As lenders and borrowers prepare to say goodbye to Libor, also known as “the most important number in finance,” are project finance professionals ready? Taryana Odayar investigates.
In less than 24 months, the sun will set on the most referenced short-term interest rate in the world. By the end of 2021, the U.K’s Financial Conduct Authority (FCA) will cease publishing the London interbank offer rate (Libor), with profound implications not only for project finance but for lending of all shapes and sizes.
However, the change is expected to have an outsized impact on project finance, where relatively long tenors mean loans—and associated interest rate swaps—tend to hang around and accumulate on bank balance sheets.
“It’s not a stretch of imagination to say that the project finance sector may involve a bit more work than most other industries as we approach the Libor transition,” says Chris Simeone, head of East West Bank’s project finance platform in New York. “Project finance bankers are generally aware of this issue, but I’m almost equally certain there are parties who are not very aware.”
The transition will involve the renegotiation of thousands of Libor-linked credit agreements which mature after the benchmark’s termination date. Rates will need to be re-modeled and re-adjusted as the market transitions to an alternative reference rate. A great deal of cooperation will be required between lenders and borrowers who are—market watchers say—by and large totally unprepared for the challenge.
The general lack of knowledge among bankers and borrowers about the impact of the end of Libor on both new and legacy project financings—and about the alternative reference rates available post-2021, such as the Secured Overnight Referencing Rate (SOFR)—has alarmed project finance lawyers and other advisers.
“The transition is really not something you want to wait until the deadline to start,” warns Steve Plake, a partner at Riverside Risk Advisors, an independent derivatives advisory focusing on fixed-income, currency and commodity derivatives. “Discontinuation of Libor may have a greater impact on project finance than some other industries given the long tenor of the debt and the number of loans that have a larger than average lending group.”
Project financings often have final maturities in the distant future—designed to match the profiles of power purchase agreements and concessions going out 20 years, 30 years or even longer—but even when they are so-called “mini-perms,” with bullet repayments due after a shorter period of time, they are structured with long-term expectations of cash flows and long-term interest rate swaps in mind.
“Unwinding existing interest rate swaps based on Libor may be one of the biggest challenges,” says Marius Griskonis, a partner in White & Case’s energy, infrastructure, project finance and asset finance practice. Bankers negotiating deals with tenors of five to seven years, based on Libor margins, need to consider what the basis differential will look like once a replacement rate, such as SOFR, is put in place.
Andrew Bailey, the chief executive of the FCA, who is transitioning to a new role as governor of the Bank of England, has stressed the need to prepare well in advance for the transition. The FCA’s work on the Libor transition is being led by Edwin Schooling Latter, director of markets and wholesale policy.
“The lifespan of Libor swaps is limited by the coming cessation of Libor itself,” Schooling Latter tells PFR. “Anyone entering a new U.S. dollar Libor swap with duration beyond end-2021 needs to plan for its conversion to SOFR and any costs that would incur. As swap market liquidity moves from Libor to SOFR, SOFR swaps will presumably become the most readily available, cheapest to trade, and most easily managed.”
To ease the transition, in 2014, the U.S. Federal Reserve created the Alternative Reference Rates Committee (ARRC) to recommend a successor rate to bankers and provide guidance for a smooth transition. In 2017, after considering several options, including the Effective Federal Funds Rate (EFFR), the Overnight Bank Funding Rate (OBFR), other secured repurchase agreements (“repo”) rates, U.S. Treasury bill and bond rates, and overnight index swap rates linked to EFFR, the Committee picked SOFR as its recommended replacement to Libor.
Unlike Libor, which is based on quotations and “expert judgment” from a panel of 11 to 16 large banks, SOFR is produced by the public sector, which derives it from the U.S. Treasury repo market, leaving less room for the kind of manipulation that brought Libor into disrepute in the first place.
SOFR is also more transparent and representative, as the volume of underlying transactions is much larger than any other U.S. money market, averaging about $1 trillion of daily trading, compared to Libor, in which the most active tenor (three months) averages less than $1 billion transactions daily.
Despite ARRC having recommended SOFR and even outlined two approaches to implement it come 2022, project finance bankers are at best vaguely familiar with the new benchmark.
Some are clueless.
“What’s SOFR?” asked a puzzled senior project finance banker in New York when PFR inquired whether he was prepared. “No one’s really talking about it. No one has talked to me about it.”
After a moment’s contemplation, a reassuring thought crossed his mind: “The lawyers are going to be the ones who help document this!”
Other bankers are similarly complacent. “The lawyers will recommend the language and advice,” says another New York-based lender. “I hope they have more work than us, because they get paid no matter what, but we only get paid when we get a deal done.”
While it is true that project finance lawyers will have their hands full, much of the work associated with the transition from Libor to SOFR will also fall on the shoulders of lenders and borrowers.
“I’ll admit that this is not the first topic that comes up during cocktail hour,” says East West’s Simeone. “But I’d personally rather almost over-care about an issue like this than be apathetic. Let’s be prepared.”
