Backup underwriting facility fee: Meaning, Criticisms & Real-World Uses

What Is Backup (Underwriting) Facility Fee?

A backup (underwriting) facility fee is a charge paid by a borrower to a financial institution for providing a committed line of credit or a standby facility that can be drawn upon if needed. This fee falls under the broader category of Corporate Finance, specifically within debt financing and liquidity management. It essentially represents the cost of having a safety net, ensuring access to funds even if other funding sources become unavailable or too expensive. Companies, particularly those that rely on issuing short-term debt like commercial paper, often maintain these backup facilities to mitigate liquidity risk. The fee compensates the bank for committing capital, even if the funds are never actually used, reflecting the bank's obligation to provide the financing when called upon.

History and Origin

The widespread adoption of backup facilities, and thus the associated fees, gained prominence following significant disruptions in short-term funding markets. A notable driver was the Penn Central Railroad's bankruptcy in 1970, which led to a major default in the commercial paper market. This event highlighted the fragility of relying solely on commercial paper issuance without a robust alternative source of liquidity. Consequently, corporate commercial paper issuers began to secure backup loan commitments from banks as a form of insurance against market-wide liquidity disruptions. Within a few years after this crisis, almost all corporate commercial paper issuers held backup loan commitments covering 100% of their outstanding commercial paper.⁶ These commitments were typically provided by banks, offering a crucial liquidity backstop. The fees for these facilities became a standard component of corporate debt financing arrangements, ensuring that companies could access funds even during periods of market stress. Similarly, during the 2008 Global Financial Crisis and the 2020 COVID-19 pandemic, the Federal Reserve established the Commercial Paper Funding Facility (CPFF) to stabilize the commercial paper market, requiring issuers to pay a facility fee for participation.⁵

Key Takeaways

A backup (underwriting) facility fee is charged for a committed line of credit that provides a liquidity safety net.
It compensates banks for reserving capital and guaranteeing fund availability.
The fee is typically a percentage of the unused portion of the committed facility.
Such facilities are crucial for companies relying on short-term financing, like commercial paper.
The fee is a cost of maintaining financial flexibility and managing liquidity risk.

Formula and Calculation

The backup (underwriting) facility fee is typically calculated as a small percentage of the unused portion of the committed credit facility.

The formula is as follows:

$\text{Backup Facility Fee} = \text{Committed Amount} \times \text{Unused Portion Percentage} \times \text{Facility Fee Rate}$

Where:

Committed Amount: The total amount of credit that the financial institution has committed to make available to the borrower.
Unused Portion Percentage: The percentage of the committed amount that has not been drawn down by the borrower.
Facility Fee Rate: The annual percentage rate charged by the bank on the unused portion, often expressed in basis points (e.g., 0.10% or 10 basis points).

For example, if a company has a \$100 million backup facility with a 0.15% annual facility fee rate on the unused portion, and \$70 million of the facility is currently unused, the annual fee would be calculated on that \$70 million.

Interpreting the Backup (Underwriting) Facility Fee

The backup (underwriting) facility fee reflects the cost a company incurs to ensure access to capital, regardless of market conditions. A higher fee rate might indicate that the lender perceives a greater risk in the borrower's ability to repay or a less robust credit rating. Conversely, a lower rate is typically offered to highly creditworthy companies. From the borrower's perspective, this fee is a recurring operational expense, often disclosed on their balance sheet or in financial statements. It's a trade-off: paying a small fee annually provides crucial peace of mind and operational stability, especially for businesses with fluctuating cash flows or those highly reliant on capital markets for funding. The existence of such a facility, supported by the fee, signals to investors and creditors that the company has a robust risk management strategy in place to handle unexpected liquidity needs.

Hypothetical Example

Imagine "GreenTech Innovations Inc." needs to ensure it can always access up to \$50 million for its operations and unforeseen investment expenditures, even if the commercial paper market tightens. They arrange a backup (underwriting) facility with "Apex Bank" for \$50 million. Apex Bank charges an annual backup facility fee of 0.10% on the unused portion.

In the first year, GreenTech draws \$10 million from the facility, leaving \$40 million unused.

The backup facility fee for that year would be calculated on the unused portion:

$\text{Fee} = \$50,000,000 \times \frac{\$40,000,000}{\$50,000,000} \times 0.0010$
$\text{Fee} = \$50,000,000 \times 0.80 \times 0.0010$
$\text{Fee} = \$40,000,000 \times 0.0010 = \$40,000$

So, GreenTech Innovations Inc. would pay Apex Bank \$40,000 for the year, in addition to any interest on the \$10 million they actually borrowed. This fee guarantees that the remaining \$40 million is available whenever GreenTech needs it, supporting their working capital and broader financial stability.

Practical Applications

Backup (underwriting) facilities and their associated fees are prevalent across various sectors of finance and business.

