Deal-contingent hedges are becoming more common in project financings.
A deal-contingent hedge is a hedging arrangement that is signed before closing on a financing transaction and does not take effect until the transaction closes. If the transaction does not close within a specified period, then the parties just walk away, without any liability so long as they do not close a similar financing within an agreed period of time.
The attraction is such hedges are a way to lock in interest rates or electricity prices to take advantage of current market conditions while the sponsor is still trying to pull a lot of moving pieces together so that the transaction can close.
Deal-contingent hedges were used in the past primarily to manage foreign exchange risk in merger and acquisition deals.
They are now playing a useful role in project financings to manage interest rate risk, particularly where financial close is not anticipated for several months.
They are being used especially in bid situations where suppliers are asked to bid fixed prices at which they are prepared to supply a commodity, such as electricity, and once awarded the offtake contract, have several years to reach commercial operation.
When to use
Deal-contingent hedges are an alternative to other, more traditional derivatives, such as options or forward-starting swaps. They are used when a company is confident that financial closing will occur, but where the financing documents are still being negotiated and there are still conditions to satisfy that could take several months, such as obtaining required governmental approvals. An example is a so-called section 203 filing with the Federal Energy Regulatory Commission or a filing with CFIUS (the Committee on Foreign Investment in the United States) that may be conditions to transferring ownership of a US power plant.
If financial close does not occur as anticipated within a specified period, then the hedge never becomes effective or terminates before taking effect without liability to either party. Unlike an option, there are no upfront payments when the deal-contingent hedge is put in place. Deal-contingent hedge providers charge a swap premium, which is reflected in the fixed rate, and sometimes an additional swap premium is collected at financial close.
For example, if a borrower wants to lock down the interest rate on a floating-rate loan by entering into a fixed-for-floating 10-year swap, the borrower could enter into the swap early. A 10-year swap today may have a rate of about 2.15 percent, including an assumed 15-basis-point credit charge. A 10-year swap that is “forward starting” by up to a year could cost as little as 2.25 percent, a premium of just 10 basis points. Recent deal-contingent swaps have traded five to 40 basis points higher than a vanilla forward-starting swap that starts immediately, depending on the probability of deal closure after considering any remaining regulatory approvals and the likelihood of successfully raising financing.
Some sponsors choose to use forward-starting swaps to lock in rates, but such swaps are not always available, such as where the project company is not creditworthy (for example, if it has no assets other than the permits and contracts for the project), so such sponsors need to consider other alternatives. Also, a sponsor may not want to lock itself into a forward-starting swap because if financial close does not occur, then the forward-starting hedge would need to be unwound and the company may be required to make a termination payment.
Deal-contingent hedges have been used lately in a variety of project financings (such as solar and liquefied natural gas) and are not specific to a particular sector. They can be used not only to manage interest rate risk, but also currency risk and in some cases credit spread risk. Frequent users of deal-contingent hedges are private equity funds and companies that would have difficulty obtaining credit prior to closing.
Timing and structure
Companies can take advantage of deal-contingent hedges as soon as they know they will require financing, which may be before any lenders commit to the financing. In acquisition deals, deal-contingent hedges are usually entered into when the bid is won, but not prior to then.
“A project has interest rate risk starting on the day it wins the bid and anticipates raising financing in the future. A rise in interest rates can significantly decrease transaction value, whether the project debt is ultimately issued fixed or floating,” says Ranga Dattatreya, a managing director who handles derivatives at Goldman Sachs. “We help issuers quantify that risk and understand what their options are. Deal-contingent hedges can form a critical part of a risk management strategy while waiting for regulatory or other approvals.”
A date certain for financial close is not necessary when the deal-contingent hedge is being entered into because the hedge provider will typically work with the company to determine a suitable backstop date, which usually can be designed to match the timeframes in any permits or other project contracts.
A deal-contingent hedge is similar to a vanilla forward-starting hedge with the additional provision that if the project financing does not occur as anticipated within a specified period, then the hedge ceases to exist, with no unwind payment being due. The dealer and the borrower work with their respective counsels to customize the definition of a successful financing as well as any other legal provisions.
