Mandatory Prepayment: a Worked Example

A loan is sized against a business as it stands: its assets, its earnings and the security behind them. A sale changes all three at once. The asset leaves the security, its earnings leave EBITDA, and unless the cash comes back to the lender, the same debt now rests on a smaller business. Insurance proceeds replace an asset that has been destroyed, so a lender wants either the asset rebuilt or the money. New borrowing or new equity changes the capital structure the lender agreed to, and a change of control changes who it is lending to.

Each of these is an event the borrower chooses or cannot avoid, not a default. The clause therefore works without any judgment about the borrower's health: when the event happens, the money follows the formula.

Each term is defined. Exclusions commonly cover disposals in the ordinary course, small disposals below a stated amount, and an annual allowance. Reinvestment rights let the borrower keep proceeds that it applies, or commits to apply, to replacement assets within a set window, with any unspent balance prepaid when the window closes. Insurance proceeds are often allowed to fund reinstatement first. Change of control is usually treated separately: some agreements let each lender cancel and be repaid, others make the whole facility fall due.

Then comes application. A prepayment can reduce the instalments in inverse order of maturity, which shortens the loan's tail; pro rata across the instalments, which lowers each repayment; or the term loan before a revolving line. A repayment of a revolver may or may not cancel the commitment. Each choice gives the lender a different loan afterwards.

A cold-storage operator, constructed for this page like every figure in it, runs four warehouses on a US$40m term loan against EBITDA of US$10m. It sells one warehouse for US$12m. The racking inside it is on equipment finance. The agreement excludes disposals under US$1m and allows proceeds to be reinvested within twelve months; both terms are the example's.

The warehouse earned US$1.8m of EBITDA, so the business that is left earns US$8.2m. The leverage the lender holds after settlement depends on how much of the cash came back. The lines count debt only, on the footing that cash not prepaid or reinvested is spent elsewhere:

Without the clause, once the cash had gone elsewhere, the operator would be more highly geared after selling an asset than before. With it, leverage is close to where it started, and the US$3.5m kept back has to earn its place: if only US$2.0m is spent by the end of the window, the remaining US$1.5m is prepaid then. The lender's mortgage over the warehouse is released at settlement against the US$6.5m, which is where the payout figure and the partial release come in.

A voluntary prepayment is the borrower's choice. It decides the timing, gives notice, repays in minimum amounts and may pay a prepayment fee for the privilege. A mandatory prepayment is the lender's right, triggered by an event, and the agreement decides the amount and the date. Agreements differ on whether a fee applies to mandatory prepayments, but break costs on fixed-rate funding usually follow either way, because the cost of unwinding the funding does not depend on who chose to repay.

Both kinds raise the same hedging question. A borrower that fixed its rate with a swap sized to the loan is left with more swap than loan once part is repaid. Leaving the swap in place means over-hedging; closing part of it crystallises its mark-to-market, which can be a cost or a gain.

DEFINED IN ONE PARAGRAPH → · PRODUCT FILE: TERM LOAN → · THE CASH SWEEP →

The clause is negotiated before signing, and its value to each side sits in the details. A borrower planning to sell surplus property wants generous exclusions and a long reinvestment window; a lender that sized the loan on that property wants the proceeds. Which subsidiaries' sales count, whether tax is deducted as paid or as estimated, and whether reinvestment must be committed or merely intended all move the amount.

Once the facility is running, the clause decides the conversation when a sale is proposed. A borrower that reads it early can structure the sale, the reinvestment and the timing of any swap break together. One that reads it after signing the sale contract finds the settlement statement already written. Insurance proceeds follow the same path, with the bank recorded as loss payee so that the money reaches the formula first.