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What are the best practices for structuring a loan agreement to minimize liquidation risk?

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When you borrow money from a lender, you enter into a loan agreement that specifies the terms and conditions of the repayment. However, what happens if you fail to meet your obligations or face financial distress? Depending on the type of loan and the clauses in the contract, you may face the risk of liquidation, which means the lender can seize your assets and sell them to recover the debt. Liquidation can have devastating consequences for your business, reputation, and credit rating. Therefore, it is crucial to understand how to structure a loan agreement to minimize liquidation risk and protect your interests. In this article, we will discuss some of the best practices for doing so, such as:

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Piragash Sivanesan

| The right funding structure for your Real Estate transaction | Structured Finance | ￡5m to ￡30m

1 Choosing the right loan type

Not all loans are created equal. Some are more flexible and forgiving than others, while some are more strict and punitive. Generally, there are two main types of loans: secured and unsecured. Secured loans require you to pledge some of your assets as collateral, which gives the lender the right to take them if you default. Unsecured loans do not require any collateral, but they usually have higher interest rates and fees. The type of loan you choose depends on your financial situation, your risk appetite, and your bargaining power. If you have valuable assets that you can afford to lose, you may opt for a secured loan to get lower interest rates and longer repayment periods. However, if you have limited assets or want to preserve them, you may prefer an unsecured loan to avoid liquidation risk. However, you should be prepared to pay more and comply with stricter terms.

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2 Negotiating the covenants

Covenants are the rules and restrictions that the lender imposes on you as a borrower. They are designed to protect the lender's interest and ensure that you maintain your creditworthiness and repayment capacity. However, some covenants can also trigger liquidation if you violate them. For example, some covenants may require you to maintain a certain level of liquidity, profitability, or debt-to-equity ratio. If you fail to do so, the lender may declare a default and demand immediate repayment or liquidation of your assets. Therefore, it is important to negotiate the covenants carefully and realistically. You should avoid agreeing to covenants that are too stringent or unrealistic for your business model and industry. You should also seek to include grace periods, waivers, or amendments clauses that allow you to adjust the covenants in case of unforeseen circumstances or changes in market conditions.

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Piragash Sivanesan

| The right funding structure for your Real Estate transaction | Structured Finance | ￡5m to ￡30m
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As an approach it is well worth sensiting your business plan to see what circumstances or events trigger the covenants. What does the loan allow you to do and is it realistic in the scenario to rectify the breach. This exercise will allow you to go into the agreement with open eyes. As part of this process you can red flag scenarios and create early warning indicators for scenarios in which you cannot find a solution. For those you can now try to negotiate those away. There may need to be a trade off on price for the degree of flexibility a lender will give you. Aside from the short term needs, consider what the lender may need from you in the medium term to remove such a covenant. Strategically ensuring no breach over time.

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3 Monitoring the triggers

Triggers are the events or conditions that activate the covenants and give the lender the right to take action against you. They can be financial or non-financial, depending on the nature of the loan and the contract. For example, some financial triggers may include missing a payment, breaching a covenant, or filing for bankruptcy. Some non-financial triggers may include losing a major customer, facing a lawsuit, or changing your management. To minimize liquidation risk, you should monitor the triggers closely and proactively communicate with your lender if you anticipate any issues or difficulties. You should also try to resolve any disputes or problems as soon as possible and seek to renegotiate or restructure the loan if necessary. By doing so, you can avoid or delay liquidation and preserve your relationship with your lender.

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4 Building a contingency plan

Even if you follow the best practices for structuring a loan agreement, you may still face the risk of liquidation due to factors beyond your control, such as a global pandemic, a natural disaster, or a market crash. Therefore, it is wise to have a contingency plan in place to deal with such scenarios. A contingency plan is a set of actions and strategies that you can implement to mitigate the impact of a crisis and protect your business. For example, a contingency plan may include cutting costs, diversifying revenue streams, seeking alternative financing, or selling non-core assets. Having a contingency plan can help you cope with the uncertainty and stress of a potential liquidation and demonstrate your commitment and resilience to your lender.

Structuring a loan agreement to minimize liquidation risk is not an easy task. It requires careful planning, negotiation, monitoring, and adaptation. However, by following these best practices, you can reduce the likelihood and severity of liquidation and increase your chances of survival and success.

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Piragash Sivanesan

| The right funding structure for your Real Estate transaction | Structured Finance | ￡5m to ￡30m
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A contingency plan could also involve insuring risks, so that some of the contingent liabilities can be passed on. This may be funded from the loan if justifiable to the Lender.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Piragash Sivanesan

| The right funding structure for your Real Estate transaction | Structured Finance | ￡5m to ￡30m
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The obvious addition to the above is to also strike the right balance of debt and equity in the first instance to ensure repayment capability or stress is dealt with from a fundamental perspective.

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What are the best practices for structuring a loan agreement to minimize liquidation risk?

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1 Choosing the right loan type

2 Negotiating the covenants

3 Monitoring the triggers

4 Building a contingency plan

5 Here’s what else to consider

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