On 11 January 2021 the Bank of England (BoE) re-affirmed the BoE’s and FCA's commitment to replace LIBOR with the RFR for Sterling (Sterling Overnight Index Average (SONIA)) by the end of 2021. This was confirmed by the FCA on 5 March 2021.
Similarly, US Dollar LIBOR and EURO LIBOR will cease, being replaced by Secured Overnight Financing Rate (SOFR) and Euro-Short Term Rate (€STR) respectively. EURIBOR will continue but the switch to €STR is recommended.
These rates, known as risk free rates (RFRs), are lookback rates based on real observable transaction data, and are considered more robust and stable than the previous LIBOR rates. SONIA, for example, reflects the average interest rate that banks pay to borrow sterling overnight from other institutions. SONIA also tracks the BoE’s bank rate very closely and is relatively predictable.
Previously LIBOR, a forward-looking rate, included bank credit risk and a liquidity premium contingent on the term. The RFRs do not include these risk elements. Accordingly, the RFRs are likely to be a lower rate than the corresponding LIBOR rates, potentially leaving a pricing gap which needs to be corrected on a switch a loan to an RFR.
Impact on project finance transactions
Every legacy project finance loan agreement based on LIBOR will need to be amended by an amendment agreement to either incorporate the chosen new RFR or include where possible a switch mechanism to an RFR.
Some loan agreements, particularly more recent agreements, may have provision for the replacement of LIBOR. However, many will not, and an amendment agreement will need to be negotiated and agreed. Both project company and lenders will want to ensure that there is no economic change as a result of the rate switch. As the switch will be to risk a free rate, and LIBOR is not risk free and priced accordingly, a credit adjustment spread will need to be agreed to record the difference between LIBOR and the RFR. In the case of Sterling LIBOR, a preferred methodology is to use the median difference (spread) between LIBOR and SONIA as calculated over the previous five years.
To assist with the change, the Loan Market Association (LMA) has published a number of "exposure drafts" of their precedent document, including facilities agreements incorporating rate switch provisions. In addition to rate switch provisions, parties in project financings should consider a number of other terms in their facility agreements, for example:
- Interest periods;
- Fall-back provisions;
- Application of any break costs;
- Aligning notice periods for prepayments with the lookback periods, to address mismatch risks;
- Market disruption provisions; and
- Forward looking debt service coverage provisions.
The industry Sterling RFR Working Group recommends the following approach for loan agreements where Sterling LIBOR is to be replaced:
- implementing SONIA via a compounded arrears methodology in place of Sterling LIBOR;
- implementing a five-banking day lookback;
- that accrued interest could be paid at the time of the principal repayment.
If there is any security, as is norm on a project financing, or guarantees, confirmations from guarantors of the changes, or retaking of security, may be required as part of the transition from LIBOR.
Project finance interest rate hedging
Hedging of floating rate interest based on LIBOR to provide certainty of financing costs is a key feature of project finance. As LIBOR is changing in finance documents, hedging arrangements will also have to change to ensure that there is no mismatch between the exposure of project companies under the finance documents the exposure of the parties under the hedging arrangements. The same benchmark will need to be used in the hedging agreements as for the loan, to avoid any mismatched payments and basis risk.
ISDA (International Swaps and Derivatives Association) has published:
- an IBOR Fallbacks Protocol (the Protocol); and
- an ISDA Fallbacks Supplement to the 2006 ISDA Definitions (the Supplement).
The IBOR Fallbacks Supplement amends ISDA’s standard definitions for interest rate derivatives to incorporate fallbacks from LIBOR to RFRs and applies automatically to new derivatives from 25 January 2021 onwards.
The IBOR Fallbacks Protocol enables parties to incorporate the fallbacks into their legacy hedging document. This is voluntary, but it is recommended that market participants amend their existing ISDA Master Agreements and other derivative contracts to incorporate new RFRs.
Updating project financial models
Financial models in projects may have been developed based on LIBOR based interest, and these will need to be checked and updated if necessary to reflect the transition to RFRs. Some projects may include provisions in loan agreements relating to the replacement of the LIBOR benchmark, which could make the transition easier. Forwarding looking projections such as debt service coverage ratios and loan life cover ratios may need to be modified. Such changes to cover ratios and financial models will require negotiation with the finance parties, and trigger levels in the finance documents for “lock up” (restrictions on payments of dividends) and default will need to be checked again. Dealing with these issues and checking that there is no substantive change due to the rate switch will take analysis and understanding of the existing position.
LIBOR and project documents
Project documents should be checked as to whether calculation of periodic payments includes any LIBOR based component or content. There may be a mechanism for agreeing a substitute benchmark. If not an amendment to the project document may be required.
Termination values in project documents are often structured so as to match the outstanding indebtedness of the project company on an early termination of the project. Such provisions will have to be re-assessed, and amended if necessary to ensure there is no value change.
Changes to payment calculations and termination value calculations may involve a negotiation with project counterparties, who could be a governmental authority, or a public authority. In a project financing, such changes will further require finance party approval and consent.
Amendments to finance documents to deal with LIBOR transition could be deemed a refinancing under the project documents, and require the consent of the project counterparty, unless the project company can demonstrate that there is no gain to it as result of the amendments.
LIBOR and other third-party contracts
LIBOR can often be used in other commercial project documents, for example, calculations of default interest. Decisions will have to be made as to whether to, and how to, adjust such provisions. Most of these agreements will not provide for a substitute rate in the event that LIBOR ceases. Rather than switch to an RFR, in many instances it will be simplest for the parties to agree an alternative default rate, such as a bank base rate.