Wholesale and specialised lending · RiskAtoms Academy

By the end you will be able to

1Tell corporate lending from specialised lending by where the repayment comes from.
2Size a project finance loan with the DSCR and LLCR, and stress it with P90 output and price shocks.
3Assess a commercial real estate loan with LTV, ICR and a yield shift.
4Read a leveraged loan's leverage multiple, see through EBITDA add-backs, and explain covenant-lite risk.

Why it matters

A solar park has no history, no other business and no balance sheet beyond its panels. A property company's only income is its tenants' rent. A vet group bought by a private equity firm owes more than seven times its profits. RiskAtoms Bank lends to all three, but the five Cs of L3.3.02: Analysing a company's credit do not fit any of them well. Each needs its own ratios and its own stress test.

Core explanation

Who repays, and from what?

Illustrative dataRiskAtoms Bank plc's credit book

The module's lending book: twelve invented corporate borrowers (exposure at default £587m, expected loss £2.81m), retail mortgages, personal loans and cards, a ten-grade master scale, personal-loan vintages and twenty past workouts. Every firm and figure is made up for teaching, in pounds, at one date; none is real data.

Pellcourt Properties Ltd (C03) is in the book; its rental income and loan rate are extras here. Quillmere Solar Ltd and Tallowfen Veterinary Group are invented borrowers for this lesson only, outside the book's totals.

The key question in wholesale lending is where the money to repay will come from. In corporate lending it is the whole company: all its products, customers and assets. The bank lends through a revolving credit facility and term loans, and protects itself with covenants tested every quarter (for example, debt no more than 3× EBITDA and interest covered at least 4×). In specialised lending the repayment comes from one asset or project. The asset is both the source of repayment and the security, so if it fails, both fail together.

Type	Repaid from	Key ratios	Main risks
Corporate	The whole company's cash flow	Debt/EBITDA, interest cover	The business, the cycle
Project finance	One project's revenue, via an SPV	DSCR, LLCR	Construction, output, prices, contracts
Commercial real estate	Rent, or a sale	LTV, ICR, debt yield	Vacancies, values, rates
Leveraged loans	A highly indebted company	Leverage multiples	Thin margins for error, weak terms

Project finance

Quillmere Solar Ltd is a special purpose vehicle that owns one solar park. Its sponsor puts in equity; the bank lends £40m over 15 years on a non-recourse basis. The bank looks only at CFADS: 100 GWh a year at £70/MWh, less £1.5m of costs, gives £5.50m in year 1, against debt service of £4.12m. The DSCR is 1.34×.

Lenders size the debt so that the DSCR stays above a target even in bad years: they test it at P90 output, which gives a minimum of 1.20×. Below 1.10× a lock-up stops dividends; below 1.05× the loan is in default. The LLCR (1.42× at P50) asks the same question over the whole loan life. The biggest risks come before the first sunny day: construction delays and cost overruns, which is why banks often lend only once a project is built, or with completion guarantees from the sponsor.

Commercial real estate

Pellcourt Properties Ltd owns let offices valued at £180m, financed by a £120m interest-only loan at 6.0%. The bank watches two ratios: the LTV, 66.7% against a covenant of 70%, and the ICR, 1.58× against 1.40×. Rent repays the loan; the property's value protects the bank if rent stops. The trap is that value depends on the yield investors demand, which rises with interest rates: the same shock can cut income cover and collateral cover at once.

Leveraged loans

Tallowfen Veterinary Group was bought by a private equity sponsor with £150m of debt: a leveraged loan. The headline leverage uses adjusted EBITDA:

	£m	Debt / EBITDA	EBITDA / interest
Reported EBITDA	20.0	7.5×	1.45×
+ Expected savings from clinics bought	3.0
+ One-off restructuring costs	2.0
Adjusted EBITDA	25.0	6.0×	1.81×

On the sponsor's numbers the deal is 6.0× levered; on what the business actually earned it is 7.5×. Interest of £13.8m a year (floating, so it rises with rates) is covered only 1.45× by reported EBITDA. The loans are covenant-lite: no quarterly leverage test, so the lenders get no early warning. Banks often arrange such loans and sell most of them on, but they carry the risk until they do.

What would worry the credit committee most?

Sort itWhich kind of lending?

A loan to a listed engineering firm, repaid from its trading profits.
A loan to an SPV building a toll road, repaid from tolls.
A loan on a shopping centre, repaid from tenants' rent.
A loan secured on three ships, repaid from their charter income.
A loan funding a private equity firm's purchase of a software company at 6.5× EBITDA.

