In this blog post, Balaji AG, a qualified ACA, ICWA, ACS and CIMA (UK) Industry Consultant and a CFO of a Listed Company for over five years, and who is currently pursuing his Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, describes the process of raising capital through institutional loans. 

Business needs four factors of production to produce goods and services. They are Land, Labour, Capital and Entrepreneurship. Capital is used to acquire both fixed assets and to fund working capital assets. Fixed assets are those assets which are purchased for long-term use and are not quickly converted into cash like land, buildings, plant and machinery, equipment, etc. Working capital assets are those assets which are likely to be converted into cash within a period of one year like raw materials, finished goods, trade receivables, etc.

Capital

Capital can be obtained primarily in two forms, i.e., equity and debt. Equity is also termed as the investment. Equity investment is the money brought in by the promoters of the organisation and other investors. Equity investment is more like a foundation to the building based on which other forms of capital can be sought. Without equity capital, it is next to impossible to secure debt. Debt is preferred in entities which expect cash flows on a regular basis and the operations are expected to be stable.  

By raising debt form of capital, promoters avoid dilution of control. Further, the return on investment to equity investors improve because of the lower cost of capital of debt. Typically, organisation raise debt to the extent of twice the amount of equity capital in a normal manufacturing organisation. In infrastructure projects, this amount increases to three or four times equity capital. Raising capital in the form of debt flows from the capital structuring decision.

Debt

Debt can be classified on the basis of security provided to debt providers (Secured, Unsecured), a basis of the period of repayment (long term, short term), the basis of interest rates (fixed, floating), the basis of purpose (fixed capital, working capital), etc. This article mainly deals with raising capital through institutional finance loans which are primarily for fixed capital. They are long-term in nature and are normally fully secured.

In India, certain development financial institutions were set up post independence to cater to the long-term finance needs of the industrial sector. IFCI, IDBI, ICICI, SIDBI, NABARD are among the top financial institutions which provided long-term finance to corporates. In the first few decades, post independence, these financial institutions were chiefly instrumental for translating government’s development priorities into reality

Fixed capital loans can be for specific equipment (high-value machinery), specific project (building of the road, port, power plant, manufacturing facility, etc.), specific transaction (acquisition of an entity as part of the inorganic growth strategy of the enterprise). Depending upon on the amount of loan sought, funding can be from one or multiple financial institutions. If it is from multiple financial institutions, it would be simpler to go through the syndicated loan route.

In early days of industrial growth in India, large projects used to be financed under the consortium arrangement. One of the development financial institutions in India would be identified as the lead bank and would conduct the project appraisal to determine the project viability. Once the institution is convinced of the project viability and possibility of project meeting its financial projections, it would sanction term loan which would be a major portion of its debt requirement. Other development financial institutions would participate in the project and provide a reminder of the debt requirements under the common appraisal/common documentation/joint supervision mode.

Subsequently, consortium lending gave way to common documentation arrangement with lead institution taking responsibility for the documentation. Other participating lenders use the project appraisal documentation of lead institution as a basis but perform a certain level of due diligence and complete their loan sanction process. The benefit of this arrangement is that the terms of the loan are standard across the financial institutions which are convenient for the borrower.

Syndication of loan is the current trend. Syndicated loan initially used for international financing arrangements with multiple institutions across different countries and currencies. This is currently followed even for domestic financing of projects. Arranger/Lead Manager typically a financial institution takes responsibility for securing the entire debt required. Lead financial institution’s credibility and appraisal expertise is the basis for other institutions accepting to participate. Agent/Security trustee is appointed who ensures the day to day compliance of the loan conditions and protection of the interest of the lenders. At times, the lead financial institution acts as the agent also. In some transactions, the Arranger role is performed by merchant bankers.

Institutional Finance Loan Process

Pre-Financing Stage: Project/Equipment/Transaction identification is the first stage. At this stage, the project which requires funding/new equipment/the acquisition target is identified. It can be a new facility/debottlenecking equipment/business which is identified for acquisition for improved synergies. Plenty of effort is devoted at this stage to ensure the viability of the proposed activity.

