International Banking

1. Sapienza Università di Roma International Banking Lecture Four Financial Innovation: Syndicated Loans & Mezzanine finance Prof. Gianfranco A. Vento

3. Agenda • Financial market classifications • Syndicated Loans • Mezzanine finance

4. 1. Different evolution of financial systems • Financial systems oriented to banks • Financial systems oriented to markets • Financial systems strongly oriented to markets

5. 1. Primary Vs. Secondary Market • Primary marketsfacilitate the issuance of new securities • Secondary marketsfacilitate the trading of existing securities • An important characteristic of securities that are traded in secondary markets is liquidity, which is the degree to which securities can be easily liquidated without a loss of value

6. 1. Organised Vs. Over-the-Counter markets • Some secondary stock market transactions occur at an organised exchange (i.e. New York Stock Exchange and American Stock Exchange) • Other financial market transactions occur in the over-the-counter market, which is basically a telecommunication network

7. 1. Securities Traded in Financial Markets • Money market securitiesare debt securities that have a maturity of one year or less • Bondsare long-term debt obligations issued by corporations and government agencies to support their operations • Mortgagesare long-term debt obligations create to finance the purchase of real estate • Stock(or equity securities) are certificates representing partial ownership in the corporations that issued them. They have no maturity and therefore they serve as a long-term source of funds

8. 1. Derivative securities • Derivative securities are financial contracts whose values derived from the value of underlying assets. Many derivative securities enable investors to engage in speculation and hedging • Speculation. Derivatives allow to speculate on movements in the underlying assets without having to purchase those assets • Hedging. Derivatives can be used in a manner to generate gains if the value of the underlying assets declines • Most common derivatives: options, futures, swaps

9. 1. Foreign Exchange Markets • International financial transactions require the exchange of currencies. The Foreign exchange market facilitate the exchange of currencies • Most currencies have a market-determined price (exchange rate) that changes in response to supply and demand conditions

10. 1. How Financial Markets Facilitate Corporate Finance and Investment Management

11. 4. Role of Nondepository Financial Institutions 1/2 • Finance companies. Most finance companies obtain funds by issuing securities and then lend the funds to individuals and small business • Mutual Funds. They sell shares to shares to surplus units and use the funds received to purchase a portfolio of securities. • Securities firms. They provide a wide variety of functions in financial markets. • Brokers. They charge a fee for executing transactions. The fee is reflected in the difference between their bid and ask quote • Dealers. They make a market in specific securities by adjusting their inventory of securities

12. 4. Role of Non-depository Financial Institutions 2/2 • Insurance companies. Insurance companies receive premiums in exchange for insurance policies payable upon death, illness or accidents, and use the fund to purchase a variety of securities • Pension funds. Many corporations and government agencies offer pension plans to their employees, which may periodically contribute fund to the plan (together with the employer)

13. 4. Comparison of Roles among Financial Institutions

14. 4. Asset Sizes of Financial Institutions (in Billions of Dollars) Source: Board of Governors, Federal Reserve System, 2007.

15. 4. Summary of Institutional Sources and Uses of Funds

16. 4. Organizational Structure of a Financial Conglomerate

17. 2. Syndicated Loans • The syndicated loans are loans in which two or more banks jointly give a loan to one single borrower. The contract is one. • A syndicate of banks cooperates, with different roles in the in structuring the operation and supplying the loan, • The market of syndicated loans has been developed in the 60s in order to make possible for the borrowers to raise a significant amount of funds as well as to allow the investment banks to create value from their relationship with the commercial banks. • The loan is divided in shares, which then are underwritten by different banks.

18. 2. Types of Syndicated Loans • There are three types of syndications: an underwritten deal, “best-efforts” syndication, and a “club deal.” • Underwritten deal • An underwritten deal is one for which the arrangers guarantee the entire commitment, then syndicate the loan. If the arrangers cannot fully subscribe the loan, they are forced to absorb the difference, which they may later try to sell to investors. This is easy, of course, if market conditions, or the credit’s fundamentals, improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper. Or the arranger may just be left above its desired hold level of the credit. • Arrangers underwrite loans for several reasons. First, offering an underwritten loan can be a competitive tool to win mandates. Second, underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk. Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did when the pricing was set in stone prior to syndication.

19. 2. Types of Syndicated Loans: Best-efforts syndication • A best-efforts syndication is one for which the arranger group commits to underwrite less than the entire amount of the loan, leaving the credit to the vicissitudes of the market. If the loan is undersubscribed, the credit may not close—or may need major surgery to clear the market. • Traditionally, best-efforts syndications were used for risky borrowers or for complex transactions. Since the late 1990s, however, the rapid acceptance of market-flex language has made best-efforts loans the rule even for investment-grade transactions.

