Guidelines on Local Government Borrowing and Recent Developments in South East Europe
6. How to find and select the lender?

6.3. How to develop the tender documentation for a loan

In the process of contracting a new loans or issuing bonds, in almost all the surveyed territories covered by NALAS members, local governments have to undergo tender procedures in order to select the lending/ underwriting financial institution. Thus it is essential for local governments to draft the tender documentation in a way which ensures (i) that eligible bidders have the adequate level of knowledge and experience for the project to be financed and (ii) that selection criteria used to assess lenders' offers enables local governments to obtain the most competitive loan structure.

6.3.1. Eligibility criteria for financial institutions

Local governments have to impose certain eligibility criteria to potential lenders in order to receive offers only from financial institutions which can prove similar experiences to that of the project to be financed. Such criteria may include:

Minimum threshold for bank's revenues from ongoing operations (interest revenues and fees and commissions);

Proof of similar projects – at least 3 – financed in the past years;

Minimum threshold for loans granted by the bank in the past to local governments;

In setting the eligibility criteria care has to be taken in order not to set the limits too restrictive for fear the competitiveness of the offers may be reduced.

6.3.1. Eligibility criteria for financial institutions

The first step in drafting the tender documentation is for the local government to establish the criteria based on which it will assess the banks' offers. Usually the following parameters are included in a credit facility contract and should be considered by the local government in the evaluation process: (i) amount, (ii) currency (iii) interest rate, (iv) fees, (v) repayment schedule, (vi) grace period, (vii) refinancing options and (viii) restructuring possibilities.

Borrowing amount – can be imposed or subject to banks' offers. In normal market conditions it is imposed. However if liquidity on the market is low (such as during the recent financial crisis) and the chances of finding the whole amount of money for the project to be financed are reduced, then it is advisable to impose only a minimum threshold on the borrowing amount. In this way, chances are high that the local government will find partial financing, which may enable it to start the project. When market conditions resume, the local government could attract the additional amount of financing through another tender.

Currency – usually the currency in which local governments wish to borrow is specified. Otherwise it would be difficult to compare and discriminate across different offers which are denominated in different currencies. Local governments should be aware of the fact that when contracting foreign currency loans, they expose themselves to currency risk (exchange rate volatility), which can offset the benefits of lower foreign currency interest rates and even generate losses. In countries where exchange rate volatility is high, it is advisable for local governments seeking to borrow in foreign currency to consider hedging their currency exposure.

Interest rate – is one of the key assessment criteria. The local government has specify in the tender documentation the type of interest rate at which they wish to borrow: fixed or variable (e.g. Euribor 6 month). If the interest rate is variable, then banks tender only the margin over the reference rate. Usually lending to local governments occurs at variable rates, as the table below indicates.

Table 13: – Local government borrowing interest rates across target territories covered by NALAS members (as of Dec 2009)

** Based on questionaire data

Fees – have also to be considered when evaluating the offers. The number and type of fees 1) Up-front Front Fee; 2) Front-end Fee; 3) Prepayment Fee; 4) Commitment Fee; 5) Management Fee; 6) Arrangement Fee; 7) Structuring Fee; 8) Agency Fee charged differ across banks and financial markets, depending on banks' individual pricing strategy and markets' competition and development. It is advisable for local governments to impose a maximum limit on early repayment fees, in order to maintain flexibility to refinance if market conditions improve. Table below contains some indicative values on fees and commissions charged by Romanian banks for loans granted in 2009.

** Based on questionaire data

Repayment schedule – usually it should be specified by the local government, depending on the future liquidity needs, debt service of outstanding loans or projected revenues and expenditures. Debt repayment can occur in equal tranches, with progressively increasing/ decreasing amortization or based on a customized schedule. Most often repayment schedule is based on equal tranches. Bullet repayments22 can also be considered as an option. However given the fact that local governments in most countries have limits placed on their maximum debt service, bullet repayment will result in loans of lower values than compared to a plain vanilla loan (amortizing). Frequency of payments can be monthly, quarterly, semiannual or annual; local governments should tailor the frequency of payments based on its projected cash-inflows (revenues), in order to avoid shortages.

Grace period represents a period of time at the beginning of the loan contract (usually 1-3 years) when the local government pays only the interest on the outstanding loans (i.e. no principal payments). Grace period should also be determined by the tender; however a minimum accepted grace period should be specified in the tender documentation. It is important for the local government to understand that, although grace period eases down debt burden in the first years, it increases the overall cost of the loan.