The second step is to identify risks associated with the proposed activity and measures for minimising or mitigating the same. In case of new projects, the identification of risks is difficult as compared to existing entity

The third step is to evaluate the technical and financial feasibility of the proposed activity. Ability to raise capital is ultimately dependent on the strong technical and financial feasibility. In determining the financial feasibility, one of the important factors is the cost of capital, which is dependent on the capital structure, i.e., quantum of equity and debt

Financing Stage: The first step in this stage is to ensure arrangement of equity capital planned for the proposed activity. This is considered as the margin money for the purpose of a loan. Many times the arrangement for equity and debt is made simultaneously to avoid delay in time. In this situation, the lenders normally stipulate equity arrangement as a Condition Precedent.

The second step is approaching the lenders and completing the appraisal process. The process at this stage will depend on upon the quantum of loan. If the debt component is a large amount, the entity may want to go through syndicated loan route. It is important to identify a proper Lead Manager/Arranger who has the specialisation in handling transactions of the size/complexity/domain. The commitment starts with the signing of mandate letter. Mandate letter contains provisions relating to the underwriting commitment, if any, duties and responsibilities of both parties, exclusivity provisions, etc. Exclusivity provisions ensure that the borrower does not approach other arrangers or other modes of raising debt capital.

Irrespective of whether the borrower follows syndicated loan route or consortium route or directly approaching lenders certain steps are required to be completed like preparation of information memorandum, presentation to lenders, negotiation of terms and conditions of the loans. In a syndicated loan process, the responsibility for some of the above activities might be with Arranger.

Information memorandum provides the entire information about the proposed activity for the lender to complete its appraisal process. It normally contains Executive Summary, Vision and Mission of the Business, Industry Overview, Current Business and Management, Proposed activity, Technical and Financial Feasibility of the proposed activity, SWOT analysis and Financial projections. Apart from this, a presentation is also required. The presentation provides a snapshot of the information memorandum and addresses possible key concerns of the proposed activity.

All lending institutions have an internal process for sanction of debt. This will include submission of the debt proposal as per their format and approval through a chain of command including their Board of Directors based on debt amount. After review of the information memorandum, the lenders will raise various queries. These are normally focused on validating the financial projections and identifying risks. They also prepare sensitivity analysis of financial projections for key risks. During this process, there would be a continuous interaction between Borrower and Lending Institutions. On completion of this process, the lending institutions issue their term sheet/sanction letter which contains the broad terms and conditions. In a syndication route/consortium route, the lead institution completes their process first which forms the basis for other participating institutions to follow. In Syndication route the Arranger has to sell the loan in the marketplace to prospective participating institutions. There will be no major differences in terms and conditions and would be easier to complete a common documentation.

In the case of multiple lenders through direct route, it would be better to have common documentation. This will reduce significant work relating to legal documentation and conflicts. To achieve this objective, all the lenders should agree broadly to the terms of the financial institution which takes majority exposure. Borrower is better placed by securing the sanction letter from the major lender and convince others to provide finance on similar terms.

Next step is to complete documentation of facility agreement, security documents and security creation. During this stage, the borrower commences fulfilment of pre-commitment and pre-disbursement conditions of the facility. On satisfactory completion of conditions and documentation, loan disbursement commences as per requirements of the proposed activity.

Key Loan Terms and Conditions

Loan documents contain financial covenants like accounting ratios which are to be achieved/not breached, negative covenants like prior approval of lenders are required before certain actions of lenders say declaration of dividend etc, events of default, consequences of uncured events of default, prepayment provisions, clause relating to creation of security on assets, material adverse effect clause, cross default provisions, etc.

The above process is followed for working capital loans except for that information requirements for the same is different from that long-term debt. Focus here is on quantum of working capital assets and liabilities and current financial performance