A strong financial profile, clear reporting, and market expertise are key to securing—and keeping—a bank line of credit.

Bank lines of credit (LOCs) can benefit private lenders in numerous ways, ranging from larger balance sheet capacity to cheaper cost of capital to a cash management line that can be used to bridge gaps in cash flow. Qualifying for these lines can be a lengthy and costly endeavor, so private lenders should have a basic understanding of the due diligence requirements, red and green flags that banks look for, covenants, and closing timelines to manage your expectations and maximize your chance of success.

Due Diligence Requirements Vary

Banks often have slightly different due diligence processes. They can be influenced by myriad factors, including loan committee members’ differing experiences with deals that have gone wrong in the past, overall concentrations within a bank’s portfolio, senior management’s economic outlook (including the future risk profile of specific industries), and how regulators have reacted and imposed changes on a bank’s lending practices.

It is important to note requirements and processes may change, so staying in contact with banks over time could help you gauge the direction a bank’s preferences are trending.

Here are several notable areas where banks’ differences in processes and requirements may impact a private lender and your ability to qualify for a bank LOC.

Due diligence and screening. The amount of due diligence conducted and the initial screening with the loan committee before issuing a term sheet may vary. More work up-front generally decreases the deviations from a term sheet—and the number of surprises during loan document negotiations.

Fee structures. The primary fees will always be the origination fee, the interest rate, and often some version of a nonuse fee since banks must pay for committed capital lines. Ancillary fees may also be significant (e.g., boarding fees, minimum interest fees, deboarding fees, etc.).

Valuation requirements. Banks are required to adhere to the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) and the Interagency Appraisal and Evaluation Guidelines, so there generally is not much variance in valuation requirements. Still, each bank may interpret these regulations slightly differently.

Deposit minimums. Most banks still require a commercial banking relationship, but the minimum amount of deposits required in these accounts and the source of those deposits can vary.

Collateral shipping. Most banks require the shipping of original loan files to the bank or a designated custodian, but a small number allow for digital files when pledging loans.

Draw process and re-underwriting. Ease of use of the line can be the most important factor for a private lender. But it may vary the most across banks and be the most difficult to assess up-front, so inquire about this process in detail and perhaps even speak to existing clients as references.

Understanding of the private lending industry. Several banks are consistently active in lending to private lenders, but a number of others have very few relationships in the industry, which can impact how reliable they may be as a partner and how creative they may be.

On the flip side, there are several areas where banks align. Banks typically prefer to work with established private lenders who understand how to hold loans on their balance sheet and work through problem loans and assets. Most also have a lengthy due diligence process (three to nine months) that involves thorough underwriting of your lending business, policies and procedures, current portfolio, and at least one approval from the loan committee. Monthly borrower bases and quarterly and annual financial reporting for the borrowing entity, the manager, and owners is also necessary as are financial covenants and periodic covenant compliance reporting.

Best Practices for Qualifying

Aside from the hard numbers that comprise the financial covenants and compliance certificate, banks consider many other factors when evaluating whether to extend a line of credit to a private lender. Similar to due diligence requirements and processes, there may be some variance between banks.

As noted, banks strongly prefer experienced private lenders that can hold loans on their balance sheet and work through issues. Aside from the tangible net-worth-related covenants mentioned on the next page, brokers or lenders that rely heavily on white labeling may be great at sourcing and originating loans but may not have the same level of experience managing balance sheet liquidity and working through challenged loans.

Local market expertise is also important. Although many banks work with private lenders throughout the country, they generally want to see originators that are experts in a few markets. Having boots on the ground where the properties are located can be important in establishing a loyal borrower base and solving problems quickly.

In addition to having geographical focus, offering consistent loan products and focusing on specific asset classes show discipline and expertise.

Finally, possessing the ability to convey and document these practices in formal underwriting guidelines, policies, and procedures not only helps private lenders qualify for bank lines of credit but also aids in capital raising from investors.

The bank underwriting process is very thorough. Lines of credit are almost always supported by fraud/”bad boy” personal guarantees, which are terms included in an agreement to provide recourse if a borrower’s poor or noncompliant conduct jeopardizes the investment. All private lenders have experienced some difficult situations, so the best approach is to be up-front about what your issues are, before you spend a lot of time and money on the due diligence process.

A thoughtful bank will consider the entire story and package for a prospective private lending client, but be prepared to spend extra time discussing and documenting any of the following potential red flags:

Substantial historical principal losses. Be prepared to explain their causes and the changes you have made to prevent these situations from reoccurring.

Inability to provide consistent reporting. This can include financial statements, loan tapes, or other relevant information related to your lending business. Banks require a fair amount of ongoing reporting, so being able to automatically produce customized reports is important.

Conflicts of interest or lack of checks and balances. Even relatively common practices like lending to related parties, determining your own valuations, or conducting draw inspections and distributions internally can open the door for potential risks that a bank may not want to take.

Current and historical delinquency rates. Typically, banks do not like elevated default rates, so if more than 5-10% of your current portfolio or historical originations have defaulted, plan to detail the likely exit strategy, timing, and associated P&L for active delinquencies and share your yields on previously liquidated defaulted loans. There is a growing understanding that the combination of low loan-to-value (LTV) lending with high default interest rates can result in higher returns if a loan does not perform, but it is not the ideal portfolio strategy for a bank.

Other areas that may not necessarily be viewed positively or negatively but are worth discussing early in the conversation with a potential bank lender include entity structure (fund or not), method of raising capital (equity, unsecured debt, secured debt), core products you lend against, and whether you outsource to third-party servicers.

Typical Bank Covenants

You can view bank underwriting as similar to how a private lender underwrites a loan for a mortgagor. There are many factors to consider, including specific ratios that are calculated for every loan opportunity. Banks have similar quantitative measures, typically known as covenants.

Tangible Net Worth (TNW) minimums, or a related calculation such as Total Liabilities/TNW (often referred to as the debt to equity or D: E ratio) are perhaps the most important covenant and easiest to understand. There are some nuances to calculating TNW, but it effectively means how much equity capital is on your private lender’s balance sheet. If you raise capital through debt rather than equity, a related calculation, Tangible Net Capital (TNC), may be used so long as the debt is unsecured or explicitly subordinated.

For new relationships, banks generally like to see TNW or TNC balances near or in excess of the size of the line of credit being requested (near or below a 1:1 D:E ratio). Some banks will go higher than this, but banks generally do not like lending to highly leveraged businesses. Some banks forego the ratio and simply require a minimum TNW or TNC balance that is below, but usually near your current amount, and in a similar relation to the proposed total debt commitment.

Debt Service Coverage Ratio (DSCR) is a common abbreviation that private lenders use when referring to long maturity rental loans. For banks, it is similar and measures the private lender’s EBITDA divided by the interest expense. This helps the bank assess whether the private lender is generating enough income to pay its debts.

Portfolio delinquency is the “canary in the coal mine” covenant some banks use to anticipate upcoming portfolio degradation. Most  banks prohibit delinquent assets in their borrowing bases but typically do not impose requirements on anything outside of the line of credit. However, portfolio delinquency is an exception—banks need to assess overall portfolio performance and may halt lending if the default rate becomes too high.

Private lenders often raise questions about the prohibition of new debt as it is defined in loan agreements, but it is a common covenant that limits the private lender from adding other debt facilities without the knowledge and approval of the incumbent bank. Additional debt can lead not only to the violation of Total Liabilities/TNW ratios or DSCR minimums but also complicate any default scenario in which multiple creditors are involved.

In practice, a bank would prefer to upsize its own commitment amount rather than allow another bank to provide credit. However, if the desired debt capacity of the private lender exceeds the amount the bank is comfortable lending or requires a structure the bank does not offer (while still complying with all covenants), adding another bank is common. The relationship between the banks is often documented by an intercreditor agreement, and typically each bank must hold their pledged loans in a special purpose entity (SPE) to clearly define their respective collateral positions.

To avoid a messy negotiation if a default should occur, it is important the banks operate similarly when it comes to default events.

The Due Diligence Process

It is important to understand the standard due diligence materials any bank prospect will be asked for and to have a basic understanding of the underwriting and closing processes. Again, there is likely to be some variance between banks, but a standard list typically includes:

Company overview/investor pitch deck. Include info on your business, history, loan products, geographies, management bios, etc.

Loan tape of current portfolio or recent loan production. Provide whatever will be representative of what you intend to pledge to the bank.

Financials. You’ll need the last three years’ year-end financials and most recent quarter-end year-to-date internal financials with comparable quarter-end year-to-date financials for prior year (both for the fund and management company if applicable). Audited or CPA-prepared financials are preferable for year ends.

Other applicable information. You may need to provide personal financial statements for guarantors/owners, entity and personnel organizational charts, complete underwriting guidelines for your various loan products, private placement memorandum or investor promissory note and security agreement, and bank questionnaire or other bank-specific forms.

These materials and corresponding follow-ups, potentially along with a loan committee prescreen, are typically sufficient to issue a term sheet.

The term sheet is typically where most of the terms are negotiated. The more comprehensive the term sheet, the longer it can take to reach agreement and execute the term sheet. But it also means fewrer surprises when loan document drafts are available.

Underwriting and Closing

After you provide the signed term sheet and associated due diligence deposit, the process moves into full underwriting. Banks typically have dedicated credit analysts independent from the main banker you primarily communicate with. This is intentional to maintain independence during the review; you will never interact with the underwriter.

During the underwriting phase, additional materials will be requested, including bank-specific forms. The process may include items like entity formation documents, principal background checks and credit pulls, mortgage loan file and collateral review, UCC checks, additional financial info, principal driver’s license, SSN, tax returns, any trust information, bank statement review, beneficial ownership forms, certificates of good standing, and proof of insurance.

In parallel with underwriting, loan documents are typically drafted and distributed and any potential pre-closing on-site field exams are conducted. Loan document negotiations are common and can be more involved if the term sheet is high level and not highly customized. The private lender is required to pay both their own and the bank’s legal bills, so be sure to negotiate only where necessary.

As underwriting is completed and these other items proceed, the opportunity is presented to final loan committee. Depending on whether there was a prescreen and what information was discovered during underwriting, changes to the terms and structure may result. With good communication from the beginning, any changes should be relatively minor.

After final loan committee approves the deal, it moves toward closing. The timeline can vary significantly, depending on whether there are incumbent banks that may require an intercreditor agreement or a bank being paid off and any remaining negotiations on the loan documents. Preparing the first borrowing base in the bank’s format is also required if any draws are to be made at closing—a process that can have a steep learning curve depending on the number of loans being pledged initially.

Once the line of credit is closed, the private lender and bank must continue to work closely together to acclimate to the loan pledging and draw process. It may take a quarter or two to eliminate the delays that can stem from incomplete data, lack of understanding of the process, or delays in required reporting. Only once the relationship has found an efficient rhythm for monthly borrowing base pledging, draws, quarterly and annual covenant compliance, and financial reporting can both sides realize the full potential of a line of credit relationship.