The first and potentially most tense step for project finance banks will be a review of fall-back language in existing credit agreements, and the addition of provisions for a transition to an alternative reference rate, like SOFR, in new agreements.
“Borrowers, together with their financial adviser, should review their credit documentation to determine what process for amendment, if any, is provided for and what the implications are for Libor being discontinued,” says Plake. “Even if the answer is that nothing has been provided for explicitly in the documentation, there are still key steps that can be taken. The bottom line is that it is important for borrowers to engage in an informed, two-way discussion with their lending syndicate.”
Failure to have meaningful discussions and transition to a successor rate by the time Libor disappears could cause loan market disruption due to valuation differences arising from interest rate swaps and other derivatives, inaccurate and outdated financial models and improper hedges.
“The earlier the borrowers start thinking about the steps needed to transition to a new borrowing index, and start getting a handle on what they have in their credit agreements, the sooner they can start formulating a strategy for an orderly and efficient transition,” says Plake.
ARRC has recommended two approaches to implementing SOFR in this regard—the “hardwired” approach and the “amendment” approach. Although the hardwired approach is the one recommended by the Fed, lawyers say that this has gained little traction with lending banks, which prefer the amendment approach.
“The challenge is, when you talk to the banks about the ‘hardwired approach’ fall-back language, it’s still unclear how it will work,” says Griskonis.
“Hardwired” means that bankers and borrowers select a successor rate and spread adjustment, which they agree to incorporate into credit agreements, either after a benchmark transition event or through an early opt-in election.
In this approach, there are four flavors of ARRC-recommended SOFR to choose from, namely Term SOFR (forward-looking term rate), Next Available Term SOFR, Compounded SOFR and Simple Average SOFR. Of these, ARRC has recommended the forward-looking term rate as the primary fall-back rate from Libor and set a goal of bringing such a rate into being by the end of 2021.
While this approach provides clarity upfront when executing a large volume of transactions, it also prevents borrowers and lenders from taking full advantage of evolving market conditions.
It is no wonder, then, that banks prefer the amendment approach, which does not prescribe a successor rate or spread adjustment, but provides a streamlined process for negotiating a benchmark replacement.
“Instead of the hardwired approach, the Libor fall-back language we are seeing in the market is the amendment approach, which is preferred by the banks at the moment,” says Griskonis. “We’ve been using similar language even before the proposed ARRC language was released last year.”
Under the amendment approach, if there is a benchmark transition event, lenders will have five days to object to the proposed amendment. If an early opt-in trigger is exercised, lenders only have to provide affirmative consent for the amendment.
The amendment approach is more flexible, as it does not reference rates or spread adjustment methods that do not yet exist. However, it is unfeasible if there is a sudden or sooner-than-expected Libor cessation and thousands of loans have to be amended simultaneously.
The amendment approach is also likely to create winners and losers, according to a report published by ARRC last April. In a borrower-friendly market, a borrower might refuse to include a compensatory spread adjustment when transitioning to SOFR, subjecting lenders to a lower rate. In a lender-friendly market, lenders might block the proposed rate, forcing the borrower to pay a higher rate.
Although market participants show a preference for the amendment approach right now, it is likely that they may move towards the more standardized, hardwired approach by next year, say lawyers. By that time, there is also likely to be further regulatory guidance and a better understanding of the market by all parties involved.
It is also to be hoped that the SOFR market will become more liquid closer to 2021. This will be one of the primary concerns in transitioning from Libor to SOFR. While Libor and Libor-based swaps are extremely liquid, the SOFR market is not as liquid yet for trading purposes, potentially resulting in overwhelmingly high liquidity costs.
“Libor is ultra-liquid and well-understood, while SOFR is not even within an earshot of Libor’s liquidity and not well understood in this market,” says Simeone.
This could also give rise to a chicken-or-the-egg scenario, where bankers want to wait for the SOFR market to develop more depth but the only way this will happen is if the banks start trading SOFR-linked derivatives.
“Good luck in solving this problem. All of this is untested,” says the second New York-based banker. “We’re talking about trillions of dollars of transition. It will be a brave new world.”
Apart from choosing an approach for the transition to SOFR, bankers can also work on enhancing relationships with borrowers to calm the potentially choppy waters of contract renegotiation.
“In my view, the best means to ‘softening the blow’ over the work involved through the transition is maintaining a strong relationship with your clients,” says Simeone. “We should know our clients well, and they should know us well—this is the real key to navigating through unusual situations. Trust and demonstrated care make negotiations and work more manageable.”
That’s not to say that transitioning in every case will be easy. Lenders will not want to leave money on the table, while clients may see it as an opportunity to lower their borrowing costs.
Although the final outcomes are unknown, project finance officials at banks, developers and other project investors would do well to educate themselves on the topic. Bankers, in particular, may find other professionals in their own institutions, such as interest rate swap personnel, can help.
Or they could try just leaving it to the lawyers.