Topics: Prehedging / Project finance / Interest rate risk
The start of this year 2022 confirms the exceptional craze for contingent hedging
witnessed in 2021 in project financings whether the financing envisioned is a fixed rate financing or a variable rate financing. Contingent hedging is not new. For more than 15 years, it has been regularly used in the context of asset acquisitions, in particular for foreign exchange (FX) hedging when the purchase price is denominated in foreign currencies.
If the acquisition goes through, the FX hedge is executed and if the acquisition is abandoned, the FX hedge disappears, and no amount is due by the purchaser to the hedging bank. Obviously, this contingency on the success of the acquisition has a cost, but unlike a traditional optional hedging, this cost is only effective if the acquisition goes through, there is no cost if the acquisition fails.
In the context of project financing, contingent hedging was rare until now. But that was before
What are the reasons for the sudden craze for contingent hedging in project finance? Which are the key triggers and limitations to the use of this solution?
The craze for prehedging
In 2021, the combination of historically low long-term interest rates, increasing inflationary pressures and highly leveraged projects thus exposed to the risk of increasing debt costs, led many borrowers to consider and put in place pre-hedging strategies. These prehedges allowed them to reduce or even eliminate the project’s risk linked to the evolution of the debt cost well in advance of the financial close allowing them to concentrate on all the other aspects of the project.
One of the pre-hedging instruments being the contingent hedge, year 2021 was therefore a fertile ground for contingent hedges but this only does not explain the enthusiasm for this instrument. Contingent hedging also met the expectations of numerous sponsors and proved to sometimes be the best, if not the only, available solution.
The advantages of contingent hedging
1. No option premium to pay, nor guarantees to give
Pre-hedging with options implies to have the necessary cash to pay the option premium, which is often not the case of SPVs as they do not have sufficient financial resources before the first debt drawdown.
Likewise, setting up a forward swap or an option with an option premium spread over the life of the project would require the bank to be able to take a credit risk on the SPV whereas the bank does not yet have access to the project security package. Giving cash as collateral or offering the bank a First Demand Guarantee is not always an easy thing to do or can have a significant financial cost.
In the case of multiple sponsors on a project, which has been increasingly the case in the recent years, this issue of guarantees or cash to be deposited, swiftly becomes a complicated matter to manage between the sponsors.
From this point of view, contingent hedging is a source of simplification.
Contingent hedging requires neither the payment of an option premium nor the provision of any guarantees to the hedging bank, even though the SPV is often still an "empty shell"
2. Not take the risk of non-completion of the project
It should be remembered here that the primary benefit of the contingent, as well as in the case of acquisitions, is above all to avoid committing financial resources and the risk of losses due to the hedging in the event of non-completion of the projects. The primary benefit of a contingent hedging is definitely to avoid having to unwind at a loss financial instrument that have become irrelevant, and this is the main reason why it is more expensive than a forward swap.
3. However, contingent hedging does not only have benefits
The contingency premium, which is included into the rate if the project materialises, remunerates the hedging bank, which is precisely taking the risk of having to unwind the hedging instrument at a loss should the project not materialise. If the project is certain or almost certain and the sponsor(s) can provide a first demand guarantee or set up a cash collateral, the contingent hedging may prove to be an unnecessarily expensive choice.
4. And not all projects are eligible for contingent hedging
Where the project completion is deemed to be too uncertain by the prehedging banks, or the project is too small or too large, contingent hedging may not be possible or may be prohibitively expensive, thereby effectively disqualifying such prehedging strategy.
Last but not least, not all banks are in a position to offer contingent hedging, and offering contingent hedging requires the bank to carry out fairly advanced due diligence on the project in order to understand the likelihood of its occurrence. This is why, when a contingent hedging needs to be put in place within a short timeframe, the lending banks are often in the best position to judge the likelihood of the project reaching financial close. Having lending banks capable of implementing contingent hedges can therefore greatly facilitate setting up contingent hedging instruments.
