Although the terms “participation” and “syndication” are commonly used interchangeably, there are significant legal and practical differences between loan participations and syndicated loans. Therefore, it is important for a lender to be aware of the differences between these two lending structures in order to make an informed business decision as to which structure best fits the lender’s interests. This article provides a lender-focused guide to the respective benefits and risks affecting loan participations and syndicated loans.
I. Loan Participations
In a loan participation, the originating lender transfers all or part of its interest in a loan to a participant pursuant to a participation agreement. The participation agreement defines the rights and obligations between the participant and the originating lender, including the participant’s rights, if any, to direct the originating lender’s actions and decisions regarding material aspects of the loan. The participant purchases an economic interest in the financing arrangements and is typically entitled to share in the economic benefit thereof, i.e., the right to receive principal and interest payments, and collect certain loan fees, while undertaking the obligation to fund any additional loans on behalf of the originating lender as required by the underlying credit agreement between the originating lender and the borrower.
In most participation agreements, the originating lender’s interest in the loan is sold outright to the participant, and the originating lender does not become an agent, trustee, or fiduciary of the participant. To ensure such a relationship is not impliedly created, the participant agreement should expressly provide that the relationship between the lender and the participant is that of a buyer and a seller, and the intention of the participation is to transfer full economic rights from the lender to the participant without the creation of a fiduciary or agent relationship.
Importantly, the borrower remains directly obligated to the originating lender under the credit agreement between the originating lender and the borrower, notwithstanding the loan participation. The participant does not become a party to the credit agreement and does not have any direct contractual relationship with the borrower. As a result, the participant does not maintain any direct claims against the borrower or any collateral securing the loan.
II. Syndicated Loans
In syndicated lending, the borrower enters into a single credit agreement with a group of lenders covering all of the loan facilities provided to the borrower by the lenders. A syndicated credit agreement might take the place of multiple bilateral credit agreements between the borrower and each lender or be used in lieu of a participation because all of the lenders are in privity with the borrower. Unlike a participation, each of the lenders in a syndication has a direct contractual relationship with the borrower. Despite the fact that all of the lenders are in privity of contract with the borrower, generally one of the lenders is designated as the agent to act on behalf of the lender group. In a syndication, there can be several different agents, with each serving a distinct role in the credit facility (e.g., administrative agent, collateral agent, etc.). The rights and obligations of the borrower, the agents and the lenders are all governed by the syndicated credit agreement.
The administrative agent administers the loan facility on behalf of the lender group. Generally, the agent is responsible for all formal communications between the lenders and the borrower, and the disbursement of the loan proceeds. Any collateral securing the loan facility is generally secured by the granting of a security interest by the borrower in favor of the administrative agent (or another lender designated as collateral agent) for the benefit of the lenders.
III. Benefits and Risks of Loan Participations
In a participation, the participant has no direct rights against the borrower, but does not have any direct obligations under the loan agreement (e.g., commitment to lend).
Participations may create value for the lender, especially in a distressed situation, by creating a market for the beneficial interest, while allowing the lender to remain the record owner of the loan for purposes of maintaining its relationship with its client.
By selling the participation, the lender is able to reduce its credit risk in the loan while adding another source of financing for the borrower in the event that the terms of the credit agreement require additional funding. Simultaneously, the sale of its beneficial interest allows the lender to realize capital while permitting the lender to use the proceeds of the sale to take advantage of new lending opportunities.
However, the participation can prove to be quite burdensome on the lender. Understandably, given the rights at stake, participation agreements can be quite complex and require substantial negotiation.
Further, servicing the participation can prove a challenge for the lender. Since the lender is the intermediary between the borrower and the participant, the lender may spend much time and effort transferring funds received by the borrower or advanced by the participant, or, to the extent required by the participation agreement, providing current information about the loan and the borrower to the participant.
Moreover, the participant may have the right to prevent material economic changes to the credit agreement. If the lender provides the participant with such veto rights, the participant, regardless of the size of its interest in the loan, may be able to block an entire restructuring of the facility. As the participation agreement must comply with the terms of the credit agreement, it is prudent for the lender to carefully analyze the terms and conditions of the credit agreement to ensure there are no inconsistent provisions.
From the perspective of the participant, because the participation agreement is solely between the lender and the participant, in most cases, the participant enjoys the benefit of purchasing a beneficial interest in the loan while keeping its anonymity. This allows the participant to shelter the existence of the participation relationship from the borrower, other lenders, and the global loan market. However, it is possible for the credit agreement to contain certain conditions upon the transfer of the lender’s beneficial interest in the loan, such as (i) requiring the borrower’s consent; (ii) requiring notice to the borrower; (iii) restricting the amount that can be transferred; and (iv) requiring that the participant be an eligible assignee.
While the participant may not have direct rights against the borrower, the participant can preserve its rights under the credit facility within the participation agreement. Significantly, participant agreements might allow the participant to prevent material amendments to the credit agreement and any material waivers of rights by the lender. It is also not uncommon for the credit agreement to provide the participant with third party beneficiary rights when participation is contemplated at the time the initial credit is extended by the lender.
As a legal matter, the participant is not in privity with the borrower and does not maintain any direct causes of action or rights of set-off against the borrower. Rather, the participant must generally rely on the lender to protect its rights. If the participation agreement does not provide the participant with the ability to force the lender to enforce remedies against the borrower, the participant could be left in a relatively weaker position.
