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Hedging interest rate risk in Private Equity and Real Assets Financing
Where does rate risk come from?
When an investment is financed by a variable-rate loan, the lenders generally require the borrower to hedge itself against the risk of a rise in interest rates for a minimum amount and a minimum term. In Private Equity, this hedging requirement has often been seen as an administrative task, inducing companies to approaching it minimally and at the lowest possible cost.
However, after years with very low interest rates, the sharp rise in rates since 2022 has reminded investors rates impact could not be disregarded. and that it remained necessary to measure interest rate sensitivity before deciding on a hedging strategy.
For most investors, and especially for a company doing its first LBO, the interest rate hedging process is often a bit of a mystery, dealt with at the last minute without always fully understanding the long-term implications of the choices made.
The role of the Hedge Advisor at your side?
In full independence.
Quantify, secure and optimize.
What instruments should be considered for interest rate hedging?
The usual hedging instruments proposed for these operations are the interest rate swap, which transforms the variable rate of the loan into a fixed rate, and the interest rate cap, which caps the variable rate of the loan and allows the borrower to benefit from a potential decrease in rates. The choice of instrument will depend on the borrower's risk appetite. For certain projects, a combination of firm instruments such as swaps and optional ones such as caps may be recommended.
In their quest to reduce the cost of hedging, some players have considered more complex strategies, such as deactivating hedges. This type of strategy is indeed cheaper but provides less protection for the investor. They should therefore be handled with caution.
The Hedge Advisor will play a special advisory role in presenting the various solutions, along with their advantages and downsides, for the investors to decide on.
Point of attention: floored rate in the loan
Most variable-rate LBO loans include a floor on the variable rate that ensures a minimum coupon for the lender. In the best case, this minimum coupon is zero, but it is often equal to the credit margin. This minimum coupon must be reflected in the hedging instruments because otherwise, a decrease in rates beyond a certain threshold leads to an unlimited increase in the borrower's financial charges.
The importance of the hedging documentation
Hedging instruments used in asset finance are documented at several levels and in various documents including the credit agreement, the ISDA, FBF (or other) master agreement and the transaction confirmations.
The documentation of hedging instruments will ensure that investors are not exposed to unnecessary risks or costs throughout the project and that future events such as restructuring or early repayments are eased.
The Hedge Advisor has experience with these contracts and knows how to interpret the clauses to deduce the potential financial impact they will have in certain future scenarios. He will be a valuable asset in analysis and negotiation.
Example clause: Disappearance of Xbor Indices
Credit contracts and hedging contracts handle the disappearance or evolution of indices differently, which can create mismatches between the loan and its hedge.
The selection of hedging banks
Once the hedging strategy has been validated, the next step is to select the hedging bank(s). The key negotiating factors will typically include:
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The level of commercial margin or swap margin.
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Execution costs, an additional margin which may be added to the commercial margin
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Negotiation of certain legal or contractual clauses.
The Hedge Advisor knows the positioning of the various counterparties and will be able to question them in a way that ensures the comparability of quotes. He leverages his experience with comparable transactions to target the right price level.
Example: Expression of swap quotations
The price/rate that the borrower will pay is generally the sum of the following three components: (i) the Mid-Market Price (MID) which fluctuates constantly but is an objective data point controlled by the Hedge Advisor, (ii) the Commercial Margin related to the instrument and is a negotiated charge specific to the transaction, and (iii) the execution costs, which are generally based on the size of the transaction and the market's liquidity/volatility. These elements are entirely different depending on whether one considers a long or short hedge, a small or large size, in a liquid or illiquid currency.
Banks on-boarding
Once the banks have been selected and the terms and conditions agreed, the next stage is to prepare for the execution of the hedging instruments. The first step is the on-boarding, which is essential for executing. There are a number of regulatory documents that need to be signed prior to any transaction, such as the documents that will allow the counterparties to know their customer (Know Your Customer or KYC), check compliance (anti-money laundering and combating the financing of terrorism, AML/CFT), prepare the mandatory reports under the EMIR regulations, including obtaining an LEI (Legal Entity Identifier), meet the requirements of the MIFID regulations, answer certain tax questionnaires, and so on.
It's a sometimes tedious and often mysterious process, but one in which a Hedge Advisor's insight is always useful.
The preparation and execution of hedging instruments
The aim is to ensure that, when the time comes, there is no room for the unexpected thanks to meticulous preparation and rehearsals for setting up the operations under real conditions. When all the lights are green, it is then possible to move on to the execution phase of the hedging instruments. Thanks to a relevant upstream preparation, this execution may only be a mere formality.
It may nevertheless happen that, and despite all the care taken in the preparation, an unexpected event occurs during execution: a hedging bank does not have the same price as expected (all other things being equal) following the dry runs, an untimely and violent market movement occurs just before execution or any other unforeseen event. These situations need to be prepared in order to react efficiently when the time comes.
Here again, the presence of a Hedge Advisor, who establishes a price/rate on the same product as the hedging banks in real time, makes it possible to manage these situations with a high degree of efficiency and transparency.
Example: execution in a volatile market
At the time of execution, the market may be particularly volatile, and rates can shift very quickly. Being able to perfectly track market movements becomes critical to avoid overpaying, sometimes significantly, for the hedge.
Checking confirmations and monitoring transactions.
Despite all the care taken by banks, it is still often that confirmations issued by banks' post-trade departments contain more or less substantial mistakes that need to be identified and corrected.
The Hedge Advisor quickly identifies these discrepancies and arranges for the counterparty to correct them.
Transactions’ lifecycle is not always a smooth ride. A deterioration in the credit quality of a counterparty, refinancing, the sale of an asset... All these events have an impact on hedging.
The Hedge Advisor will be your partner and may also offer a regular valuation service.
The ESTER hedging guide
To learn more, ask for a free copy of the ESTER hedging guide below.
