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Tying Loan Costs to Performance

Linking borrowing costs to your company's financial performance.
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What can you do if you don't like the borrowing terms your bank is offering? If you think you can do better elsewhere, go out and try. Or you might just ask your banker about linking your borrowing costs to your company's financial performance. That's assuming you think things will improve.

Performance-based pricing has become increasingly popular for large and midsize companies, but there's no reason, say bankers, smaller companies can't apply some of the elements to their own borrowing. There are built-in advantages for both borrowers and lenders: businesses can reduce their costs by prenegotiated amounts if their credit improves; and banks can increase their charges as the risk level moves upward. Small companies may have a hard time getting bankers to sign on to specific cost reductions ahead of time, says Jim Menzies, executive vice-president of KeyCorp., an Albany, N.Y., bank holding company. "But you should be able to agree on the circumstances when you sit down and discuss price."

Most performance-based loans are tied to one or more of the following:

* Changes in financial ratios. Say your business has a debt-to-equity ratio of three to one, but you're planning significant debt reduction over the next year. You might ask your banker to reward you with a lower interest rate if your leverage drops to, say, two and a half to one. "The risk would be lower," Menzies notes. The same might go for an improved coverage ratio (reflecting the availability of cash to service debt), although any banker would want protection if and when the shift went the other way.

* Changes in equity or ownership. Or suppose you contemplate selling off some assets or raising capital by bringing in a new investor. You could ask your banker to adjust your loan costs if such events occurred (again, because of the lower risk). Odds are, though, that he or she would want to see what you do with the new money before agreeing to anything.

* Reclassification of a loan. Bank regulators require banks to set up additional capital reserves for any loans on their books that are classified as highly leveraged transactions. Those borrowers pay more than others. But once their position improves (and the extra reserves are no longer necessary) the overall costs should drop. The extent to which their situation improves -- and how soon -- is, as they say, negotiable.

-- Bruce G. Posner

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Last updated: Mar 1, 1992




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