Loan-on-loan financing – looking beyond the underlying loan

A typical structure might see, by way of example, a credit fund originate a loan to an underlying borrower and then raise financing against that loan from a bank. In some cases, that bank may itself have competed to provide the underlying financing but lost out - whether on pricing, structure or speed to market. Loan-on-loan financing can give the bank another route into the credit, while allowing the credit fund to recycle capital, increase its lending capacity and potentially improve returns.

The structure is relatively straightforward, but the credit analysis is not.

The loan-on-loan lender is not simply taking credit risk on its immediate borrower, otherwise known as the whole loan lender. Its repayment ultimately depends on the downstream loan, made to a separate borrower and often secured against assets sitting further down the structure.

Understanding the underlying borrower is important, but it is only part of the exercise. The lender also needs to understand the underlying loan itself: the rights it contains, how those rights can change and, critically, who controls them when something goes wrong.

What is the loan-on-loan lender really lending against?

Using the earlier example, imagine a credit fund has made a £100 million loan and wants to raise £70 million of financing against it. At first glance, the analysis would typically be about leverage. Is a 70% advance rate appropriate against the underlying exposure?

The difficulty is that the underlying loan is not a static asset. Its value can change because the underlying borrower performs badly or the value of its assets falls, but also because the terms of the loan itself may change over time.

The underlying lender might agree to extend maturity, waive a financial covenant, permit additional debt, release security, make a further advance or waive an existing default. Each decision may be perfectly sensible in the context of its relationship with the underlying borrower, but may also affect the asset against which the loan-on-loan lender has advanced funds.

The loan-on-loan lender therefore needs to underwrite two things: the underlying credit and the loan through which it is exposed to that credit.

Security is only part of the answer

The starting point will usually be a security package giving the loan-on-loan lender security over the underlying lender's rights, together with control over the accounts into which payments under that loan are made.

Security alone does not solve the problem. The lender also needs to protect the value of its collateral while the financing remains outstanding. Financial covenants, valuation requirements, cash controls and mandatory prepayment provisions determine what happens if the quality or value of the underlying exposure changes.

The right protections will depend on what sits underneath the structure. A facility financing a diversified pool of loans presents a different risk from one financing a single £100 million real estate asset. A performing senior loan secured against a stabilised asset presents a different risk from a development or major capex facility with substantial undrawn commitments.

Looking up the fund structure

The underlying loan may be the principal asset supporting the financing, but it does not need to be the loan-on-loan lender's only source of protection.

Returning to our earlier example, the whole loan credit fund lender is likely to be a special purpose vehicle with limited substance of its own. Depending on the structure and the credit, the loan-on-loan lender could look further up the credit fund structure for additional support.

That might take the form of a guarantee from a sufficiently capitalised fund entity or an equity commitment letter under which a fund commits to provide capital to the borrowing vehicle.

Where meaningful support is available higher up the structure, it can provide an important hedge against some of the structural risks inherent in lending to an SPV whose principal asset is another loan. It does not replace proper underwriting of the underlying credit, but can give the lender an additional route to repayment if that credit does not perform as expected.

The credit analysis might need to look in both directions: down through the underlying loan to the ultimate borrower and assets, and up through the fund structure to understand what additional capital stands behind the financing.

Who controls the underlying loan?

The most difficult question is how much freedom the underlying lender should retain to manage its own borrower relationship.

It clearly needs some flexibility! Borrowers request waivers and amendments. Business plans change. Maturity extensions may preserve rather than destroy value. An underlying lender that has to obtain its own lender's consent every time it responds to an underlying borrower may find the structure unworkable.

The loan-on-loan lender, however, cannot be indifferent to those decisions. If its collateral is the underlying loan, material changes to that loan can materially change its credit position.

The documentation needs to draw a sensible line between decisions the underlying lender can take in the ordinary course and those requiring the loan-on-loan lender's consent. Changes to principal, interest, maturity, financial covenants, security, ranking, permitted indebtedness, further advances and enforcement rights are obvious areas of focus.

Too little control can leave the loan-on-loan lender exposed to decisions that alter the asset it originally agreed to finance. Too much can prevent the underlying lender from managing the loan effectively.

Those control rights also need to be supported by an effective flow of information from the underlying loan, so that the loan-on-loan lender receives the financial, valuation, covenant and default information it needs to monitor its exposure.

What happens when the underlying loan deteriorates?

The real test of a loan-on-loan structure often comes before an underlying payment default.

An LTV covenant may be breached, a valuation may fall, the underlying borrower may request a maturity extension or additional liquidity, or a development may run late or require more capital.

The question is how that deterioration feeds through into the loan-on-loan financing. Depending on the structure, it may result in a reduction in the borrowing base, a requirement to prepay part of the facility, a cash trap or, at the more serious end, an event of default.

A structure that reacts to every technical breach by immediately requiring repayment may offer considerable protection on paper but prove difficult to operate in practice. Equally, waiting until the underlying loan has suffered a payment default may be too late.

The better structures identify the points at which deterioration becomes relevant to the loan-on-loan lender and provide a proportionate response.

Is it a securitisation?

The regulatory analysis should also be considered early rather than treated as an afterthought.

A loan-on-loan financing is not automatically a securitisation. Equally, describing a transaction as "loan-on-loan" does not determine the regulatory analysis.

The structure needs to be considered against the relevant securitisation rules, including whether there is a tranching of credit risk and whether the underlying exposure falls within the specialised lending analysis.

Where the securitisation regime does apply, risk retention, investor due diligence, transparency and credit granting requirements need to be built into the structure from the outset.

Key considerations

The distinction between lending directly to an underlying borrower and providing loan-on-loan financing is perhaps best illustrated by comparing the key considerations for each structure:

Looking beyond the loan

Loan-on-loan financing can appear relatively simple because the principal collateral is itself a loan. In practice, that is what makes the structure interesting.

The loan-on-loan lender is relying not only on the underlying borrower being able to repay, but on the terms of the underlying financing continuing to protect the value of its exposure. That requires the right balance of security, cash control, financial protections and consent rights.

Getting that balance right is what turns a loan secured against another loan into a financing structure that works for both sides.

At Trowers & Hamlins, we regularly advise on structured finance transactions involving banks and other lenders providing back leverage to credit funds and other originators, including the financing of existing and future loan portfolios through loan-on-loan, warehouse and forward flow financing structures. If you would like to discuss this in more detail, please do not hesitate to get in touch.