Benchmark reform: the impact of LIBOR transition on the African project finance market

Quick read

• LIBOR is commonly used in project finance transactions as the basis for the calculation of a floating interest rate for sterling and US dollar loans. It is very likely that LIBOR will cease to be published after 2021. LIBOR will need to be replaced with an alternative “risk-free rate”.
• New project finance documents will need to allow for the new rate and market wording is expected to develop over the coming months.
• The transition to an alternative rate raises issues for existing transactions: finance and project documents extending beyond 2021 will need to be amended to reflect the alternative rates and hedging arrangements may need to be revisited. These changes may necessitate negotiation and agreement between various project parties, not just the lenders and borrower.
• The challenge of transition is particularly pronounced in the project finance market given the long tenor of the financing arrangements, the prevalence of matched interest rate hedging, the often large and varied financing syndicates and the complex documentation and project party structure.
• Market participants should be reviewing their financing arrangements to assess what steps they need to take to ensure a smooth transition to replacement rates.

What is LIBOR and how is it used in project transaction documents?

LIBOR (the London interbank offered rate) is a benchmark interest rate which is supposed to represent the rate at which banks lend to one another in the international interbank market for short-term loans. The rate is forward looking and is calculated and published each day for different tenors in various currencies, including sterling and US dollars. The rate is based on submissions by panel banks.

LIBOR is used in project finance documents as the basis for the floating interest payable by the borrower – usually LIBOR plus a margin. It is also used in other transaction documents. For example, it may be used in a concession contract or power purchase agreement as the assumed basis on which the project is paying interest on its project financing loans or used to determine default interest rates for non-payment of amounts due.

Why is LIBOR being replaced?

A series of scandals surrounding interbank offering rates (IBORs) has prompted a move in the UK, US and many other jurisdictions to discontinue IBORs, such as LIBOR, forcing a move to new benchmark rates (alternate reference rates or risk-free rates). These new rates are based on actual transaction data rather than panel bank forecasts. The impact of this transition on the financial services sector, and all businesses that deal with it, is likely to be significant.

What are risk-free rates?

Risk-free rates are benchmarks generally based on overnight deposit rates. A risk-free rate has been identified for each currency for which LIBOR is currently published.

For sterling, the risk-free rate is the Sterling Over Night Index Average (SONIA) and for US dollars it is the Secured Overnight Financing Rate (SOFR).

What are the disadvantages of using risk-free rates?

SONIA and SOFR are backwards looking - they are published the day after the period to which they relate. This creates challenges for loans, making it more difficult for borrowers to know at the outset of the interest period what will be payable at the end. To deal with this, the market is moving towards a compounded rate, calculated over an observation period which starts a number of business days before the end of the previous interest period and ends a number of business days before the end of the current interest period, giving the borrower at least a few business days’ notice of the payment amount. The market is also considering term risk-free rates, which would be forward looking. However, these may not be in place in time for the end of December 2021 and may not be appropriate for all types of transaction.

In addition, SONIA and SOFR do not include a premium for term or counterparty credit risk so there is likely to be a difference in value between SONIA or SOFR calculated on a compound basis and the equivalent LIBOR term rate. For this reason, market participants are considering whether a spread value adjustment or payment may need to be built into any new interest rate to achieve the same economic effect for a bank as a LIBOR based rate.

What is the impact of transition on project finance transactions?

The challenges associated with LIBOR transition are particularly pronounced in the project finance market given the long tenor of financing arrangements, the prevalence of matched interest rate hedging, the often large and varied financing syndicates and the complex documentation and project party structure.

• Financial models and forecasts - For existing transactions, economic assumptions, financial models and forecasts will need to be updated to reflect the new benchmarks, involving lender and borrower negotiation. The transition to a new risk-free rate may have an impact on the financial ratios for the project, although it is anticipated that the market approach will be to introduce a new rate which has the same economic effect as a LIBOR based rate so far as possible.
• Changes to finance documents - In many existing LIBOR-based loan agreements, LIBOR cessation will trigger interest calculation fallback provisions which were only ever intended to deal with a short term unavailability of the screen rate. The fallback options could involve the rate being determined by reference to an historic rate, to a reference bank rate and ultimately by reference to the lenders’ cost of funds. None of these are likely to be appropriate for facilities with a significant remaining tenor. Any amendment to the calculation of interest has historically been subject to all lender consent.