Corporate Liquidity: Many large corporations utilize these facilities to backstop their commercial paper programs. Should the money market become illiquid or their commercial paper become difficult to roll over, the backup facility ensures continued access to funds.⁴
Project Finance: In large-scale infrastructure or development projects, a backup facility might be mandated by lenders to ensure that the project has sufficient liquidity to complete construction or meet unexpected costs, providing a safety net against unforeseen delays or cost overruns.
Mergers & Acquisitions: Companies involved in M&A often secure significant credit facilities, some of which act as backup lines, to ensure they can fund acquisitions or manage post-merger integration costs if market conditions deteriorate.
Crisis Management: During periods of economic uncertainty or financial crisis, companies frequently draw down on their pre-committed credit lines to shore up cash positions, demonstrating the critical role of these backup facilities. For instance, in spring 2020, during the onset of the COVID-19 pandemic, nonfinancial firms drew down an estimated half-trillion USD from their pre-committed lines of credit to bolster liquidity.³ This "dash for cash" highlighted how these facilities provide crucial stability in times of stress.
Regulatory Compliance: Banks themselves, as financial institutions, often hold backup facilities or participate in syndicated loan agreements that provide liquidity support, especially in light of stricter liquidity requirements imposed by regulatory bodies like the Basel Committee on Banking Supervision. The Bank for International Settlements (BIS) plays a role in fostering cooperation among central banks regarding financial stability, which includes discussions on liquidity requirements and facilities.²

Limitations and Criticisms

While backup (underwriting) facilities are essential for corporate liquidity and risk management, they are not without limitations or criticisms. One primary concern is the "material adverse change" (MAC) clause often included in facility agreements. This clause allows the lending bank to refuse to honor a drawdown if the borrower experiences a significant deterioration in its financial condition, precisely when the borrower needs the funds most. This can undermine the very purpose of the backup facility as a reliable safety net.

Another criticism relates to the cost. While the fee is usually a small percentage, it is still an expense incurred even if the facility is never used. For companies operating on thin margins, this recurring fee can be a drain on profitability, particularly if alternative, cheaper funding avenues are always available. However, this perspective often overlooks the implicit insurance value of the fee.

Furthermore, the very act of drawing down a backup facility, especially during a crisis, can sometimes be interpreted by the market as a sign of financial distress, potentially leading to negative perceptions, even if the drawdown is purely precautionary. This can impact a company's stock price or future borrowing costs in the capital markets. Studies have shown that while firms use drawdowns to sustain investment after an idiosyncratic liquidity shock, the effect is significantly amplified during a financial crisis.¹

Finally, from a systemic perspective, widespread, simultaneous drawdowns by multiple companies during a broad economic crisis could theoretically strain the banks providing these facilities, even though post-crisis regulations aim to ensure banks maintain sufficient liquidity to meet such demands.

Backup (Underwriting) Facility Fee vs. Commitment Fee

The terms "backup (underwriting) facility fee" and "commitment fee" are often used interchangeably because they refer to essentially the same concept in the context of a credit facility. Both are charges paid by a borrower to a lender for keeping a specified amount of credit available for use.

Backup (Underwriting) Facility Fee: This term emphasizes the purpose of the fee—to backstop a company's funding, often specifically its commercial paper or other short-term debt, providing an underwriting-like assurance of liquidity. The "underwriting" aspect highlights the bank's role in providing a guaranteed source of funds, much like an underwriter guarantees the sale of securities.
Commitment Fee: This is a broader term that simply refers to the fee charged for a lender's commitment to make funds available. It applies to various types of credit lines, including revolving credit facilities, and does not necessarily imply a specific purpose like backing commercial paper.

In practice, a backup facility fee is a type of commitment fee, specifically one levied on a credit line designed to serve as a secondary or emergency source of funds. The calculation method (percentage of the unused portion) is identical for both. The distinction, if any, often lies in the specific context and the primary intended use of the facility.

FAQs

Why do companies pay a backup (underwriting) facility fee if they don't use the credit?

Companies pay this fee because it's the cost of having guaranteed access to funds when needed, even if they don't actually borrow. It's like paying for an insurance policy; the fee ensures financial stability and provides a crucial liquidity backstop in case primary funding sources become unavailable or too expensive.

Is the backup facility fee a one-time charge or recurring?

The backup (underwriting) facility fee is typically a recurring charge, usually paid annually or quarterly, for as long as the credit facility remains active. It compensates the bank for committing capital over time.

How does a backup facility help a company's credit rating?

Maintaining a robust backup facility can positively influence a company's credit rating. Rating agencies view these facilities as a sign of strong liquidity management and reduced financial risk, indicating that the company is prepared for unforeseen funding challenges.

Can the backup facility fee rate change?

Yes, the backup (underwriting) facility fee rate can change. It is usually determined by market conditions, the borrower's creditworthiness, and the specific terms negotiated with the lending financial institution. Rates may be adjusted upon renewal of the facility or if there's a significant change in the borrower's financial health.