The decision to end Libor after 2021 has set hares running among the finance industry. And there are a number of consequences for infrastructure debt providers, borrowers and advisors. In this latest in depth article, Tom Lane examines the implictions and what is being done to handle the potential fallout.
The Financial Conduct Authority’s (FCA) decision to drop Libor after 2021 has huge implications for financial markets, including infrastructure.
The reference rate is arguably the most established benchmark in the world: linked to USD 350trn of financial products globally, including billions of infrastructure debt.
Libor is the floating component with lenders adding a margin, for the risk of lending to businesses, to calculate the interest rate.
Nearly all sterling and dollar floating-rate infrastructure debt – be it a loan facility or a floating rate note (FRN) – will rely on Libor for these calculations. Without Libor calculating interest gets complicated with both administrative and commercial implications. But unfortunately, so does implementing a replacement rate.
No Libor – Plan B
Generally European infrastructure loan agreements follow template documentation or “boilerplates” created by the Loan Market Association (LMA), the loan industry trade body. So if Libor disappears after 2021 infrastructure credit agreements will likely include a prescribed menu of fall back options for calculating interest payments.
Under these provisions, if an up to date Libor rate – often referred to as the “Screen Rate” – is unavailable, a historic rate is used. If historic rate’s are unavailable, a reference rate option comes into play. This is called the “reference bank” option.
This involves the administration agent – usually one of the lenders in the loan – to select one or a group of lenders to create a new “reference rate”. If for some reason this fails the next option is a lenders “cost of funds.”
But the language around how this cost of funds is calculated, which lender or lenders are selected, is typically quite vague.
“The wording around the cost of funds we have in loan agreements is very broad. Working through this would be new ground for us,” says one lender.
Consequently, finance lawyers are questioning the workability of the cost of funds option in the event that Libor disappears.
“The fall back regimes are interim measures. Used for calculating the odd day of interest here or there. It’s not workable on an ongoing basis. Not only is it unpredictable in terms of where the cost of funds approach would come out, but it’s also an administrative hassle, which the agent bank and borrower won’t want,” according to a lawyer with knowledge of the problem.
In addition to being administratively complex, the fall back provisions also pose clear commercial risks.
As such, it will be difficult for infrastructure borrowers and lenders to know whether their interest payments would rise or fall under the fall back options provided. A rise would clearly benefit lenders but might be unsustainable for borrowers. Likewise lenders do not want to left holding lower yielding loans if rates fall.
Existing FRN credit agreements have a slightly different problem. If Libor is unavailable, the reference rate for interest calculation falls back to the last Libor rate used.
Effectively, an FRN would switch into a fixed rate bond, undermining the issuer’s decision to choose floating rate debt and removing interest rate protection sought by FRN investors.
Transitioning in a new Libor rate – if one emerges – represents its own challenge for infrastructure lawyers, lenders and borrowers.
If a new Libor rate is agreed across the market, say Libor 2.0, the rate will need to be transitioned into existing credit documentation. This opens up a power play between lenders and borrowers who may or may not agree on the new rate depending on whether or not it is to their individual advantage.
As a result, infrastructure finance lawyers are assessing voting regimes baked into existing documentation as well as prepping new deals for the switchover.
Incorporating a new rate into a credit agreement generally requires compliance with consent procedures – an exercise in lender democracy. Typically this would require majority lender consent (two-thirds by volume of debt) and approval by the parent company (the borrower).
“This is a topic that is coming up consistently in conversation, according to another lawyer with knowledge of the process. “Lenders and borrowers want to have a majority lender consent threshold rather than an “all-lender” threshold.
“If you hold 30-40% of the debt and you agree with the borrower on the replacement rate, you don’t want a lender with 1% holding you to ransom.”
This is a focal point for conversation among infrastructure issuers, prospective lenders and their lawyers.
Borrowers and majority lenders do not want to be held to ransom by minority lenders under an “all lender” consent regime. Likewise, minority lenders do not want to be forced into accepting a new reference rate through a majority consent regime.
This area of credit agreement documents is receiving scrutiny in other asset classes too. Leveraged finance lawyers, working on the credit agreements backing buyouts by private equity firms are already seeing a struggle emerge between lenders and borrowers. Lenders are pushing for all lender consent requirements when it comes to incorporating a new reference rate, while borrowers are pushing back.
In the US – which will be transitioning away from dollar Libor – the debate is heating up. Certain lender groups have criticised the majority lender approach for something as fundamental as reference rate changes or subsequent margin changes.
