The monumental shift from the London Interbank Offered Rate, which has long been the primary benchmark for securities, loans and derivatives, will have broad impacts on trillions of dollars of financial instruments. Initially slated to stop by the end of 2021, regulators say the markets may need more time to fully appreciate the effect of the proposed changes and to implement transition plans that account for all potential elements of the migration.
Despite the recent announcement that the anticipated halt of ‘LIBORs’ would be extended as far as 2023 for certain US-dollar LIBOR fixings, the event, and the preparations for it, remain at the forefront of considerations for most private debt investors and issuers. Deadlines have been set for when the last LIBOR-based issuance can occur by instrument type, with the stoppage of all new issuances by the end of 2021, if not sooner. Banks are encouraged to complete their transitions as soon as practicable and no later than the end of 2021.
A transformation like no other
Although the postponement of most US-dollar LIBOR benchmarks may have bought the market additional time to transition, it should not be a reason for delay. There is a tremendous amount of work to be done in both the public and private debt markets to adequately prepare for the LIBOR cessation. Understanding the nature of your exposures, developing a comprehensive plan, identifying the appropriate personnel to be part of the transition team and documenting progress will allow for a smooth transition.
In terms of preparation, there are many factors to be considered by both issuers and investors. First, they must understand their exposures, in particular the contractual provisions regarding alternative reference rates, fallbacks, governing jurisdiction and amendments. For example, we have observed private credit agreements where, to the extent there is no amendment specifying the alternative rate, the lender’s obligation to make advances at the LIBOR rate will be suspended.
Understanding the breadth of exposure is daunting. Implementing an effective plan is predicated on a thorough review of all relevant governing documentation, which likely means hundreds of thousands of pages to go through.
This has proven so formidable that many market participants have either purchased, outsourced or internally developed technology-based document review tools, and employed advisors to increase efficiencies and aid implementation. This process must be undertaken to understand the existing transition language, such as fallback terms and timing, as well as to identify responsibilities, inclusive of disclosures to both counterparties and regulators.
There are several focal areas for issuers and investors to study when making a comprehensive exposure assessment and transition execution plan. These areas are based on recommendations from the Alternative Reference Rate Committee, Office of Compliance Inspections and Examinations, International Swaps and Derivatives Association and the Financial Conduct Authority.
Robust governance, in which senior executives direct and oversee the coordination and delivery of results in line with the institutions’ objectives, is critical. A smooth transition requires platform-wide integration to effectively evaluate and mitigate the risks associated with both existing and new exposures. To accomplish this, the appropriate key resources in each functional area of the organisation must be identified. Proper communication channels and educational resources must also be established and documented to inform internal and external stakeholders, as needed.
We are working with clients at varying stages of their transition planning. Some are still hoping for legislative relief, while others have teams that have already performed impact assessment analyses to guide them and are issuing non-LIBOR instruments and remediating legacy contracts as needed.
One size does not fit all
For many private debt investors, a comprehensive exposure assessment and transition execution plan are further complicated by portfolios spanning multiple instrument types. For example, credit funds often hold or issue a broad mix of instruments that must be considered independently and in the context of the overall portfolio to appreciate the full LIBOR transition scope.
Many of our private debt clients have exposure to various types of loans (broadly syndicated, mid-market and private), as well as collateralised loan obligations, either via direct investment or through issuance activity with varying requirements to consider.
When serving in a non-agent capacity, the investor’s LIBOR transition exercise is more focused on understanding what they own, how and when the investor is expected to transition, and what is required to ensure that they are properly positioned for the move to an alternative rate. For example, have systems been prepared and tested to process multiple reference rates with potentially updated calculations and methodologies, as well as proper flow through to accounting, tax, valuation, treasury and risk models? Have analyses been performed to understand what, if any, changes in future cashflows are expected based on the transition provisions?
For instruments where clients are acting in an agent, or issuer, capacity, the process entails more detailed steps including, at its core, a contract mediation strategy and execution plan. Ultimately, the selected transition implementation methodology that works best for a market participant depends on their specific strategy, objectives and exposures.
Clear organisation, documentation and communication with LPs, regulators and advisors are critical to a successful transition plan.
It is important to note that the transition of legacy instruments, even within the same asset class and from the same issuer, may not occur at the same time. For example, some legacy CLO governing documentation indicates that the liabilities will transition as soon as the first underlying asset references a new rate. Alternatively, other legacy CLO governing documentation may indicate that the majority of the collateral has transitioned. This means some deals will have liabilities transitioning to the Secured Overnight Financing Rate sometime in 2021, while others may not transition until 2023 should the extension be granted.
Time is of the essence
Once the contract review process has been conducted, institutions need to forecast the impact of the anticipated transition to better understand and inform potential remediation steps and priorities. For existing contracts and benchmarks that reference LIBOR, strategies for renegotiating and repapering to negotiate fallbacks where they do not adequately exist, with enhanced fallbacks or amendments considered, along with potential refinancing or restructuring activities, as needed, must be documented and approved appropriately.
Regardless of whether your strategy is to await further announcements or to begin the move to an alternative reference rate, preparing a comprehensive inventory that quantifies and documents your exposures is a critical initial step to a successful transition. Once the key LIBOR transition provisions are catalogued, a clearly communicated transition timeline and plan, as well as the identification of the key professionals throughout the institution as well as outside advisors, will enable effective communication with regulators, investors and counterparties, and allow for a smooth transition.
Jennifer Press is a managing director and Aaron Read a director in alternative asset advisory at financial consultancy Duff & Phelps