Saudi Arabia’s economy is booming.Bond Market Tells: Kingdom Bank Expands Over R2.2 trillion — which is equivalent to $587 billion in US dollars — as of December 2022, lines of credit to the private sector, and half of these lines of credit are long-term. These are record numbers and reveal the momentum behind Saudi Arabia’s extraordinary growth story.
Public-Private Partnership (PPP) deals and the broader project finance industry are at the core of the momentum. In fact, such projects are expanding at an accelerating pace, fueled by government-prioritized infrastructure projects and mega- and giga-projects across the country.
But this impressive growth comes with risks. Especially interest rate risk. Three-month Saudi Arabian Interbank Offer Rate (SAIBOR) over the last decade shows recent spikes and increased volatility. His standard deviation per day has more than doubled to 1.21% in the last five years, compared to just 0.52% in the first five years.
3-month SAIBOR historical curve
This raises the question of how interest rate risk should be allocated between the two main stakeholders in a project finance transaction: the project company and the beneficiaries. The former is a special purpose entity created to deliver the project, whose sole asset is the project, while the latter, also known as the off-taker or procurer, pays the project company to deliver the agreed scope. increase.
So how can these two stakeholders split interest rate risk optimally?
Local market overview
The allocation of interest rate risk varies from project to project, but the traditional approach in Saudi Arabia puts the responsibility on the off-taker. These beneficiaries assume the interest rate risk outlined in the winning bidder’s original financial model until the date of execution of the hedge. Bidder profitability is protected from interest rate fluctuations until hedge execution.
If interest rates exceed the assumed interest rate on the execution date, the financial model will be adjusted to maintain profitability metrics and the off-taker will pay the interest rate deviation. But if interest rates go down, the benefits go to the offtakers.
To balance this equation, stakeholders need to agree on the optimal hedging strategy and understand from the outset how interest rate risk will be allocated.
Here’s what you need to do during the four key stages of the project finance process to achieve these outcomes.
1. Pre-bidding stage
The project company should devise and articulate a hedging strategy that specifies, among other important factors, the hedging period, the optimal amount of hedging, and the instrument under consideration. Smooth closeouts require buy-ins from lenders and hedge providers.
The goal of the project company is to finish successfully. Therefore, you should focus on securing funding and preparing relevant documents as soon as possible. Poorly planned hedging elements can result in delays and impose unfavorable economic conditions on the project company.
To establish financial models and projections, the project company should calculate the interest rate risk allocation before submitting a bid. For example, if the planned funding is long-term and the funding currency is not sufficiently liquid for the entire hedging period, the project company should quantify the impact and incorporate it into the economics of the project. Will the off-taker continue to indemnify the project company for the unhedged portion of the interest rate risk after execution of the hedge? Will the off-taker participate in subsequent profits but not losses?
Margins made by the hedge provider are usually excluded from the off-taker’s compensation plan because the project company covers the costs. As such, project companies should plan and discuss hedging credit spreads with their hedging providers.
2. Pre-account settlement stage after bidding
This is an important turning point in project finance, and its success or failure depends on the project company’s understanding of the agreements made at the pre-bid stage.
The project company may prefer that all parties agree on the hedging credit spread, or that the spread be uniform across lenders or hedge providers. However, in some cases a credit spread based on the risk borne by the lender makes sense.
In other cases, project companies prefer competitive credit spreads among hedge providers. In that case, all lenders have the right to match on a pro-rata basis according to the size of the debt. The downside of this approach is that lenders may lose the opportunity to participate in income-generating transactions. This may make trading less profitable than expected.
If there is a minimum mandatory hedging requirement for long-term funding, the project company can obtain tighter credit spreads on subsequent tranches. However, lower risk during project completion or operation could mean that this spread is better than the first tranche. Without an initial open dialogue, the project company defaults to accepting the first credit spread of subsequent hedges.
A hedging protocol should be drafted early and aligned with the agreed hedging strategy. Parties that assume interest rate risk typically have more flexibility in designing their protocols to ensure fairness, prudence and transparency.
A hedging run-in (rehearsal) is useful for testing the reliability of the protocol. But that requires independent benchmarks to verify lowest competitiveness. The lowest rate is not always the highest.
Project finance transactions involve complex financial modeling and cash flows vary based on hedge ratios. Therefore, aligning updated cash flow with timely turnaround is critical. A financial/hedging advisor must manage the process as defined in the hedging protocol. Some project companies and off-takers may set acceptable deviation limits between the assumed variation curve and the actual market rate, but each party should be aware of what is at stake. You need to understand and set appropriate thresholds.
International Swaps and Derivatives Association (ISDA) Contracts and schedules specify the terms of derivative transactions. Schedules are customized and negotiated on both commercial and legal grounds. Hedge advisors cover commercial aspects to ensure they are reasonable, consistent and reasonable. It becomes even more important for long-term hedges with potential risks. The project company should approach this process carefully and negotiate every language to fully grasp the meaning. Again, this document should be finalized first in this step.
3. Hedging execution stage
After a satisfactory dry run and with the documentation completed, the big day arrives: the execution of the hedge. At this point, the project company should have a clear picture of the economic terms and hedging details. Nevertheless, to avoid any last minute surprises, a sanity check of the indicative hedge term sheet from the hedge provider should be conducted to identify any discrepancies before executing the hedge. Stakeholders should also discuss the best execution as determined by the assumed hedge size, currency, term, etc.
Given the sensitivity of live hedge quotations and the market forces at play, the hedge advisor will ensure that all stakeholders agree to terms and prospects in order to avoid slippage costs and excessive hedge execution fees is needed. All hedging providers are brought into one quote request. Each party offers the best swap rate. If the off-taker takes interest rate risk when interest rates rise from the original financial model, the off-taker needs to quickly verify that the best interest rate is fair and reasonable. Please note that the lowest price quoted is not always the best.
4. Post-Hedge Execution Phase
If an unhedged portion of long-term debt remains, the project company should carefully manage future hedging and keep interest rate risk allocation in mind. In some cases, additional hedges may be permitted only for a short period of time before the initial hedge expires. Full discretion as to when to hedge the remaining portion of the liability, subject to risk appetite, hedging strategy and project terms and conditions, as this can be costly if the project company puts the interest at risk must have
Some project companies take into account the accounting impact of derivative instruments.As a result, any IFRS9 hedge accounting Standards that protect profits and losses from potential volatility are becoming more common.
The best hedging strategies for project companies and offtakers are the product of a delicate process. Success requires early mutual understanding. During planning, the checklist helps the project company ensure that all interrelated factors of hedging have been considered.
Of course, each project is unique, so there is no one-size-fits-all hedging strategy. Small differences between the two projects can lead to big differences in both hedging strategies and protocols.
Such wide variations highlight how important it is to set expectations and define the responsibilities of each stakeholder at the start of every project. This avoids duplication of tasks and ensures a smooth and seamless hedging process.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of CFA Institute or the author’s employer.
Image credit: ©Getty Images/ Lebazele
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