What it means
Guarantees turn up constantly in business life: a parent company standing behind a subsidiary's lease, an owner personally guaranteeing a company overdraft, a government agency backing export finance, or an insurer wrapping a bond issue. In each case the lender is looking past the immediate borrower to a stronger balance sheet.
The credit decision effectively becomes a decision about the guarantor. They matter because they change pricing.
A young company with two years of trading history might borrow at 11%, while the same loan guaranteed by an established parent might cost 7.5%, because the lender's expected loss has fallen. Guarantees can also make the difference between a facility being declined and approved, which is often more valuable than the rate.
Guarantees vary in scope and this is where the detail bites. A limited guarantee caps the guarantor's liability at a stated amount, while an unlimited one does not; a several guarantee covers only that guarantor's share, while a joint and several guarantee means the lender can pursue any one guarantor for the whole amount.
On-demand guarantees can be called simply by the lender asserting default, whereas conditional ones require proof. The nuance that catches people out is accounting and disclosure.
A guarantee usually sits off the balance sheet as a contingent liability until it becomes probable that it will be called, so a company can carry very large obligations that never appear in headline debt figures. Anyone assessing a business should read the notes to the accounts, not just the balance sheet.
In practice
Real-world examples.
Example
A holding company guarantees a ten-year property lease taken by its newest subsidiary. The landlord accepts a two-month deposit instead of the twelve months it would otherwise have demanded, freeing about $180,000 of cash for the subsidiary.
Example
A bank lends $350,000 to a two-year-old consultancy only after both founders sign personal guarantees. When the business later struggles, the founders discover the guarantee is joint and several, so the bank can pursue either of them for the full balance.
Example
An exporter wins a $1,200,000 order from an overseas buyer and obtains a government-backed export guarantee covering 80% of the value. The exporter's own bank then agrees to fund the production costs, which it had previously refused.
Formula
Calculation
Guarantee Fee = Guaranteed Amount x Fee Rate
Expected Cost to Guarantor = Guaranteed Amount x Probability of Default x Loss Given Default
A specialist guarantor agrees to back a $2,000,000 facility for a fee of 1.5% a year.
Guarantee fee = $2,000,000 x 1.5% = $30,000 a year
The guarantor assesses a 2% annual chance of default with an expected recovery of 30%, giving a loss given default of 70%.
Expected cost = $2,000,000 x 2% x 70%
= $2,000,000 x 0.02 = $40,000
= $40,000 x 0.70 = $28,000
The guarantor earns $30,000 against an expected cost of $28,000, a margin of only $2,000, which explains why guarantors price carefully and often demand security of their own. For the borrower the arithmetic looks better: if the guarantee cuts the borrowing rate from 11% to 7.5%, the interest saving is $2,000,000 x 3.5% = $70,000, leaving a net gain of $40,000 a year after the fee.Case study
Seen in the real world.
Halloway Print Group is a fictional company invented to illustrate how guarantees work. Its newly formed packaging division needed a $2,000,000 facility to buy a digital press, and lenders quoted 11% because the division had no trading record of its own.
The illustrative solution was a guarantee from a specialist credit guarantor charging 1.5%, or $30,000 a year. With the guarantee in place the lender dropped the rate to 7.5%, saving $70,000 a year in interest and leaving Halloway $40,000 a year better off after the fee. The guarantor took a charge over the press itself as security.
What the fictional board almost missed was the disclosure point: the guarantee did not reduce the group's obligation if things went wrong, it merely changed who stood in front of it. The audit committee added a standing agenda item to review contingent liabilities every quarter.
Watch out
Common mistakes.
- Treating a guarantee as a formality because default seems unlikely. Guarantors are called on regularly, and a personal guarantee can reach a family home.
- Assuming a guarantee is capped at the original loan amount. Unless the wording says otherwise it can extend to interest, fees, legal costs and later facilities.
- Ignoring guarantees when assessing a company's debt. They sit in the notes as contingent liabilities and can dwarf the borrowings shown on the balance sheet.
Questions
People also ask.
What is the difference between a guarantee and a letter of comfort?
A guarantee is legally enforceable, while a letter of comfort is usually a statement of intent that a lender cannot sue on.
Can a guarantee be released?
Sometimes, typically once the borrower meets agreed financial tests or the facility is refinanced, but the lender has to agree and rarely does so automatically.
Does the guarantor charge for providing one?
Third-party and intragroup guarantors often charge an arm's-length fee, commonly between 0.5% and 3% of the guaranteed amount a year, depending on risk.
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