If there is any point in the loan process that is the most critical it is the presentation of the term sheet. If done right, the term sheet ends up closing a profitable loan and if done wrong, it generates more questions and begs to be negotiated. One feature that we have found advantageous to the process is the inclusion of multiple options in loan structuring. By presenting various structural options, banks will often shift the conversation away from price, differentiate themselves from the competition and assist in optimal structure discovery. The net result is a higher level of service, the best structure for the customer and a higher ROE for the bank.
So how many options should a term sheet contain and how should bankers position their offering? The answer to the above question depends on a number of variables that should be considered holistically. First, while one option is not sufficient in most circumstances, there is also a point where too many options confuse the customer and create decision paralysis. Second, more sophisticated borrowers are able to digest and analyze more options. Third, the banker’s understanding of the borrower’s need is an important factor in dictating the number of options presented. Fourth, the complexity of the transaction will also dictate the number of options presented. As complexity increases, by necessity, the number of options for the borrower to consider may also increase. Fifth, the more complex the product the fewer options should be presented. The last point may seem counterintuitive, but consider an example of choosing from hundreds of flavors of jelly beans, and from just a handful of automobile trims. Adding more options to an already complex product can overwhelm customers.
Three is Key
The “good,” “better,” “best” option often times works in banking. The three-option term sheet helps prospects find his/her sweet spot. In most cases, three options are usually enough. Many times presenting more than three choices confuses the decision make process. Furthermore, typically bankers should make the midrange choice seem most appealing.
For example, the borrower wants a fixed rate loan. The banker presents Option 1 which is a term that is shorter than the borrower truly wants. Option 2 is a term that the borrower may accept, and option 3 is a longer term but is priced substantially higher. The customer is made to focus on Option 2, as the features of Option 1 are inferior and the pricing of Option 3 is inferior.
Understand the Borrower’s Hot Topics
We often hear from lenders that their customer is price sensitive and to win the business we need to present a term sheet that matches a competitive offer. However, when we talk to the borrowers, this is rarely the case. It is true that borrowers always want a fair price/structure, but they rarely want the lowest price and the loosest structure. Loan pricing is what gets negotiated when there is nothing else to talk about.
For example, we recently saw a term sheet for a fixed rate loan and the negotiations centered exclusively on price. The borrower obviously wanted the lowest rate. It wasn’t until some various other options were presented, did the banker find out what the borrower really wanted. The winning structure was a floating rate loan, with an option for the borrower to fix the rate in the future at a predetermined spread to Treasury rate. The borrower was not trying to push the bank on pricing but wanted the ability to take advantage of the shape of the yield curve. That is, they wanted lower rates today and the ability to fix their loan should rates rise in the future. What is most interesting is that the borrower agreed to a fixed rate in the future based on a spread to Treasury that was a higher rate than they so vigorously negotiated in the original term sheet. It turned out that the borrower wasn’t sensitive to the rate so much as they were sensitive to the interest cost during the first year before their operating income increased.
Customers, for any product, do not really know how much something should cost. Even sophisticated borrowers rely on advisors, lawyers and accounts to understand the market’s prevailing pricing and structure. To learn the market, borrowers take offers from multiple vendors (to obtain a context for pricing). Your job is to create a term sheet that creates context, or creates the perception that the borrower can compare options within the term sheet to make up their mind if the product is properly priced. This concept cannot be achieved with one or two options, which is another reason to present three (or occasionally more) options. The key to contextual pricing is to offer related choices so that customer feels comfortable making a decision. Each choice should focus the customer on one different variable and the cost of that variable. For example, give the customer the price of a floating, five, seven and ten-year fixed rate, and they can make a contextual choice based on the term structure of rates. If the customer creates their context by obtaining competing term sheets, your bank’s ROE will suffer (of course, this may be unavoidable, but keep this in strategy in mind on your next proposal).
Do not Anchor Your Price
A dangerous pitfall, particularly in this current environment, is to show a borrower a fixed loan rate that may change in the future with rising rates. Borrower’s expectations are anchored by the first price they see. If that price rises before closing, you may have a dissatisfied or frustrated customer (or worse yet, no customer at all). Between the term sheet stage and the loan closing, many months can transpire. Identify in the term sheet how changes rates in rates may influence the borrower’s rate at closing. We see lenders hide this for probably a good intent - they want to earn more if rates drop. However, invariably the strategy backfires. If rates drop the borrower is cognizant that they should receive a lower rate, but if rates rise, the borrower is indignant that their loan rate is above the anchored price.
Price to Your Competitive Advantage
All too often we see the exact same terms presented to the borrower from multiple community banks. The most frequent example is the 5-year fixed rate term loan. If you are the fifth bank showing a borrower this option, your only way to win the business is on lower price or looser credit terms (both a detriment to your bank’s ROE). You must create a differentiator that capitalizes on your bank’s competitive advantage. Can you instead offer a 15 or 20-year fixed? Can you offer the fixed rate without a prepayment penalty? Can you offer that same loan without closing costs to the borrower? If your term sheet looks similar to your competitors’, you can only negotiate on price – which is not where you want to be.
Term sheet proposals are a combination art and science. We have seen some great term sheets that won the business even though competing offers were plainly cheaper for the borrower. The above strategies are just some that we used here at CenterState that have increased our acceptance rate and created value for both the borrower and the bank.
Submitted by Chris Nichols on June 30, 2015