Backup underwriting facility

What Is a Backup (Underwriting) Facility?

A backup (underwriting) facility is a specialized form of credit line provided by a bank or a syndicate of banks to a corporate borrower. Its primary purpose within the realm of corporate finance is to serve as a contingency source of liquidity management, ensuring that a company can meet its short-term financial obligations, particularly in the event it cannot roll over its outstanding commercial paper or access other forms of short-term funding in the capital markets. This facility effectively acts as a safety net, enhancing the issuer's creditworthiness and reassuring investors.

History and Origin

The evolution of the backup (underwriting) facility is closely tied to the development of short-term debt markets and the increasing sophistication of financial institutions. As corporations began to rely heavily on commercial paper for short-term financing, the need arose for a mechanism to mitigate rollover risk—the risk that maturing commercial paper cannot be reissued or repaid. Commercial banks, with their deep lending relationships and role in underwriting various securities, naturally stepped in to provide these crucial facilities.

Historically, commercial banks faced regulatory restrictions, such as those imposed by the Glass-Steagall Act of 1933, which limited their involvement in securities underwriting. However, reforms in the late 20th century gradually dismantled these barriers. For instance, in 1987, the Federal Reserve began allowing commercial banks to underwrite commercial paper, municipal revenue bonds, and asset-backed debt through special "Section 20 subsidiaries." This expansion of permissible activities for commercial banks fostered greater competition in the underwriting market, leading to lower underwriting spreads for companies. Research indicates that commercial bank entry into underwriting had a pro-competitive effect that persisted for many years after their initial entry.

¹⁴## Key Takeaways

• A backup (underwriting) facility is a committed credit line that provides a company with a guaranteed source of funds.
• It primarily serves as liquidity support for issuers of short-term debt instruments, such as commercial paper.
• This facility helps mitigate rollover risk, assuring investors that the issuer can repay maturing obligations even if market conditions are unfavorable.
• Banks charge a commitment fee for providing a backup (underwriting) facility, which contributes to the overall cost of issuing commercial paper.
• Possessing such a facility can improve a company's credit rating and reduce its borrowing costs.

Interpreting the Backup (Underwriting) Facility

A backup (underwriting) facility is not typically drawn upon unless market conditions prevent an issuer from rolling over its commercial paper or if the company experiences a sudden cash flow shortfall. Its mere existence signals financial strength and prudent risk management to the market.

For an issuer, having a backup (underwriting) facility means that its commercial paper is effectively "liquidity enhanced." Credit rating agencies often require evidence of short-term liquidity, and a robust backup facility is a key factor in achieving and maintaining a strong credit rating for commercial paper. Highly rated issuers of commercial paper may maintain backup liquidity for as little as 50% of their outstanding paper, while those with lower investment grade ratings often need to maintain 100% backup coverage.

¹³## Hypothetical Example

Consider "Tech Innovations Inc.," a publicly traded technology company that frequently issues commercial paper to finance its working capital needs, such as inventory and payroll. Tech Innovations needs $50 million for three months and plans to issue commercial paper to raise these funds.

To enhance the market's confidence in its commercial paper, especially given potential market volatility, Tech Innovations approaches "Global Bank." Global Bank agrees to provide a $50 million backup (underwriting) facility. In exchange for this commitment, Tech Innovations pays Global Bank an annual commitment fee, typically a small percentage of the unused portion of the facility.

Suppose that two months after issuing the commercial paper, unexpected market turmoil makes it difficult for Tech Innovations to issue new commercial paper to repay the maturing debt. Because it has the backup (underwriting) facility in place, Tech Innovations can draw on the $50 million credit line from Global Bank to pay off its maturing commercial paper. This prevents a default, protects investors, and allows Tech Innovations to maintain its financial reputation and stability. Once market conditions improve, Tech Innovations can then issue new commercial paper or arrange alternative financing to repay Global Bank.

Practical Applications

Backup (underwriting) facilities are commonly used by large, creditworthy corporations that rely on the commercial paper market for flexible, short-term funding. These facilities are integral to effective corporate liquidity management.

Specific applications include:

• Commercial Paper Support: The most common use is to provide liquidity support for commercial paper programs, mitigating rollover risk. This ensures that issuers can always repay maturing commercial paper, even if market conditions deteriorate. As demonstrated by the contraction of the Swedish commercial-paper market during the COVID-19 pandemic, backup lines provide reliable liquidity insurance to commercial-paper issuers.
  *¹² Contingency Funding: Companies utilize these facilities as a general contingency funding source to cover unexpected needs or shortfalls in operating cash flow, acting as a buffer against unforeseen expenses.
• Credit Enhancement: The presence of a backup (underwriting) facility can significantly enhance a company's creditworthiness in the eyes of investors and credit rating agencies. This can lead to lower interest rates on their commercial paper and other borrowings, as well as broader access to various funding sources. S&P Global Ratings, for example, assigns forward-looking opinions on an issuer's relative creditworthiness, which can be positively influenced by such facilities.
  *¹¹ Regulatory Compliance: For some financial entities, maintaining specific types of liquidity facilities, including backup lines, may be influenced by regulatory requirements like the Liquidity Coverage Ratio (LCR), which dictates how much high-quality liquid assets banks must hold against undrawn credit lines.