Transitioning to a risk-free rate will involve significant changes to finance documents which reference LIBOR. Project finance transactions are often complex transactions involving different categories of lender - commercial banks, development finance institutions and multilateral agencies. This could lead to delays in decision-making regarding the new rate, particularly where all lender consent is required.

In transactions (for example, public private partnership financings) where a procuring authority is obliged to make a termination payment to the financiers based on the amount of principal and interest outstanding plus any hedging termination payment, the authority’s consent may be required if the amendments to the calculation of interest increase the authority’s liability above that envisaged at financial close.

Consents to finance document changes may also be required from other project parties, for example, an export credit agency or multilateral agency providing a guarantee or insurance to senior lenders or an offtaker, particularly if these changes might increase the obligations of these parties.

• Changes to project documents - Exposure to LIBOR extends beyond its use as a benchmark in loan agreements. The use of LIBOR can arise in other contexts, for example, assumed borrowing rates in the tariff calculation under a concession contract or power purchase agreement, or default rates in project documents. Often the use of LIBOR is referenced in ancillary documentation without the inclusion of any methodology for determining the rate if it ceases to be published. Parties will need to review project documents for LIBOR references and determine if amendments need to be made.
• Hedging - The floating interest on most infrastructure and energy project finance term debt is hedged to provide cost certainty to the project. The loan market and the derivatives market may take different approaches in transitioning away from LIBOR and care will need to be taken to avoid any mismatch in coordinating the amendment of hedging and loan documentation in existing transactions and also in structuring hedging arrangements for future transactions.

A prospective mismatch may have accounting implications for the borrower and its wider group, particularly public reporting companies, which may no longer have an “effective” hedge for hedge accounting purposes. The market is adapting to this by introducing temporary accounting standards to ensure a smooth transition for affected companies.

• Transaction security and guarantees - Amendments to the underlying finance documents may impact on the security and guarantees given as part of the financing. Consent of guarantors may need to be obtained, or new security may need to be granted, depending on the drafting of the original security and guarantee documents. In some jurisdictions, the requirement for new security will mean additional stamp duty payments. Local law advice will be needed.
• Loan administration - The loan administration function of a bank is structured around the current process for determining LIBOR. Change to an alternative benchmark will impact upon a bank’s systems and organisation. This will be a big challenge for agent banks, but the market is already exploring how the new rates can be managed.

What next?

Existing transactions

For existing transactions, the loan agreement is unlikely to adequately provide for LIBOR cessation and amendments will be required. The Loan Market Association (LMA) has devised language so that amendments required on a cessation of LIBOR are subject to a majority lender, rather than all lender, threshold. This language is now commonly included in LMA style loan agreements.

The LMA has also published a form of reference rate selection agreement for parties to LMA-style loan agreements to streamline the amendment process. It includes a binding summary of agreed terms which will need to be supplemented by a formal amendment agreement at a later date. It also provides authorisation for certain parties, rather than all, to sign the formal amendment agreement.

New transactions

The Bank of England's Working Group on Sterling Risk-Free Reference Rates has set a target of end Q3 2020 to cease issuance of GBP LIBOR-based cash products with tenors past the end of 2021.

For new transactions, the market is moving towards using risk-free rates instead of LIBOR as the relevant benchmark. Risk-free rates have been used recently in the bond market and in bilateral sterling loan facilities. In September 2019, the LMA published “exposure drafts” of compounded RFR facilities agreements for SONIA and SOFR loans. The stated aim of these drafts is to facilitate awareness around the issues involved in structuring syndicated loans which reference compounded SOFR, SONIA or other near risk-free reference rates. They do not, however, represent a standardised market position. Given the target set by the Bank of England Working Group, we expect to see loans referencing the new risk-free rates very soon.

What should market participants be doing now?

Planning is critical - managing LIBOR transition will involve an analysis of the consequences for transactions which are likely to extend beyond 2021, how these can be amended to reflect any new benchmark and the financial, regulatory, contractual, tax and accounting implications of such transition. Market participants should already be reviewing their financing arrangements to assess what steps they need to take to ensure a smooth transition to the risk-free rates.

For further information and regular updates on LIBOR transition, subscribe to the Norton Rose Fulbright Institute IBOR transition hub.

A version of this article was published in January 2020 in Project Finance International Magazine.