior debt is one of the less risky structures, as repayment to senior debt takes precedence to the repayments of all other debt issued by a company. Senior debt also charges a lower rate of interest because of its relative safety. A senior loan may or may not be protected by collateral.
Secured debt, or a secured loan, is a loan that is protected by some form of collateral. It means, in case of a default, the lender can sell the specified assets of the borrower to recover the maximum possible portion of the loan amount.
Debentures are an unsecured form of debt with a fixed interest rate. They are typically junior debt and thus come with a lower claim than other forms of debt. It is important to note that the term debenture refers to different types of structures in different parts of the world. For example, in Canada, a debenture is secured but does not require a specific collateral attached to it, such as secured debt.
Subordinated debt is a riskier form of debt and provides a higher rate of return relative to other loan structures. In case of insolvency or bankruptcy, subordinated debt is paid after all other debt.
Some classes of preferred stock can also be considered a form of debt because they come with mandatory dividend payments. Some preferred shares even provide deferred dividends, which means any missed dividend payments must be paid later. Preferred stock is riskier than debt, being senior only to common equity in its claim to a company’s cash flows.
Other Terms of Loan Structure
Risk, repayment, and tenor alone do not describe all loan structures. They are terms that are present in other forms.
The collateral is an asset or a collection of assets belonging to the borrower that a provider of a secured loan can take ownership of in case of a default. The lender is then free to sell the said asset(s) to recover the loan.
Covenants are restrictions that a lender places on the borrower as a condition for the loan. Covenants can be financial or non-financial. A financial covenant can take the form of maintaining a certain interest coverage ratio or debt-equity ratio. A non-financial covenant can be a restriction on strategy or certain corporate actions like acquisitions.
Some loans are guaranteed by third parties, which means, in case of default, by a borrower, the guarantor will make payments on the loan. It is a common practice to reduce the cost of debt with smaller subsidiaries of a large parent organization.
Any fees associated with the loan are also included in the loan structure. Even though they are very small, they are real costs and can influence the decision of preferring one structure over others.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: