Financing Capital Assets

Financing Capital AssetsRelationships between parties

Risks and mitigationsSample credit transactions

Financial markets & debt instruments

Dan Goldzband, CMAFinancial Management

BUSA 40439UCSD Extension

Part 1:Relationships between parties

Note: All primary parties are shaded throughout this presentation.

Capital asset sale: cash flows between parties

Lender/source of funds:• Short-term

(whse line) to finance inventory

• Long-term financing of sale contracts

Seller (manufacturer or dealer)

Buyer

Captive finance company or independent leasing/finance company

(sale)

Payments from buyer to finance company

Sale proceeds from finance company (not buyer) to seller

Cash flowsindicated bysolid arrows

Capital assettransfer indicatedby dashed arrow

Relationships between parties:commercial real estate loan

Capital sources (depositors)

Lender (bank, finance company, etc)

Borrowing entity

Principle (general partner, etc.)

Collateral

Contractors and service providers

Tenants

Agreements/contractsindicated bysolid arrows

Security interest indicated bydashed arrows

Part 2:Risks and mitigations

Borrower risk and mitigation


Borrowing entity

Risk MitigationCredit evaluation Credit reports

Tax return copy from IRS

Late payment Late feePayment default ForeclosureTechnical default Default interest rate

Collateral risk and mitigation(pre-loan/underwriting phase)


Collateral

Risk MitigationTitle Title insurancePhysical condition Inspection, reserve loan funds for repairsEnvironmental contamination Phase 1 reviewAdequacy of value AppraisalViolation of building code Certificate of occupancyViolation of zoning, land use Zoning confirmationAbsence of utilities service Utilities’ confirmations of service

Collateral risk and mitigation(post-funding)


Collateral

Risk Mitigation

Insurance coverage Notification of coverage lapse by carrierForce-placed insurance

Loss due to property tax default Annual check of property tax statusFailure to pay insurance, taxes Additional advances from loanLoss from fire, accident, etc. Insurance proceeds payable to lenderSecondary financing Balance due upon any further encumbrance

Tenant risk and mitigation


Collateral

Tenants

Risk MitigationVacancy upon foreclosure Subordination, non-disburbance and

attornment agreementsAdequate tenant improvement funds Reserve loan funds for this purposeNew tenant’s effect on value Lender’s review of proposed new leases

Contractor & service provider risk and mitigationLender (bank, finance company, etc)

CollateralContractors and service providers

Risk MitigationMechanics’ liens Lien releases from contractors, separate bond

to offset any lienService provider liability Proof of liability insuranceIncomplete / inadequate work Holdback of portion of each progress payment

by contractor/service provider until satisfactory completionInsurance carrier financially weak Minimum carrier standards (AB Best ratings, etc.)

Separate loan guaranty: mitigation of previous risks



Risk MitigationInadequacy of previous remedies Loan guaranty by principle or independent party

Note: effectiveness depends upon state law. CA law holds guarantees by related parties to be invalid.

Loan guaranty

Guarantee invoked in event of failure or inadequacy of: Borrower’s ability to pay Collateral value (after foreclosure) Other means to repay loan.

Interest rate risk

Capital sources (depositors)


Borrowing entity

Loan payments at X%

Interest on deposits or other capital sources at Y%

Risk MitigationDisintermediation (X% < Y%) Loan sale to fixed-income investor

Short-to-medium loan term to minimize exposure

Part 3:Sample credit transactions

Transaction 1: Production and trade financing, followed by repayment

and take-out financing

Short-term financing: L/C trade credit

Seller’s bank

BuyerSeller/mfgr

Buyer’s bankLetter of credit

Equipment

L/C agreement

Short-term production loan

• Buyer & Seller conclude a sale contract, but have no credit relationship between them.• Buyer and Seller each have a banking relationship with credit facility.• The two banks are correspondent banks, with a credit relationship between them• Buyer’s Bank issues letter of credit to Seller’s Bank.• Seller’s Bank makes production loan to Seller on basis of L/C (source of repayment).• Seller ships goods, consigned to Buyer’s Bank per L/C instructions.• Seller present’s shipping docs to Seller’s Bank, receives Banker’s Acceptance & 90-day draft.• Seller discounts draft to Seller’s Bank for proceeds. • Seller’s Bank presents draft to Buyer’s Bank for ultimate payment.

Paying off short-term financing, replacing with medium-term loan

Seller’s bank

BuyerSeller/mfgr

Buyer’s bankFunds per L/C (disbursed 90 days later)

Equipment

Equipment loan replaces L/C , finances equipment.

L/C funds repay production loan.

