What is a Revolving Loan?
Revolvers are some of the most common loan products available from commercial banking and corporate banking.
Most people are familiar with the concept of a regular loan. The borrower takes out a fixed amount of money (the loan principal) that must be paid off along with the interest over the term of the loan. This regular loan is commonly referred to as an installment loan or term loan.
However, often the borrower’s situation often requires more flexibility than what the term loan can offer due to its fixed nature of interest and the principal payments. Certain borrowers such as businesses, entrepreneurs, and contractors often experience uneven cash flows, and they might need access to funding that will smooth out the cash flow between the paycheques or inflows. That need is resolved by revolving debt – kind of like a credit card for business borrowers.
Revolver debt, which is also referred to as revolving debt, is a type of line of credit that provides the borrower with access to a set amount of funds that can be drawn at their discretion. The borrower has a significant amount of flexibility to draw, repay, and redraw the sum at any time needed as long as it is before the final maturity of the loan contract – which is often extended. The borrower can use it repeatedly as long as the outstanding amounts are paid off and capacity remains available.
Revolving Loan Example
Jessie’s Bakery Shoppes (“Jessie”) gets a committed revolving loan from the Bank of Nova Scotia with $30 million of capacity (what is available – the revolver will start out undrawn), with the purpose of the loan for general corporate purposes and working capital. Jessie’s Bakery Shoppes uses the loan from time to time to make purchases. It purchases $12 million of flour and other cooking inputs for the central baking facility. These are used to create baked goods which are shipped out to individual shops and sold to end users.
Throughout the month, Jessie’s Bakery Shoppes earns revenues from the sale of goods and uses the proceeds to pay down the outstanding revolver.
Jessie pays the Bank of Nova Scotia 50 basis points (bps) for entering into the lending agreement with her. 0.005% x $30 million = $150,000. This is called the upfront fee.
Jessie will also have to pay interest on the drawn and undrawn portion of the loan. Jessie pays for the unutilized portion because the bank has committed to set aside the capital for her. Jessie pays for the drawn portion because that is money that is actually being lent to Jessie directly. The fee for the drawn portion will be higher than the undrawn portion.
As bank loans are and given the revolving nature of the loan (which means the bank has to source the funds from somewhere quickly), interest rates are floating for the drawn portion. So for this loan, Jessie will pay Prime + 350 bps on drawn amounts and a 50 bps utilization fee on anything that is not drawn. So for the duration of when that $12 million was drawn, Jessie would pay Prime (3.45%) + 3.50% for a 6.95% interest rate and 50 bps on $18 million (the unutilized portion). For the remainder of the time, Jessie pays 50 bps on the full $30 million.
Credit Decision in Extending Revolving Loans
The maximum amount for the revolver is set when the financial institution agrees to provide the advancement based on factors such as the borrower’s ability to pay, cash reserves and credit score (Altman’s Z-Score for corporates).
The revolver usually has a lower maximum amount/capacity than term loans or bonds as this type of credit is mostly used for the working capital management of continued operations. Debt that is seen as more permanent capital (term loans and bonds) will be the primary conduit for funding expansion. The revolver is for convenience.
The primary advantages of the revolver line of credit are the purchase and payment flexibility; the heavier drawn interest is not charged unless the money is drawn and payments can be made without a fixed schedule (whereas term loans and mortgages may have prepayment penalties).
In addition, this type of credit does not have to be tailored to a specific purchase, but, much rather function as a line of credit. Often, for large term loans and bonds, the banks will want a defined purpose before they front the money. Small things that the revolver is used for will not be audited too closely.
All things considered, the revolving credit is somewhat similar to the business credit card, but it still has several differences: the absence of the physical card, lower interest rate compared to the credit card, and the availability of the funds without the requirement of an actual transaction. Similarly to the business credit card, when the borrower has sufficient cash reserves and makes regular payments, the financial institution can agree to increase the maximum limit.
Bilateral vs Syndicated Revolvers
The number of parties involved in the revolver depends on whether the arranged revolving credit facility is bilateral or syndicated.
