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Customisation is possible in debt products the customisable features in debt financing are amount, price, repayment pattern, and security. There are a variety of combinations of these features that are possible.
Customisation and personalisation are the buzzwords that are the “holy grail” for designing products and services. The marketing collaterals talk about how this product or service is just made for you to address your unique requirements, which fits perfectly in your budget and which will make you keep coming back to consuming it. What does customization mean in debt products? Is it even possible?
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Customisation is possible in debt products the customisable features in debt financing are amount, price, repayment pattern, and security. There are a variety of combinations of these features that are possible. However, we must understand that customisation of debt has to be done while keeping the risk profile of the same.
The conditions for each company are unique - their own financial position i.e., cash availability, leverage, consistency of payment by customers, timelines for project and sale cycle execution, dependability of their suppliers, availability of mortgage collateral, and relationship with financial institutions. This means that a borrowing company either has to find a ready product that suits its situation or has to work with a lender who is ready to customise the product.
Here are some ways in which customisation of debt can be done:
: Estimating the correct amount of loan is important. It must strike the right balance between the repayment capacity and the requirement of the business. Ideally, both should be in sync even if one of them is out of sync, it will not have an optimal solution for the company. Higher business needs but lower repayment capacity would mean the need to fund business with equity or taking a loan that allows repayment over a much longer period if the risk profile permits that. In addition, having a higher repayment capacity does not mean that the company should borrow and incur unnecessary interest costs.
Sometimes lenders do not want to lend smaller amounts and companies are forced to borrow bigger amounts than required. Such situations are best avoided, or you can negotiate with the lender to not disburse the entire amount in one go. Instead, request appropriate drawdown period for you to receive the full amount over a period. The lender may ask you for a commitment fee for that arrangement. Typically, that would be significantly cheaper than you draw down the entire amount that you otherwise do not need.
The reverse can also happen. You may need a larger amount of money, but the lender may not be willing to lend that amount. In such cases, you can negotiate a set of milestones on achieving which the lender will disburse the remaining amount. If you do not achieve the milestones, the amount would not be disbursed. The flexibility can be built around the quantum by adding the feature of frequency of drawdown.
2. Repayment Pattern: A repayment schedule for a loan consists of a calendar of expected interest and principal repayments or installments over the duration of loan. Repaying specific amounts at specific intervals is a critical commitment by the borrower at the time of taking the loan. The installment consists of the principal and interest portions. Flexibility can be built around structuring principal in several ways.
The repayment amount per installment depends on the length of the loan term considering all other variables remain constant. It is important to note that the shorter the loan period, the higher the installment amount but it also lowers the cost borne in the form of interest paid. The ideal term is the one that matches your business cycle and smoothens your cash flows. You can have options to pay the entire principal at one go (bullet repayment) at the end of a term, or quarterly Principal payment, or an EMI or principal payments linked to revenues. These repayment schedules, if designed appropriately can take care of the seasonality of businesses
3. Adjustable Interest: Sometimes the interest component may also vary. The interest rate charged can be fixed or floating. Fixed interest rate as the name itself suggests remains fixed during the entire loan duration. Floating rates are linked to Marginal Cost of Funds based Lending Rate (MCLR) and hence the costs of borrowing and repayment instrument fluctuate. Some companies like to fix the repayment amount, in the beginning, to plan for the cash flows, others prefer a floating rate to take advantage of policy changes. Typically, a fixed rate requires you to agree to a higher rate or a higher processing fee because it is giving you complete certainty on the amount you need to pay on every installment date.
At other times, the initial capacity of the company of bearing the interest cost is low but has a confirmed long term order book which will bring in significant revenues in the future - in this case, a low rate of interest is charged during the tenor of the loan and an additional rate of interest is charged at the end of the loan or an equity upside is built into the loan term.
4. Amortising vs Revolving Limits: Fundamentally there are two types of loans - Term Loan which is about the principal amount being paid systematically over the duration of the loan, and Revolving loans which allow for multiple drawdowns and repayments and interest is paid only on the amount drawn. Sometimes your business may be highly dependent upon the availability of orders. Your debt requirement may arise only when you have larger orders and otherwise, you are able to run your operations well without any debt.
For such situations, which is typically faced by seasonal companies or B2B order-based companies, a debt line with the flexibility to repay amounts drawn down after the need is over and then draw it down again when the need arises is required. So, while the term for which you may have the facility may be one year, you may be able to draw down and repay the amount within (say) 3 months and then draw it down again after a month for another 3 months. In this case, you will end up bearing interest cost only for 6 months instead of the 12 months.
5. Prepayment: If you get a loan of 24 months but you get a large inflow of cash from some source, you may not want to continue with the full amount of the loan. In such cases, you may want to prepay and close the loan. However, in such cases, the lender loses interest income for the remaining tenor and hence some lenders have steep prepayment penalties. One way to deal with this is to understand if you can predict when you will get a large inflow of cash. Based on the timing, you can commit a lock-in period to the lender, during which you will not prepay any amount over the repayment schedule and reduce the prepayment penalty over the remaining period.
There are several ways more ways to customise loan products in between the two spectrum of fixed term loan and revolving facility. Sometimes, only one type of product is available with one lender. Hence, it is necessary for borrowers to consider partnerships with lenders who can customise and provide different kinds of product variations.
Customisation of debt to meet a company’s requirements is very important as it has long-term implications for their cash flow management. Missing repayments due to poorly designed repayment schedules can have serious consequences for the creditworthiness of the company and its future fund-raising capacity. The onus of providing the right terms and receiving the right terms lies with both the debt provider and receiver.
The author, Avishek Gupta is Head at Caspian Debt. The views expressed are personal
(Edited by : Anshul)
First Published: Nov 2, 2021 12:56 PM IST