It Can Be Hard to Share

Buyer beware. Take it or leave it. We all know It Can Be Hard to Share.

Not exactly what a bank wants to hear, particularly from another bank.

Each new year brings a new or renewed focus on adding new assets to the loan portfolio. Many (if not all?) markets have more money and competitors chasing few quality opportunities. To reach out for new clients, many financial institutions have opted to expand their portfolios. How? By purchasing a participation in lending arrangements originated by another institution.

Such an arrangement can have benefits to both parties. For example, the seller (originator) can reduce exposure to a borrower for risk management reasons. These include lending limit, exposure to an industry, balance sheet funding, or improving return. The buyer (participant), on the other hand, gains a new borrower. They also manage to an exposure level, minimize servicing expenses, and diversify the portfolio.

Buyer Beware

So, what could go wrong with this arrangement? Plenty! First and foremost, it is important to understand that the relationship between the originating financial institution and the participant is that of buyer and seller. Not debtor and creditor. The originating financial institution (seller) does not have a fiduciary obligation to the participant (buyer).

That said, the originating financial institution must exercise the same degree of care and discretion in managing the relationship as it would in servicing, managing, and monitoring a relationship for its own account.

Given this distinction in the relationship, participants need to do more than just get copies of documents from the seller and file them away. Financial institutions that engage in the practice of buying participations should establish clear loan policies and procedures on underwriting such participations. As a buyer, the participant needs to obtain copies of all relevant financial and underwriting documents. This would be to the same extent as if the credit was being extending on its own account.

In addition, the participant needs to obtain copies of all loan/credit documents. Credit approvals for the participant need to document independent analysis of the proposed transaction. Not “cut and paste” the originating financial institution’s credit analysis. Participants need to rely solely on their own analysis before entering into the relationship. Not just because they sign an agreement that represents that they did and examiners expect them to, but because it is just good business.

Buyers of participations should apply the same credit underwriting standards that they would use for their own relationships. They should not follow (or chase) transactions outside their typical geographic limits or deal in industries or loan types outside their expertise. It probably wouldn’t be prudent for a financial institution in northern Wisconsin to buy a 10% participation in an oil field services company operating in the Permian Basin in Texas.

Before getting into some of the pluses and minuses and/or issues, it is worth noting that not all participations are created equal, although there are standard issues. For most community financial institutions, participations will likely fall into the category of “club” deals. Club deals generally involve a maximum of four banks, including the lead or originating financial institution. Participants will likely know the borrower and the other participants and, most importantly, the originator.

Larger credits tend to be more widely syndicated and could involve dozens of participants. As will be discussed later, a participant should not underestimate the value of knowing the originating institution. Differences in credit culture and/or philosophy can result in very fractured relationship. Further, just like setting concentration limits on specific industries, an institution that purchases a significant number of participations should consider limits on the exposure to a particular originating lender.

Take it or Leave it

In general, there is an inverse relationship between the number of participants and the amount of control a participant can exert in the relationship. With smaller two- and three-financial institution deals, all participants will likely have a direct relationship with the borrower. They will likely have more flexibility in terms of access and communication with the borrower.

In larger, more widely syndicated transactions, it will be required that any communication with the borrower will need to be routed through the originating institution. In addition, deals with a smaller number of participants typically allow for more input in strategy, structure, and management of the relationship. Whereas with a large number of participants, each financial institution is relegated to more of a “take it or leave it” position. This is particularly true for those institutions that take a small fraction of a transaction.

Finally, the larger the number of participants, the fewer the opportunities to earn non-credit services from the borrower. Standard language in participation agreements gives wide latitude to the originating financial institution. This refers to terms of servicing and managing of the loan relationship. In many cases, the originating financial institution retains the authority to enter into any amendment of, or waive compliance with the term of, any loan documents without obtaining prior approval of the participant(s).

Exceptions to this involve CRAM issues (Collateral, Rate, Amortization and Maturity). In relationships that involve two financial institutions, CRAM issues generally require the consent of both parties. However, as the number of participants grows, the participation agreement gets more complex. Various levels of “voting rights” are established based upon the percentage each participant financial institution holds of the overall relationship. CRAM issues will generally require a super-majority (2/3) approval vote based on the outstanding indebtedness. Less significant items (such as a covenant waiver) would require approval of participants holding 50% of the indebtedness. This is also called tyranny of the majority.

At issue for community banking institutions is that a $1 million share (large relative exposure) of a really large transaction (relatively insignificant on the whole) is more “risky” from a management perspective. This is because you will have little to no control over the management. On the flip side, if you are the lead and hold over 50% of the exposure, obtaining concurrence from participants is not of great concern.

It is worth noting that even in relationships that involve just two financial institutions, depending on the specific language of the participation agreement, in the event that the originating financial institution (seller) proposes an action that requires purchaser’s consent and the purchaser does not object in writing to a written proposed action within five business days, the purchaser will be deemed to have approved the action.

It Can Be Hard to Share

From the above discussion and recalling that the originating financial institution does not have a fiduciary responsibility to the participant, and given the wide latitude that the lead financial institution has in managing the relationship, institutions that do more than a casual business in participations with a local financial institution they know well should include in their loan policy and procedures for participations, a methodology to analyze and approve financial institutions with which the institution will consider buying participations.

This analysis would consider the systems capability to manage the administrative issues of a multiple-financial institution relationship with various percentages of investment in a particular transaction. But it would also include an analysis of the credit culture of the originating financial institution. (Do they “think” like you do? Are they more or less aggressive? etc.).

Also, what is the past track record for managing a multi-financial institution relationship when borrower performance declines? Since, as a participant, you are not controlling the relationship; so how does the lead financial institution treat the participants?

It is worth noting that participant financial institutions give the originating financial institution their agreement to pay their pro-rata portion of legal fees incurred by the agent to manage and document the relationship. This happens even though you may not concur in or approved a specific action in a workout strategy. In a deteriorating situation, a participant will probably have few options to get out of the transaction. Except, perhaps, at a discount. You may truly just be “along for the ride”.

Certainly, participations serve a very real need in the financial services arena. They can provide a necessary service for originating institutions and participants alike. However, like so many other actions that involve sharing, It Can Be Hard to Share! Do clear-eyed independent analysis at the outset and have a partner that you know and trust. It can make all the difference in the success of the relationship.

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133