LIBOR AND SWAPS
In the US a group of private-market participants was convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from US dollar Libor to a more robust benchmark rate . This committee , the Alternative Reference Rates Committee ( ARRC ), has subsequently recommended the Secured Overnight Financing Rate ( SOFR ) as their recommended alternative to Libor for US dollar products , and Bloomberg is already publishing term forward rates for SOFR .
The initial methodology used to calculate the interest rate that Zombanakis devised is in fact similar to SOFR ( the primary point of difference being that SOFR is representative of the cost of funding on a secured basis , whereas Zombanakis ’ s rate is unsecured ). In the words of Mark Twain , history doesn ’ t repeat itself but it often rhymes .
Mismatch risk allocation Until 2019 , generally speaking , loan documentation for project financings barely addressed the demise of Libor and the parties just agreed to negotiate in good faith at a later stage . However , various LMA updates have been subsequently introduced with a view to allowing a negotiated transition from Libor to a new benchmark rate within the confines of the loan documentation .
The LMA is currently updating its February 2020 form of Revised Replacement of Screen Rate Clause and their latest exposure draft proposes a more prescriptive amendment approach with the aim of avoiding protracted negotiations .
The most recent market development has been a concerted push to introduce hard-wired triggers and fallback provisions that are based on the June 2020 ARRC recommendations . Throughout the course of this year , market participants have spent time grappling with the potential negative impacts on the project finance market of the replacement of Libor with RFRs .
As regular PFI readers will be aware , project finance is , at its heart , primarily an exercise in risk allocation . There are two ways in which a project company can mitigate the risk of a floating interest rate :
* The first method is to simply enter into loans with a fixed interest rate . Given the long-term nature of project finance loans , this is not a loan product that is typically offered by commercial banks .
A more viable alternative is for borrowers to seek out export credit agency ( ECA ) backed loans where an ECA may be able to offer a Commercial Interest Reference Rate ( CIRR ), which is a fixed interest rate that is calculated by reference to government bonds and regulated by the OECD .
In addition , fixed interest rates may also be possible for loans from multilateral agencies or development finance institutions ( DFIs ). Another alternative would be to issue bonds in the capital markets , however this is often only an option after a project achieves completion and retires the construction risk .
• The second , more common , method of mitigating floating interest rate risk is for the project company to enter into interest rate hedging agreements . A project finance borrower will therefore typically be required to enter into interest rate hedging agreements in accordance with a pre-determined hedging strategy that is set out in the loan documentation .
This hedging strategy will be negotiated and agreed at the initial term sheet stages of the financing and will typically require higher levels of debt to be hedged at the outset of the financing . The percentage of a project ’ s debt that is required to be hedged will then likely decrease over time as the borrower repays the debt and its exposure to interest rate fluctuations declines .
The loan documentation for the project financing will stipulate the terms upon which the borrower can enter into a hedging agreement , which will be in the form of a 2002 or , less often , 1992 International Swaps and Derivatives Association ( ISDA ) master agreement with a negotiated schedule and associated trade confirmations .
As the hedge providers ’ rights under the interest rate swaps will typically be secured by the same collateral package as the project finance lenders on a pari passu basis , the finance documentation for the project financing will also include an intercreditor agreement . This intercreditor agreement would then restrict the hedge providers ’ ability to terminate the interest rate swaps other than in limited circumstances – such as when the lenders are taking enforcement action or there has been a payment default that has continued for a specified period .
Somewhat ironically , the risk mitigation exercise of a project finance borrower entering into interest rate swaps , so as to remove uncertainty , is now being challenged by the uncertainties of the transition from Libor to an unspecified replacement benchmark rate .
Reality check Although the intercreditor arrangements between lenders and the hedge providers for a project financing are usually subject to some discussion and negotiation , the imminent demise of Libor has added a new complexity to these discussions .
Most , if not all , loan agreements now contain triggers for the replacement of Libor , typically referred to as a Screen Rate Replacement Event . The market is still evolving on the treatment of Libor replacement in hedging agreements :
• Some ISDAs piggyback off the trigger and replacement rate mechanisms in the loan agreement , which ensures consistency with the loan replacement benchmark rate and preserves the full value of the interest rate hedges .
• Some ISDAs contain formulations that provide for a common trigger in the loan agreement and hedging agreement , but an independent determination of the benchmark rate .
• A common trend is for ISDAs to incorporate , on a trade-by-trade basis or at a relationship
Project Finance International September 23 2020 61