Senior Pensions Consultant
Out-Law Analysis | 30 Oct 2020 | 4:32 pm | 6 min. read
There is just over a year to go before the London Interbank Offered Rate (LIBOR) ceases to be used as the measure of the average rate at which banks are willing to borrow certain funds, and it is time for those involved in the financing of energy and infrastructure projects to adapt.
The end of LIBOR will mean the financial markets must adopt other standardised methods of calculating cost of funds; it will also mean that LIBOR in existing documents could take on a whole new meaning – or none at all.
The market for energy, infrastructure and other real estate assest is already starting to move to new reference rates such as the Sterling Overnight Index Average (SONIA) across loan and hedging documentation for new transactions, but there is a significant exercise to carry out on existing portfolios of assets which largely has not yet started.
Failing to address these issues will leave lenders, hedge counterparties and borrowers exposed to regulatory scrutiny and contractual arrangements which may no longer be enforceable or mismatched. On the current timetable, LIBOR will not be quoted after the end of 2021.
LIBOR exists in multiple contracts across the complex suite of documents that supports large-scale energy and infrastructure assets. The most clearly affected will be financing documents – where no fixed-rate financing is in place in the primary debt documentation, there will be floating rate LIBOR-linked loan facilities with linked hedging arrangements to remove the LIBOR risk from the structure.
The long-term nature of the financing arrangements and structures means that proactive steps will be needed to amend the provisions that no longer function. The amendments need to satisfy regulators that adequate steps to protect the portfolios from LIBOR reform have been taken and satisfy the parties that the contractual protections in place still work as originally intended.
Changes may also be necessary within the wider contractual framework, from concession agreements through engineering, procurement and construction to operations and maintenance (O&M). Interbank offered rates lurk in many places.
The documentation for loan arrangements in place to finance projects could be in place for decades. In the last 30 years, the form of documentation has developed consistently and regularly as concepts became more refined and new risks were identified and allocated. Numerous versions of Loan Market Association or Loan Syndications and Trading Association standard forms, together with various in-house pro-formas or precedents, have emerged and regulate the financings that remain in place.
Very few of these will have any provision for a replacement of LIBOR on a long-term basis, although more recently there has been a concerted effort to anticipate changes to reference rates within the structures.
As SONIA is adopted, borrowers and lenders alike will want to ensure that the economic effect of the move away from LIBOR does not prejudice either party. As SONIA is a risk-free rate, and LIBOR was not, some form of adjustment or spread may be needed to reflect the credit risk and this is one area where all parties will need to reach agreement.
In new loans, margins will be adjusted to take this into account but back-book loans will need to either identify an additional spread or adjust the margin payable to bring the loans back into line with a similar pricing profile to that provided under LIBOR. Retrofitting the spread – and the amount of the spread – will be a commercial negotiation but hopefully one where the parties can work through the ramifications in the contractual suite.
The rare existence of drafting to support a transition away from LIBOR may not fully eliminate the risk of disagreement. Project finance structures will often involve numerous lenders and more than one hedging bank, which opens the door to mismatching internal policies or drivers. Relationships will be vital to work through to a position that represents the best outcome for all involved.
Most long-term financings have risk mitigation products in place to manage certain issues that are too big to leave unhedged – and fluctuations in interest rates, driven by LIBOR, is one.
The expectation might be that the same approach to adjusting LIBOR in the loan documentation will be carried across into the hedging documentation, but the possibility of orphan swaps or (conversely) lenders who are not swap providers in the structure could result in a mismatch.
The International Swaps and Derivatives Association (ISDA) has approached the market-wide issue by proposing a protocol that would apply to all parties that agree to its application. Adopting the ISDA approach should quickly become the accepted approach by hedging providers, reducing the level of possible conflict.
That gives lenders and borrowers alike a reference point around which to coalesce for the wider financing, despite ISDA making clear that the approach on hedging may not carry across into lending structures without detailed consideration.
Where hedging arrangements are amended, care will be needed to make sure a hedge accounting problem is not inadvertently created. Regulators are smoothing the path to allow SONIA to replace LIBOR without an undue impact on accounting, yet it remains an area to approach with care to ensure the correct application of accounting rules is taken.
A key dependency for projects based on concession arrangements, such as public-private partnership (PPP) contracts, will be compensation arrangements linked to the financing that supports the concession.
A change to the financing arrangements, such as a move away from LIBOR, will impact the provisions of project agreements in several places and will require the consent of the relevant public authority to ensure that the compensation arrangements are not jeopardised.
In addition, an amendment to finance documents will generally result in a refinancing under PPP rules. Unless the borrower can demonstrate that there is no benefit, however small, resulting from the switch from LIBOR to SONIA, consent from the public sector will be needed.
In most cases, securing consent from the public authority will be part of the process and needs to be part of the strategy. Wider discussions continue to seek a market-wide answer to some of the difficulties of re-opening concession arrangements, perhaps by taking a protocol-type approach or guidance being issued on how different parties in such structures are expected to react to the necessary changes to SONIA.
The use of LIBOR is common in many commercial and financial arrangements within the confines of a project. Default interest is calculated by reference to LIBOR plus a margin; or other payments or calculations such as power purchase arrangements, construction arrangements, or O&M provisions might use LIBOR as a proxy.
Often, these commercial contracts have no guidance on what to do if LIBOR is no longer in existence and it may be that amendments to these contracts require the consent of third parties. Building a strategy around the project and identifying the changes and associated consents required, alongside timelines and timeframes that can allow this to happen in an orderly manner, could be time-consuming. In some cases, a particular phase of a project such as construction may make the process simpler.
It is unlikely that SONIA is the right reference rate to be used in replacing LIBOR in all of these commercial contracts – a simple base rate could be much more suitable.
Again, relationships are important. Any contract amendment can open the door for unrelated negotiations – understanding the extent of the necessary changes across a portfolio and approaching negotiations in a structured way across portfolios will assist in reaching a position that recognises the value within the wider contractual relationships that often exist with parties in particular sectors.
As LIBOR is critical to the calculation of interest amounts, it is no surprise that financial models will need to be updated to reflect changes in the economic assumption of SONIA. Most projects will contain a mechanic to adjust economic assumptions and the intrinsic involvement of lenders in the LIBOR replacement process should make these adjustments easier to agree, but it will be another aspect to be addressed.
There is also a possible knock-on effect on the calculation of ratios and there might well be issues at the boundaries of defaults and lock-up ratios. Working through the challenges in a collaborative way in the knowledge that each aspect is being taken into account will help build trust between the parties and hopefully smooth the process.
Dealing with the transition away from LIBOR will take planning and careful analysis. For a significant majority, the process has the potential to be straightforward where there is a willing lender and a willing borrower.
This will not address the more complex transactions, where a sound knowledge of the underlying structuring is required to navigate the issues as well as an understanding of the likely position to be adopted by different counterparties.
Large-scale documentation reviews and the use of automation technology is likely to be helpful to allow lenders and borrowers alike to focus on the relationship element of SONIA transition, approaching the transition with an understanding of the potential areas of risk in particular asset pools and minimising the risks that the transition brings in unforeseen consequences.
06 Aug 2020
21 Nov 2019
Senior Pensions Consultant