Promissory note loans have been an established part of the German market for over 100 years and are currently enjoying renewed popularity, in particular among medium-sized companies. Promissory notes amounting to approximately EUR 10 billion were placed in 2011, with the figure rising to around EUR 13 billion in 2012. In addition to banks, it is mainly insurance companies and pension funds that invest in these financial instruments, attracted by the opportunity to invest their customers’ money in an additional asset class. Companies can in turn broaden their investor base via promissory note loans.
What is a promissory note loan?
Promissory note loans combine features of both traditional bank loans and bonds. They are not usually agreed directly with the actual lenders; rather, banks typically act as “brokers” for these transactions. Banks place the promissory note loan with a circle of potential investors, meaning that borrowers do not have to search out investors themselves. Benefits for companies include in particular the ability to expand their circle of financiers. Furthermore, unlike with bonds, companies do not have to prepare a sales prospectus in association with the promissory note loan. In addition, there is no need to switch to IFRS accounting standards.
The documentation is relatively “slim” and generally comprises less than 30 pages. Repayments under a promissory note loan usually need to be made as a bullet repayment on the final maturity date. The total amount of the loan is frequently split up into several tranches with differing terms (e.g. of three, five and seven years), mainly to prevent the total loan amount being repayable at the same time and thus needing to be refinanced all at once. In addition, there is a tendency that there are tranches with fixed and other tranches with variable interest rates. While commercial banks in particular generally have a preference for variable interest rates, insurance companies and pension funds prefer tranches with fixed interest rates, partly in view of their “refinancing” via their customers’ money, for which they grant guaranteed fixed interest rates as part of life insurance policies and similar products. In practice, this means that not all tranches are included in a single promissory note loan agreement, but rather that multiple agreements are entered into which are identical except in relation to the term and the interest payable (this means that if there are tranches with three different terms each with variable and fixed interest rates a total of six agreements have to be signed).
In addition to the promissory note loan agreement, a paying agent agreement is entered into, generally with the bank that arranged the promissory note loan. Under this agreement, the bank takes responsibility for collecting the interest due during the term of the loan and distributing it to the individual investors in return for a specified fee.
A number of special features need to be considered when raising funds via promissory note loans as compared with traditional bank loans:
Firstly, this type of financing requires a certain lead time. In addition to negotiating the documentation with the arranger, the company also generally has to give presentations to the potential investors at a number of events. This is followed by a period of several weeks where the investors decide whether they will invest in the relevant promissory note loan. It is only when this period has expired that the promissory note is “placed” and the loan can be paid out.
Therefore, with a promissory note certainty of financing is only achieved after placement, unless the arranger underwrites for a certain amount. There is also the risk that the amount of financing which was envisaged to be raised is not actually raised, for instance because the potential investors have already subscribed promissory notes from other companies. It is therefore important to go to the market with a promissory note at the right time, after consulting with the arranger accordingly.
Furthermore, the number of investors is generally significantly larger with a promissory note loan than with a club deal, for example. Unlike with a club deal or a syndicated loan, the investors are also not bound by contractual provisions whereby certain decisions that are binding on the syndicate are taken by simple or qualified majority (usually 66 2 / 3) of the members of the syndicate. It can therefore become difficult to obtain a waiver from investors if certain terms of the loan agreement are breached. As a result, any future changes which may occur in the borrower’s business operations over the term of the promissory note, or other relevant aspects, should be anticipated in the documentation wherever possible.