The UK’s Financial Conduct Authority (FCA) made it clear some time ago that, from the end of 2021, it will no longer seek to persuade or compel banks to submit the rates required to calculate LIBOR (the London Interbank Offered Rate), signalling the end of one of the world’s most important benchmark rates. LIBOR is used as a reference point for most sterling-denominated corporate loans and many bonds, and is the basis for many obligations in private equity fund documents. The end of LIBOR is a problem that needs to be addressed in the coming years, and it will entail some planning on the part of private equity firms and the lenders to their portfolio companies.
LIBOR first appeared in the 1980s and is calculated on the basis of submissions from panel banks as to the rate at which they could borrow funds. The reference rate was discredited in 2012, when it emerged that it had been widely manipulated by multiple banks in rate-fixing scandals. The FCA has reformed LIBOR’s governance since then but, as the FCA’s chief executive said in July, LIBOR is still not fit for purpose: among other things, it relies heavily on judgement – being based on a very thin underlying market for short-term wholesale unsecured funding – and it requires borrowers to assume the risk of bank funding costs. Borrowers are already demanding that banks use an alternative risk-free rate, and some are in a position to do so, even before LIBOR disappears altogether.
Phasing out LIBOR will take time. The FCA is warning the firms it regulates to assume that LIBOR will not be available after the end of 2021. Even if it may limp on after that date with a few panel banks contributing, it will probably not be representative of an underlying market. However, all of the substitute benchmarks for LIBOR which have been proposed are overnight rates, which price in substantially less credit risk than the three or six month LIBOR typically used in floating rate loans. SONIA – the Sterling Overnight Index Average – is perhaps the most widely used reference rate for sterling overnight indexed swaps and discounting for sterling interest rate portfolios, and is gaining traction. The use of SONIA in loan agreements will, however, require not just a change in references to the benchmark rate but also potentially an adjustment to the margin as well.
In 2014, the Loan Market Association (LMA) published an optional “Replacement of Screen Rate” clause which authorises amendments providing for the use of a replacement benchmark rate (including adjusting the pricing to eliminate or reduce any transfer of economic value from one party to another as a result of the adoption of the replacement benchmark) subject to majority lender consent. This was revised again in 2018 to provide further flexibility in anticipation of the potential adoption of replacement benchmark rates. As replacement benchmark rates are still being considered, the optional LMA clause and various other “agree to agree”/ good faith type provisions have made their way into loan agreements since 2014, with a view to providing borrowers with additional flexibility and making it easier to amend documents at the appropriate time.
A number of these “agree to agree” provisions go on to provide what happens if the borrower and the majority lenders cannot reach an agreement on the alternative benchmark and related changes; namely, the screen rate will be the rate certified by each lender as its cost of funding its participation in the loan (the “Final Default Rate”). If the loan agreement does not contain an “agree to agree” provision, or does contain such a provision but no agreement is actually reached, the Final Default Rate will generally apply. If the “agree to agree” provisions fail to specify what happens in the event that the borrower and the lenders cannot reach an agreement, a borrower may be left without an interest rate. It is therefore advisable for lenders and borrowers to include some form of fallback cost-of-funding type provision, until SONIA (or an alternative LIBOR replacement) has been fully adopted in the loan market.
Older agreements that do not contemplate the replacement of LIBOR also need to be thought about and steps taken to ensure that these remain operable after LIBOR is discontinued. This may not be an urgent task for firms, but it is one that will need to be addressed at some point soon.