Beware of particular provisions in contingent hedging
Contingent hedge requires a precise definitionof the event that triggers the contingency. In the case of an acquisition, this is the acquisition of the target. In the case of a project financing, it may be the signing of the financing documents (financial close) or the first drawdown of the debt.
If the project runs smoothly, the contingent hedging behaves like a forward swap, with an additional cost related to the contingency premium charged by the bank.
But if the project does not work out as planned, it is important that the contingency protects the borrower effectively, unless the borrower is himself at fault… The borrower must act in a transparent manner, much like the insured party vis-à-vis its insurer. Hence the implementation of borrower's commitments, which are typically found in the documentation of contingent hedges
Careful attention must be paid to these clauses, which may, in case of a breach, result in the contingent hedging becoming a firm hedging, with thus an unlimited risk of termination in the event of a fall in interest rates and non-completion of the project.
Some of these commitments are unavoidable :
An information undertaking: the borrower shallinform the contingent hedging bank of any event thatmakes it less likely that the contingency clause will beenforced. The definition of such an event leaves someroom for discretion, and an insignificant piece ofinformation may turn out ex-post to be the startingpoint of a situation preventing to reach financial closeor the first drawdown of the debt. Care shouldtherefore be taken not to draft this clause too vaguely,especially if the lack of information would allow thehedging bank to claim the termination balance of thehedging instrument as if it were firm.
An undertaking not to take out an alternativefinancing: the borrower may not decide to finance itsproject with an alternative financing structure thatwould de facto make it impossible to meet thecontingency clause.
However, some other clauses can prove to be dangerous for the borrower:
More or less clearly defined autonomousevents of default may also be proposed by the hedgingbank, such as "frustration" clauses which allow the bankto claim the termination balance on the grounds thatthe borrower has not done all that was necessary tocomplete the project.
Or "good faith" clauses which may weaken theborrowers' negotiating position in the documentationof the financing documents to the extent that thehedging bank could use a disagreement on a particularclause or feature of the financing and blame it on theborrower in order to claim payment of the terminationbalance.
All of these clauses that are exceptions to contingency may have the effect of blurring the line between a contingent hedging and a firm forward swap
Even though the borrower is charged a contingency premium and generally does not consider at any time the adverse scenarios where the hedging bank could be led to claim the termination balance despite the contingency.
And from the bank's point of view ?
From the bank's point of view, the risk of a contingent hedging is not obvious to manage because the risk of non-realisation of the closing is not hedgeable on the markets. It is a risk that the counterparty must carry in its balance sheet.
In situations where rates fall and the project does not go through, the risk of financial loss is high. For this reason, the hedging bank will screen projects carefully and accept that entering into such a contract is a market risk and not a credit risk. It will therefore not need to go to a credit committee but rather a market risk committee. Among the criteria that the hedging bank takes into account, apart from its analysis of the probability that the project will go ahead, is also the loss that the sponsors themselves would suffer should the project not be completed, the "skin in the game" of the sponsors.
If the project appears to be highly probable, the hedging bank will be tempted to hedge the contingent transaction with a firm market hedge and thus earn the contingency premium if the project goes ahead. But the market risk committee may require that a certain portion of the bank's risk be covered by options or any equivalent technique.
The pricing of the contingency premium will have to take into account this probability of achieving the contingency, which can be estimated quite differently by the different potential counterparties.
Depending on the project, contingency premiums can vary between 20% and 65% of the spread premium price of the corresponding option
Anticipating the conversion of a contingent into the final project hedging
As with all pre-hedges, it is essential to anticipate the outcome of pre-hedges when they are converted into final project hedging instruments.
What will be the final hedging banks? Will the prehedge have to be unwound and new hedging instruments put in place? With what risks and at which cost? Answers to all these questions are essential before an effective contingent hedge can be put in place and the risk reduced.
Conclusion
ESTER is by your side to set up the perfect prehedging strategy, should it be contingent or not.
Each situation has its own hedging - as always, the hedging strategy must be adapted to all the parameters. With contingent hedging, there are many parameters to take into account, but there are good benefits when the situation is appropriate, and the transactions are well managed.