The participant should negotiate for entitlement to certain information about the borrower. If the participant does not have a great deal of knowledge about the borrower and its business operations, evaluating the likelihood of the borrower’s default or the prospects of the borrower becoming insolvent becomes a challenging endeavor.
IV. Benefits and Risks of Syndicated Loans
The syndicated loan is a helpful tool for administrative agents and non-agent lenders. The syndicated loan allows the administrative agent (which typically arranges the syndicated credit facility) or a group of lenders to provide borrowers with access to larger credit facilities which might otherwise exceed the agent’s or any single lender’s internal and external credit exposure limits. By allocating the credit facility among a group of lenders rather than committing to fund the entire credit facility itself, the agent lender is able to maintain its relationship with its borrower and provide a large amount of funding, while, at the same time, remaining within its credit exposure limits and sharing risk among the lender group. In addition, the agent lender benefits from collecting additional fees (e.g., arrangement fees, administrative fees and fronting fees) in its capacity as administrative agent.
Likewise, a syndicated loan allows a non-agent lender to take part in a large or complex credit facility which the non-agent lender may not have the expertise or administrative capacity to handle independently. A non-agent lender also benefits from collecting a portion of lender fees (e.g., commitment fees) in accordance with its share of the loan. In addition, as a practical matter, a syndicated loan facility is less expensive and more efficient to administer than several bilateral loan facilities between the borrower and the lenders.
From the perspective of the non-agent lender, a syndicated loan generally provides for more rights for the members than a typical participation. First, each lender is a party to the credit agreement and has a direct contractual relationship with the borrower. To the extent expressly permitted by the credit agreement, each lender may maintain direct causes of action against the borrower for breach of the credit agreement and may also exercise any set-off rights against the borrower. Second, as a party to the credit agreement at origination, each lender is involved (at times, through the administrative agent) in negotiating the respective terms or covenants contained in the credit agreement, including the rights of the lenders under the credit agreement.
Also, the lenders themselves may determine the percentage of lender approval required in order to direct the administrative agent to take action or modify the terms of the agreement. For example, some minor amendments to the credit agreement may require the approval of only a simple majority of lenders, while material amendments, such as changing the interest rate or maturity date, may require the approval of two-thirds of the lenders.
There is also an informational benefit to being a lender in a syndicated loan, as opposed to a participant. Unlike a participation, each lender separately underwrites its portion of the loan and, therefore, is entitled to receive, prior to origination, all information regarding the borrower’s finances and business operations which helps the lender ascertain if the borrower is an acceptable risk based on the lender’s own criteria. Also, the non-agent lenders may require the credit agreement to provide that any material disclosures made by the borrower to the administrative agent under the credit agreement be provided to all members of the lending group, either directly by the borrower or through the administrative agent.
One potential risk to a non-agent lender in a syndicated loan is the limitation on the lender’s ability to control the administrative agent’s exercise of remedies after an event of default. The agent generally exercises remedies after an event of default subject only to the direction of the lenders holding a certain percentage of the commitments (e.g., 51 percent of the commitments). As a result, a non-agent lender—particularly a lender holding a smaller percentage of the commitments—may be constrained by the course of action selected by the agent and other lenders after a default. For instance, the agent and the required majority of the lenders may wish to tolerate a continuing default under the credit agreement in order to preserve the credit facility and their relationship with the borrower, while a smaller lender instead may wish to direct the agent to proceed against the collateral securing the loan and exit the credit facility.
A problem in syndicated loans that generally does not arise in the context of a participation is where a member of the lending group runs into financial distress or is unable to satisfy its obligations under the credit agreement. A default by one of the lenders does not eliminate the obligations of the remaining lenders to make advances as requested by the borrower in accordance with the credit agreement. To address this situation, the syndicated credit agreement will generally permit the borrower to force the defaulting lender to terminate its commitment in the loan or to assign its commitment to the other lenders or a third party. If the defaulting lender is in bankruptcy, however, the forced assignment would be subject to bankruptcy court approval. In the case of a defaulting lender, the agent’s risk is limited because the credit agreement typically provides that the borrower is required to immediately repay any advance made by the agent on behalf of the defaulting lender.
Syndicated credit agreements do not always address a situation where the agent is the defaulting lender. In the case of a bankruptcy or an insolvency proceeding involving the agent, any loan payments from the borrower to be distributed to the lenders that is held by the agent at the time that the proceeding is commenced could, but likely would not, constitute property of the agent’s estate, except to the extent of the agent’s pro rata interest in the loan payments in its capacity as a lender. The lenders likely would, however, need to seek court approval prior to realizing payments under the loan.
Further, the existence of a bankruptcy may constrain the agent from performing its other administrative functions under the credit agreement to the extent that the agent is not removed from its position as administrative agent. The agent’s exercise of certain of its powers and obligations (such as approving amendments to the credit agreement, actions with respect to the loan collateral, or consenting to a lender assignment of its rights under the loan) would likely require court approval.
When organizing a particular credit deal, lenders should assess the various loan structures and the associated benefits and risks. Multiple lender financing provides lenders with the ability to share credit risk with other lenders and diversify their credit portfolios by seizing other lending opportunities. Loan participations allow a lender to take part in a credit agreement without abdicating much control over the credit and announcing its presence to the borrower and the global loan market. Syndicated loans provide the other lenders with direct rights against the borrower and are structured to create ease in the administration and servicing of large or complex loans. To ensure that a lender can structure a credit facility to accommodate its needs and adequately protect its rights, a lender’s awareness of the key differences between loan participations and loan syndications, especially when the underlying credit becomes distressed, is paramount.