M29A2 International Banking and Finance Law : Viability of Commercial Bonds

From: [email protected]

To: [email protected]om

Subject: Financial advice regarding Project Daisy.

Dear Richard,

I am a trainee working for Guy Rogers who is helping you in determining the financial aspect of the acquisition of the ‘Target’ company. The contents that will be discussed in the mail will provide a clear picture of the viability of the options of finance which will ensure the completion of the acquisition process.

In the present scenario it can be understood that the financier in your case is Prime Bank. In the present case, the available option of lending is either through syndicate loans or through bond issue. However the interest rates charged by the bank are 2.00% above the London Interbank Offer Rate (LIBOR) and for bond issue 1.75% above the LIBOR. In order to understand the financial aspects of this matter, one has to know about LIBOR, syndicate loans and bond issues. The LIBOR or the ICE LIBOR acts a benchmark rate used by leading banks in the world with respect to short term loans. This rate is the initial step for calculation of interest rates with respect to different loans across the world. The LIBOR depends on five currencies across the world namely US dollar, pound sterling of Great Britain, yen of Japan, Swiss franc and Euro. Thus this rate acts as the prime indicator of the average rates which the banks contribute for obtaining short term loans within the London interbank market. For every business day 35 rates are submitted. The most common rate submitted is the US dollar rate whose loan matures within 3 months. Hence LIBOR’s main function is to act as a benchmark reference rate for instruments of debt like corporate and government bonds, student loans, mortgages and credit cards. The benchmark rate is also applicable for derivatives like interest swaps and currency.

Viability of corporate loans

In the instant case syndicate loan has been considered as an option for funding the acquisition process. These are alternatively known as syndicate bank facility. These loans are provided by groups of lenders known as syndicate. These groups work in a collaborative manner for providing funds to a lone borrower. Usually the borrowers in this case are companies. The government also opt for such loans for large projects. Aspects which are involved within such loans include fixed amount of funds, a credit limit or both. For acquisition of a company, the amount of funds required is high. These funds are required for projects where the loan money is high with respect to a single lender. These loans are also applicable in case of projects which require lenders with specialisation with respect to a certain class of asset. When the loan is syndicated or borne by a group of lenders the risks are reduced. It also ensures that the lenders are able to participate in financial projects which are usually not feasible with their individual capital. The interest rates with respect to these kinds of loans are either fixed or kept flexible depending on benchmark rates like London Interbank Offered Rates (LIBOR).

With respect to syndicated loans there are certain elements. There is a primary bank or underwriter of the loan. It is known as the arranger, the main lender or the agent. Their functions involve providing a bigger share of the loan. They perform certain duties like distributing influx of cash for administrative tasks among other members of the syndicate. The primary aim of syndicated loans is to ensure that the risk arising from the default of a borrower among various lenders such as investment banks or among organisational investors like hedge funds and pension funds. Thus, from the fact that Prime Bank insists on you’re opting for syndicated loans is to make their investment safe. The levels of syndicated loans are higher compared to regular bank loans. In case even a single borrower defaults in payment, there is a risk which has serious implications. These loans are usually used by leveraged buyers for funding huge corporate acquisitions with the help of debt funding. The syndicated loans are arranged on the basis of best efforts. In case sufficient number of investors is unavailable, the actual amount tendered to the borrower is lower compared to the original agreed amount. It seems that syndicated loans are commercially better for the bank. It is because the risk is equally distributed among the lenders. Moreover loans can be paid only when the maturity period is attained. There no risk for the company to pay off the bank at an earlier date.

Viability of commercial bonds

Another option available for funding the acquisition is corporate bonds. These bonds act as a collateral security for debts and are sold to prospective investors. The company usually shows the financial statements to the prospective investors to convince them of their ability to pay which can be determined from what they will earn from future operations. At times the company uses its physical assets as collateral security for issuing the bonds. The risk borne in case of corporate bonds are higher compared to government bonds. Thus even if the company is AA rated organisation in terms of credit ratings, the interests charged are high. These bonds are issued with a minimum par value. They have a payment structure similar to coupons. During the period of holding the bond, the investor receives interest from the issuer till the time the bond matures. When the bond matures the investor has the right to claim the face value of the bond. If the existing rates of repayment change, the issuer has to adhere to call provisions and arrange for an early repayment. In such cases the investors have the right to sell the bonds prior to the maturing of the bonds.

Suitability of each of the options with respect to the acquisition

Thus there are significant differences between bonds and syndicated loans. The bonds are highly tradable. While buying bonds, there are specified markets where the bonds can be traded. The bonds can be sold at any time unlike loans where there is a fixed time of repayment. Bonds are preferred by people for developing their portfolios. On the other hand loans act as agreement between the customers and the banks. As a form of debt finance, loans cannot be sold or traded. The banks have to wait till the loan amount reaches its maturity date. Thus in the present case scenario, the current bank is clearly pushing for syndicated loans as they are aware that the loans are made safe with the help of derivatives and securitisation. The high rate of interest is not a catch. In case of corporate bonds you may have to return the money if the interest rates fluctuate.

This means that the quotation of 1.75% over LIBOR may fluctuate and your company may have to pay the money before the maturity date. This will require you to arrange for funds well before the maturity date. However in the case of syndicated loans they are perfectly suited for your business purpose since the interest rate can be fixed according to the LIBOR rates. Your company will have to repay the money only when the time of maturity comes. The time period can also be decided between the company and the bank. Moreover since the scale of acquisition seems to be significant, your company can generate sufficient money for funding your purpose. Syndicated loans are ideal for the purpose of setting up a new subsidiary as the amount of money that can be taken by the UniDairy Plc is high. Moreover the date of repayment can be fixed. During this period they can accumulate the required amount to repay the money. However if one opts for bond financing, the period of repayment is flexible. The company to whom the bonds will be sold will have the option of selling the bond at any time. Thus the risk and liability is higher in case of bonds. One has to prepare for alternative financial options in case of using corporate bonds as source of finance. The corporate bond route would involve many procedures. The company will have to arrange for a director’s meeting to get approval for issuing corporate bonds. They will have to identify customers for the bonds. Moreover their obligations for repayment of the money collected will increase. This is not so in the case of loans. The bank and the borrower can plan the time for the repayment of loans. The method of taking loan and the procedures involved are far less compared to corporate bonds.

Thus it can be concluded that syndicated loans are much safer as source of investment compared to corporate bonds and the repayment rules are more flexible.

Regards,

Trainee

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