In a recent US dollar leveraged loan financing issued by Surgery Partners, the company included the option for the borrower and the loans administrative agent to designate an alternative to Libor without any consultation with lenders, which was duly criticised.
Such responses by US issuers are being closely monitored by practitioners in Europe, as are the reactions of issuers in other asset classes.
It has been suggested that infrastructure finance could look to leveraged finance for examples of current legal technology on this issue, given the speed with which new loan agreements are drawn up thanks to the market’s propensity for refinancing.
Derivatives including interest rate swaps – heavily used in infrastructure finance – are also worked from Libor, adding an extra layer of complexity.
Counterparties will have to agree to transition to a new rate, and swaps contracts tend to have similar fall back provisions if Libor is unavailable. Borrowers would not want their swap contracts being worked off a different reference rate from the one underlying their loans.
Being bespoke agreements, swaps would also require renegotiation or unwinding on a deal by deal basis in what would surely be an uncertain and time consuming process.
In the absence of clear outcomes, the global derivatives trade body, the International Securities and Derivatives Association (ISDA) is already suggesting a new market in “basis risk”, allowing lenders and borrowers to hedge the risk of materially different interest rates as a result of the Libor phase out.
But some suggest this may simply be a plug for fresh derivative market making, rather than a workable solution given the uncertainty surrounding replacement rates.
Another potential outcome is that infrastructure lenders increasingly turn to fixed rate debt lending to avoid the hazard of the Libor transition.
Such a move would serve to speed up an already established trend, with the bulk of direct infrastructure debt lending by pension funds, insurers and infrastructure credit funds already being made on a fixed term basis. It would also reduce complications come 2021.
Second guessing the commercial implications is tough for all parties given the lack of clarity surrounding Libor’s replacement.
The FCA’s position is that Libor is no longer viable, so it is withdrawing its support.
The regulator helps to maintain the reference rate’s creation by having the ability to compel the 20 “panel banks” which submit their judgements or evidence of what Libor should be.
The FCA’s reasoning for withdrawing this support is simple: Libor today relies more on expert “opinions” than real transactions and banks providing these views are unhappy doing so.
The problem is that Libor is calculated from a type of lending activity which has dried up since the financial crisis – unsecured interbank lending.
In 2016 just 15 unsecured wholesale interbank lending transactions occurred that could be included in Libor, according to the FCA.
Expert opinions are sought in place of data points from real lending activity and so Libor ends up being based on views rather than concrete transactions. The FCA – like many in the market – think this is inadequate for a rate underlying so many billions of financial products, including floating rate infrastructure loans.
Instead, the regulator would like to see a market-led replacement that better reflects “market conditions”. One rate thrown up as a potential contender is SONIA (The Sterling Overnight Index Average). SONIA is a benchmark for unsecured overnight sterling lending between banks and building societies in the UK and is regulated by the Bank of England (BoE).
It is broadly viewed as the “risk free rate” for sterling and is based on a vastly liquid market with a depth of transactions. But it nonetheless has pitfalls.
First, SONIA lacks the credit risk premium implicit in Libor as the “interbank” rate. This extra risk premium would have to be designed and added on to get back to what Libor represents today – adding further complexity to the task.
SONIA is also an overnight rate, while Libor used for interest rate calculations in infrastructure lending is typically three or six months. Quite how SONIA could be extended to reach the same maturity is not clear. SONIA also only applies to sterling.
Libor which is administered by the ICE Benchmark Administration also produces dollar Libor as well as Libor for EUR, JPY and CHF.
However, the bulk of euro infrastructure deals involving international sponsors and lenders are worked from Euribor – calculated by the European Money Market Institute (EMMI) – and so remain unaffected, for now.
The US derivatives market is opting towards a “broad treasury repo rate”. But whether this is workable for other asset classes, including infrastructure lending, is unclear.
Fortunately for the market, both in Europe and the US, the LMA is leading the charge to find another rate, with the market expected to follow the LMA’s guidance.
“We are working with members, other trade bodies and regulators to establish an alternative to Libor, says Nick Voisey, managing director at the LMA. “I’d imagine the industry will seek to coalesce around a new transparent rate based on a depth of transactions. We will review all the options.”
The LMA is providing feedback to the Bank of England (BoE) on the latter’s White Paper on the role of SONIA and its appropriateness as a risk free rate for sterling.
The FCA, however, may well be taking a back seat, with its role in setting a new rate as yet unclear.
The FCA intends any new or updated benchmarks to be market-led and it is unclear whether the regulator would oversee a replacement rate, as it does the current ICE Libor. New EU benchmark regulations due in early 2018 may, however, necessitate greater oversight.