- What should one expect while approaching debt capital markets for a potential refinancing in today’s market?
Credit markets are tight, but refinancing is absolutely possible in today’s markets. Borrowers should consider the following realities while considering refinancing:
- Lenders are slow to respond, more selective and largely unpredictable. This environment is created by the combination of increasing cost of capital for lenders, higher demand for their product compared to the capital they want to deploy and a general unease about the macroeconomic picture.
- Banks still provide the cheapest capital, but they want a much higher credit quality – aka, lower leverage, higher fixed charge coverage, long track record of positive cash flows and ideally, support from a sponsor with deep-pockets.
- Cash is king, especially if you want a loan from regional banks. Following the Silicon Valley Bank failure induced capital flight, regional banks are largely focused on finding clients that can bring a meaningful amount of cash to the depository accounts. A borrower with cash deposits not only gives credit comfort, it helps banks prop up depleted capital reserves without having to purchase CDs in the expensive wholesale market.
- Direct lenders (or non-bank lenders) are active, as long as you are willing to pay low teens in interest, and higher.
- In general, the process would take much longer and require a well diversified outreach to multiple lenders to achieve the results you are aiming for.
2. When should middle-market (MM) borrowers consider refinancing their loan?
Three scenarios typically prompt a borrower to seek refinancing:
- High interest expense – 30-day SOFR, which is the index used by most bank loans, was under 0.15% before April 2022 – today it is 5.3%. In other words, a loan priced at 3% in April 2022 requires 8% interest today. More importantly, a loan priced at 7% in April 2022 would require over 12% in interest today. 12%+ debt is a good reason to find a cheaper alternative, any day!
- Covenant compliance – Extending the logic above, it can be difficult to comply with fixed charge coverage covenant when interest increases by 5% in 18 months but operating income or margins do not. Lenders will either demand even higher interest to compensate for covenant failure or force borrowers to refinance (some lenders would rather have their capital on their balance sheet vs. borrower’s).
- Constrained liquidity – Some lenders might not be able or willing to modify terms and structure of a loan to provide additional capital even when the loan structure is unnecessarily restrictive for a healthy borrower. In such cases, refinancing becomes the only solution.
- Upcoming maturity – term debt, typically classified as long term liability, is classified as current liability if the maturity is within twelve months. For most CFOs, the twelve months before scheduled maturity is a good marker to refinance or extend the maturity. In today’s slow-credit environment, borrowers should start the refinancing process 16-18 months prior to scheduled maturity.
3. How should a borrower prepare for refinancing and how long does it take to refinance?
The first step is to exhaust all possibilities for obtaining a better deal with your existing lender. By offering additional collateral, changing the structure from cash flow to asset backed or by agreeing to additional covenants or monitoring if you can improve your current loan facility, that would save a lot of time and effort. If you cannot get what you need from the current lender, you should think through the following timeline and steps.
Once a borrower and lender agree on a term sheet, it typically takes 45-60 days to close a debt deal. The key issue is how long it would take a borrower to find the right lender and acceptable term sheets.
On CAPX, we start getting term sheets within day 3-5 of launching the deal due to our targeted digital approach to connect borrowers with multiple lenders offering multiple structures simultaneously. However, if a borrower is following a conventional path of ‘dialing for dollars’, we recommend allocating 3 months or more to find a lender.
In either case, before you approach lenders for refinancing, have the following ready:
- Most recent trailing twelve months financials, ideally in a monthly template (income statement, balance sheet and statement of cash flows)
- Audited or reviewed financials for last three fiscal years and projected financials for the current fiscal year and three years in future, ideally in a monthly or quarterly format
- Background of the company and business in a presentation or a write up
- A well thought out credit structure and sources and uses that reflect the transaction
On CAPX, our platform takes users through steps to collect all the relevant information needed for refinancing. Our algorithms not only process the raw financial data entered by you to identify the right credit structures and appropriate lenders to you, it also creates a uniform and cohesive credit story in a format that saves lenders hours of busy work, making decision making much faster.
If you don’t have time or resources to go through the CAPX process, you can assign it to us through our CAPX Assist service – we will have your deal launched to the right lenders within 24 hours.
4. What challenges do MM borrowers typically face when it comes to refinancing?
The primary challenge is often regarding the right debt structure to pursue. At times, there could be multiple debt structures that can be applicable. A structure that is inappropriate for the current credit quality and long term strategic needs of a borrower can set them on a path of repeated calls with many irrelevant lenders over many months, which often result in either (a) aborted refinancing process, or worse (b) an inefficient and much more expensive structure that can limit future strategic options.
The second challenge is network specific. Even if a borrower identifies the debt structure they want to pursue, finding the right lenders who would extend needed capital under the identified structure remains a time consuming endeavor. This is true even for PE firms who typically know many lenders.
