Updated: Sep 24, 2024
On certain markets, the granting of a floating rate financing is usually associated with a full or partial interest rate (IR) hedging requirement.
Should there be several lenders, they would sometimes request that the IR hedging instruments be implemented on a pro-rata basis with each bank, in other terms, that each bank benefits from the same allocation percentage in the IR hedge (as hedging bank) as in the financing (as lending bank) : for instance, whoever lends 25% of the total debt amount, will have the right to provide 25% of the hedge amount.
On certain markets, should there be several lenders, they would sometimes request that the IR hedging instruments be implemented on a pro-rata basis with each bank
Is such pro-rata allocation always the rule? Is it always possible to implement? Is it always desirable? Which alternatives may be considered, and for which benefits? This is a multi-dimensional issue, which is important to understand properly.
Benefits and drawbacks of the pro-rata
1. A potentially significant extra cost for borrowers
Generally speaking, but even more logically in the case of complex projects or ones that are difficult to finance, the lenders who have undertaken a substantial amount of work in due diligence and credit analysis and who support the project by setting up the financing, are legitimate to have priority in the position of hedging bank.
The pro-rata basis could therefore appear as obvious: the bank knows about the file and if the setting-up of the interest rate hedging requires the hedging bank to obtain a committee agreement (such as for e.g., a swap or a cap with a running premium), it will be potentially quicker to obtain.
However, the main drawback of the pro-rata for the borrower is that it can remove the competitive pressure on the implementation terms of the hedging instruments[1].
In cases where the selection of lending banks has been made based on a comprehensive disclosure of the terms and conditions of the loan, the hedging strategy and the terms of the hedging instruments, these issues may appear to be low. But when the hedging strategy alongside the pricing and documentation conditions applicable to the hedging instruments are not yet determined, the pro-rata very often leads in the end to an alignment with the highest price offered by the hedging banks and reduces the borrower's negotiation power on the documentation. A result at the opposite of what would be obtained with a normal competitive process.
From the borrower's point of view, the pro-rata allocation of hedging instruments can thus have a significant cost
From the borrower's point of view, the pro-rata allocation of hedging instruments can thus have a significant cost.
The potential additional cost related to pro-rata is even greater when considering "off-market" transactions, i.e., those which fixed rate is not aligned with the mid-market rate when they are set up. As these transactions intrinsically bear a funding cost or benefit for the hedging banks, they will lead to very different prices from one bank to another, making the effect of a forced alignment even more costly.
This is particularly the case for loans that have been the subject of a pre-hedge, which has been more frequent since the start of 2022, when the upward trend in interest rates was gradually taking hold.
Whether it is a contingent swap or a forward starting swap, or even a swaption, the borrower will most often seek to ensure, by way of a novation of the pre-hedge to the final hedging banks, that there is continuity between the pre-hedge and the final hedge in order inter alia to avoid tax frictions. Such a situation may lead to the final hedging instruments between the different hedging banks being treated at very different market levels.
In that context, a strict requirement of pro-rata and lenders alignment may be detrimental to the borrower.
2. The benefit of an alignement between lending banks and hedging banks
Pro-rata does not only have downsides, however.
The main argument in favor of pro-rata applied to hedging instruments is that it allows the interests of the lending banks and the hedging banks to be aligned. Indeed, whatever the evolution of the market value of the hedging instruments, it maintains, over time, the share that each lender takes in the total project risk exposure, which is the aggregate of the loan exposure and the hedging instruments exposure (which may increase or reduce the loan exposure depending on the market value of the hedging instruments).
The other advantage of pro-rata is that it makes it easier to enforce a matching rule over time between the terms of the financing and the terms of the variable leg of the hedging instrument. This has been particularly noticeable over the last two years in the discussions on the LIBOR indexes termination, insofar as the least risky situation for the borrower was to perfectly match its loan and its derivative. This was made easier when the lending bank was also acting as hedging bank.
It is all about balance. Ideally, the borrower should be able to decide whether to allocate the hedging instruments pro-rata to the lending banks, considering all the benefits and drawbacks of pro-rata, without being compelled to do so by a contractual or commercial requirement.
Ideally, the borrower should be able to decide whether to allocate the hedging instruments pro-rata to the lending banks (…) without being compelled to do so by a contractual or commercial requirement
Pro-rata, a variable -geometry requirement
Each situation and market are specific in terms of whether pro-rata is required.
In LBO financings, where the financial stakes of the hedging instruments are lower because maturities are shorter and hedging ratios are often lower, pro-rata is not the standard rule.
In mature infrastructure projects with sponsors and investment funds benefiting of a strong bargaining power, pro-rata is often used, but is not set as an unbreakable rule.
In the renewable energy sector, where sponsors are generally more dependent on lending banks, pro-rata is more clearly requested by the banks, but the market is evolving.
In the real estate sector, the pro-rata rule is still quite common if the hedging bank needs access to mortgage collateral (e.g., for a swap) but the market is much more open otherwise (e.g., for a cap with a premium paid upfront).
And in each category of financing, hedging banks will naturally be stricter on pro-rata when they identify that borrowers have limited negotiation power.
