The process of identifying and implementing a new benchmark rate of interest to replace LIBOR for U.S. Dollar-denominated loans is underway. On account of the widely reported charges of manipulation in connection with the setting of LIBOR rates and with global lending regulators confirming that LIBOR will cease as a reference rate by early 2022, sponsors and other participants in the syndicated and direct loan markets should be aware of the coming transition to a replacement benchmark rate.
The industry working groups considering alternative benchmark rates have all but settled now on the secured overnight financing rate (SOFR) as the benchmark interest rate that will replace LIBOR. SOFR is a (virtually) risk-free rate based on the actual overnight interest rates charged on secured loans backed by U.S. Treasury securities in the extensive U.S. Treasury repo market. Because it is based on actual transactions, SOFR would not be subject to potential manipulation in the way an indicative rate like LIBOR is, being determined as it is through a survey of reference banks.
But issues abound in connection with the adoption of SOFR as the replacement rate.
First, it will be a major operational challenge to replace a forward-looking interest rate such as LIBOR (i.e., an interest rate that is known in advance of the selection by a borrower of an interest period for a loan) with a backward-looking rate such as SOFR that is based on prior transactions. There are not as yet any forward-looking SOFR published rates, and likely will not be for some time, until a robust loan market using the SOFR benchmark develops.
Second, borrowers’ inability to know the amount of interest that will accrue on a particular loan in advance of the relevant interest period may pose certain cash-management issues for borrowers.
Third, because SOFR is a risk-free rate of interest (calculated with reference to transactions fully secured by U.S. Treasury securities), while LIBOR represents a rate of interest for unsecured interbank lending transactions that entail a degree of risk that is priced into the rate, the SOFR rate will generally be lower than LIBOR, meaning that some increase in the spread or margin will be needed in the context of conversion of a particular loan from LIBOR to SOFR, in order to maintain the overall yield to lenders.
Additional operational and practical challenges will need to be overcome as well in connection with the transition.
U.S. Dollar-denominated loan agreements now typically provide that, on the unavailability of LIBOR, the parties will negotiate in good faith to amend the loan agreement to provide for a replacement benchmark interest rate. Absent such an amendment, borrowers typically would be forced to convert outstanding loans into prime-rate based loans, usually at an interest rate significantly higher than was accruing at the LIBOR rate. Sponsors and their portfolio company borrowers are therefore at risk that the rates of interest on the outstanding loans under their credit facilities may unexpectedly turn higher once LIBOR ceases to be available, in the event lenders are not accommodating in respect of amendments to replace their benchmark interest rate. This may prove particularly worrisome in the context of a portfolio company’s credit facility whose lenders, for whatever reason, have grown unhappy or have become uncomfortable with it, and against which they may be seeking a leverage point or negotiating tool.
Some borrowers have been able successfully to negotiate for a consent right over any replacement benchmark rate and related spread adjustment, without having their loans subject to automatic conversion in the absence of a mutually satisfactory, negotiated replacement rate. Such an arrangement imposes significant risks for lenders, however, since, without a mandatory prepayment or hardwired replacement rate kicking in when the parties cannot agree on a replacement rate, presumably a court would ultimately be needed to impose some commercially reasonable replacement rate, and that is not a position that lenders can be expected to accede to easily.
The dynamic in the direct lending market is similar to that in the syndicated loan market. The direct lending market is just not quite as far along in adjusting to the demise of LIBOR as is the syndicated loan market.
Once there is some additional development and clarity on SOFR rates and the related operational issues, it will become advisable at that point for sponsors to hardwire a benchmark replacement rate into the credit facilities of their portfolio companies. This will achieve a measure of added protection against unexpectedly higher interest rates on outstanding loans, and also potentially remove an arrow from the quiver of lenders.
We look forward to keeping you posted on further developments.
