Understanding the Economics of Syndicated Loan Trading and Funding Memos

Syndicated loan trading is a vital component of the broader leveraged finance market, allowing lenders to manage risk exposure, optimize capital allocation, and enhance liquidity. However, loan trading is complex due to settlement delays, accrued interest considerations, and various economic components that affect both buyers and sellers. This article will break down key financial elements such as delayed compensation (delayed comp), cost of carry, net back, economic benefit, and the assignment fee—all critical components of a funding memo.

In this writing, I will do my best to keep it basic and for the LSTA United States way of doing funding memos. In other blog posts I will share more complex examples like – multiple contracts, PIK, non pro-rata, multi-currency. I will also share about European and Asian markets in other writings.

The Role of the Funding Memo in Syndicated Loan Trading

A funding memo is a document prepared when a loan trade is set to settle. It outlines the detailed economics of the transaction, including all costs, fees, and adjustments that determine the final amount payable by the buyer and the proceeds received by the seller.

Because syndicated loan settlements often do not occur instantly (unlike public equities, which typically settle in T+2 or T+1 or same day settlement), various financial adjustments ensure both parties receive fair compensation for the time between trade execution and settlement.

Delayed Compensation (Delayed Comp) and Cost of Carry

Delayed Compensation (Delayed Comp)

Delayed compensation, often referred to as delayed comp, is a key mechanism designed to ensure fair economic treatment between the buyer and seller when settlement is delayed beyond the industry standard settlement period.

• How It Works:

• When a syndicated loan trade does not settle within the standard LSTA settlement window (T+7 for par trades and T+20 for distressed trades), the seller compensates the buyer for the interest and fees that accrued beyond the standard settlement period. The agent bank will pay the interest to the holder of the record until actual settlement date.

• Delayed comp applies when the delay is not the fault of the buyer (e.g., agent bank processing delays or administrative bottlenecks).

• If a delay is caused by the buyer (e.g., incomplete documentation), delayed comp may not apply, or it may be adjusted.

• Why It Matters:

• Since loans accrue daily interest, delayed comp prevents a situation where the buyer loses out on accrued interest while waiting for settlement.

• Delayed comp is calculated based on the principal amount of the traded loan and the loan’s interest rate and the number of business days post contractual settlement date to actual settlement date.

Example (LSTA) (Note: in Europe and other countries standards are different):

Let’s say we have a trade for 1,000,000 quantity facility term loan at a price of 95 and the trade date is Monday, July 8th, 2024, the contractual settlement date is T+7, making Wednesday July 17th, 2024 that date. The trade actually settles on Wednesday July 31st, 2024; this is 10 days past the contractual settle date.

The seller owes the buyer 10 days of delayed compensation. Let’s say the all in rate is 8%, which is comprised from a spread of 3% and a base rate of 5%. The calendar rate is actual/360 for the calculation.

The amount due from seller to buyer would be $2,222.22 for delayed compensation.

Cost of Carry

Cost of carry refers to the economic burden of holding a loan between the contractual settlement date and actually settlement date. Had the trade settled on time, the seller could have used that money to invest in the market. Because the trade did not settle, the seller does not have those funds available to reinvest and thus is due a cost of carry compensation.

• For the Buyer:

• The buyer is compensated with delayed compensation, as if they had settled the trade on time. This amount was $2,222.22 in the example above.

• For the Seller:

• The seller continues to hold the loan on its books until actual settlement, and the agent bank pays the seller for interest accrued, but paid this in delayed compensation. The seller then receives compensation for not receiving the funds on the contractual settlement date.

In summary, cost of carry represents the financial burden associated with delays, and traders incorporate this factor into their pricing models when buying and selling loans.

Example (LSTA):

The buyer owes the seller 10 days of cost of carry. Let’s say the all in rate is 8%, which is comprised from a spread of 3% and a base rate of 5%. The calendar rate is actual/360 for the calculation. Cost of carry is calculated using the average of the base rate for the 10 days. Let’s assume the average of the base rate for the 10 days, is also 5% (note it could be slightly different depending on the fluctuation of the reference rate associated with the base rate allocation – in the US typically SOFR). The base for calculating the cost of carry is the quantity * price, in this example would be 950,000

The amount due from buyer to seller would be $1,319.44 for cost of carry.

