Commercial Loan Structuring

When businesses need money to buy a new piece of equipment or to fund short-term operational costs, they’ll most likely consider taking out a commercial loan. A commercial loan is credit that’s typically extended to businesses, such as partnerships and corporations, which are looking to fund a particular expenditure (e.g., new equipment) or another specific business purpose. 

This debt typically involves a security, meaning businesses might be required to submit their financial statements or put up a collateral, which can be equipment, other business property, or even accounts receivables. The most common types of commercial loans include lines of credit, term loans, commercial mortgages, and acquisition loans. 

Now with each commercial loan comes specific terms that the business as a debtor must abide by. These terms include the purpose of the loan, its amortization period, the repayment schedule or interval, the loan collateral, and the interest rate. All of these compose the commercial loan structure. 

What is commercial loan structuring?

At its core, commercial loan structuring is a matching game: Commercial lenders identify the needs of the business and its repayment source and compare those with the available financing options that fit. A loan structure is designed to cater to the needs of both the lender and the borrower. The business receives the funds it needs, while the lender is protected from risks and potential losses should the business default on its payments. In short, it provides a win-win solution to both parties.

According to the Risk Management Association, commercial lenders make use of four keys to come up with the best loan structuring possible for each business borrower. The first two are the goals of the bank or commercial lender and those of the customer or debtor. The third key is the source or sources of repayment and the competition the lender faces for them, and the fourth key are the loan elements that the commercial lender or bank deem are appropriate for the other three keys.

The components of a commercial loan structure

A commercial loan structure consists of the following components. When people talk about commercial loan structure, this is what they typically mean.

• Loan term – This is the period in which the business has to repay the loan. This period is determined by the lender.
  
  
• Interest rate – This is the amount the lender charges the business debtor and is usually a percentage of the principal loan amount.
  
  
• Credit risk – Simply put, this refers to the probability that the lender won’t receive the loan repayments from the business. That is, the debtor or borrower has defaulted on the loan or failed to pay for the principal and interest owed to the lender. In addition to financial loss, high credit risk also increases collection costs.
  
  
• Loan collateral – This is a valuable item that a business pledges as security for the loan. A collateral reduces the risk of the debtor defaulting on the commercial loan as it can be sold so that the lender can recover its losses.
  
  
• Repayment – This refers to a period in which the business can pay back the principal and the interest of the loan. Commercial lenders typically ask about the business’ source of repayment and if it has alternative sources of repayment.

Factors that influence commercial loan structuring

There are several factors that influence how a commercial loan will be structured. These are as follows: 

• Purpose of the loan

For what purpose is the business taking on the commercial loan? It could be to reduce an existing term debt or so that the business has revolving credit available.

• Risk profile of the business

Is the business more likely to default on its loan repayments? This is the question that commercial lenders seek to answer when assessing a business’ risk profile. They do so through complex models that help them determine the risk rating of a borrower. Normally, the higher the risk rating is, the greater the possibility of that debtor to default on a repayment.

• Ability to pay the repayments

Does the business have the ability to fulfill the payments within the loan term? Where does its repayment funds come from? Does it have other sources it can tap to fulfill the loan repayments?

• Desirability and useful life of the collateral

Most commercial loans require collateral, and this influences the loan structure too. In this case, the commercial lender will check the quality of the asset. The higher the asset’s quality is, the more desirable it is, and as a result, the loan structure will be more flexible. The collateral’s quality is determined by how likely it will retain its value, how active the secondary market is, and if its price can be ascertained easily.

• Transaction or asset-specific risks

This covers the details of the loan agreement. For instance, should a loan covenant be in place to safeguard the interests of the commercial lender and if yes, what should the covenant include? Basically, anything that the lender finds is risky, it can try to mitigate through the terms or covenants included in the commercial loan agreement. 

Why is loan structuring important?

Loan structuring is important for both commercial lenders and their debtors, aka businesses. For businesses, especially those involved in an enterprise that’s seasonal in nature, commercial loan structuring can allow them access to funds during their low or off season. On the other hand, for commercial lenders, loan structuring means securing the best chance for the loan to be repaid by the business, whether that’s from cash flow, asset liquidation, or other sources. If a commercial loan is not structured properly, both parties won’t be able to achieve their individual goals. 

On the other hand, appropriate commercial loan structuring can provide many benefits to the lender and the borrower. A properly structured commercial loan can help the lender mitigate risks and price the loan so that it provides an acceptable yield. For the business, it means tax benefits, protection of collateral, and the opportunity to be able to restructure the loan in case there’s a change in its situation.

Commercial loan structuring

In short, appropriate commercial loan structuring is a win-win for both the lender and the borrower.