During her work with bankers, Gita Thollesson – PrecisionLender’s SVP of Client Success and Market Insights – receives lots of questions about best practices for pricing. We’re going to publishing her answers to those questions periodically here on the blog.
If you have a nagging pricing question you’d like to ask Gita, email it to email@example.com.
Question: “My bank is considering implementing performance-based pricing. How widespread is the practice and is it worth doing?”
It may come as a surprise to large corporate and upper middle market bankers – who routinely tie credit pricing to a grid – that performance-based pricing is inconsistently used across the middle market and seldom used in the business banking space.
In fact, grid or “matrix” pricing is arguably one of the most underutilized best practices in the market.
Why is it a best practice? Because performance-based pricing:
- Helps banks maintain their risk/return even as a borrower migrates across the credit spectrum.
- Provides for more frequent pricing adjustments than on a typical one-year renewal.
- Frees relationship managers (RMs) from having the difficult conversation about repricing at maturity.
- Gives banks a competitive edge in deal negotiations (most importantly).
Performance-based pricing is a structure whereby a credit’s margin and even fees are tied to specific financial metrics. Rather than committing to pricing based on the borrower’s financial strength at closing and then not having a repricing opportunity until maturity, the grid allows pricing to change mid-cycle, as risk migrates.
The specific risk metrics depend on the type of borrower. For investment-grade borrowers, the grids are most often tied to the borrower’s senior debt rating, while non-investment grade deals are more often pegged to a leverage ratio or cash flow coverage ratio. For companies that are not publicly-rated, as with most middle market borrowers, the grids are usually set up with risk measures that are relevant to the company’s business, such as: debt to tangible net worth, debt service coverage, funded debt to EBITDA, or a measure of income.
Grid pricing like the example above is common on broadly syndicated loans, with both margins and unused commitment fees adjusting immediately upon a change in the corporate rating. On bilateral deals, performance-based pricing is more often triggered at a predetermined frequency, such as monthly or quarterly, based on the compliance certificates used for the financial covenant tests.
Bankers note that the grids are more straightforward to implement when the risk metrics align with the financial covenants already in place on the deal, as this eliminates any added process burden for the customer. In addition, the repricing dates should coincide with the borrower’s audited financials. While middle market pricing matrices are typically set up with quarterly monitoring, some bankers have even set up grids with annual resets to avoid placing an undue workload on the customer’s staff.
In light of the compliance work required of the borrower, coupled with the prospect of paying higher pricing before maturity, how could grid pricing actually be a competitive advantage for banks? RMs report that customers tend to be optimistic about their future financial performance, so they typically focus on the low end of the grid. Some bankers have won business even when the initial pricing was higher than a competitor’s offer, just by giving the customer a way down, via the grid.
The reality is RMs don’t typically adjust pricing on renewals even in the event of deteriorating financials.
Most often, RMs use the company’s own financial projections to set up the low points on the grid, even when those projections appear to be a stretch goal. They set the starting point somewhere in the middle of the grid, which protects the bank against deterioration, while also giving the borrower a carrot. (We talk more about other strategies and tactics RMs use in our podcast Winning Tactics of Top RMs: Performance-Based Pricing
Banks who have institutionalized grid pricing do not view the potential for pricing reductions as a negative aspect to the grids. One commercial banking leader, who has performance-based pricing grids on 90% of his bank’s middle market portfolio (defined as revenue of $50 million to $1 billion) noted: “It’s an incentive for the company to deleverage.”
Certainly, any improvement not only benefits the bank from a credit-quality perspective, it also reduces the likelihood the borrower would shop the credit, given that pricing would step down on their existing deal without requiring a renegotiation.
But what about borrowers with one-year lines of credit that report audited financials on an annual basis? Can performance-based pricing grids provide any real bank benefit in these situations? Absolutely.
Although banks assume any migrated credits would be repriced upon maturity, the reality is that RMs don’t typically adjust pricing on renewals even in the event of deteriorating financials. Even among banks that have a mechanism in place to revisit pricing on renewals, RMs either don’t want to "kick the customer while they’re down" or just don’t know how to have the conversation with the borrower.
One commercial executive recounted an instance in which a customer was downgraded upon renewal and the bank lost the business after asking for an upward pricing adjustment.
"We said, ‘We have to get paid.’ And we did,” he said. “We got paid … off."
While the performance-based pricing grid does not guarantee the customer won’t shop the credit, it reduces the need for every adjustment to be a negotiation. Customers also appreciate the pricing rationale implicit in a grid and are empowered by the knowledge that they have some control over their pricing.
With all these benefits to both the bank and borrower, why aren’t grids standardized across the market?
Implementation of grid pricing requires monitoring and oversight, and the process is more manual than automated. Human intervention is needed to track down the financials, determine the pricing adjustment, and implement the changes in the loan system. While most commercial loan systems are set up to automatically generate invoices based on interest income, accrual fees and even late charges, there is no mechanism to electronically track financials and automatically adjust pricing.
Still, bankers agree that on larger deals, the incremental revenue is well worth the added effort.
The business case is harder to make on smaller middle market credits. That said, the banker described above — who achieved 90% incidence of grid pricing on the middle market portfolio — acknowledged the manual effort involved in administering the grids, but said it wasn’t prohibitive. Grids have been institutionalized in that bank’s culture and RMs are accustomed to checking the financials quarterly, identifying the change, and informing Loan Ops. It has become a routine process, and the bank is reaping the benefits: a steeper risk/return, better customer retention, stronger credit quality, and less contentious deal negotiations.
If your bank has not yet institutionalized performance-based pricing, think about reviewing your maturing lines with financial covenants and proposing a grid during the next renewal. The next time you’re competing for a new piece of business, a grid may just be the secret weapon that wins the deal.