The formal version

For a project with cash flow available for debt service $\text{CFADS}_t$ in year $t$ , debt service $\text{DS}_t$ , debt rate $r$ and debt $D_0$ outstanding over $T$ years:

\begin{aligned} \text{DSCR}_t &= \frac{\text{CFADS}_t}{\text{DS}_t}, \qquad \text{DS} = D_0\,\frac{r}{1-(1+r)^{-T}} = \text{£}40\text{m}\times\frac{0.06}{1-1.06^{-15}} = \text{£}4.119\text{m} \\ \text{LLCR} &= \frac{\sum_{t=1}^{T} \text{CFADS}_t\,(1+r)^{-t}}{D_0} = \frac{\text{£}56.9\text{m}}{\text{£}40\text{m}} = 1.42 \end{aligned}

For a property loan $L$ on a property with net operating income $\text{NOI}$ and value $V$ at yield $y$ , paying rate $i$ :

\begin{aligned} V &= \frac{\text{NOI}}{y}, \qquad \text{LTV} = \frac{L}{V}, \qquad \text{ICR} = \frac{\text{NOI}}{i\,L}, \qquad \text{debt yield} = \frac{\text{NOI}}{L} \\ \text{LTV} &= \frac{L\,y}{\text{NOI}} \;\Rightarrow\; \text{a rise in } y \text{ from } 6.33\% \text{ to } 7.33\% \text{ lifts LTV from } 66.7\% \text{ to } 77.2\% \end{aligned}

For a leveraged company with total debt $D$ :

\text{leverage} = \frac{D}{\text{EBITDA}}, \qquad \frac{\text{£}150\text{m}}{\text{£}25\text{m}} = 6.0\times \;\text{(adjusted)}, \qquad \frac{\text{£}150\text{m}}{\text{£}20\text{m}} = 7.5\times \;\text{(reported)}

Shown in full: these are ratios. The assumptions behind the solar case (0.5% a year output degradation, 2% price indexation, 3% cost inflation, level annual debt service at 6%) are illustrative.

Try it

Switch to P90, then cut the power price. How large a fall can the project take before the lock-up bites, and before it defaults? At P50 the minimum DSCR reaches the default level after a price fall of about 17%. Then raise operating costs with the price unchanged: costs matter much less, because they are a small share of revenue.

Try itStress the solar project

Generation

Power price change0% (year 1: £70.0/MWh)

Operating cost change0%

Bars: DSCR in each year of the 15-year loan. Amber line: lock-up at 1.10×. Red line: default at 1.05×.

Year-1 CFADS£5.50m

Debt service each year£4.12m

Minimum DSCR1.34×

Average DSCR1.44×

LLCR1.42×

Years in lock-up0

Years below the default covenant0

Worked example

Stress-testing Pellcourt Properties Ltd's loan

LTV and ICR under three shocks

Step 1 of 5

1
Today
$\text{LTV} = \frac{\text{£}120\text{m}}{\text{£}180\text{m}} = 66.7\%, \quad \text{ICR} = \frac{\text{£}11.4\text{m}}{0.060\times \text{£}120\text{m}} = 1.58\times$ . The net yield is 6.33% and the debt yield 9.5%. Both covenants pass. Value can fall 4.8% before the LTV covenant breaks, and 33.3% before the loan is uncovered.

What the credit officer writes

Pellcourt: LTV 66.7%, ICR 1.58×, both within covenant. Most sensitive to rates: +1.5 points breaches the ICR covenant. Recommend a rate cap as a condition of any increase, and a revaluation every six months.

Regulatory lens

Basel's internal ratings-based approach treats five kinds of loan as specialised lending: project finance, object finance, commodities finance, income-producing real estate and high-volatility commercial real estate. A bank that cannot estimate a reliable PD for them uses supervisory slotting, placing each loan in a category from its ratios, structure and security; the capital detail is in M4.2: Credit risk capital. For leveraged lending, the ECB's guidance on leveraged transactions (May 2017) treats a loan as leveraged if the borrower is owned by a financial sponsor or its total debt exceeds 4× EBITDA, and says new deals above 6× should be exceptional. Tallowfen's senior debt alone is 4.8× adjusted EBITDA.

Spark Atoms

Spark AtomThe tunnel that cost twice the plan

The Channel Tunnel was built and financed privately, with about £5 billion of bank loans and letters of credit arranged by a syndicate of banks. It opened in May 1994 at a cost of about £9.5 billion, roughly double the original estimate, and its owner Eurotunnel carried about £8 billion of debt in its first year. The debt was restructured in 1997–98 and again in 2007, after a French court placed the company under bankruptcy protection in 2006.