Buyer’s Bank receives security interest in equipment (lien on collateral).

• Seller has been paid via discounted draft.• Seller’s Bank is repaid for production loan via L/C funds.• Buyer obtains equipment after signing equipment loan,

which replaces L/C agreement.• Buyer’s Bank is repaid for funds disbursed under L/C by

equipment loan principle payments.

Part 3:Sample credit transactions

Transaction 2: Commercial construction loan, followed by

repayment and take-out financing

Commercial construction loan: Construction phase

Lender (commercial bank)

Borrowing entity (property owner/developer)

Collateral (land and improvements) General

contractor• Lender receives security interest in collateral (dotted line).• All service providers (contractor, architect, etc.) contract with

developer but assign their contracts to lender (dotted lines).• Separate loan guaranty from principle or independent party.• Lender disburses funds (progress payments) directly to

contractor and subcontractor, in exchange for lien releases, less any holdbacks.

Subcontractors

Architect, engineers, etc.

Risk mitigations:

Service providers:


Loan guaranty (separate from loan)

Commercial construction loan: leasing / stabilization phase

Lender (commercial bank)


Tenants

Lease

SNDA

Lender reviews proposed leases and prospective tenant credit (to determine effect on collateral value).

SNDA: Subordination, non-disturbance and attornment agreement (between tenant and lender). Provides for subordination of lease to lender’s security in collateral, and, in event of foreclosure, guarantees non-disturbance of tenant and preservation of lease by lender and attornment by tenant to lender (as new landlord).

Risk mitigations:

Loan guaranty continues (but is not shown).

Commercial construction loan: takeout / permanent financing

Permanent lender (life insurance company, pension fund), pays off construction loan with “permanent mortgage”


Tenants

Lease (unchanged)

SNDA (with new lender)

Separate guarantee may or may not be required (varies by lender).Lender reviews proposed leases and prospective tenant credit (to determine effect on

collateral value), in addition to all other underwriting of borrower and guarantor.SNDA: Subordination, non-disturbance and attornment agreement (between tenant and

lender). Provides for subordination of lease to lender’s security in collateral, and, in event of foreclosure, guarantees non-disturbance of tenant and preservation of lease by lender and attornment by tenant to lender (as new landlord).

Risk mitigations:

Part 4:Financial markets and debt instruments

Financial Markets & Debt Instruments

Overview: Financial market structure and organization. Financial markets divided into two sectors:• Equity markets (trade & set prices for equity securities)

• Debt markets (trade & set prices for debt securities)

Submarket Securities tradedMoney markets Original duration <= 1 yearCapital markets Original duration > 1 year

Money markets• Used to trade short-term securities (<= 1 year)• Purpose of short-term financing: to meet transactional,

production, seasonal or operating cycle needs. Types of financing include:

Short-term loansA/R financingINV flooring linesLetters of creditRevolving credit lines

• Examples of securities created and traded: Commercial paperShort-term negotiable CD’sBankers’ acceptances

Money markets

• Sources of financing:Commercial banksFactors, commercial credit companies, asset-based

lendersMoney market funds

Debt markets

Organization: two ways to organize/divide:• By issuer: government & corporate• By term: medium-term (1-5 years) and long-

term (>5 years) debt instruments

Debt markets--issuers

• Government debt :1) Federal (US treasury securities & others backed by

“full faith & credit of US goverment”)2) State, municipality and other govt agency debt

(incl. special districts and US debt not fully guaranteed)

• Corporate debt:1) Debentures (unsecured corporate bonds)2) Secured corporate debt instruments (often issued

by special purpose entities)

Medium-term financing• Purpose: to meet project or medium-term asset financing needs.

• Types of financing:Auto and truck loansEquipment purchases and leasesOther medium-term consumer loansConstruction loansInterim / mezzanine financing

• Sources of financing:Commercial banksCaptive finance companiesCommercial finance companies

• Securities created: generally 3-5 year asset-backed securities

Long-term (permanent) financing

• Purpose: to provide long-term (“permanent”) financing of major capital assets (including corporate acquisitions) and meet general financing needs of large public corporations and governments.

• Types of financing:Home mortgages and equity linesCommercial real estate mortgages (incl. “take-out” loans)Major (non-real estate) fixed asset loans (large equipment, aircraft, etc.)Infrastructure construction financing

Long-term financing

• Sources of financing:Commercial banks (as brokers and arrangers)Mortgage companiesInvestment banksLife insurance companiesPension funds

• Securities created: Long-term , fixed-rate instruments:Unsecured bondsBonds secured by specific assets or pools of assets

Financing Capital Assets

Documents

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