Project Finance International: Square Pegs and Round Holes




As market commentators and regulators have been highlighting for many months, the scale and complexity of the London interbank offered rate (Libor) replacement exercise requires all market participants to prepare for a coordinated transition as soon as possible. As we approach the end-game of this exercise, new project finance debt facilities and their interest rate hedging agreements continue to use Libor as a benchmark rate, albeit with various fall-back regimes depending on the governing law of the loan agreements and associated interest rate hedging agreements. This article explores some of the risk allocation issues that arise in connection with English law governed Loan Market Association (LMA) based project finance loan agreements and their associated ISDA interest rate swaps, as well as some of the recent positions being adopted on transactions. So long Libor... Libor’s creation is widely credited to Minos Zombanakis, a Greek banker who arranged a US$80m syndicated loan for the Shah of Iran in 1969 that contained a floating interest rate that was, at the time, uniquely priced on a formula that was linked to each syndicate bank’s cost of funds. Under Zombanakis’s structure, the banks charged the borrower an interest rate that would be periodically recalculated every few months and funded their loans with a series of rolling deposits. Pursuant to this simple formula, the various syndicate banks would report their funding costs before each loan-rollover date. The weighted average, rounded to the nearest eighth of a percentage point plus a spread for profit, became the price of the loan for the next interest period. Libor soon became the linchpin for a flourishing syndicated loan and derivatives market, and the accepted benchmark for floating interest rates. Often referred to as “the world’s most important number”, Libor is now used as the reference interest rate for a range of US dollar-denominated commercial and financial contracts worth around US$200trn, and more than US$370trn if other currencies are taken into account. Libor is intended to produce a rate that is representative of the rate at which financial

institutions could fund themselves in the wholesale unsecured funding market for a particular currency and tenor. However, even though around US$200trn worth of US dollar financial contracts reference Libor, the wholesale unsecured funding market is a, comparatively, tiny US$500m, which means that these activity levels are insufficient and therefore not a reliable sample for the underlying transactions that are underpinned by Libor. Partly as a consequence of the changing nature of financial markets, and partly as a response to high profile rate-rigging scandals, the UK’s Financial Conduct Authority (FCA), the body that regulates the administrator of Libor, announced in 2017 that it did not expect Libor to remain as an acceptable benchmark for the setting of interest rates beyond 2021. For some years regulators in various jurisdictions have been grappling with the problem of how to transition the financial markets to an appropriate replacement benchmark rate. Notwithstanding the recent turbulence in the financial markets due to the impact of the ongoing Covid-19 global pandemic, the FCA, the Bank of England and members of the Working Group on Sterling Risk-Free Reference Rates – the primary coordinating body for the objective of achieving market-led transition in sterling markets – continue to advise that market participants should prepare for transition to a new benchmark rate well in advance of the official target of the end of 2021 for the discontinuance of Libor. In fact, regulators in jurisdictions such as the US and Hong Kong are encouraging financial institutions not to provide any Libor-linked products after the first half of 2021. One interesting outcome of the effect of Covid-19 on the financial markets was that, at the peak of its impact, the importance of the transition from Libor to RFRs was in fact underlined by a further decline in actual interbank transactions – making Libor even less of a reliable representative rate.

Regulators in UK and Hong Kong have been encourgaging financial institutions not to provide any Libor-linked products after H1 2021


Project Finance International September 23 2020


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. 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. Mismatch risk allocation Until 2019, generally speaking, loan

• 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


level, the ISDA Benchmark Supplement, which has been developed by hedge dealers to provide uniform fallbacks across all hedge transactions in a portfolio. ISDA is currently in the process of updating the 2006 ISDA Definitions to incorporate new fallbacks relating to permanent discontinuation of certain “IBORs”, the IBOR Fallbacks. The ISDA Benchmark Supplement is drafted so that once the 2006 ISDA Definitions are updated and the IBOR Fallbacks are implemented, those new fallbacks will apply in priority to the fallbacks set out in the existing ISDA Benchmark Supplement. It is expected that ISDA will soon publish the IBOR Fallback Protocol and supplement, which will facilitate the inclusion of the new fallbacks in existing non-cleared IBOR derivatives transactions between counterparties. The LMA’s recommended definition for a Screen Rate Replacement Event, which is the triggering event for the replacement of the benchmark screen rate, lists certain events leading to a replacement of the interest rate that are objective, such as: “the supervisor of the administrator of that Screen Rate publicly announces that such Screen Rate has been or will be permanently or indefinitely discontinued”. However, this definition also includes certain events that are not objective, such as: “in the opinion of the [Majority Lenders] and the Borrower, that Screen Rate is otherwise no longer appropriate for the purposes of calculating interest under this Agreement”). Although the lender and the hedge provider in a project financing are often the same financial institution, they will wear different hats as they negotiate the terms of the financing and so a Screen Rate Replacement Event that can be unilaterally triggered by Unless the terms of the hedging agreement track the trigger event in the related loan agreement, the ISDA trigger event may be similar, but not identical to, the LMA Screen Rate Replacement Event definition. Such ISDA regimes will most likely follow the ISDA Benchmark Supplement, which updates the 2006 ISDA Definitions to include fallbacks that would apply following the Permanent Cessation Events – which are public statements or publication of information by the relevant supervisor or administrator that Libor has ceased to be provided – or the Pre-cessation Events – which are, again, public statements or publication of information by the relevant supervisor or administrator that Libor is or will no longer be capable of being relied on or is non-representative of the underlying market or economic reality that it is intended to measure. The objective measures in the LMA definition of Screen Rate Replacement Event do, more or less, align with the ISDA Permanent Cessation agreement between the lenders and the borrower can be problematic for hedge providers and vice versa.

