LIBOR Transition

Drawing on recent LMA webcasts on the transition from LIBOR to so-called "risk-free rates" ("RFRs") (and particularly to compounded SONIA (the Sterling Overnight Index Average)) and reflecting on our own transactional experience in recent months, we have identified the 5 key documentary and operational issues in real estate financings which have attracted the most REF market discussion to date.  Most of these are not in fact REF-specific issues but nonetheless need highlighting as they will impact REF loans just as significantly as other types of financing.

1. Break Costs

As SONIA is a daily, backwards-looking rate, the issues that have always applied when breaking a longer-tenor forward-looking LIBOR rate part way through an interest period are no longer relevant. The current market thinking is that for SONIA-based loans break costs wording will need be replaced in facility agreements by providing for a (nominal) administrative fee or break fee, with the related voluntary prepayment provisions being tweaked accordingly. The exact shape of this wording has yet to be decided, and in two recent SONIA transactions for a UK clearer and the wealth division of a Swiss investment bank the break costs concept was simply removed wholesale.

2. Fallback Benchmark Rates

The question of suitable fallback rates if, for any reason, SONIA is unavailable remains a live issue and one on which a market consensus has yet to fully emerge.  In the LMA's exposure draft, rate switch provisions cost of funds has been included as an (optional) ultimate fallback, after central bank rates. However, due to its deficiencies, even having cost of funds as the fallback of last resort is problematic. These deficiencies include (i) the practical difficulties that some lenders experience in accurately assessing their cost of funds, (ii) the administrative burden placed on the facility agent when the interest rate for any particular loan falls to be determined on a cost of funds basis, and (iii) the perception among some borrowers of a lack of transparency.

3. Hedging

Interest rate hedging will need to match correctly the rate of interest charged under a SONIA-based loan (the oft-quoted mantra here being "same date, same rate, same methodology"). ISDA have considered the impact of the switch to RFRs on hedging instruments and have produced the ISDA Fallback Protocol.  However, this protocol provides for a 2 Business Days lookback period whereas much of the REF loan market seems to be coalescing around the adoption of a 5BDs lookback period for compounded SONIA-based loans (though the LMA have recently confirmed that they are in discussions with ISDA about this with a view to closing this gap by persuading ISDA to move to 5BDs).  This current divergence - and the fact that hedging instruments will often need to match SONIA floors as these are expected to be a frequent feature of new REF loans (in the same way as LIBOR floors have been for some time) - is likely to lead in numerous instances to bilateral amendments being required to hedging documents.  

(NB The "lookback period" referred to above is a function of SONIA being a backward-looking daily rate - as an operational matter it is generally accepted that a lead-in time will be needed in order to calculate, communicate and tee up each interest payment so that it happens as normal on the relevant IPD; moreover, the necessary internal systems within some lenders are not yet in place to allow this to be done.  5BDs seems to be becoming fairly standard in the REF loan market for this lead-in time).

4. Financial Covenants - Interest Cover and Debt Service Cover

In forward-looking (aka "projected" or "anticipated") ICR/DSCR tests in LIBOR-based facilities the "finance costs" will often be calculated using a projected 3-month or 12-month LIBOR term rate.  For SONIA-based loans this will need to be changed so that projected finance costs are calculated by reference to a different rate - the question is, which one?  REF market convention has yet to be established on this but some of the alternatives we are seeing are: (i) an estimate linked to the forward sterling overnight index swap rate, (ii) an appropriate term SONIA rate (if available), or (iii) the most recent compounded daily SONIA rate for the preceding interest period. (NB Where the finance costs in an ICR test are instead calculated using the hedged rate the above issue should not arise.)

5. Delivery of Compliance Certificates

If a 5BD lookback period is adopted by the REF market (see section 3 above), this means that the requirement (which is currently standard in the LMA REF facility agreements) for the Borrower to deliver a compliance certificate 5BDs before each IPD no longer works. Possible solutions to this include (i) extending the lookback period (but note again the need to match the lookback period in the relevant hedging instrument), (ii) pushing back the deadline for compliance certificate delivery, eg so that it falls a few days after each IPD, still running the waterfall on the IPD but withholding payment of any surplus into the General Account until such time as a satisfactory compliance certificate has been delivered, or (iii) retaining the current LMA provisions regarding the timing of delivery of compliance certificates but allowing compliance certificates to be based on estimated figures.