Net Back: For the Unfunded Portion

What Is Net Back?

The net back refers to the adjustment made for the unfunded portion of a loan when it is trading above or below par (100). If the loan is trading below par, the buyer will eventually fund the unfunded portion at par (100) but will receive the difference between the purchase price and par as compensation. Conversely, if the loan is trading above par, the buyer will still fund the unfunded portion at 100 but will pay the difference between 100 and the higher purchase price to the seller. This adjustment ensures that the economics of the trade remain fair when factoring in future funding obligations. Economic not to be confused with economic benefit of the trade.

Example:

Let’s say we have a 2,000,000 quantity facility revolver for which 1,500,000 is funded and 500,000 is unfunded. The price of the trade is 90. The dates in this example do not matter, those are handled in the delayed compensation and cost of carry calculation. To help comprehend this net back charge, if the trade settled today for a quantity of 2,000,000 at 90, and the next day the borrower requests the 500,000 that was unfunded to be funded the buyer would have to fund this loan at 100; so immediately the buyer would have a loss. Thus, the 500,000 * .10 = $50,000 is paid to the buyer from the seller for net back of the unfunded portion.

Economic Benefit: Understanding Profitability

The economic benefit in a syndicated loan trade is impacted by any principal paydown (or prepayment) that occurs between the trade date and the settlement date. If a paydown occurs, the funding memo must account for the economic adjustment between the buyer and seller.

If the paydown is at par (100) and the trade price is 90, the buyer—had the trade settled on time—would have received the paydown at 100. To reflect this, the seller compensates the buyer for the difference of 10 per unit of principal that was paid down.

Similarly, if the trade price is 120 and the paydown occurs at 100, the buyer should have received the paydown at 100, not at the higher trade price. To correct this, the seller reimburses the buyer for the 20 per unit of principal that was paid down, ensuring the buyer is made whole as if they had held the position at the time of the paydown.

Example:

Let’s say we have a 1,000,000 quantity facility term loan. The trade is for a price of 90. After trade date there is 10% paydown of the term loan at a price of 100, making the quantity 900,000. The calculation for this trade would be 900,000 *.90 = $810,000 now take into account the paydown difference of 100 to 90, thus subtract from the cost the difference the buyer is entitled to post trade date 100,000 * .10 = 10,000, total settlement of the trade being $800,000 ($810,000 minus $10,000) the buyer pays seller for the trade.

Additional note. When a paydown has occurred for a facility and there are pending trades, typically the cost of carry is calculated on the updated quantity amount for the entire calculation period, the delayed compensation quantity is calculated to the exact quantity amount for each date – thus if the paydown occurs between contractual and actual settlement date – then the quantity calculation will be different for the periods of actual quantity pre and post the paydown. If the paydown occurs on a revolver and the commitment is not reduce thus changing the funded and unfunded portions, the net back will be calculated based on the updated amount.

Assignment Fee: The Cost of Loan Transfers

What Is the Assignment Fee?

The assignment fee is a charge imposed by the agent bank to process the transfer of loan ownership from the seller to the buyer.

• Typical Assignment Fees:

• Par trades: $3,500 per assignment (LSTA standard).

• Distressed trades: Higher fees, often exceeding $7,500, due to increased administrative complexity.

• Who Pays?

• In most cases, the buyer pays the assignment fee.

• Some trades negotiate a split fee arrangement, or the seller may pay in cases where the trade was initiated at their request.

Why It Matters:

• Assignment fees add to the cost of trading, making it important for buyers to factor them into trade economics.

• Certain large trades involve multiple assignments, multiplying the assignment fee cost for participants.

• Fees can differ based on the agent bank, region, and type of loan, requiring careful due diligence.

Why These Elements Matter in Loan Trading

Understanding the economic mechanics of syndicated loan trading is essential for institutional investors, banks, and funds that participate in the market. Every transaction involves more than just the principal amount—factors like delayed compensation, cost of carry, net back, economic benefit, and assignment fees can significantly impact a trade’s profitability.

The funding memo consolidates all these moving pieces into a single document, ensuring transparency in trade settlements. Mastering these concepts allows market participants to optimize their trading strategies, mitigate risk, and maximize returns in the ever-evolving syndicated loan market.

Cheers,

Gage Gorman