Small Business Loan Underwriting and Structure written by Blair Groves

There have been many changes in recent years that affect how small business loans are underwritten and structured. In this article, we review several of these changes, as well as offer some best practices for loan underwriting and structure.

Basel III and Credit Lines
Before the Basel III banking reform measures took effect, banks were not required to maintain capital reserves against loan commitments of one year or less. Therefore, banks commonly structured lines of credit to mature in one year to lessen their capital and equity reserve requirements.

Now, capital reserves must be maintained against all loan commitments, including lines of credit that mature in one year or less. So most banks are structuring new lines that would typically be renewed with two to four year maturities. In addition, they are extending existing lines for two to four years after they mature — realizing that at some point in the future, they will be converted to term loans.

The net result of this has generally been positive for both borrowers and banks. For example, it has streamlined loan monitoring for bank and reduced borrower cost and hassles. And loans are treated as long-term debt on the borrower’s financial statement rather than current liabilities, which improves the borrower’s working capital position.

Measures of Cash Flow Leverage
In recent years, many banks have begun moving toward using leveraged EBITDA as a measure of cash flow leverage.

The formula: Funded debt (senior interest-bearing obligations) / EBITDA

Most loan agreements stipulate that leveraged EBITDA should not exceed 3x or 4x. For their part, the regulators state that anything above 6x is a highly leveraged transaction.

Participation Loans: Read the Agreement
Many community banks are increasingly turning to participation loans as a source of loan volume and to reduce their exposure to the regulators’ CRE loan guidance. Before buying or selling participation loans, it’s important to carefully read the loan agreement so you understand the rights and obligations of both the lead and participating banks.

The lead bank often has a relationship with the borrower that goes beyond the participation loan. This can result in conflicts of interest if there are problems with the loan. For example, the lead bank may want to be more flexible with the borrower than the participating bank by adjusting the interest rate or extending the maturity of the loan.

With no vested interest in preserving a relationship, however, the participating bank will probably want to show less flexibility and liquidate the collateral faster. The participation agreement needs to be clear in spelling out the rights and obligations of both the lead and participating banks — not only when everything is going well, but also when borrower gets in trouble.

If you have questions about any of these best practices, please give us a call 417-881-0145.

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