Loan Tail: a Worked Example

Much business lending is repaid from a source with an end date: a council contract, a building's leases, a machine's working life, a concession. A lender sizing a loan against that income can choose when the loan finishes, and the tail is the part of the income it deliberately leaves outside the repayment schedule.

The reason is what happens when a forecast slips. If the loan matures before the contract ends, a fall in income can be absorbed by stretching what is still owed into years the contract still pays for. If the loan matures on the contract's last day, the only room is the cover left in each remaining year, and a fall that outlasts it leaves debt owing when the income stops. That debt must then come from a renewal not yet won, from the owners, or from a new lender asked to fund a business whose income is about to stop. The tail is what turns a lasting shortfall into an amendment rather than a default.

Years are the simplest measure. Cash matters because a contract's last years can be its weakest, with handback obligations or decommissioning costs. The value measure sets the loan life cover ratio beside the project life cover ratio, which discounts the same cash flow to the end of the contract or asset life rather than to the end of the loan; the difference between the two is the tail expressed as cover. In mining and oil and gas the idea is measured in the ground, as the share of reserves forecast to remain when the loan is repaid.

What counts as the end of the income is a credit choice. A cautious lender measures to the contract's expiry date, not to the renewal the borrower expects; for a property, the lease expiries summarised in the weighted average lease expiry; for equipment, its working life. The Basel Committee's slotting criteria for project finance, applied in national form by banks with approval to use internal ratings, grade a project partly on whether its useful life exceeds the loan's tenor and whether an off-take contract outlasts the debt. A contract that ends before the debt matures is listed among the weak features.

A waste-collection contractor, constructed for this page like every figure in it, borrows US$10m to replace its truck fleet. Its council contract has nine years to run, and the cash it leaves for debt service is forecast at US$2.4m a year. The loan costs 7% and is repaid in equal annual instalments of interest and principal. The bank compares two schedules. Neither the rate nor the tail is offered as a market norm.

The nine-year loan looks safer on every annual ratio. The seven-year loan has thinner cover but leaves two years of contract income, US$4.8m before discounting, outside the schedule. The PLCR is the same for both because the business and its contract are the same; what differs is how much of the contract's value the loan leaves unused.

Now let the cost base move for good. From year 3, fuel and wages rise faster than the contract's annual price review allows, and cash for debt service settles at US$1.5m a year for the rest of the contract.

The nine-year loan misses by little, but it misses in every remaining year, and the only place left for the shortfall is past the contract's end, where repayment rests on a renewal the council has not offered. The seven-year lender stretches its loan over the two years it left behind and is repaid, thinly, inside the contract. Part of the difference was earned in the good years, when the faster schedule repaid US$0.66m more principal; the rest is the two years of income the loan did not rely on. The tail is what lets that conversation end in a rescheduling the contract can pay for.

Tenor is the length of the loan itself; the tail is measured against something outside the loan. Two seven-year loans can have tails of two years or none, depending on what repays them. Refinancing risk is the risk that a loan falling due cannot be replaced. A loan that ends in a large balloon carries that risk, and its tail is what the next lender would be lending against: a balloon due two years before the contract ends asks a new lender to accept, at most, two years of income behind its loan.

The tail also differs from a debt service reserve account. A reserve holds cash already earned, set aside against the next payment dates. The tail is cash not yet earned, available only if the contract keeps paying. A file can carry both, and they answer different questions: the reserve, whether the next instalment can be met; the tail, whether the loan can still finish.

DEFINED IN ONE PARAGRAPH → · LOAN LIFE COVER RATIO → · THE TERM LOAN, PRODUCT FILE →

The tail is set when the loan is structured, in the same conversation as tenor and repayment profile. A borrower asks for the longest amortisation because it lowers the instalment and lifts the cover ratio, as the example shows. A lender weighs that against what is left behind the loan. The trade shows in the term sheet's final maturity set against the contract's expiry, in any cover ratio measured to the end of the project rather than the end of the loan, and in what the bank asks for when renewal is the hoped-for source of repayment: a decision date on the renewal well before maturity, or a cash sweep that shortens the loan if the renewal is not won.

Outside project finance, a property loan is read against when its leases expire, and an equipment loan against the machine's working life, because a loan that outlives its asset is secured on something that has stopped earning. In each, the question is the same: if the forecast slips by a year, is there anything left to slip into?

REFINANCING A BUSINESS LOAN → · SIX MONTHS BEFORE YOUR LOAN MATURES → · DEBT SERVICE COVER →