Term Loan
A term loan is a fixed-principal loan from a bank or institutional lender with a specified maturity date, scheduled repayment terms, and either a fixed or floating interest rate. Unlike revolving credit facilities, once repaid, a term loan cannot be re-drawn and represents a single-purpose amortizing or bullet debt obligation typically used for capital expenditures, acquisitions, or refinancing.
Key takeaways
- Term Loan A (TLA) is amortizing (repaid in installments over the loan term) and is typically held by commercial banks, while Term Loan B (TLB) is primarily a bullet maturity loan with minimal amortization held by institutional investors such as CLO managers.
- Term loans are priced as a spread over SOFR (or formerly LIBOR), with the spread reflecting the borrower's credit quality, leverage, and covenant package.
- First-lien term loans in leveraged buyouts are secured by a lien on substantially all company assets and represent the senior, lowest-cost component of leveraged capital structures.
- Prepayment provisions—including soft call premiums (101 or 102 cents on the dollar if called within 6 or 12 months) and restricted prepayments for purposes of dividend recapitalizations—protect term loan lenders from early redemption at unfavorable times.
- Term loan credit agreement covenants may include financial maintenance tests (requiring the borrower to maintain minimum coverage ratios) or incurrence-only covenants for 'covenant-lite' loans common in the leveraged segment.
Explanation
The term loan is the foundational instrument of corporate lending, predating both the bond market and the modern leveraged finance market by centuries. In its most basic form, a term loan is straightforward: a lender advances a sum of money to a borrower at an agreed interest rate, with the principal repaid over a defined schedule. The term loan's defining characteristics—fixed principal, defined maturity, scheduled repayment—distinguish it from revolving credit facilities (which allow repeated drawdown and repayment) and from bonds (which are publicly registered securities traded in secondary markets, while term loans are private bilateral or syndicated contracts).
In modern corporate finance, term loans are most commonly discussed in the context of leveraged buyout (LBO) financing, where they serve as the primary instrument of acquisition leverage. The LBO term loan market in the United States—dominated by Term Loan B (TLB) structures—has grown into a $1.4 trillion market that forms the primary feedstock for the Collateralized Loan Obligation (CLO) industry. A TLB typically has a maturity of 5–7 years, requires 1% annual amortization of original principal (with the remaining 99% due at maturity as a 'bullet' payment), and is priced at SOFR plus a credit spread ranging from 250 to 600 basis points depending on the borrower's credit quality and leverage.
The distinction between Term Loan A (TLA) and Term Loan B (TLB) structures reflects the bifurcation of the leveraged lending market into bank and institutional investor segments. TLAs are held primarily by commercial banks that maintain ongoing lending relationships with the borrower; they amortize at a rate of 15–25% per year, reflecting banks' preference for faster principal repayment that reduces their credit exposure over time. TLBs are held predominantly by institutional investors—CLO managers, loan mutual funds, insurance companies, and hedge funds—who prefer the bullet structure because it maximizes the term of their floating-rate investment without requiring reinvestment of returned principal annually.
Credit analysis of term loans focuses on a company's ability to service its debt through operating cash flow. The most important metrics include leverage (Total Debt / EBITDA and First-Lien Debt / EBITDA), interest coverage (EBITDA / Interest Expense), and free cash flow conversion (the percentage of EBITDA that converts to free cash flow after capital expenditures and working capital changes). Lender protections in the credit agreement include financial covenants (for TLAs) specifying maximum leverage ratios and minimum coverage ratios measured quarterly, collateral security (first-priority liens on all assets), and negative covenants restricting additional debt issuance, asset sales, and dividends without lender consent.
The covenant-lite structure, which became dominant in US leveraged lending after 2010, removes financial maintenance covenants from TLB agreements, leaving only incurrence-based restrictions that are triggered only when the borrower takes affirmative actions (incurring additional debt, making investments) rather than at routine measurement dates. This shift has been controversial: proponents argue it reduces operational interference and provides borrowers with flexibility to manage through cycles, while critics argue it eliminates the 'early warning' function of financial covenants that historically triggered restructuring negotiations before distress became irreversible, ultimately increasing lender loss given default.
Example
A private equity firm finances the $800 million acquisition of a manufacturing company with the following capital structure: $400 million First-Lien Term Loan B at SOFR + 350 bps (7-year maturity, 1% annual amortization), $150 million Second-Lien Term Loan at SOFR + 700 bps (8-year maturity, bullet), and $250 million equity. The first-lien TLB implies a leverage ratio of $400M / $80M EBITDA = 5.0x, with all-in interest cost of approximately SOFR (5.3%) + 3.5% = 8.8%, or $35.2 million annually. The second-lien TL at SOFR + 7.0% = 12.3% costs $18.5 million annually. Total annual interest expense of $53.7 million is covered 1.5x by EBITDA. Over the first year, the first-lien TLB requires a $4 million amortization payment (1% of $400 million). Five years in, with improved performance raising EBITDA to $110 million, the PE firm refinances both term loans at better pricing, repaying the existing lenders and issuing a single new $450 million TLB at SOFR + 275 bps.
Related terms
Basis Bond Capital Structure Collateralized Loan Obligation Credit Analysis Credit Spread Default Drawdown Ebitda Equity Free Cash Flow Interest Rate