High dollar projects and banks’ house limits are major drivers of commercial loan participations. This article addresses why and how banks join together to make a single commercial loan.
What is a loan participation?
A loan participation is an arrangement among banks in which one bank shares part of its loan with one or more banks. The arrangement is governed by a participation agreement, which outlines the participation amount and the rights and obligations of the parties. In lieu of a promissory note, the purchasing bank accepts the participation agreement as evidence of its interest or receives a participation certificate.
In a typical commercial participation, the lead originating bank retains a significant interest in the loan, holds all loan documentation in its own name, services the loan, and deals directly with the customer for the benefit of all participants.
Common parlance can be confusing and imprecise. The bank loan participation discussed in this article differs from (1) a “loan syndication,” which is a single contract among the borrower, lead lender and syndicate member banks and used in very high dollar transactions; (2) a “club loan” in which a few banks appoint a single bank as the agent for the group but all banks are named as co-lenders in loan documents and usually receive a separate promissory note; (3) a “sale” or assignment in which the originating bank transfers all interest in the loan to another bank, though it may retain servicing rights; and (4) similar arrangements used in non-bank transactions.
Why have participations?
The major impetuses for participations are loans that exceed (i) a bank’s house limit on total dollars to a single borrower, and (ii) a bank’s appetite. Motivating factors include liquidity enhancement, interest rate risk management, and portfolio diversification.
House Limit. A major curb to a lead bank retaining an entire loan is the internally established “house limit” – the maximum indebtedness a bank is willing to have on its books to a particular borrower or borrower type. This restriction is usually significantly lower than the bank’s legal lending limit imposed by law and tied to a bank’s capital.
Appetites & Concentrations. Banks mitigate the risk of loan defaults by diversifying – not putting all their eggs in one regional or market sector basket. Banks compile detailed statistics in order to analyze loan concentrations. Even if a bank isn’t approaching a house limit, it might cap a particular loan to avoid exceeding a desired market saturation level. (Just talk to a banker about loan concentration in the Florida Panhandle in 2007 and 2008.) One need not be an actuary to question whether a bank should be overly concentrated in the energy sector, generally, or multi-family housing in a particular metropolitan statistical area.
Consequently, a bank with the inside track to loan $10 million to a favored hotel developer might decide to lessen its overall risk and seek one or more participants to take 50 percent – even if the loan falls under its house limit. Or, the bank might have too big of a borrower fish on the line and need other participants to reel in the deal. Occasionally, a relationship bank may tender the lead to another bank with a particular expertise – construction, field inspections, build-to-suit, covenant monitoring, treasury services, etc. – leaving the relationship bank to simply participate in the loan.
The participation agreement addresses the relationship of the lead and participants. The comprehensive agreement should cover the purchase price, ownership interest, fee sharing, expenses, funding mechanisms, number of participants, collateral, restrictions on modification/extension, voting rights, transfers, future loans, swaps, information dissemination, repurchase rights, loan defaults/remedies, and termination rights.
Usually, loan participations are sold “at par” and any loan fees are shared prorata, though occasionally a lead bank may receive a “shave” of a fee to cover the significant time and expense the lead bank spends identifying, landing and/or administering the loan. In a single-advance term loan, there is less administration for the lead bank than with a multiple-draw construction project. Relatedly, BOANs – loans disguised as government bonds – create additional duties and responsibilities on the lead bank.
More often than not, participations are pre-arranged and documented concurrently with the loan closing, with the participants known to the borrower. Most banks have their favorite go-to participants and present those to the borrower for approval. Some participations are not visible (or even known) to the borrower. This “blind” arrangement is more likely to occur later in the life of the loan when a lead bank decides it needs to lower its exposure to a borrower or market sector.
Words from the regulators
The Office of the Comptroller of the Currency (OCC), one of numerous agencies regulating banks, recognizes that participations are an “established banking practice” serving “legitimate needs” of banks and the public. The OCC, however, cautions that a participation “may constitute an unsafe or unsound banking practice in the absence of satisfactory documentation, credit analysis and other controls over risk.” (Actually, we think this caveat applies to any loan.) The FDIC examination manual instructs examiners to “determine the nature and adequacy of the participation arrangement as well as analyze the credit quality of the loan.”
Each bank must separately conduct its own credit underwriting. No piggybacking off of another bank’s review. No reliance on a credit rating issued by a credit rating institution. Naturally, the lead bank will gather and circulate all the due diligence information – financials, appraisals, project documents, title, survey, etc. – which, although addressed to the lead bank, may be relied upon by the participants.
Wrapup and summary
Loan participations are beneficial to lenders and borrowers. From a bank’s standpoint, they facilitate loans exceeding a bank’s house limit, provide liquidity enhancement, support interest rate risk management efforts, and aid in portfolio diversification. From a borrower’s standpoint, the arrangement boosts available credit for large projects.
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» Ben Williams and Molly Jeffcoat Moody are attorneys in a commercial law practice at Watkins & Eager PLLC (watkinseager.com). Ben is recognized by Chambers USA and Best Lawyers in America and was selected as Best Lawyer’s 2014 Commercial Finance Lawyer of the Year in Jackson. Molly is recognized by Chambers USA in the area of Real Estate Law.