Spark AtomWhy P90 and not P50?

A P50 output is as likely to be missed as beaten: a loan sized on it would fail its DSCR test half the time. Lenders size debt on a downside case such as P90, the output a project should beat in nine years out of ten, and keep the upside for the equity.

Key takeaways

Corporate lending is repaid by the whole business; specialised lending by one asset, which is also the security.
Project finance is sized on DSCR = CFADS / debt service, tested at P90; lock-up and default covenants act on it.
Commercial real estate is watched with LTV and ICR; value = NOI / yield, so higher yields raise LTV with no change in rent.
Leveraged loans are judged on debt / EBITDA; add-backs flatter it, and covenant-lite terms remove early warnings.
Basel groups specialised lending into five classes and offers slotting when PDs cannot be estimated.

Reaction

Check what stuck

Question 1 · objective 2

A wind farm's CFADS this year is £6.6m and its debt service is £5.5m. What is its DSCR (two decimals)?

×

Question 2 · objective 3

A £45m loan is secured on a warehouse valued at £60m. What is the LTV, in %?

%

Question 3 · objective 3

Rents on an office building are unchanged, but investors now want a net yield of 7% instead of 6%. What happens to its loan?

ANothing: the rent and the interest cover are unchangedBThe value falls by about a seventh, so the LTV rises even though the rent has not changedCThe LTV falls because yields are higherDThe interest cover falls

Question 4 · objective 4

A sponsor-backed company has £180m of debt and reported EBITDA of £30m. What is its leverage multiple? (Under the ECB's guidance, is it above the 6× level that should be exceptional?)

×

Question 5 · objective 4

Why does a covenant-lite loan tend to recover less when the borrower defaults?

ABecause its interest rate is lowerBBecause without quarterly tests the lenders cannot step in early, so the business has usually deteriorated further by the time it defaultsCBecause it is always unsecuredDIt recovers more, because it defaults later

Glossary

Revolving credit facility: Revolving credit facility: a committed line the borrower can draw, repay and draw again up to a limit.
Covenant: A promise in the loan agreement. Financial covenants set limits on ratios (leverage, interest cover, LTV); breaking one lets the lender renegotiate or demand repayment.
Specialised lending: Specialised lending: loans repaid mainly from the income of the one asset or project being financed, not from a company's general business.
Special purpose vehicle: Special purpose vehicle: a company set up only to own and run one project, so the lenders' claim is ring-fenced from the sponsor's other businesses.
Non-recourse: Lenders can look only to the project's cash flows and assets, not to the sponsor's other money.
CFADS: Cash flow available for debt service: the project's revenue less operating costs and taxes, before paying lenders.
DSCR: Debt service cover ratio: CFADS in a period divided by the interest and principal due in that period.
LLCR: Loan life cover ratio: the present value of CFADS over the remaining loan life divided by the debt outstanding.
Lock-up: A covenant that stops dividends to the sponsor while the DSCR is below a threshold, keeping cash in the project.
P50 and P90: P50 and P90: the output the project is expected to beat with 50% and 90% probability (from resource studies).
Income-producing real estate: Income-producing real estate: loans on offices, shops, warehouses or flats, repaid from the rent or a sale.
LTV: Loan to value: the loan divided by the property's market value.
ICR: Interest cover ratio: net rental income divided by the interest due on the loan.
Net initial yield: Net initial yield: a property's net rent divided by its value. When investors demand a higher yield, values fall.
Leveraged loan: A loan to a company with high debt, typically after a buyout by a private equity firm (the sponsor).
EBITDA add-back: An adjustment that raises EBITDA for costs said to be one-off, or savings not yet achieved.
Covenant-lite: A loan with no maintenance covenants: the borrower is not tested each quarter, only when it takes an action such as borrowing more.
Supervisory slotting: The Basel method for specialised lending when a bank cannot estimate PD: each loan is placed in one of five categories (strong, good, satisfactory, weak, default) with a set risk weight.

Deep Dives & Origins

Deep Dives

E. R. Yescombe, Principles of Project Finance, 2nd ed., Academic Press, 2014. Intermediate.
European Central Bank, Guidance on leveraged transactions, May 2017. Intermediate.

Origins

Basel Committee on Banking Supervision, The Basel Framework, CRE30 (IRB approach: overview and asset class definitions), specialised lending.
European Central Bank, Guidance on leveraged transactions, 16 May 2017, as summarised by White & Case.
“Getlink” (Eurotunnel), Wikipedia, for the Channel Tunnel cost and debt figures.

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