The LIBOR Saga Continues

February 3, 2022

M. Ryan, Weir, Jr., Vice President and John J. Whalen, Head of Capital Advisory Investment Banking
Capital Advisory Investment Banking Group

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By now you have likely heard that LIBOR (“London Interbank Offered Rate”) will soon become unavailable as a benchmark rate for lending transactions. Since 1969, this benchmark has been used for most middle-market, real estate, and large corporate transactions, but ceased use for new transactions at the end of 2021. Most LIBOR contracts will remain available through their typical publishing channels through June of 2023, but borrowers with existing LIBOR based loans need to closely review their loan documentation prior to the cessation of LIBOR to better understand their options and embedded transition language.

Most lenders, through participation in the Alternative Reference Rates Committee (“ARRC”), generally coalesced around the Secured Overnight Funding Rate (“SOFR”) as the designated replacement rate. There have been a handful of other benchmarks proposed to replace LIBOR, most notably Bloomberg’s BSBY index and AMERIBOR. The BSBY benchmark rate has seen limited use over the last several months in the syndicated market and the AMERIBOR rate has made some in-roads with smaller community banks that don’t have funding sources based on LIBOR or SOFR; however, most market participants are expected to transition to SOFR.

The SOFR market is composed primarily of U.S. Treasury repos with volumes of over $1 trillion daily, thereby adding significant transparency to a corner of the market that has traditionally had a black eye due to the historical manipulation of LIBOR. However, SOFR isn’t a perfect solution either as the market can be highly volatile during market dislocations and lacks a credit risk premium. Complicating the transition in the near term is the inability to have a term SOFR rate that aligns with the familiar monthly LIBOR contracts borrowers typically use. Most credit documentation has taken an interim step with the use of daily simple SOFR compounded in arrears. The ARRC formally recommended a forward-looking term SOFR solution at the end of July 2021 utilizing published term SOFR rates from CME, but the market hasn’t fully adopted term SOFR in documentation and borrowings just yet. Many lending institutions are navigating systems upgrades, patches, and licensing to resolve changes in how interest and hedging contracts are calculated and billed.

Borrowers still utilizing LIBOR in 2022 need to closely review their loan documentation to understand the benchmark “fall back” provisions so that they know their new cost of borrowing. Banks and non-banks utilized numerous variations to the LIBOR replacement language over the last two to three years with each iteration providing a bit more clarity. Borrowers with early or no replacement language may notice that their rate flips from a LIBOR benchmarked loan to the Prime Rate which could result in a material increase in borrowing cost. In other cases, the transition language can be quite broad and reference “generally accepted market practices”.

Borrowers that have had an amendment with SOFR language in the last 18 months will likely notice references to a spread adjustment factor to compensate for the lack of a credit risk premium in the SOFR market, and adjustment for the term of borrowing. The credit spread adjustment is largely intended to make the transition to SOFR an economically neutral event for both borrower and lender.

The credit spread adjustment was fixed in March of 2021 which, at that point in time, more closely represented the five-year average differential between the various term LIBORs and SOFR (ranging from 11.448 bps for 1-month to 42.826 bps for 6-month). Due to the current low-rate environment, we have seen LIBOR/SOFR trade much closer to parity. The smaller differential between the two referenced rates inherently results in an increased cost to the borrower and additional margin for the lender. If you look back to that differential pre-covid, the adjustment is very close to the ARRC adjustments. Looking at the forward curve, that differential is expected to climb over the next two years, getting closer to the ARRC recommended credit spread adjustment.

The traditional bank loan market has taken a very firm stance to preserve the fixed spread adjustments and the window to negotiate a better deal effectively closed at the end of last year. Just prior to year-end, Fanatics rushed to complete a $500 million LIBOR-based loan which likely saved them money due to the differential between LIBOR and SOFR. The institutional term loan market (rated term loans primarily purchased by non-banks) is more efficient at pricing assets and has taken a somewhat different approach to the credit spread adjustment. Most institutional transactions priced at SOFR in the last several weeks closed with spread adjustments ranging from 10 bps for 1-month, 15 bps for 3-month, and 25 bps for 6-month. These spread adjustments reflect a more graduated approach in the near term to solve for an economically neutral benchmark change. As previously mentioned, the futures curve suggests the spread will approach the five-year average that was fixed in March of 2021 but, in the interim, the fixed spread adjustments are not quite neutral. Covenant Review recently noted that 63% of loans with LIBOR fallback language include a requirement that the agent and the issuer give due consideration to prevailing market convention when choosing the spread adjustment. For some borrowers, this language provides a window to argue that, at the time of transition, the market approach to credit spread adjustments for new-issue loans should be considered.

In the first month of 2022, 67 of 78 institutional loans in market were SOFR-based. Excluding add-ons, 57 of 61 deals had SOFR-based pricing indicating the market is quickly adopting SOFR as the benchmark replacement. As volume picked up, credit spread adjustments became less prevalent, though still the majority (47 of 67 loans). Some market participants are anticipating credit spread adjustments to go away entirely. The Golden Nugget was recently in market with a $3.3 billion term loan with language that could reduce or even eliminate the credit spread adjustment should the market move away from the adjustment in new-issue transactions in the future.

The complexity of most loan agreements makes this transition particularly challenging for companies navigating a host of more pressing issues in the current economic environment. Nuances in the loan agreement such as the frequency of interest payments can result in different credit spread adjustments that unnecessarily increase the spread for a borrower. While the opportunity to negotiate a better spread adjustment is largely in the rear-view mirror, it is important for borrowers to review their LIBOR fallback language and understand exactly what it means in terms of cost of capital. In some cases, it will be in a borrower’s best interest to simply refinance their capital structure into a SOFR benchmarked deal. With less than 18 months to go until the full cessation of LIBOR, now is the time for borrowers to consult with a capital advisor and/or their attorney to review existing language and make recommendations. Current tailwinds and investor appetite presents a window for borrowers to opportunistically refinance their capital structure in an extremely liquid credit market.

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