The financial terms of the swap such as payment dates, calculation periods and notional amounts are usually aligned with the anticipated amortization schedule of the financing. There may be further flexibility added if certain terms of the financing, such as the initial borrowing date or the expected maturity date, are not yet known.
While hedge providers have historically been chosen from project lenders, not all lenders can provide deal-contingent hedges. Deal-contingent hedge providers can be a subset of the anticipated lender group, but if the lender group has not been set, some dealers can provide deal-contingent hedges even if the company does not anticipate the hedge provider becoming a lender in the financing or the hedge provider chooses not to be a lender.
In order to determine the deal-contingent premium, the hedge provider will need to understand the financing structure and principal terms and conditions. It will need to determine how likely the closing is to occur and will look for strong economic incentives for the company to close. Since the deal-contingent hedge provider’s fees are contingent on financial close occurring, the deal-contingent hedge provider will want to be confident that financial closing will occur by the backstop date.
Documenting the deal
Deal-contingent hedges are usually documented in one of two ways.
One is a long-form “confirmation” as if the parties had entered into an International Swap Dealers Association, or ISDA, master agreement with standard terms, and the confirmation is just filling in specific details of the transaction. The assumption is the parties will be governed by the standard ISDA terms.
Alternatively, in some cases, the parties sign an ISDA master agreement, schedule and confirmation, but the papers may leave specific provisions to be negotiated later once the financing is farther along, such as negotiated events of default, termination events and covenants that are customarily included in closing date hedges.
There usually is no ISDA credit support annex or other credit support documentation for the transaction, as deal-contingent hedge obligations are generally unsecured (if permitted by the new margin rules adopted by the Commodity Futures Trading Commission and US prudential regulators).
Although covenants in deal-contingent hedges are limited, the parties may negotiate certain company covenants related to achieving financial close, such as, for example, the company agreeing not to amend certain key existing project documents in a manner that could hinder the financing or the timing of financial close, agreeing not to assign certain project documents, agreeing to notify the hedge provider of circumstances that could delay the financial close, or agreeing to use commercially reasonable efforts to achieve financial close.
The deal-contingent hedge provider often negotiates a post termination settlement payment if the financial closing (or similar floating rate funding) is achieved within a certain period after the backstop date. The period usually ranges from six months to about two years after the backstop date. This provision exists to avoid a “moral hazard” of delaying a deal to trigger certain swap provisions.
The hedge provider’s position may be transferable. The company, the deal-contingent hedge provider and the lenders may negotiate to move the deal-contingent hedge simultaneously upon financial close from the deal-contingent hedge provider to one or more lenders on commercial and economic terms (including credit spreads) acceptable to all parties. Depending on the needs of the financing arrangement, the hedge may instead be designed to be unwound (with a termination being payable by the deal-contingent hedge provider or the company) upon financial close, such as, for example, if the lenders insist that they be the post-closing hedge providers and are unable to agree to assumption of the existing hedge.
As with any derivative, the deal-contingent hedge documentation usually requires delivery of certain items at signing such as tax forms, corporate authorizations and incumbencies. Tax representations and other standard hedge representations are also included. In addition to the deal-contingent hedge documentation, the parties will also need to ensure that all regulatory requirements for hedges are satisfied, such as swap reporting under the Dodd-Frank Act. Some such requirements must be addressed prior to entry into the deal-contingent hedge.
When financial close occurs and if the parties intend for the hedge to continue as-is, the deal-contingent hedge usually becomes subject to a negotiated ISDA master agreement and schedule that is linked to the financing documents, including having additional termination events, events of default and covenants. Additional document deliverables, such as opinions, are often required. The obligations are usually secured by the same collateral that secures the loan obligations, and inter-creditor provisions are negotiated.
When negotiating the deal-contingent hedge, the company should ensure that the documentation does not contain economic or commercial terms that would be unacceptable to its lenders or other potential hedge providers. The provisions in the deal-contingent hedge documentation should be carefully negotiated as the company may be subject to a termination payment for certain covenant breaches or if certain additional events occur, even when financial close is not achieved by the backstop date.
“No two projects are identical, so the hedge providers must be flexible,” Dattatreya says.