Previously in Rethinking Treasury we discussed how interest rate volatility can represent a significant proportion of the Value at Risk (“VaR”) to equity Sponsors of infrastructure projects in the context of future leverage and anticipated M&A activity.
- Future Leverage: For Sponsors that plan to develop and operate assets through the entire lifecycle, the interest rate risk is embedded in the future debt financing they anticipate to obtain.
- Anticipated M&A: For Sponsors that plan to sell assets to other Sponsors, the interest rate risk is embedded in the valuation of the purchase price (“bids”) obtained from a potential buyer(s).
While the economic exposure to interest rate fluctuations remains borne by the initial Sponsor, neither the anticipated future debt financing nor the economic valuation of pre-development infrastructure projects flow through the financial statements of the initial Sponsor. As a result, obtaining Hedge Accounting can be difficult. Recall, in the absence of Hedge Accounting, the Mark-to-Market (“MTM”) of a hedge contract can flow through the Net Income and EPS of the Sponsor’s holding company, increasing the volatility of reported earnings. Moreover, for Sponsors that intend to hold their investment through its full life cycle, they can face a liquidity event from unwinding a hedge after it is no longer needed. If the Sponsor breaks its hedge in the future after interest rates decrease, it could be forced to pay an upfront breakage cost (i.e. the MTM of the hedge contract), but the benefit it realizes will accrue over time in the form of lower interest payments. This cash outlay is often a consideration for Sponsors as investors typically require an IRR well in excess of swap rates.
When deciding on a hedge, the Sponsor, may want to balance hedging the economic exposure to interest rates with the accounting and liquidity impact.
If a Sponsor is concerned about both the loss of economic value from rising rates and potentially large accounting losses and liquidity requirements from these hedges, there may not be a perfect solution. Rather the Sponsor must find the best balance. The most obvious way to balance the economic benefits of hedging vs. potential accounting volatility and liquidity needs is to simply scale down the hedge ratio below 100 per cent. This approach may yield a trade-off that is more acceptable than either fully hedging or not hedging at all. However, this approach may not yield the best possible alternative. For instance, “small” accounting losses or liquidity requirements may be acceptable, but it is important to maintain a full economic hedge. Or, “small” losses in economic value may be okay, but it is critical to avoid “large” losses. In the case of these objectives, a reduced hedge ratio may not be the best approach for the Sponsor as the resulting economic impact of the hedging strategy would still be linear with respect to interest rates albeit with a reduced sensitivity. However, employing bespoke hedging solutions may help provide an effective solution to help the Sponsor better balance these competing goals.
For example, Sponsors can customise the hedge to include a feature whereby the breakage cost of the hedge is capped at a pre-determined level. The provision of such a feature would necessitate a premium over a standard interest rate hedge, akin to purchasing insurance on the breakage cost payable. Such a strategy will provide the sponsors with greater certainty around their IRR, with the worst-case breakage cost being determined at the outset.
Hedges are sometimes not broken entirely but instead amended to better match the interest rate risk profile as the visibility around the exact debt drawdown and repayment profile improves. This occurs frequently as projects rarely adhere in all aspects to the schedule envisaged at inception. In such cases, if the proportion of the interest rate risk hedged is low, then it could be the case that no adjustment to the hedges is necessary- the adjustment will simply manifest itself as a change to the proportion of risk hedged. However, if the proportion of the interest rate risk hedged is close to 100 per cent, then the required adjustment to the hedges might result in some partial breakage costs. Should such situations be of concern, the most suitable hedging strategy would be one where there the hedger retains some flexibility around adjusting the interest rate risk profile dynamically- such solutions exist although they may be more expensive. Another example would be to deploy a strategy whereby the sponsor is unhedged as long as rates stay within a certain pre-determined range. If rates move outside this range, the sponsor is protected. This is akin to a popular strategy treasurers often use when hedging FX risks on cashflows, namely collars. Such strategies would be relevant for Sponsors who wish to mitigate the risk of extreme rate moves causing unexpected shocks to the IRR. This would still achieve the objective of reducing the unpredictability of the IRR due to moves in interest rates.
Sponsors often are cognisant of impending interest rate risk on their constantly growing portfolio of assets but are hesitant to proactively hedge this risk. This often prevents them from capitalising on market levels they deem attractive because they may not be entirely confident of winning the bid on a particular project. The concern tends to typically be around having to unwind the hedge if the underlying bid is unsuccessful. In several cases, Sponsors are able to put hedges in place prior to Financial Close that only become effective should the project proceed to achieve Financial Close. Such solutions create a virtuous cycle of value by providing Sponsors with greater IRR certainty around the time of submitting binding offers for the project. This in turn enables Sponsors to submit more aggressive bids for the project, increasing the probability of realising the envisaged IRR.
It is important to remember that derivatives offer a high degree of flexibility to Sponsors to sculpt specific risk management solutions bespoke to the requirements. Therefore, when considering an interest rate risk management strategy, various alternatives must be explored so that they can be confident they are selecting appropriate hedges aligned with their fundamental priorities of economic value, accounting and liquidity requirements. The impact of each alternative on costs and risk must be considered together and over a horizon that spans at least the lifetime of the underlying exposure.
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