Generally, promissory notes represent an alternative to borrowing compared to traditional bank loans and have gained significance in recent years. The issue volumes for promissory notes start in the double-digit million range, with even higher transaction volumes not being uncommon. Promissory notes frequently serve as an additional source of financing for larger investments or to refinance existing debt instruments.
Traditional promissory note arrangements distinguish between three main players: issuers (companies), arrangers (banks, brokers) and investors. Usually, the arrangers provide advice to issuers on the promissory note structure and subsequently take care of the structuring and marketing of the promissory note to investors.1 The corresponding loan is usually granted directly between the issuer and the arranger and governed by a loan agreement. The related activities performed by the arranger are invoiced to the issuer in accordance with the respective arrangement.
The preparation required for issuing promissory notes is generally manageable and the publication requirements at the time of issue and during their term are also low compared to other capital market instruments. A major difference compared to bonds is the requirement of a minimum credit rating for the borrower. The individual arrangement generally allows great flexibility with respect to the contract parameters (term, issue volume, securitisation, etc.) and combines the benefits of issuing a senior note with those of the discretion of a bank loan.2
On the other hand, the individual arrangement may lead to a non-transparent cost structure. For this reason, further digitalisation of promissory notes is seen as having great potential, making it possible to present the structuring and placement of promissory notes in digital form.3 In addition to the increasing digitalisation of promissory notes, promissory notes are increasingly also linked to certain sustainability KPIs. These so-called green finance instruments can, for example, limit the use of funds exclusively to sustainable projects (green promissory note) or require adherence to sustainability KPIs, with the use of funds not being restricted.
With regard to financial risk management, the promissory notes must be analysed further with a view to financial risks. Generally, financial risks can be categorised as follows:
- Market risk: interest rate and foreign exchange risk,
- Credit risk, and
- Liquidity risk.
The specific risks must be assessed depending on the contractual arrangements for the promissory note. With regard to interest rate exposure, fixed interest leads to the risk of a change in value (fair value risk), however not to any cash flow risk. For floating-rate promissory notes the opposite applies. A wide variety of hedging instruments (e.g. interest rate swaps) can be used to control interest rate risk, so that a company-specific separation into variable and fixed-interest portions can be made. In addition to a purely economic hedge, a promissory note can usually also be designated as a hedged item in hedge accounting, provided that the related application requirements are considered fulfilled (cf. IFRS 220.127.116.11 et seqq.). Should a promissory note be denominated in foreign currency, it is subject to foreign exchange risk (currency risk) accordingly, which can also be reduced or eliminated by means of suitable hedging strategies and instruments.
With regard to financial risks, the credit risk from promissory notes is of no significance for the issuer. Credit risk reflects the risk of complete or partial default of a counterparty.
Another financial risk from promissory notes is the liquidity risk arising from financial obligations not being fulfilled in due time. Depending on the contractual characteristics, future cash outflows resulting from repayments of principal and interest must be taken into account and controlled accordingly. In this context it should be mentioned that promissory notes do not allow repurchase in the open market, meaning that cash (out)flows are fixed until (final) maturity. Accordingly, extension risk may arise at maturity. Analogous to interest rate risk management for loan agreements and/or debt securities, an adequate spread of repayments of principal and interest is important and risk concentrations of fixed interest rates should be avoided as far as possible. In the case of repayment at final maturity, there is an additional refinancing risk because, at maturity, refinancing is only possible at the terms applicable at maturity and any potentially more favourable interim refinancing does not apply.
In addition to general financial risks, the specific risks must also be considered depending on the individual contractual terms of the promissory note concerned. Promissory note contracts usually provide for extraordinary termination rights on the part of the creditors, for instance in the event of imminent insolvency or sale of substantial parts of the operations of the issuing company. Depending on the specific form of the termination rights, this may result in the requirement to separate embedded derivatives under both German commercial law (HGB) and International Financial Reporting Standards (IFRS), with considerable consequences for accounting.
Pursuant to IFRS, at initial recognition, financial liabilities must be measured at their fair value (cf. IFRS 18.104.22.168). Issued promissory notes are subsequently measured at amortised cost, whereby the estimated future inflows/outflows are discounted at the effective interest rate over the expected residual term of the financial liability (cf. IFRS 22.214.171.124). When calculating the effective interest rate, directly attributable transaction costs as well as premiums and discounts must also be considered (cf. IFRS 9 Appendix A).
If the specific contract parameters of a promissory note also fulfil the criteria for the existence of an embedded derivative or embedded derivatives, the issuer must assess whether they are required to be separated.4 If there are embedded derivatives that are required to be separated, the entire contract is assessed as a hybrid contract, with the legally inseparable combination of the financial instrument having to be separated for financial reporting purposes into a non-derivative host contract (i.e. the promissory note) and a derivative financial instrument (e.g. termination rights in certain cases). Pursuant to IFRS 126.96.36.199, an embedded derivative shall be accounted for separately if:
- the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;
- a separate instrument with the same terms (as the embedded derivative) would meet the definition of a derivative; and
- the hybrid contract is not measured (as a whole) at fair value with changes in fair value recognised in profit or loss.
Especially the assessment of whether the economic characteristics and risks are closely related is very complex.
If a separable embedded derivative is identified, the issuer shall account for and measure the embedded derivative (e.g. termination right) separately from the host instrument (promissory note) (cf. IFRS 188.8.131.52).5 As the embedded derivative must subsequently be measured at fair value through profit or loss, remeasurement at the reporting date may significantly impact profit or loss, so that separable embedded derivatives can inevitably lead to higher volatility in profit and loss.
It is therefore advisable when issuing a promissory note, in addition to its consideration and integration into financial risk management, to also analyse the contract as to whether it contains embedded derivatives and/or whether these must be separated.
The Finance and Treasury Management Team of KPMG has extensive expertise in assessing promissory note instruments and would be happy to discuss this with you further.
Source: KPMG Corporate Treasury News, Edition 113, July/August 2021
Authors: Ralph Schilling, Partner, Finanz- und Treasury-Management, KPMG AG; Björn Beckmann, Manager, Finanz- und Treasury Management, KPMG AG
1 However, lending can also be handled directly via the investors.
2 In most cases, a promissory note does not fulfil the necessary criteria of a financial instrument within the meaning of the German Banking Act [KWG] and does not require KWG-specific approval. As it is not classified as a security and not traded on the stock exchange, it is also not necessary to prepare an issue prospectus in accordance with the EU Prospectus Regulation.
3 In this regard, see also KPMG Corporate Treasury News, Issue 99, March 2020.
4 The presence of embedded derivatives must be assessed according to both the International Financial Reporting Standards and German GAAP (German Commercial Code – HGB).
5 An entity shall assess whether an embedded derivative is required to be separated from the host contract when the entity first becomes a party to the contract, i.e. on initial recognition of the financial liability (cf. IFRS 9.B4.3.11).