Fungible Term Loan: a Worked Example

Inside a facility agreement, a tranche is a class. Its lenders share every payment pro rata, vote together on matters that affect the class, and are treated alike in a restructuring. An add-on that is fungible joins that class, so the agent tracks one loan, the borrower makes one set of payments, and a lender holding a slice cannot tell whether it bought old money or new.

Where loans trade, as institutional term loans do in the US and European markets, one class also means one market. A small add-on folded into a large existing tranche trades as easily as the tranche, which helps the arranger place it. A separate tranche, however close in its terms, is a different instrument with its own price, its own holders and, in a vote that treats classes separately, its own interests. In bilateral and club bank lending, the form many mid-market facilities in New Zealand and Australia take, there is usually no trading identifier, and the question is documentary: is the increase part of the existing facility or a new facility beside it?

Everything a lender would price or vote on: final maturity, the base rate and margin including any floor, the repayment schedule, prepayment protection, the covenants and guarantees, and the ranking of the security. The upfront fee and any discount at which the new money is lent can differ, because they are paid once at the start and change nothing about the loan afterwards.

Two mechanical points follow. Interest periods have to be aligned, so the add-on either starts with a short first period ending on the existing loan's next payment date or the existing loans are re-set on the day of the increase. And the scheduled repayments have to be scaled up, so that the combined loan repays at the existing rate without reducing what the existing lenders receive:

In the US market, tax rules add a test of their own. Under the Treasury regulation on reopenings, additional debt is part of the same issue as the original only if it meets conditions on timing, yield or the size of any discount. A discounted add-on that fails them can be identical on paper and still not fungible for tax purposes.

A testing-laboratory group, constructed for this page, has an institutional term loan with US$150m outstanding, three years to maturity, a margin of 3.50% and quarterly repayments of US$0.40m. It wants to add US$30m to buy a competitor. The arranger reports that new lenders would want the equivalent of a 4.00% margin. All of these figures are the example's.

Route B is the cheaper way to keep one class: a discount of 1.5 points spread over three years is roughly the 0.50% a year the new lenders want, ignoring compounding and early repayment. Route A pays the same premium to the US$150m of lenders who asked for nothing. Route C keeps the existing margin intact but creates a second class, which new lenders may price above 4.00% because it trades less easily. If the agreement has a most-favoured-nation clause, a separate tranche priced above the existing loan by more than the clause allows can lift the existing margin anyway, and Route C moves towards Route A.

An incremental facility or accordion is the permission: the clause that lets the borrower add debt without asking every existing lender. Fungibility is one possible result of using it. The same permission can produce an increase to the existing tranche, fungible with it, or a new tranche with its own maturity and margin, such as a separate term loan B beside the first.

Fungibility is also different from ranking. Two tranches can share the same security and rank pari passu, paid side by side in an enforcement, and still be separate classes that price, trade and vote apart. Equal ranking is about what lenders recover; fungibility is about whether they hold the same thing.

DEFINED IN ONE PARAGRAPH → · THE INCREMENTAL FACILITY → · PRODUCT FILE: TERM LOAN →

For an existing lender, a fungible add-on changes two things it did not negotiate: its share of the class falls, so its vote counts for less, and the borrower carries more debt on the same covenants. Whether the agreement lets that happen without its consent, and up to what amount and leverage, was settled when the incremental clause was agreed. A bank that holds part of the tranche decides whether to take its pro rata share of the add-on, which is a new credit approval at the higher debt level.

For the borrower, the choice in the example is a pricing decision with documentary consequences. Paying a discount keeps one loan; refusing it creates two. A separate tranche is more than a label: it can mature, reprice and vote on its own, and at the next amendment the borrower has two groups of lenders to satisfy instead of one.