What’s the deal with LIBOR?

February 13, 2019

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by Chris Heys PwC Partner

Email +44 (0)7715034667

Credit funds and private equity dealmakers need to be aware of the consequences of the change-over from LIBOR to a new set of benchmark rates. Ignoring the transition risks a last-minute scramble to refinance or renegotiate portfolio company funding, with the challenges heightened by potential value leakage and a squeeze on liquidity. How can you get set for the big switch?

The London Interbank Offered Rate (LIBOR) provides a benchmark rate for at least USD 370 trillion worth of financial contracts worldwide. It’s calculated as the trimmed average of the rates submitted by a panel of international banks. However, confidence in LIBOR has been dented by manipulation scandals and the growing lack of interbank lending upon which to set a reliable rate. As a result, the Bank of England will no longer be compelling banks to make their submissions beyond 2021, and so LIBOR’s days look numbered.

The UK, US, Eurozone, Switzerland and Japan are bringing in their own new benchmark rates to replace the relevant IBOR. The Eurozone is leading the way with its Euro Short-Term Rate (ESTER) currently due at the end of this year, followed by the UK’s reformed version of the Sterling Overnight Index Average (SONIA) at the end of 2021. The rates won’t be the same as the existing IBORs and therefore counterparties won’t be able to simply ‘find and replace’.

Why worry?

If you’re from a credit fund, private equity (PE) firm or corporate backed by PE reading this, you’re probably wondering: “Why should I be bothered - deadlines are still some way off and surely this is a matter for regulators or banks to deal with, not me?”

Well, no. As someone who works with major banks and dealmakers, it’s clear that the disruptive impact will have to be managed by both.  

Many financial services organisations are pouring a huge amount of effort into unravelling existing contracts and preparing for the new benchmarks. The more they do, the more they find they have to do. And you could face the same kind of headaches with all the funding and hedging instruments you have in place that expire beyond the deadlines. In judging why, it’s worth separating the potential impacts on derivatives and debt.

Even though swaps and derivatives make up a much smaller amount of PE backed companies’ finance structures, this is the best place to start as market preparations for transition seem to be further forward than for debt. The International Swaps and Derivatives Association (ISDA) is coming up with standardised fall-back rates that can be applied to existing contracts to minimise value-transfer when LIBOR goes. Yet, the difference between the LIBOR and the fall-back rates will mean that many valuations are likely to change on the switch to new benchmarks. Portfolio companies may gain, but could also lose out. It’s also important to bear in mind that both contractual parties must agree to applying the fall-back to existing terms, though it’s expected that many will follow the protocol. The impact could potentially be significant over multiple contracts and multiple portfolio companies.  

The impact on debt instruments is likely to be even more disruptive. There are proposed debt market fall-backs currently out for consultation in the US and UK, but with varying market feedback.  Even if market wide debt instrument fall-backs are agreed over time, there are still many types of debt instrument that might still need to be renegotiated one-by-one, due to the bespoke nature of contracts.  Again, there could be a significant downsides or upsides to both PE and credit funds, over multiple portfolio companies and investments.

Unexpected re-financing?

What this boils down to, is that LIBOR reform could give some portfolio companies an opportunity to volunteer for an early refinancing, which might mean paying less on funding. On the other hand, it could result in some portfolio companies being forced by into an unexpected refinancing sooner than planned, which might mean paying more.

The other big factor is time. Far from being a long way off, we’re already well into the transition. When the plug is finally pulled at the end of 2021, market liquidity is likely to have been squeezed well before then, and so favourable contract terms will harder to secure in a final rush to meet the deadlines.

What should dealmakers be doing now?

If you haven’t already, you should consider doing the following:

  1. Put someone in charge of assessing the impact and planning, deciding whether to mobilise a LIBOR transition program.
  2. Review all debt and derivative contracts, understanding existing LIBOR fall-back clauses and whether these need to be re-papered.
  3. Think about the potential scenarios and implications for portfolio company debt and derivative contracts, identifying those in most urgent need of renegotiation and determining the right strategy and timing for renegotiations.
  4. Think about your communications to investors, clients and other key stakeholders. What information, and when, will you share on your plans to address LIBOR reform.

Private equity firms will also need to consider how the finance and treasury functions of your portfolio companies are assessing the wider impacts, such as the hedge accounting and tax. They may also need a plan for adapting IT, Treasury and operating systems to be ready for the incoming benchmark rates.  

While there is a lot to do and less time to do it in than you might think, you’ll be in a much stronger position if you know what’s coming and get on the front foot now.

European Banking Transformation and M&A Conference

On 27 March 2019 we’re holding our next European Banking Transformation and M&A Conference where you can hear from our experts on the future of banking, the resulting M&A opportunities in the industry and what this means for sellers, investors, new players and other market participants. We will be running a panel session on the potential impacts of LIBOR to dealmakers. Register now.

by Chris Heys PwC Partner

Email +44 (0)7715034667