What is the best group structure? Understanding the funding risks

What risks should we look out for?

 

Like structure trends, loan agreements have also evolved over time. 

 

Understandably, lenders often look at and want to understand the group as a whole. 

 

This simply recognises the nature of risk within structures. Often the RP is funding and resourcing activity of subsidiaries, therefore a risk crystallising elsewhere in the group can also pose a risk to the RP itself.

 

It is not unusual to have representations, obligations and default clauses in the loan agreement which extend to all members of the group (for example, mergers, on-lending, environmental claims or breaches, regulatory provisions, pensions, insolvency etc).   

 

A key aspect of risk management is therefore recognising where such risks might crystallise, what the impact of these provisions might be and monitoring and testing them regularly.

 

Where in the group do most risks sit?

 

It is important to check the definition of ‘group’ in a loan agreement as it usually captures any subsidiaries, but may also extend to the parent and any of the parent’s other subsidiaries, which can cut across ringfencing of commercial risks from the core business.  

 

While 50:50 joint ventures (JVs) may not usually be caught, it will depend on the restriction and the rights of the respective members at any time.

 

For example, if you needed to buy out your JV partner, would you need consent to form the JV as a subsidiary? 

Cross defaults – the domino effect

 

The most significant structural risks in a group’s funding agreements are the cross default and insolvency clauses. 

 

A cross-default clause automatically defaults a party under one loan agreement where they have defaulted (eg stopped making repayments or breached a term) under another, separate agreement relating to financial indebtedness (eg another loan agreement, a guarantee or hire purchase/car leasing arrangements).

 

Depending on how wide the definition of group is drawn, these may be triggered if any member of the group – however large or small – becomes insolvent or breaches a financial commitment.

 

This means the RP could be in default under its loan agreements as a result of financial issues elsewhere in the group.  

 

These are particularly relevant where there are substantial commercial interests in a group and/or if any member of the group (other than the RP) has third-party funding arrangements, for example development finance for a JV.  

 

The key risk is that the RP is backed into a corner to support a subsidiary (eg by lending money) to avoid triggering a cross-default for the RP.  

 

However, the RP is likely to have restrictions in its loan agreement on its ability to on-lend.  

 

In addition, if the RP is charitable there will naturally be a limit on how much the RP wishes to make commercial investments while still complying with its charitable status and achieving its core purpose.

 

How to manage the risk?

 

This kind of structuring is specifically aimed at ringfencing your social housing assets from risk; this can be undermined by a failure to negotiate flexibility wherever possible. 

 

Sometimes it is a matter of allocation of risk between the lenders and the RP.

 

But one of the key protections is the use of materiality qualifications, notably ensuring that where possible any clauses that extend to the group are only triggered when the relevant event would have a material adverse effect on the RP. 

 

Beware if the material adverse effect extends to the “group as a whole”, particularly if there are substantial commercial interests within the group. 

 

There are various risk management tools that can support the review and analysis of your loans and any risks arising from your group structure.

 

For example, plotting a matrix of all your loan obligations against members of the group, regularly reviewing the nature of the entities within your group and monitoring your exposure.

 

The board should be aware of, and consider, these risks as part of their ongoing risk management and stress-testing.

 

Louise Leaver, partner, Bevan Brittan