Let’s say your business wants to invest in a new commercial property to host its expansion. You certainly don’t want to pay for the expenses in cash. That will leave a huge hole in your cash reserves that will also drag your cash flow down. Your best course of action is to apply for a non-recourse commercial loan to finance the acquisition of the property.
Defining the Non-Recourse Commercial Loan
Non-recourse commercial financing is a form of secured loan. Borrowers will have to pledge an asset as collateral to qualify for this loan. However, the lender’s claim is limited only to that pre-selected asset. This means that the creditor will not be able to go after any other assets owned by the borrower in case there is a default.
Another difference is the repayment term. Traditional loans require the borrower to make fixed monthly payments over a predetermined repayment term. Non-recourse commercial loans, on the other hand, are paid by any profits generated by the project that had been financed.
What Benefits Does Non-Recourse Commercial Loans Have For the Borrower?
One of these advantages is the protection of the borrower’s assets. Business owners are not required to provide a personal guarantee in this form of financing. This means that their personal assets as well as the business’ other assets are not in danger of being repossessed if they fail to keep up with their obligations.
Unlike recourse financing, borrowers that have non-recourse debts need not be pressured to make fixed payments every month. All of the payments for the dent will be taken from any future profits that the business makes from the additional investment. Theoretically, it protects the enterprise’s cash flow from being stretched thin.
Non-recourse financing can also be used to enhance a borrower’s credit access when used strategically. For instance, a business that has recently achieved financial success may choose to refinance existing debts with a non-recourse loan secured by real estate. This strategy effectively decreases the company’s debt-to-income ratio and opens it up to more avenues for traditional financing.
What Types of Collateral Are Used for Non-Recourse Commercial Loans?
Entrepreneurs typically use commercial loans to fund long-term projects like acquiring new real estate, developing new facilities, or purchasing new equipment for the business. The loan is secured by these assets that the business is looking to add to its portfolio.
For example, a car manufacturer plans to expand its operations by adding a new assembly plant in a city near its corporate headquarters. The company will need to acquire the real estate as well as build the assembly plant. For that, the enterprise applies for a non-recourse commercial loan. The lender deems the business qualified for the loan, which is secured by the real estate on top of which the plant is to be built.
Securities or stock holdings, as well as pending invoices, can also be used as collateral for non-recourse financing. Although similar, these work differently from non-commercial loans that involve fixed assets and real estate.
What Is Non-Recourse Invoice Factoring?
Non-recourse invoice factoring is a sub-set of non-recourse financing that accepts pending invoices as collateral. Also known as invoice financing, lenders give qualified borrowers a cash advance equal to a fraction of the invoices’ total value. The lender then assumes the responsibility of collecting the invoices on the borrower’s behalf and returns the remaining amount when the collection concludes.
Invoices have inherent uncertainty. There’s always the risk that the customer that owes the invoice cannot settle his obligation. This makes the pending invoice a liability, but who assumes that liability depends on the type of factoring. In non-recourse invoice factoring, that liability falls upon the lender. The factor, or the company that advances money to the borrower, writes those delinquent invoices as losses.
By comparison, recourse invoice factoring reverts the liability for the unpaid invoices back to the borrower. The business has to repay the factoring company the value of the invoices that remain pending. It is up to the enterprise to collect on the invoices, or ultimately write them off as losses.
What is Securities Non-Recourse Financing?
This form of non-recourse financing provides immediate cash to people who have stock holdings. Borrowers simply transfer the shares to the borrower as security for the loan and then pay the interest every month.
This form of financing usually awards up to 90% of the stock value as a cash advance. The stock value remains in the borrower’s portfolio, although they have no rights to liquidate the stocks as long as the loan is in effect.
Non-recourse financing secured by stocks has a unique feature. When the stock’s value increases at the loan’s maturity date, borrowers can receive an extra cash payment from the lender. On the other hand, borrowers can opt to transfer full ownership of the securities to the lender if the price drops at the end of the loan.
What Happens When the Borrower Defaults on Payments?
Unlike conventional financing, non-recourse loans remove the liability of the default from the borrower and place it back to the lender. The lender, however, will exercise the right to repossess the pledged asset to recover its losses.
This arrangement places a considerable amount of risk on the part of the lender. They can seize the asset, but the burden of depreciation is on them. For instance, the business defaults on a loan that financed the construction of a new commercial property. The lender seizes both the building and the land but finds that the property has declined in value. The creditor has no choice but to write it off as a loss.
On the other hand, the borrower loses all obligation to the lender once the asset has been seized. The entire debt is considered repaid at that point, regardless of the asset’s actual value upon seizure.
What Constitutes a Default in Non-Recourse Financing?
As mentioned earlier, non-recourse financing does not require monthly installments from the borrower. Instead, the financing is repaid by future profits earned from the financed project.
For instance, a non-recourse loan that provided funds for the construction of a manufacturing facility expects payment from profits earned when the facility goes into operation. The borrower is considered to be in default when the facility does not turn in any profit from which payment can be made. It is the lender’s discretion to provide a grace period, after which it can exercise its right to the seizure of the asset.
A further example would be non-recourse financing that refinances a mortgage for a commercial property. The borrower pays off the mortgage and gains the right to either sell off the property for a profit or offer it for a long-term lease. The property owner is considered in default if he fails to sell off the property, or nobody leases the property within a certain time.
How Does a Borrower Qualify for Non-Recourse Financing?
Non-recourse financing is actually a very uncommon form of financing. It also has very stringent requirements from the borrower.
The company must, first and foremost, maintain a very high credit score. The business should also demonstrate consistent profitability in its most recent financial statements. It must also have a doable business plan with clear goals and action items. These are necessary to make sure that the project to be financed can turn in profits once it is operational.
In other words, the business must demonstrate good financial standing and a positive history of settling existing debts. The business should also demonstrate the long-term viability of the project and its plans to achieve profits in the future.
Aside from its strict rules on qualification, non-recourse financing also slaps borrowers with higher interest rates than its recourse counterpart. This is one of the means for the lender to protect itself from the inherent risk, together with the Bad Boy Guaranty.
What Is a “Bad Boy Guaranty”?
As mentioned earlier, non-recourse financing involves a tremendous amount of risk for the lender. Their only means of compensation in case of a default is to repossess the collateral. However, they have to seize the asset regardless of its actual value. Thus, the lender incurs more losses if the asset’s value has depreciated at the time of default.
The law, however, provides protection for the lender through the Bad Boy Guaranty. Businesses that do qualify for non-recourse financing are required to sign this guaranty. This document establishes provisions that enable the lender to go after assets beyond the collateral if the borrower has willfully committed acts that diluted its value right before default.
The actual guarantee provisions vary from lender to lender. However, the following events are commonly covered by carve-out provisions in non-recourse financing:
- The business has filed for protection under bankruptcy law.
- The borrower was unable to pay taxes on the property.
- The borrower is involved in fraudulent activities and other criminal acts related to the business.
- The borrower has failed to keep up with insurance requirements for the pledged asset.
Non-recourse financing is a more difficult option to qualify for. However, businesses that do qualify for these types of loans can enjoy several distinct benefits to their cash flow. Aside from cash flow advantages, these loans also provide protection to the borrower’s assets as well as clear enough credit for traditional and recourse financing.