Refinancing Debt (#125)
/In this podcast episode, we discuss the pros and cons of debt refinancing. Key points made are:
Is it Possible to Refinance at All?
There are a surprising number of issues to consider, and they’re not all about saving money. First, there may be a technical issue. If you’re with a large company and you’ve issued bonds to investors, then refinancing debt really depends on whether the bonds are callable, and when they’re callable. If there’s no call date in the immediate future, then you’re out of luck on the refinancing.
The Lending Relationship
The next issue, and a much bigger one, is the lending relationship. I talked a lot more about this in the last episode. You need to weigh the possibility of getting lower-cost debt elsewhere against losing the relationship with your existing lender. This has a couple of ramifications. First, if you depart for greener pastures, how do you know that the new lender will be willing to work with you as well as the old one did? Of course, that’s assuming the old lender did help you out. If the old relationship was horrific, then I’d be willing to switch to more expensive debt with someone else just to get out the relationship.
But let’s assume that the old lender was pretty good. If your company falls on hard times, the existing lender has a lot of history with you, and might be willing to be more accommodating on debt repayment, or loosening up covenants. A new lender doesn’t have that kind of history with you, and there certainly hasn’t been a chance to build up any loyalty, so you might find yourself in trouble with a new lender who’s pretty rigid in its lending practices.
The Transfer of Banking Activity
A second problem with switching lenders is if it’s a bank doing the lending, and the bank wants you to switch over all of your banking activity to them. Now if you’re a treasurer and you’re the one who has to switch over all of the bank accounts, and ACH debits, and check stock, and lock boxes, and so on, you might consider suicide before making the switch. It’s a lot of work. And that’s a serious consideration.
The Interest Rate Swap
So here’s another issue. Do you want to refinance debt, not because of the interest rate, but because it’s a variable interest rate and you want a fixed rate? Or, in a few rare cases, the other way around? If so, it might be possible to do an interest rate swap. These are usually limited to larger companies, but it may be possible. So, for example, if you have a variable rate and you want a fixed one, you can offload the risk of interest rate changes to somebody else, and keep the debt you have.
The Need for More Equity
Here’s another thought. Over time, the risk position of a company changes. Maybe when you first lined up a loan arrangement, the company had a lot of equity and some cash reserves. What if that’s no longer the case? If you try to refinance your debt, any lender will look at your financial position right now, not the way it was a year or two ago. Bottom line, you may find that changes in your balance sheet will force you to bring in more equity in order to qualify for lower-cost debt. Does the ownership of the company want to do that? Maybe not. If not, you won’t be allowed to refinance debt, even if it otherwise seems like a good idea.
When to Load Up on Debt
Now, let’s flip that concept around. What if the company’s position has really improved since you lined up the existing debt package? In that case, absolutely try to refinance. And especially if lenders seem eager to lend. The credit markets have been horribly tight lately, but that can change – and over time, it probably will.
If you have that perfect convergence of great looking financials and an easy credit market, then refinance right away. It’s kind of like the parliamentary system – you call an election when you think you’ll have the best chance of winning it. The same thing goes with refinancing. You do it when you think you can get the best deal. Not when the old debt agreement is about to expire.
Parting Thoughts
In fact, I’d say the mark of a really great treasurer is someone who keeps a close eye on financial statements and the credit markets, and pretty much always refinances early, when the timing is just right. And not only that, but when the timing is just right, go for as much debt as you can take, and for the longest possible period of time, and with very few covenants that are easy to meet. Those conditions don’t come along every day, so if you can use the cash – take it. And keep it for as long as possible.
So you can see that there’re a lot of issues. First in priority for most companies is maintaining a long-term, trusting relationship with a good lender. If the interest rate they offer is a little high, I might try to work them down on the rate, but I wouldn’t be overly inclined to switch to a new lender if I could help it. Maybe this is old school, but I think the relationship comes first, and saving a small amount on interest expense comes second. Maybe a long way second.
But. If the conditions are right – which means great financials and easy credit - and you can make a killing on a great refinancing, then strike hard and go for four things: a low interest rate, a lot of debt, a long debt term, and really easy covenants. It’s absolutely preferable to do this with your existing lender, but if someone else offers a killer deal, you’ve just got to take it.