Splitting the Risk: How to Manage Interest Rate Risk in Project Finance

Saudi Arabia’s economic system is surging. The debt market tells the story: Banks within the Kingdom have prolonged greater than SAR 2.2 trillion — that’s $587 billion in US {dollars} — in credit score services to the non-public sector, with half of these credit score services long-term, as of December 2022. These are report numbers and reveal the momentum behind Saud Arabia’s distinctive development story.

Public-private partnership (PPP) transactions and the broader challenge finance business are core to that momentum. Certainly, such initiatives are increasing at an accelerated tempo, supported by infrastructure initiatives prioritized by the federal government in addition to mega and giga initiatives throughout the nation.

But this exceptional development comes with dangers — rate of interest threat, particularly. The three-month Saudi Arabian Interbank Supply Price (SAIBOR) during the last 10 years exhibits a latest surge and rising volatility. In contrast with simply 0.52% for the primary 5 years, the each day normal deviation has greater than doubled to 1.21% during the last 5.

Three-Month SAIBOR Historic Curve

This raises questions on how rate of interest threat needs to be allotted between the 2 major stakeholders in any challenge finance transaction: the challenge firm and the beneficiary entity. The previous is a particular function entity created to ship the challenge and whose solely asset is the challenge, whereas the latter, additionally known as the off-taker or the procurer, pays the challenge firm to ship the agreed scope.

So, how can these two stakeholders finest break up the rate of interest threat?

The Native Market Transient

The allocation of rate of interest threat differs by challenge, however the typical method in Saudi Arabia places the onus on off-takers. These beneficiary entities assume the rate of interest threat as outlined within the successful bidder’s preliminary monetary mannequin by way of the hedge execution date. The bidder’s profitability is shielded from any rate of interest volatility till the hedge execution.

If the rate of interest rises above the assumed charge on the execution date, the monetary mannequin is adjusted to take care of the profitability metrics, with the off-taker paying for the rate of interest deviation. If the rate of interest falls, nonetheless, the advantages go to the off-taker.

To steadiness this equation, the stakeholders must agree on an optimum hedging technique and perceive from the outset how the rate of interest threat is allotted.

Right here’s what must be performed on the 4 key levels of the challenge finance course of to attain these outcomes.

1. The Pre-Bid Stage

The challenge firm should devise and articulate a hedging technique that specifies the hedge length, optimum hedging quantum, and the instrument into account, amongst different crucial components. A easy close-out requires buy-in from the lenders and hedge suppliers.

The challenge firm’s purpose is a profitable shut. As such, it ought to deal with securing the financing and executing the related paperwork as quickly as doable. If the hedging aspect isn’t properly deliberate, it might create delays and saddle the challenge firm with unfavorable financial phrases.

To determine the monetary mannequin and forecast, the challenge firm should calculate the rate of interest threat allocation earlier than submitting its bid. For example, if the deliberate financing is long run and the financing foreign money is just not liquid sufficient for the entire hedge tenor, the challenge firm ought to quantify the impression and construct it into the challenge economics. Will the off-taker proceed to compensate the challenge firm for the rate of interest threat of the unhedged portion after hedge execution? That should be clear early on. Will the off-taker take part within the subsequent good points however not the losses? In that case, the challenge firm must make an evaluation.

Any margin the hedge suppliers make is often excluded from the off-taker compensation plan for the reason that challenge firm bears the associated fee. That’s why the challenge firm must plan and talk about the hedging credit score unfold with the hedge suppliers.

2. The Submit-Bid Pre-Monetary Shut Stage

That is the important thing juncture in challenge finance, and its success or failure hinges on the challenge firm’s grasp of the pre-bid stage settlement.

The challenge firm may desire that every one events agree on a hedge credit score unfold or that the unfold be uniform throughout the lenders or hedge suppliers. However typically a credit score unfold primarily based on the dangers carried by the lenders could make sense.

At different instances, the challenge firm could favor credit score unfold competitors among the many hedge suppliers. In that case, each lender has a proper to match in accordance with the debt measurement on a prorated foundation. The draw back of this method is that it may cost a little the lender a chance to take part in an income-generating commerce, which might make the transactions much less worthwhile than forecast. 

