LIBOR AND SWAPS agreement , and the hedge provider and the borrower are unable to agree a replacement benchmark under that hedging agreement , this may give rise to a Force Majeure Event under the interest rate swap or the right to terminate the affected hedging transactions as an Additional Termination Event .
In practice , we would expect that termination of the hedging agreement is an unlikely outcome and that the parties would decide to continue with the swaps , even though they are no longer fit for the purpose of mitigating the floating interest rate risk in the underlying loan .
That said , although unlikely , this possibility still needs to be considered in the context of a project financing as any such termination would mean that the borrower could potentially be in breach of its undertaking to the lenders to comply with the hedging strategy ; and could also face the prospect of having to make an unbudgeted lump-sum payment to the hedge provider if the terminated swap is out of the money – which is also potentially a problem for the hedge provider as hedging termination payments are typically lower in priority than debt service in the project ’ s cashflow waterfall .
3 – Different adjustment spread conventions evolve for loans and swaps .
An additional intercreditor issue that requires some consideration is that the mark-to-market calculation for the borrower under an interest rate swap with an RFR benchmark rate is likely to be less than the amount under a Libor interest rate swap , as Libor is not a risk-free rate as it historically has taken into account credit risk . This means that lenders will likely look to charge the borrower an additional top-up margin / spread , the adjustment spread , so as to replicate the returns they would have received when using Libor as a benchmark rate .
ARRC ’ s June 2020 fallback recommendations promoted the use of approved methodologies to obtain an adjustment spread . In addition , the New York Fed has hosted workshops with US regional banks to review the credit risk component in Libor to ( i ) determine the adjustment spread that could be added to SOFR , ( ii ) discuss the attributes of such an adjustment spread , and ( iii ) consider how best to approach the calculation of such a potentially creditsensitive adjustment for SOFR .
It remains to be seen what impact these approaches will have on the project finance market – in the meantime the introduction of an adjustment spread gives rise to additional levels of uncertainty as it is not possible to accurately quantify the financial impact of the Libor transition at the outset ( which is not ideal in the context of a project financing ). This uncertainty , coupled with the divergence in approach between the LMA and ISDA based documents , gives rise to potential risks that have , to-date , not been a factor in intercreditor discussions for project finance transactions .
The differing objectives of the parties when negotiating the intercreditor arrangements for a screen rate replacement event can be summarised as follows :
• Borrower – The borrower is concerned to ensure that it maintains the fixed rate of interest it has forecast in its financial model , and that it is not going to be subject to unexpected additional debt service that will jeopardise its ability to meet the permitted distributions cover ratio test and diminish the amount of excess cash that can be distributed to its shareholders .
This concern is particularly acute in projects that are , for example , financed on the basis of long-term PPAs where there is less headroom in the distribution cover ratios .
• Lender – The lenders ’ interests are also aligned with the borrower in that they do not want the project to be exposed to the fluctuations , and thus uncertainty , of floating interest rates and / or for there to be a mismatch between the rate for the loan and the associated interest rate swaps . The lender will also want to ensure that its returns are not affected by any transfer of value as a result of the transition , hence the introduction of an adjustment spread .
• Hedging bank – The hedging bank has a different objective to the borrower and the lender as its primary motive is to ensure that it will be able to settle its back-to-back hedging liabilities , which are most likely managed on a portfolio basis . This means that the hedging bank will seek to ensure that the terms of its hedging products align – meaning that if the rest of its portfolio has migrated to , for example , the SOFR benchmark , the hedging bank cannot comfortably retain a Libor interest rate swap and will strongly resist entering into a swap based on a different RFR .
That said , the hedge provider will also not want to have a trade on its books with a creditimpaired counterparty , and so will be mindful of the economic impact its actions may have on the project .
Risk-free rate solution To-date we have seen a number of different approaches adopted and championed by project sponsors and their lenders to address the issue .
An aspirational position for borrowers would be that the hedge provider is required to adopt whatever replacement benchmark is agreed pursuant to the underlying loan agreement . This could potentially be acceptable to lenders and hedge providers on smaller bilateral financings , such as equity bridge loans , where the recourse is ultimately to the project sponsor and not to the project company , but is a harder position to sustain in a project financing comprising one or more lenders , which is typically the case .
Alternatively , the replacement benchmark agreed pursuant to the underlying loan agreement could be used as the starting position for discussions between the parties , but the hedge provider would not be bound to accept that rate .
The downside of this approach is that it does not alleviate the concerns of the borrower or the
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