Events definitions. That said, Pre-cessation Events are still not a wholly objective test. A trigger event under a loan agreement and its associated interest rate swap that gives rise to a unilateral determination made by different parties, ie the lenders or the hedge provider, is potentially problematic for a project financing. Basis risk and other issues When a trigger event occurs under the loan or hedging agreement, the finance documentation will typically require the relevant parties to inform the facility agent, who, in keeping with its general coordination role, will inform the other group accordingly. It is possible, and indeed likely, that this will give rise to a period of time in which the parties will discuss and consider the proposed replacement benchmark. If all parties can agree to the replacement benchmark, then there is an easy transition to the new rate in accordance with the various provisions in the finance documents that allow for the documents to be amended with minimal, if any, additional approvals. However, not unreasonably, the various parties will need to consider at the outset of the financing what should be the outcome in a scenario where the proposed replacement benchmark is not accepted by the lenders or hedge providers. This means that, prior to the Libor transition, participants in new project financings have had to consider how best to document and allocate the following risks: 1 – A mismatch in the timing for the trigger event under the loan agreement and the associated interest rate swap, meaning that the floating interest rate risk under the loan is no longer offset by the swap, basis risk. Both ISDA and ARRC are working towards aligning the Permanent Cessation Events and Pre-cessation Events, which may, in time, create consensus in the market for SOFR related RFRs for US dollar loans. This would mean that any timing mismatch for US dollar loans and hedging agreements would not affect the rate replacement decision-making process, irrespective of whether the triggering event occurs under the loan or the hedge. 2 – The market standard for benchmark rates for the loan market and the swap market could differ. There are already different manifestations of the SOFR RFR, such as a Term SOFR, a daily SOFR and a SOFR compounded in arrears or advance. If the replacement benchmark under a loan agreement is different from the proposed replacement benchmark under a hedging

Both ISDA and ARRC are working towards aligning the Permanent Cessation Events and Pre-cessation Events


Project Finance International September 23 2020


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 credit- sensitive 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 credit- impaired counterparty, and so will be mindful of the economic impact its actions may have on the project. 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 Risk-free rate solution To-date we have seen a number of different

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lender that there could be a mismatch between the rate in the loan agreement and the associated interest rate swap, but at least the timing and the triggers are aligned. The project finance market differs in its approach to this issue compared with other forms of structured finance due to the prevalence of public agency lenders, such as ECAs, multilateral agencies and DFIs. While some ECAs can provide direct loans, they have not, to-date, been able to provide interest rate hedging solutions other than the CIRRs offered by some of the ECAs. This is not the case for multilateral agencies and DFIs, which regularly provide interest rate swaps alongside their loans. These institutions have traditionally taken a conservative position in relation to risk allocation and as such we do not expect that they will be willing to accept any link in their interest rate swaps to the floating rate in their corresponding loan agreements. The rationale for this is that, unlike a major international bank that has greater ability to manage its hedging portfolio, a multilateral agency or DFI may be tied to the terms of whatever back-to-back hedging arrangements it entered into at the time it executed its Libor interest rate swap. The project finance market also differs in its approach to other forms of structured finance in another key respect, and this is due to the close-knit relationships that are formed between project sponsors and project financiers, who have

often worked together on multiple projects over many years, and the, relatively, small number of participants who can act as both a lender and a hedge provider. The practical reality of this dynamic means that for a hedge provider to do anything other than act in a constructive and co-operative manner following a Screen Rate Replacement Event under the loan would not only cause major relationship issues, but would also be against that financial institutions’ interests in its capacity as a lender. In addition, many participants in the project finance market take the view that, in the case of US dollar financings, which is usually the currency of choice for project financings in emerging or developing markets, the forward market for SOFR will be sufficiently liquid by 2021 so that its adoption will be a mechanical, rather than commercial, exercise. In the meantime, participants in the project finance market will continue to work towards ensuring: (1) a clear understanding of the trigger events in the loan and hedging documentation (2) a transparent approach to the determination of the replacement benchmark rate – ideally with clearly defined fallback mechanisms in the documentation (3) a transparent approach to the determination of any adjustment spread, with a clearly defined methodology and (4) the further alignment of the loan and hedging market in its consideration of this issue. n

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Project Finance International September 23 2020

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