If there’s a minimal obligatory hedging requirement for long-term financing, the challenge firm might get hold of a tighter credit score unfold for the next tranches. Nevertheless, decrease threat in the course of the challenge completion or operation intervals might imply this unfold is healthier than the primary tranche. With out an open dialogue on the outset, the challenge firm accepts — by default — the preliminary credit score unfold for the next hedges.

A hedging protocol needs to be drafted early and align with the agreed hedging technique. The social gathering that assumes the rate of interest threat usually has extra flexibility to design the protocol to make sure equity, prudence, and transparency.

A dry run (rehearsal) of the hedge helps check the protocol’s reliability. However that requires an unbiased bench marker to validate the bottom aggressive charge. The bottom charge is just not at all times the very best.

Mission finance transactions contain complicated monetary modeling, and the money flows change primarily based on the hedge charge. Due to this fact, coordinating well timed turnarounds with the up to date money circulation is essential. The monetary/hedge adviser should administer the method in accordance with how the hedging protocol defines it. Some challenge corporations and off-takers could put a suitable deviation restrict between the assumed floating curve and the precise market charges, however every social gathering should perceive what’s at stake and set applicable thresholds.

The Worldwide Swaps and Derivatives Affiliation (ISDA) Settlement and schedule specify the phrases of the spinoff dealings. The schedule is custom-made and negotiated on each business and authorized grounds. The hedge adviser covers the business features to make sure they’re rational, coherent, and affordable. This turns into extra vital for long-dated hedges the place rates of interest could also be transformed to various floating charges sooner or later. The challenge firm should method this course of cautiously and negotiate any language to completely grasp the implications. Once more, this doc needs to be among the many first to be finalized throughout this step.

3. The Hedge Execution Stage

After a passable dry run and as soon as documentation is full, the massive day — the hedge execution — arrives. At this level, the challenge firm ought to have a transparent view of the financial phrases and hedge particulars. Nonetheless, to keep away from last-minute surprises, it ought to conduct a sanity test on the indicative hedge time period sheets from the hedge suppliers to establish any misalignment earlier than it executes the hedge. The stakeholders also needs to talk about the very best execution methodology, which is dictated by the envisioned hedge measurement, foreign money, length, and so forth.

Given the dwell hedge citation’s sensitivity and the market forces at work, to keep away from slippage prices and extreme hedge execution fees, the hedge adviser should affirm that every one stakeholders agree on the phrases and the outlook. All hedge suppliers are introduced onto one name to cite; every social gathering presents the very best swap charge. If the off-taker bears the rate of interest threat when charges have elevated from the preliminary monetary mannequin, they need to rapidly validate that the very best charge is truthful and affordable. Bear in mind, the bottom supplied charge is just not at all times the very best.

4. The Submit-Hedge Execution Stage

If an unhedged portion of long-term debt stays, the challenge firm ought to handle the long run hedging fastidiously and maintain the rate of interest threat allocation in thoughts. Typically, further hedges are solely permitted for a brief timeframe earlier than the preliminary hedge expires. This might value the challenge firm if it holds the curiosity in danger, so it ought to have full discretion over when to hedge the remaining debt parts in accordance with its threat urge for food, the hedging technique, and the challenge covenants.

Some challenge corporations issue within the accounting impression of the spinoff devices. Because of this, software of the voluntary IFRS9 hedge accounting normal to defend the revenue and loss from potential volatility has turn into extra widespread.

Conclusion

The optimum hedging technique for the challenge firm and off-taker is the product of a fragile course of. Success requires an early and mutual understanding. Through the planning, a guidelines may help the challenge firm affirm that each interrelated issue of the hedge has been considered.

After all, every challenge is exclusive, so there is no such thing as a one-size-fits-all hedging technique. The smallest distinction between two initiatives can imply big variations in each the hedging technique and protocol.

Such extensive variations emphasize how crucial it’s to set expectations and outline every stakeholder’s duties on the outset of each challenge. It will assist keep away from overlapping duties and guarantee a easy and seamless hedging course of.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.

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