20. 3. Types of Syndicated Loans: Club Deal • A club deal is a smaller loan—usually $25 million to $100 million, but as high as $150 million—that is premarketed to a group of relationship lenders. The arranger is generally a first among equals, and each lender gets a full cut, or nearly a full cut, of the fees.

21. 2. The Syndication Process • Before awarding a mandate, an issuer might solicit bids from arrangers. The banks will outline their syndication strategy and qualifications, as well as their view on the way the loan will price in market. Once the mandate is awarded, the syndication process starts. The arranger will prepare an information memo (IM) describing the terms of the transactions. The IM typically will include an executive summary, investment considerations, a list of terms and conditions, an industry overview, and a financial model. • Because loans are unregistered securities, this will be a confidential offering made only to qualified banks and accredited investors. If the issuer is speculative grade and seeking capital from nonbank investors, the arranger will often prepare a “public” version of the IM. This version will be stripped of all confidential material such as management financial projections so that it can be viewed by accounts that operate on the public side of the wall or that want to preserve their ability to buy bonds or stock or other public securities of the particular issuer

22. 3. The Syndication Process • As the IM (or “bank book”) is being prepared, the syndicate desk will solicit informal feedback from potential investors on what their appetite for the deal will be and at what price they are willing to invest. Once this intelligence has been gathered, the agent will formally market the deal to potential investors. • The executive summary will include a description of the issuer, an overview of the transaction and rationale, sources and uses, and key statistics on the financials. The list of terms and conditions will be a preliminary term sheet describing the pricing, structure, collateral, covenants, and other terms of the credit (covenants are usually negotiated in detail after the arranger receives investor feedback). • The industry overview will be a description of the company’s industry and competitive position relative to its industry peers. • The financial model will be a detailed model of the issuer’s historical, pro forma, and projected financials including management’s high, low, and base case for the issuer.

23. 2. The Syndication Process • Most new acquisition-related loans are kicked off at a bank meeting at which potential lenders hear management and the sponsor group (if there is one) describe what the terms of the loan are and what transaction it backs. Management will provide its vision for the transaction and, most important, tell why and how the lenders will be repaid on or ahead of schedule. • In addition, investors will be briefed regarding the multiple exit strategies, including second ways out via asset sales. (If it is a small deal or a refinancing instead of a formal meeting, there may be a series of calls or one-on-one meetings with potential investors.) Once the loan is closed, the final terms are then documented in detailed credit and security agreements. Subsequently, liens are perfected and collateral is attached. • Loans, by their nature, are flexible documents that can be revised and amended from time to time. These amendments require different levels of approval. Amendments can range from something as simple as a covenant waiver to something as complex as a change in the collateral package or allowing the issuer to stretch out its payments or make an acquisition.

24. 2. Advantages and disadvantages in different funding alternatives Bilateral loan • Rapidity • Small amounts • Standard conditions Loans from several different banks • Higher amounts • Higher transaction costs • Standard conditions Syndicated loans • High amount • Cost reduction • Rapidity • High flexibility • Stronger links with banks involve in the syndicate Bond issue • High amount • Standardization • High cost

25. 2. Syndicated Loans: Advantages for Banks • To participate in operations on international markets • To limit the risk of opportunistic behaviour, thanks to the better information distribution and the cross-default clause • Diversification, because a small or medium size bank can finance companies abroad.

26. 2. Syndicated loans: The remunaration of banks Three fees: • Management fee: it is a flat fee paid by the borrower to the arranger • Commitment fee: It is a fee paid to the banks on the credit line agreed, but not used. • Agency fee: It is the remuneration that has to be paid to the agent bank for managing the loan. • The second source of revenue is given by the interest on the percentage of loans actually used.

27. 2. Syndicated Loans: Reimbursement Plan • Two different options: • Term loans: distintion between the moment of use of the loan and reimboursement. In the first stage (grace period) the borrower pays interest on the actually used credit only. The capital reimboursement starts at the end of the grace period. • Revolving credits: No distintion between the use and the reimboursement of the loan. The borrower has a huge discretionality, provided that the loan is repaid at the end.

28. Mezzanine Finance • Mezzanine capital refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock. • Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure (i.e., in the event of default, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placement, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market; as such, they involve additional risk. • In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.

29. Mezzanine Finance: Structure • Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are subordinated notes and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return which can come from four sources (each individual security can be made up of any of the following or a combination thereof): • Cash interest — A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates. • PIK interest — Payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest). • Ownership — Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. The ownership component in mezzanine securities are almost always accompanied by either cash interest or PIK interest and in many cases by both.

30. Next Lecture : Hedge FUNDS