Interest rate swap for an LBO financing: Three benefits of hiring an advisor

During the buy-out process borrowers often encounter interest rate hedging (interest rate swaps or interest rate caps) in conjunction with debt financings. In many European LBOs the borrower is required to hedge its floating exposure for a minimum amount and duration. For most borrowers, a swap, offered with a floating-rate loan, is an efficient way to achieve a desired ratio of fixed vs. floating debt. Often, these swaps must be secured and therefore are commonly executed directly with the lender or members of the lending group, if it is a syndicated loan.

As most aspects of the swap’s economics and legal terms may be negotiable with the lender and can impact investment returns, many private equity investors choose to engage an advisor to assist in structuring and negotiating swaps, even if they are executed directly with a single lender.

The following are some of the key benefits of engaging an advisor for an interest rate swap.

Benefit 1: Pricing transparency

A borrower’s total swap rate generally consists of the three components listed below. The total all-in fixed-rate that a borrower pays will therefore be the sum of these components, plus the loan spread/margin.

• Mid-market rate: A market driven rate based on current market expectations for the floating rate over the term of the swap. This fluctuates over time with market movements but should largely be an objective and verifiable number.

• Execution charge (or mid to offer charge): A mid-market rate is the average of the trader's bid and ask rates and is not a rate at which you can execute. The bank needs to cover their market risk associated with the trade, and they do this by adding an execution charge on top of the mid-rate. This charge is a function of the size of the trade and market liquidity.

• Credit charge: A negotiated, deal-specific charge based on the perceived credit quality of the borrowing entity and the profit expectations of the lender’s swaps desk, which is separate from the loan returns. This may be thought of as an additional component of the loan spread, albeit one paid to the lender’s swap desk, not their lending group.

An advisor can assist the borrower with breaking their lender’s swaps desk component pricing into the following two parts and provide transparency, including:

• Assisting the borrower in negotiating the bank’s credit and execution charge: Agreeing on swap credit and execution charges (expressed in basis points) upfront and as a part of the overall loan terms will enable both parties to know the final rate the borrower needs to pay, even as the underlying mid-market rate fluctuates over time.

• Assisting the borrower in executing the swap at or after closing: At the time of entering into the swap, the negotiated credit and execution charges are added to the mid-market rate, the swap rate, and the all-in loan coupon. While many large banks are required by law to disclose their mid-market rate, many smaller banks are not.

An advisor can routinely save the borrower at least several basis points in the overall fixed loan rate, and, in many cases, substantially more.

Benefit 2: Economic risk analysis and structuring

Many borrowers rightly think of swaps and the underlying buy-out debt as part of the same overall transaction. In most cases the swap cannot exist without the underlying loan, but both are typically documented as two separate, yet interrelated contracts. If structured without consideration for the underlying loan terms or the underlying asset plan, a swap may result in unintended consequences over the life of the investment. An advisor identifies and analyses these risks to help borrowers weigh the costs and benefits of potential structures. Examples include:

• Loan floors: Most floating-rate LBO loans include a floor on the floating rate (often 0% and sometimes higher for private debt funds), which guarantees a minimum rate for the lender if the floating rate falls below the floor. If a swap on such a loan is not structured with the floor in mind, the borrower creates the risk of their interest expense to increase if the floating rate falls below the floor rate.

• Prepayment risk: Swaps do not have upfront costs, but they can be future liabilities and result in breakage costs if terminated early. The swap breakage cost is the present value difference between the borrower’s contracted swap rate and the prevailing mid-market swap rate for the remaining swap term (the replacement rate). If the borrower’s rate is above the replacement rate, the swap will be a liability. Conversely, if the borrower’s rate is below the replacement rate, the swap will be an asset.

Benefit 3: Documentation review and negotiation

Swaps are documented separately from a loan agreement using an industry standard document known as an ISDA. While often presented to borrowers by their lender as a boilerplate document, parts of the document may be negotiated to be more or less favorable to the borrower, particularly with respect to default and termination events and ties to other investments that the owners of the borrower may have. While some outside counsel that represent borrowers have expertise in this area, many do not. An advisor will review and coordinate other swap-related documentation such as:

• Pre-trade Dodd-Frank/EMIR compliance forms with the bank

• IBOR fallback language in loan agreements in conjunction with the borrower’s legal counsel

• Trade documentation (i.e. swap confirmations) to ensure the bank has accurately summarised the trade terms after execution

Why work with Chatham on an interest rate swap?

Pricing transparency

Chatham advises on $2.9 billion of hedged notional every day, giving us significant visibility into market credit charges for different lenders and financing profiles. We leverage this market presence to reduce the borrower’s all-in synthetically fixed loan coupon and to quantify the cash value of the credit charge being paid to the lender’s swaps desk.

During execution, Chatham validates the mid-market rate to which the credit charge is being added and advises on the appropriateness of any mid-to-offer spread based on then current market conditions.

Economic risk analysis and structuring

Chatham works with borrowers to quantify potential breakage costs in consideration of the plans for the underlying asset and provides what-if scenarios to help quantify possible outcomes.

Documentation review and negotiation

Chatham reviews and negotiates over 3,000 ISDAs annually, giving us unmatched insight into which provisions are negotiable with different lenders and what may be appropriate for different sponsors and borrowing situations, allowing a borrower to quickly get to market terms independent of or in conjunction with a borrower’s outside counsel.

Derivatives experts with unmatched perspective

Chatham brings transparency to each of these components and leverages its expertise and market awareness to ensure that the borrower gets best possible terms and has no surprises over the term of the swap. Chatham is the market leading advisor for interest rate swaps, executing over 7,000 swaps every year. And with over 700 employees globally, 3,500 clients, and $1 trillion in transaction volume annually, Chatham helps private equity investors maximise their value in the capital markets, every day.