This LIBOR transition update, directed primarily at private
credit lenders, provides a recap of recent trends and reflects new
developments on the eve of LIBOR transition for banks, including
new SOFR issuance by private credit lenders and context around
“spread adjustments.” We are actively monitoring LIBOR
transition developments and will continue to provide pertinent
updates.
December 31, 2021 deadline; Relevant
regulation
As readers will no doubt be aware, relevant federal bank
regulatory agencies, in consultation with the administrator of
LIBOR and various state agencies, have made clear that the banks
they regulate are to cease making new extensions of credit based on
LIBOR by December 31, 2021.
In anticipation of this deadline, several investment banks have,
in recent weeks and months, arranged new syndicated credit
facilities based on alternative reference rates (principally,
SOFR). As we enter the new year, we expect that the vast majority
of syndicated credit facilities will be based on alternative
reference rates like SOFR.
Direct lenders are, generally, not subject to bank regulation
and do not fall under the purview of the agencies that set the
December 31 deadline. As a result, in discussing LIBOR succession
with many of our clients throughout the year, we do not anticipate
an immediate transition to SOFR (or any other alternative reference
rate) by private credit lenders in 2022. However, many direct
lenders may be subject to other regulatory schema, including, for
example, regulation by the SEC, an agency which has made its
concerns about LIBOR clear. For this reason and for some of the
reasons we outline below, we anticipate that direct lenders will
likely provide an increasing number of loans based on SOFR in the
coming months.
LIBOR replacement documentation
While direct lenders continue to prepare to issue new loans
based on alternative reference rates, we have continued to see a
general trend toward including “hardwired” LIBOR
replacement “fallback” language in credit documentation.
As a refresher, there are generally two options for addressing
LIBOR succession in credit agreements: the “hardwired
approach,” which provides for the automatic replacement of
LIBOR with SOFR upon certain triggering events, and the
“amendment approach,” which is effectively an
“agreement to agree” giving the agent authority to amend
the document to replace LIBOR when appropriate, subject to borrower
consent, and often with required lender negative consent rights. A
considerable number of private credit lenders now favor the
hardwired approach in LIBOR credit facilities (but see our notes
below concerning “spread adjustments” in hardwired
documents).
SOFR issuance by private credit lenders
With the advent of new SOFR-based syndicated credit facilities,
SOFR term sheets, financing grids, commitment letters and credit
agreements are working their way into the private markets as well.
(To be clear, as noted in previous bulletins, the trend towards
SOFR as opposed to other alternative references rates is at this
point a strong one, and we are aware of very few, if any, credit
facilities based on non-SOFR alternatives in the private markets).
We have seen a noticeable (though still modest) uptick of SOFR
issuance (or proposed SOFR issuance) in recent weeks. We expect
this trend to continue and likely to increase in 2022, for several
reasons.
First, any private credit lender considering participation in a
junior tranche of capital (a second lien, for example) in a
structure in which the senior tranche is syndicated or otherwise
provided by a bank will likely come under some pressure to provide
a SOFR-based loan, since the senior tranche will almost certainly
be based on SOFR. Although it is possible to bifurcate reference
rates (and, indeed, we are aware of at least one credit facility in
which revolving commitments were based on SOFR and the term loan
was based on LIBOR) we expect that most borrowers will insist on a
single rate across tranches for ease of administration.
Second, many direct lenders incur leverage or subscription-based
debt facilities of their own as part of their overall strategy. Any
such facility that is provided or arranged by a regulated bank
(which is to say, the vast majority of them) and is entered into
after December 31 will be based on SOFR. A lender with a leverage
facility based on SOFR but a portfolio of loans based primarily on
LIBOR may be subject to risk management challenges brought on by
this mismatch between liabilities and assets, and those challenges
might lead to greater SOFR issuance.
Third, to the extent interest rates increase over time,
borrowers may become more likely to enter into interest rate swaps
and hedges, which (given the derivative market’s own transition
from LIBOR) may further incentivize loan market participants to
move to SOFR.
Finally, direct lenders will be subject to the same macro trends
that led to the shift from LIBOR in the first place. As noted
above, regulatory pressure may continue to increase, and lenders
may have concerns (or their investors may have concerns) about the
shrinking LIBOR market and the inherent instability of LIBOR that
initially brought on the push for a successor rate.
Of course, ultimately the question of the private credit
market’s transition away from LIBOR is one of timing. As
readers know, the ultimate deadline for LIBOR is June 30, 2023,
after which it will no longer be published, and all new and
existing credit facilities will need to transition to an
alternative reference rate prior to that date.
A few words on spread adjustments
Spread adjustments, the precise mechanics of which we covered in
our previous bulletin, are designed to compensate lenders for the
difference between LIBOR (an unsecured, “credit
sensitive” rate) and SOFR (a secured rate which has
historically traded at a discount to LIBOR).
For new SOFR-based loans, the syndicated market has seen several
different approaches taken on spread adjustments. One approach has
been to apply a 10 basis point spread adjustment for one-month
SOFR, 15 basis points for three-month SOFR and 25 basis points for
six-month SOFR. Another approach has been to price with no spread
adjustment at all, but to instead include the economics of the
spread adjustment directly into the margin. We expect to see
additional options tested in the market as the transition commences
in earnest. As issuance of SOFR loans in the private market
increases, we expect to see the same price exploration there as
well.
For new LIBOR-based loans with hardwired fallback language, the
standard form of language published by the Alternative Reference
Rates Committee contemplates spread adjustments of approximately
11, 26 and 42 basis points for one-, three- and six-month tenors,
respectively. (This is the same spread adjustment recommended by
ISDA). Recent months have shown some negotiation around these
spread adjustments as well, although the ARRC recommendations
remain common in the market.
Key takeaways
As the transition from LIBOR continues, private credit lenders
should:
- complete a portfolio review to understand the transition and/or
fallback language in existing credit documents (keeping in mind the
ultimate deadline for amending existing LIBOR transactions in June
of 2023); - consider formulating a policy on fallback language for new
LIBOR-based transactions (including on spread adjustments); - prepare business, legal, operational and agency functions for
new SOFR issuance; and - continue to monitor the issue closely, including as it unfolds
in the syndicated markets.
We continue to follow this issue closely and will provide
additional updates as relevant.
LIBOR Transition Update
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