¹⁰Raising capital, whether through commercial paper or other securities, often involves navigating regulatory frameworks. The U.S. Securities and Exchange Commission (SEC) provides guidance and regulations for companies issuing securities. For instance, while commercial paper with maturities under nine months is generally exempt from SEC registration, ensuring adequate liquidity and investor protection remains paramount, which backup facilities help address. The SEC offers various resources for companies looking to raise capital, outlining different pathways and compliance requirements.

⁹## Limitations and Criticisms

While highly beneficial, backup (underwriting) facilities are not without limitations or criticisms:

• Cost: Banks charge a commitment fee for providing a backup (underwriting) facility, which can be a significant expense, especially for large facilities that remain undrawn. These fees increase the overall cost of short-term financing, even if the facility is never used.
• Conditions Precedent: Although committed, these facilities are subject to certain conditions precedent. If a company's financial condition deteriorates severely (e.g., a breach of financial covenants on its balance sheet), the bank may be able to avoid its obligation to lend, precisely when the company needs the funds most.
• Moral Hazard: Some critics argue that the availability of backup facilities could create a moral hazard, where companies might take on more credit risk by relying too heavily on the implicit guarantee rather than maintaining sufficient internal liquidity.
• Over-reliance: An over-reliance on external liquidity providers, even committed ones, can be a vulnerability. In systemic crises, even committed facilities could face challenges if numerous borrowers attempt to draw simultaneously, straining the banking system. The Federal Reserve, for example, has historically established various liquidity facilities during financial crises to support market functioning when private markets are impaired.

⁸## Backup (Underwriting) Facility vs. Committed Credit Line

A backup (underwriting) facility is a specific type of committed credit line, but the terms are not entirely interchangeable.

| Feature | Backup (Underwriting) Facility
[TERM_CATEGORY] is a financial concept that falls under the broader category of liquidity management, encompassing strategies that enable firms to maintain sufficient cash and access to funding to meet their short-term obligations and capitalize on opportunities.

A backup (underwriting) facility is a formal, committed agreement between a company and one or more banks, serving as a contingent source of liquidity. This facility assures investors, particularly those in the commercial paper market, that the issuer has guaranteed access to funds to repay maturing short-term debt, even if market conditions prevent the reissuance or "rollover" of new commercial paper. This provides crucial financial stability for the issuing company.

History and Origin

The concept of a backup (underwriting) facility emerged as a critical component in the evolution of corporate financing, particularly with the widespread adoption of commercial paper as a short-term funding tool. Corporations recognized the cost-effectiveness and flexibility of issuing commercial paper directly to investors, bypassing traditional bank loans for certain liquidity needs. However, this form of unsecured debt carried the inherent risk that an issuer might not be able to sell new paper to repay old paper when it matured—known as rollover risk.

To mitigate this risk and enhance the marketability of their commercial paper, companies began securing lines of credit from banks that would "back up" their commercial paper programs. Initially, the involvement of commercial banks in securities underwriting was restricted by legislation like the Glass-Steagall Act of 1933 in the United States, which aimed to separate commercial banking from investment banking activities.

However, over several decades, regulatory changes allowed commercial banks to gradually re-enter the securities business. Notably, in the late 1980s, the Federal Reserve Board granted commercial banks "Section 20 powers," permitting them to engage in limited securities underwriting activities through specialized subsidiaries. This included the ability to underwrite commercial paper. Thi⁷s pivotal shift enabled commercial banks to formally offer backup facilities as part of their broader underwriting services, solidifying their role as providers of liquidity insurance to corporate issuers. Academic research has shown that the entry of commercial banks into underwriting had a pro-competitive effect on the market, contributing to lower underwriting spreads.

##⁶ Key Takeaways

• A backup (underwriting) facility is a committed line of credit that guarantees a company access to funds from a bank.
• Its primary function is to provide liquidity insurance for short-term debt, particularly commercial paper, safeguarding against rollover risk.
• Companies pay a commitment fee to the bank for the availability of the facility, regardless of whether it is drawn upon.
• Having a backup facility can improve a company's credit ratings and make its short-term debt more attractive to investors.
• These facilities are vital for corporate liquidity management and maintaining financial flexibility.

Interpreting the Backup (Underwriting) Facility

The presence and size of a backup (underwriting) facility are important indicators¹²³⁴⁵