And in each category of financing, hedging banks will naturally be stricter on pro-rata when they identify that borrowers have limited negotiation power
Pro-rata is not always possible
In practice, it is not always possible to apply a strict pro-rata. This is the case, for e.g., when lenders would offer floating rates financings but are not able to act as hedging banks. Examples include BPI or multilateral institutions which, usually, do not offer hedging instruments. It also happens that some commercial banks have lending capacity in certain currencies or maturities but not necessarily the same capacities on IR hedging instruments, making pro-rata impossible in practice.
However, lenders still require this part of the loan, when indexed to a floating rate, to be hedged.
In these situations where the lack of pro-rata is a de facto starting point, hedging banks do not systematically request that the allocation of surplus derivatives be pro-rata allocated to the hedging banks. Especially since some hedging banks cannot get internal approval to deal with more derivative par value than their loan par value. Lenders will then readily admit that pro-rata is not possible, and the excess cover can be more conveniently allocated by the borrower.
What deviations from the pro-rata?
Where the documentation allows deviations from the prorate rule, these deviations may take several forms.
1. Orphan hedging banks
The strongest deviation consists for one or more hedging banks not to belong to the lending banks. They are then called "orphan hedging banks".
Some French, Japanese, American or Canadian banks have clearly identified themselves as potential hedging banks for projects in which they are not involved as lenders. These hedging banks generally require guaranteeing their potential claims via a "pari passu" access to the same “Security Package” as that of the lenders, which implies that in case of a credit event, all the creditors (lenders and hedging banks) will benefit from the same recovery rate, in percentage, of their claim.
When some hedging banks are "orphans", lenders would often ask to restrict the rights of such "orphan" hedging banks, in order to avoid that a hedging bank with a potentially low or no credit exposure (or in its favor) depending on the level and direction of the market value of the relevant instrument, be tempted to trigger a credit event against the lenders’ will, who are much more exposed to credit risk. Especially since the documentation will generally allow the orphan bank to accelerate its credit margin on the hedging instrument. This is one of the main arguments that banks use to oppose the involvement of an “orphan” hedging bank when their trading room has appetite to provide hedging.
Except that in practice, the documentation most often contains clauses that only allows the orphan hedging bank to trigger a credit event in the event of a default by the borrower on the hedging instrument.
In any event, it will be for the legal counsels to draft the documentation so that the rights of the parties are well calibrated
In any event, it will be for the legal counsels to draft the documentation so that the rights of the parties are well calibrated.
Some lenders will sometimes require an orphan bank to be subordinated (hence, not on a pari passu basis) to the other creditors, which would lead the orphan bank to come after the other creditors to recover its claim and would result in a lower recovery rate. This requirement is a discreet but effective way of discouraging the use of an “orphan” hedging bank because this subordination, which is unnecessary in the presence of a properly documented standstill clause, will have the effect of increasing the credit risk and the capital requirements for the “orphan” hedging bank, making it de facto uncompetitive on the margin terms.
2. Deviations from pro-rata between lending banks
Halfway between pro-rata and no pro-rata, it is sometimes stipulated that the pro-rata on hedging instruments will be implemented, only if the financial terms offered by each hedging bank are competitive, which allows to signal an intent while maintaining a form of competitive pressure.
Alternatively, or additionally, it is possible to provide that these deviations from the pro-rata rule at the start of the operations and/or throughout the life of the transactions will not be implemented in full but will stay framed by clearly established rules allowing to limit the risks of a misalignment of interests between the lenders.
Such framing methods are often applied to partial unwinding of hedges, typically when hedging instruments are partially terminated because of a faster than expected amortization of the financing (e.g., in the case of a cashsweep). When remedying an over-hedge situation, this flexibility in the evolution of each bank's respective share will simplify the administrative and operational management of these hedging re-adjustments. In the absence of such clauses, a borrower might have to undertake any partial termination of the hedge with all the hedging banks, which would lead him to add up the fixed costs of each bank for micro-transactions and executed with less competitive banks for this unwinding.
Conclusion
The degree of pro-rata applicable to each transaction forms part of the overall negotiation elements of a transaction, in the same way as the other financial cursors relating to the relevant financing.
The degree of pro-rata applicable to each transaction forms part of the overall negotiation elements of a transaction
Not giving in, prematurely to lenders’ requests for a pro-rata on the hedging instruments allows borrowers to maintain flexibility in the negotiation of the overall parameters related to hedging instruments backing financings.
Fully aware of these issues, the specificities of each market as well as the lenders constraints and the potential advantages of pro-rata in certain situations, ESTER teams can help you manage the pro-rata challenges as best as possible, in full respect of each transaction balance and closing schedule.
[1] On this subject read the report of European Commission "Loan syndication in the EU and its competitive impact on the credit market" which indicates about hedging instruments page 15 «In the segment PF/ INFRA, it is more common that the ancillary services directly related to the loan are allocated by the borrower/sponsor to the lending banks at the initial stage of the setting of the general conditions of the loan. Knowing who will provide the services allows them to discuss and agree on pricing (i.e., it is easier for them to disrupt the agreed process)”
