Lenders and borrowers can team up with other lenders and borrowers to reduce their exposure to risk and increase their profits. These relationships, which come in many flavors, are called participation loans.
At one time in life, you may have considered going in on purchasing a boat or a mountain cabin with your friends. It's certainly true that, where money's involved, there's power in numbers. Pooling investment dollars is a popular practice-one that's resulted in the advent of mutual funds, REITs and the like. Participation loans follow the same concept, only the investment at hand is a credit facility.
In a generic sense, the term participation loan refers to three different types of partnerships that involve financing. A group of owners can get together as borrowers; a lender can partner with the borrower, taking an ownership stake in the project being financed; or a group of lenders can partner up, jointly fulfilling the debt needs of one borrower.
Participation among borrowers
When borrowers team up, it's usually to increase purchasing power and reduce risk. For the purposes of the financing, each partner in the project becomes an individual borrower or mortgagee on the loan. In most cases, the lender would require each borrower to be individually responsible for the entire amount of the loan.
Participation between borrower and lender
Participation between a borrower and lender occurs most often in commercial real estate mortgages. The lender offers more attractive loan terms in exchange for a share of the proceeds when the property is sold. A lender might ask for a participation arrangement if the mortgage is funding the purchase of undeveloped commercial property that will be developed and sold for profit.
Participation among lenders
Participation among lenders is a common practice in the realm of commercial business lending. There are several reasons why a lender would be motivated to team up with its competitors, but most of them can be boiled down to risk and the need to diversify. Lenders manage their loan portfolios as carefully as investors manage their investments; they diversify and avoid over-exposure in one particular industry or economic segment. Since a large credit facility could easily upset a lender's diversification strategy, the lender may have to recruit partner lenders to share in the risk. On the flip side, a lender with small capital assets may have difficulty lending out enough to keep its loans diversified. Participation allows this lender to diversify by taking small shares in various credit facilities.
Under a participation arrangement, the originating lender, called the lead bank, is the customer's primary point of contact. The lender usually informs the customer of its intention to bring in partner lenders during the proposal and negotiation phase.
In short, borrowers and lenders are often open to new partnerships that help them reduce risk. Just as you wouldn't have considered buying that boat on your own, many financing transactions wouldn't be possible without participation arrangements.