Participation loans are lending arrangements that require the involvement of multiple lenders. A loan of this type is often employed when financing through a single entity would place too great a demand on the resources of the lender. While a participation loan functions in a manner similar to any type of bank loan, there are a couple of significant differences.
The first characteristic that distinguishes a participation loan from other types of loans is the involvement of two or more lenders. Generally, the lenders involved in the execution of the loan are banks. However, other financial institutions, such as mortgage companies or building societies, may also be included in the joint venture. This aspect requires some structuring on the part of the lenders, so payments can be submitted to the correct holder, and be credited accordingly.
Another distinguishing mark of the participation loan is the fact that each of the lenders functions as an investor in the project funded with the proceeds from the loan. As such, each lender receives a portion of the profits generated as a result of the project. This share of the profits is above and beyond the repayment of the principle plus interest that each of the lenders receives over time.
There are a couple of good reasons why lenders would choose to band together and extend a participation loan. The first has to do with the amount of the loan itself. A loan that would place significant stress on the assets of one lender creates a situation where that lender may not be able to adequately provide services to its other customers. Rather than run the risk of endangering those relationships, the lender helps to gather several other lenders, with each underwriting a portion of the loan, and sharing in the profits.
Risk of another kind is also one of the reasons why several financial institutions may decide to collectively approve a participation loan. Since there is always a chance of the borrower defaulting on the loan, sharing that risk of default with others means that if the worst case scenario does come to pass, each institution will be in a better position to absorb the loss and move on. Without uniting with other lenders to grant this type of loan, the risk could be so great that a default would permanently cripple a single lender.
A participation loan is often used for major projects, such as the development of large commercial real estate holdings. For example, the acquisition of land for a shopping mall, as well as the subsequent construction of the mall, could be financed with this kind of loan. As the mall opens and begins to generate a profit, each lender receives a percentage of those profits, based on the portion of the loan that each institution assumed. This percentage is often paid at specific points during the life of the loan, as outlined in the terms and conditions that govern the loan contract. At the same time, each lender continues to receive regular payments on the outstanding balance of the loan, plus any applicable interest.