Co-Authored by Jordan Peters.
When school districts consider their options for bringing an issue to market, whether it is for a new project or refinancing existing debt, the most common alternatives tend to be a competitive or negotiated transaction in the capital market. Another choice that in some cases may be suitable for school districts to consider in their decision-making process is a direct bank purchase. The working group, document preparation, structural considerations, and other transaction procedures differ from a capital markets issue. These differences, among others, are discussed below.
A Bank Purchase and the Participants
In a direct bank purchase, a school district works with a bank to structure a loan that is purchased by the bank at a single interest rate for each maturity. For a capital markets transaction, an underwriter offers the school district’s bonds to the public at a unique interest rate per maturity and takes any unsold balances into inventory to trade at either a profit or a loss. The school district, as in a capital markets transaction, works with its bond counsel to obtain the necessary resolutions and ensure that all legal requirements are met. If the school district has a municipal advisor, the advisor can assist in document review, structuring the transaction, reviewing proposals from the bank(s), providing analysis of bank placement or capital markets options, and coordinating the closing process, although due to regulatory restrictions, they cannot negotiate the interest rate directly with a bank. A recent Securities and Exchange Commission (SEC) temporary exemptive order, however, allowed municipal advisors to solicit banks in connection with direct placements of securities issued by their municipal issuer clients effective through Dec. 31, 2020.
Any bank purchasing the debt may choose to engage legal counsel to review documents and assist the bank with its own legal requirements throughout the transaction. Some banks may have an in-house counsel that will act in this capacity. If the contemplated transaction is a refunding, a verification agent will likely be involved and an escrow agent may also participate, depending on the type of refunding.
Documents and Credit Review
A bank purchase, just as a capital markets transaction, requires authorization from the school district’s board of education. If a bank purchase is under consideration, a bond resolution may include the option of either a capital markets transaction or a bank direct purchase to provide the school district flexibility to move forward with the transaction deemed most appropriate given the structure. Because a bank purchase is not offered to the wide breadth of investors that a capital markets transaction is, an official statement is not required, in most cases, to complete this type of issue. Additionally, a credit rating obtained from a major credit rating agency is also not likely required. A bank will conduct its own credit review of the school district and may work with the district to review its financial position as the transaction progresses. With no offering document or credit rating, bank purchases can be executed in a shorter period compared to a capital markets issue and potentially, at a lower cost. Given recent developments with disclosure requirements, school districts may need to disclose the bank purchase as a financial obligation. Bond counsel can assist school districts with making that determination and help navigate them through that process if necessary.
Structural Considerations for Bank Purchases
Shorter transactions tend to be more suitable for bank purchases. Numerous banks are willing to lend funds to school districts for transactions that mature within ten years. Fewer banks are willing or able to lend out to 15 years and even fewer out to 20 years. Smaller transactions for which a capital markets issue may be cost-prohibitive and which may be subject to higher interest rates because of small principal payments each year may lend themselves to a bank purchase as well. Many school districts rely on the generation of additional bond proceeds in a capital markets transaction to pay the costs of the transaction or to fund an escrow (if necessary) for a refunding. Few banks offer a structure that will generate these additional proceeds; thus, school districts may need to pay transaction costs out-of-pocket or contribute additional equity to a refunding.
In deciding if a direct bank purchase or capital markets transaction is appropriate for the district, the potential financial and administration advantages, including estimates of costs of issuance and underwriter’s expenses, should be weighed.
Bank Selection
School districts moving forward with a bank purchase may identify a particular bank with whom they are interested in working or engage in a competitive request for proposal (RFP) process to select a bank for the transaction. In an RFP process, the school district will send information about the transaction, including the purpose and authorization, security for the repayment, preliminary amortization, information on potential optional redemption dates, and an official proposal form for interested banks to submit on the specified date and time. The bank with the lowest interest rate on the school district’s preferred structure (if multiple options are presented) is typically awarded the transaction, barring any terms or conditions that would prevent the school district from entering into an agreement. Banks generally require approximately two weeks to complete their credit reviews and respond to an RFP upon receipt, although occasionally may need some additional time depending on market activity. School districts may have a particular bank with whom they would prefer to work rather than conduct an RFP process. In identifying a specific bank, a school district may want to consider the bank’s experience providing these loans to municipal issuers, particularly other school districts, and how that experience impacts the potential interest rate that the school district is offered as well as the terms and conditions of the bank purchase.
What Else to Know About Bank Purchases
In March and April 2020, as the COVID-19 pandemic resulted in an increase in interest rates and credit spreads for municipal issuers, all but shuttering the municipal market, banks continued to provide school districts and other issuers an avenue to execute financings, both short- and longer-term. Research by the Municipal Securities Rulemaking Board (MSRB) indicated that disclosures of bank purchases have increased in 2020 relative to 2019 activity.
Tax-exempt and taxable transactions are eligible for bank purchases. Interest rates provided by banks for direct purchases are influenced by the banks’ tax rate. A tax policy change that impacts the corporate tax rate in the form of an increase or decrease can change the accounting on a bank purchase, particularly a tax-exempt loan. Consequently, banks may try to include language that will allow for the adjustment of the interest rate on the debt if there is a change to tax policy. Such language could put school districts in the position of seeing their rate change through the course of the loan, which is not allowable under the Ohio Revised Code. The working group can review any proposed language provided by the banks and determine the appropriate course of action regarding its inclusion. Tax policy changes can also impact the economic benefits of executing tax-exempt bank purchases as the interest rate offered by the banks may reflect those changes.
Many other nuances and considerations are at play for school districts when thinking about the appropriate method of sale for a potential issuance. The factors outlined here provide an overview of many of the items the school district and its financing team should evaluate given the characteristics of a capital improvement financing or potential refunding transaction.
Marvin Founds is Director at Baker Tilly Municipal Advisors. marvin.founds@bakertilly.com | 614.987.1689.
Jordan Peters is Manager at Baker Tilly Municipal Advisors. jordan.peters@bakertilly.com | 614.987.1687.