With a bilateral revolver loan, the only entities involved are the lending financial institution and the borrower. The direct deals between the lender and borrower tend to be less complex and require no intermediaries or arrangers like bankers, which usually makes this deal less expensive for the borrower. As there is a one to one arrangement, the contract can be non-standard with terms to fit the needs of borrower and lender. The interest rate also tends to be cheaper whereas syndicated loans will have more market driven pricing due to the participants involved.
Bilateral facilities are more common in the case of smaller revolver debt facilities, where a single lender can provide the entire amount.
On the other hand, the syndicated revolver loans involve several entities. The single borrower receives funds from several lenders who were arranged through the paid intermediaries (the agent bank, or the main bank).
Syndicated loans tend to be more complex, and most commonly used by the large companies who seek a larger maximum amount that a single lender cannot or is not willing to provide. Also, having a banking syndicate is a good way to anchor business relationships for other capital markets capabilities, such as ECM and DCM.
Consequently, syndicated loans tend to be more expensive due to both higher charge by lenders and the fees to the arrangers.
Committed vs Uncommitted Revolvers
The terms committed and uncommitted are used to describe the terms and conditions of capital funding in credit facilities.
A committed revolver is an agreement where the lender commits to provide the funds to the borrower given that the specific terms and requirements are met – it does not matter if you think the company is going bankrupt and will not be able to repay before they ask for money, if all criteria are satisfied you must lend. In addition to meeting the documentation and contract requirements, the borrower pays the lender a fee to compensate the lender for its commitment to lend, or a commitment fee.
The commitment fee compensates the lender for setting aside the funds to provide an access to the potential loan. A portion of those funds is idle as the borrower might not draw the revolver to its maximum, and hence the interest cannot be charged.
The commitment fee is usually set as either a flat fee or the percentage of the undisbursed loan amount and is paid as a one-time fee at the end of the transaction. That way, the committed revolver credit provides the borrower with a guaranteed source of funding for the duration of the agreement. The committed revolvers are usually provided for longer periods of time like 5 years.
In contrast to committed revolver line of credit, an uncommitted revolver is a line of credit where the financial institution does not guarantee to provide the credit when there is a request from the borrower. The lender usually agrees to provide a short-term funding for seasonal or temporary needs of under a year in many cases. Uncommitted facilities are cheaper for the borrower than committed facilities since there are fewer documentation requirements and the amount provided is relatively small in comparison to the committed revolver.
Secured vs Unsecured Revolvers
Just like any other credit facility, the revolver debt can be secured or unsecured. The secured revolver is the agreement where the borrower pledges an asset to serve as a collateral against the revolver maximum amount. The collateral can be seized or liquidated if the event of borrower’s default and provides the lender with the confidence that translates into lower the higher maximum amount and a lower interest rate in comparison to an unsecured revolver.
The unsecured revolver, as the name implies, is not secured by the borrowers’ asset that acts as collateral, and assumes a larger risk for the lending institution. That affects both the amount advanced by the lender and the interest charged for the facility.
Commercial Paper Backstop Facility (CPBF)
CPBF is a special purpose revolver that enhances the liquidity of the commercial paper market by increasing the availability of the term paper funding and providing the assurance to both the issuers and investors.
At times when the commercial paper market experiences a liquidity strain, CPBF provides a last-resort support. Revolving credit loans are often used as a backstop for commercial papers in the event when the issuer defaults on his payment. The revolver serves as an insurance of secondary form of repayment for the commercial paper, improving the investors’ confidence and retaining the credit rating of the commercial paper.
Generally, if a corporate has access to commercial paper it is much cheaper and more convenient than bank debt. The revolver will accordingly generally be undrawn.
A short-term revolver can also be used as a Warehousing Lending facility, a line of credit extended to the mortgage banker to fund the mortgage loans. In essence, the financial institution provides the mortgage banker with a line of credit to finance the mortgage that the borrower uses to buy a property.
The mortgage banker then sells the mortgage loan to the secondary market buyer and uses the proceeds to repay the line of credit advanced by the financial institution. That way, the banker provides funds to the borrower without using his own capital and only deals with application and approval of the loan. The Warehouse Lending can be classified as an asset-based lending as it secures the loan by the home-buyer.
Modeling Revolvers on Excel
Revolvers are very common in LBO models and corporate models. We have an article on this here.