Maturity – Infrastructure projects usually require large initial outlays compared to the local government budget. Long term-loans result in lower debt service burden for the local budget, which is easier to sustain from own revenues. Thus maturity should also be among the criteria used to assess banks' offers.

Refinancing possibilities – local governments have to ensure that they have the flexibility to refinance the loans if market conditions improve in the future. To this end, local governments should avoid entering a loan agreement which contains restrictive refinancing conditions, such as high refinancing commissions or constraints on where to refinance from.

Restructuring options – can also be foreseen in the tender documentation as criteria to evaluate banks' offers. Such options usually stipulate the conditions and fees under which a loan is restructured by extending its maturity or rearranging the debt service payments.

6.3.3. Assessing the loan to identify the most competitive offer

To compare and discriminate across banks offers, the local government has to aggregate the loan components in a transparent and objective way. In this context, we present a comprehensive methodology by means of which a local government could sum up the assessment criteria:

a) Financial pressure of the loan on the local government budget: three aspects are important here, namely, grace period, maturity and debt repayment schedule. For each factor a score is assigned based on the following table:

Table 5: Type of allowed guarantees and collaterals:

Factor Minimum score Maximum score
Grace period 0 – Bank with the lowest grace period 10 – Bank with the highest grace period
Maturity 0 – Bank with the lowest maturity 10 – Bank that offers the highest maturity
Repayment schedule 0 – Bank for which the repayment schedule results in the highest debt burden* as a percentage of local government revenues 10 – Bank for which the repayment schedule results in the lowest debt burden as a percentage of local government revenues
* debt burden – calculated as the maximum debt service incurred in any period over the life of the loan

Each factor should receive a weight, based on its importance for the local government. In general total weight of financial pressure on the aggregate score should not exceed 20-30%.

b) Overall effective cost incorporates besides interest costs all other fees and commissions that are due. It is calculated as the yield which discounts future cash-flows related to debt repayment (principal, interest and commissions) to the present value of the loan:

where: r – represents the overall effective cost of the loan
C – loan facility amount
N – maturity of the loan (years)
m – periodicity of debt repayments (m=12 for monthly payments, m=3 for quarterly payments etc)
xk, yk and zk – represent the fees and commissions, principal and interest payments paid at time k

If interest rate is variable, in order to be able to calculate a repayment schedule, the local government should specify a unique value for the reference rate, which will be used by all the banks when making the offer.

The Bank with the highest overall effective cost should receive a score of 0 whereas the bank offering the lowest overall effective cost would receive 10 points. The weight of this factor in the aggregate score should be high, around 40-50%.

c) Refinancing and early repayment fees: a similar evaluation grid can be used in order to assess the degree of flexibility which a bank offers in terms of refinancing options.

Table 5: Type of allowed guarantees and collaterals:

Factor Minimum score Maximum score
Early repayment fee 0 – Bank with the highest early repayment fee 10 – Bank with the lowest repayment fee
Restructuring fees 0 – Bank with the highest restructuring fees 10 – Bank that offers lowest restructuring fees

Each factor from this section should be weighted, so as to ensure an overall weight of around 20-40%.
The aggregate score is calculated from the weighted average score of individual factors described at points a, b and c. The Bank with the highest score should win the tender.

Figure 4: Example of identifying the best offer in a tender procedure
Local government "L" wants to borrow EUR 10 million for a local infrastructure project, with a maturity of minimum 10 years, repayment in semi-annual installments and a grace period of minimum 1 year. Following a short tender procedure, L receives offers from three banks:

In terms financial pressure Bank C has the highest grace period, the longest
maturity and the lowest maximum debt service burden over the life of the
loan. Bank A has the lowest score in this respect.
Financial pressure

Factor Bank A Bank B Bank C Bank D
Grace period 5 0 10 5%
Maturity 0 3.75 10 7%
Repayment schedule 0 8.2 10 8%

In terms of overall effective cost, Bank B has the lowest cost with an internal
rate of return of 4.4%, followed by Bank A with 4.9% and Bank C with 5.2%.
This results in the following score:

Factor Bank A Bank B Bank C Bank D
Overall effective cost 7 10 0 50%

From the point of view of refinancing and restructuring options the best offer
is from Bank C

Factor Bank A Bank B Bank C Bank D
Early repaiment fee 2 0 10 20%
Restructuring fee 5.7 0 10 10%