The third challenge is borne out of the combination of the two described above – time! In a recent survey conducted by CAPX, almost 60% of middle-market executives and PE professionals indicated that it is too time consuming to obtain debt. As a result, most borrowers finally give up and accept less than ideal debt deal with less than cutting edge economics, just to be done with the process.
A uniform credit story, a comprehensive credit package targeted to the right lenders for the right structure and the power of digital distribution avoid all of these issues for prospective borrowers on CAPX.
5. How would lenders assess a refinancing opportunity and how can CAPX help borrowers check their eligibility before seeking a new loan?
Lenders make credit decisions based on sustainability of the value of collateral that is backing the loans. While there are multiple ways of approaching this credit analysis, but we do not expect you to become credit underwriters. On CAPX, we ask you to give us the information you know better than anyone else, i.e. your company’s financials and your capital needs, and our algorithms do the rest – in seconds.
CAPX uses its algorithm-based match engine to assess the risk of your credit and match your deal with the lenders that might be willing to take such risk by extending credit. If we show you matching lenders, you are eligible!
6. Is there anything in particular that middle market borrowers need to know before refinancing?
Borrowers should be aware of the pros and cons of different types of loan structures, such as asset-backed loans (ABL) or leveraged loans, and understand how the choice of lender and loan structure can impact their business. Refer to CAPX Insights for an in-depth review of all different types of loan structures available to middle-market borrowers on CAPX.
Borrowers also need to have a good idea of how to tell their credit story uniformly to all lenders they approach and they need to know what they can offer to lenders to make the credit risk manageable. This could be the value of current and/or fixed assets, long history of stable cash flows, diversified customer base, leading market share, unique IP, recurring revenues for a SaaS business model, etc.
7. What are the biggest mistakes that MM borrowers typically make when refinancing and how can CAPX help them avoid those mistakes?
Increasingly, the most common mistake is not diversifying the lender base and relying on a handful of lender relationships. All lending institutions are unpredictable due to their internal challenges, so the only way to guarantee an optimal outcome is to approach a variety of lenders.
Other common mistakes include not exploring all available capital options, not negotiating with existing lenders to restructure deals, and often turning to equity financing without fully analyzing the relative cost of equity compared to debt.
Some of these mistakes can be expensive in the short to medium term, e.g. unusually high interest rate, restrictive debt structure and high prepayment penalties. Worse yet, some of these mistakes can be very difficult to rectify, e.g. equity investment from a party with misaligned interests.
8. What are the most important tips to keep in mind while negotiating for refinancing?
Negotiations should focus on more than just the interest rate. Consider the following:
- Liquidity to manage through economic uncertainties should be on the top of the list of priorities. Under an asset backed structure, liquidity would be driven by collateral eligibility criteria and advance rates. For leveraged or cash flow structures, it will be driven by leverage ratios. Negotiate for no more than an annual appraisal of asset values and monthly borrowing base for asset backed structures. For better flexibility, negotiate for lower reporting requirement as your financial performance improves. For financial covenants, ask for 25%-30% cushion over projections.
- Flexibility to take advantage of strategic opportunities created by the economic uncertainties should follow closely. If potential acquisitions or opportunistic expansion of existing operations is possible, negotiate to obtain delayed draw term loan (DDTL). The cost of having additional debt capital available to quickly execute on strategic opportunities is a meager premium for that real option.
- For interest rates, insist on a pricing grid. Surely, the economy is going to improve some day and so will your financial performance. Build in the ability to automatically reduce your interest costs by negotiating a pricing grid.
9. What types of corporate loans can be refinanced?
In general, all secured bank loans can be refinanced. Some loans provided by non-bank lenders would have a no-call period of a year and then some prepayment period. If you are within the no call period, time your refinancing to match the end of the no call period. Hopefully, the cost of prepayment premium would be covered through a cheaper replacement loan.
For bonds, convertible as well as long term, prepayment periods can be much longer – 3 years+. Convertible debt, if out of money and within the callable period, can be refinanced with conventional bank debt to avoid equity dilution in future.
10. What are the pros and cons of refinancing and what are the key factors that determine whether it’s a wise choice to refinance a loan at this time?
Let’s be honest, getting a new corporate loan is a process. Unless you are really fatigued by your current lender or have unusually high interest expense, the process of refinancing itself is a big negative.
On the positive side, higher liquidity, additional capital, lower interest rates and reprieve from aggressive covenant structure could more than make up for the efforts required to refinance.
11. What should MM borrowers look for when selecting a MM lender?
In order to have a selection of lenders to choose from, in today’s market, borrowers have to go well beyond their immediate relationships and locations. Nationwide campaigns are a must.
Seek lenders that are responsive and creative problem solvers. It is worth paying 25 or 50 bps more for a lender that is not dogmatic vs. the one that works just with a formulaic approach.