Of all the headaches that infrastructure financing can cause, expensive debt markets have not been high on firms’ lists in recent years. Infra players have enjoyed the long bull market for duration as much as any corporate or emerging market issuer.
But long-term rates are rising and for infrastructure players, dearer long-dated debt will warrant an assessment of their funding.
That outlook is moving banks and advisers to pitch deal-contingent hedges to the infrastructure sector. Private equity firms commonly use the hedge to lock in the foreign currency purchase price of a target company. But infrastructure firms can adapt it to secure a low funding cost on their projects. The product’s appeal is the right for the buyer to walk away from any obligation to unwind the position if their deal falls through.
“We are seeing increased interest in using deal-contingent technology in infrastructure financing,” says Selim Toker, head of risk solutions group EMEA at Nomura in London. “Infrastructure funds are bidding for assets and then using deal-contingent interest rate hedges to lock in their financing costs. That theme played out last year as interest rates began to rise and clients became more concerned than before about locking in those costs.”
Even those who have to tap long-dated markets still question if the cost of any hedge, especially one with a deal-contingent product’s higher premium, is justifiable when rates are rising so gently. But Toker says that long lead times for closing infrastructure finance make the tool useful.
“Given that there could be a delay between signing and closing, and that financing typically occurs only after closing — once there is certainty that it is required — the deal-contingent interest rate hedge allows clients to lock the level of interest rates at time of signing in a cost-efficient manner.
“Even though interest rate rises may be gradual, the sensitivity of the project’s internal rate of return maybe be significant enough to warrant the hedging and remove one element of uncertainty from the bidding process.”
Brian Conly, managing director for private equity and infrastructure at Chatham Financial in Pennsylvania, has discussed using deal-contingent hedging with infrastructure clients and agrees that the product has a logical place in the market. But he adds that the derivative has not yet reached its full potential.
“There is a complication,” says Conly. “It is one thing if the hedge is for a standard sale and purchase agreement-based asset that is changing hands: it is an existing stabilised asset and would be a perfect candidate for a deal-contingent hedge.
“It is different for a construction project — for example, a wind farm in the North Sea in a couple of years’ time. We have been pushing hard on the use of deal-contingent hedging during the construction phase, when infrastructure players have a meaningful concern about the risk, often longer dated than for a stabilised asset that is just being bought and sold and for which you need only a couple of months. There is not the same concern about rate risk that there would be for the nine month period on a complex deal that would require construction.”
Pushing deal-contingent technology further into the debt markets is challenged by accounting, though. Under US GAAP and IFRS standards, a deal-contingent derivative receives mark to market treatment, which could create substantial volatility in an earnings statement, especially for larger transactions. While private companies often have the stomach for mark to market, the earnings volatility it can cause is a turn-off for public transactions.
If the deal-contingent derivative can qualify for hedge accounting, its user can defer any change in fair value on its balance sheet until interest rate payments come due on the issuance being hedged. But that treatment is far from guaranteed.
“There are accounting problems that come up on the deal-contingent aspect of the trade,” says Conly’s colleague Dan Gentzel, managing director for accounting advisory.
“Unfortunately if a company wants to apply hedge accounting, the item being hedged has to be likely to occur. So for a deal-contingent rates hedge, the question is how probable is it that debt will be issued? If it does not hit the probability threshold of 80%, then it can’t qualify for hedge accounting.
“So clients may have to use mark to market accounting until they get through the deal-contingent period of the hedge. So you may be able to actually designate it for hedge accounting only at the point where the debt gets issued. We have seen a couple of cases where clients are able to prove that the issuance is probable and that the deal will happen and get the beneficial treatment of hedge accounting, but more often than not they don’t because of the deal contingency aspect.”
Dry powder stands ready to ignite volumes
While deal-contingent experts push for a place in infrastructure, the market where the product is mature has rosy prospects this year. Private equity firms are sitting on a record $906bn of dry powder, according to Preqin data. As acquisition opportunities lag that heavy fundraising, sponsors have good reason to consider overseas targets as they look to deploy their firepower. Those market conditions are ripe for deal-contingent hedging.
“Private equity firms have raised a record level of capital and are sitting on billions of dry powder,” says Antoine Jacquemin, global head of market risk advisory group at Société Générale in London. “If that cash is put to work, it will continue to generate opportunities for using the product, especially when it comes to investment overseas and the associated FX risk.”
Banks competing for this business will have to maintain strict discipline in their risk assessments. Judging whether to provide the hedge goes well beyond analysing currency movements or the direction of rates. No one acquisition is the same as another and the underlying risk of a transaction is demanding to assess, requiring as much visibility as possible. For that reason, some banks will provide the hedge only if they are on the advisory team for an acquisition, so they can better keep a pulse on the life of the deal. Despite the attractive premium on offer, the consequences of a failed deal are anxiety inducing.
Lessons from the past
The Ontario Teachers’ Pension Plan-led failed $48.5bn leveraged buy-out of Bell Canada in 2007 provides a useful reminder of the dangers of pre-hedging. With terms agreed in the run-up to the great financial crisis, banks involved in the transaction agreed in principle to provide $30bn-$40bn of hedging for the deal, which was scuppered by shrinking credit markets. So big was the hedge that concerns were raised that it would move the Canadian and US dollars’ exchange rate.
Banks were eventually let off the hedge as auditors were unable to sign a solvency statement on the deal. But Chris Arnold, partner at Mayer Brown in London, who worked on the transaction, says that pre-hedges of that size have been rare ever since and lessons have been learnt on the technology’s dangers.
“A principal part of the market is assessing the likelihood of a deal completing. It goes beyond the documentation of derivatives transactions and into looking at share purchase agreements, pre-conditions to closing and the likelihood of them being met,” says Arnold. “You are looking at government and anti-trust proposals — any poison pill that could disincentive players to complete.”
A poison pill for this year may be regulation, under the Markets in Financial Instruments Directive II.
“Uncleared margin rules are a potential issue,” says Arnold. “FX is out of scope for margining in the US but FX forwards are going to come into scope in Europe when MiFID II goes live.
“So players will have to look at whether deal-contingent hedging for FX would have to be margined, even if there is a walk-away at a long stop date. You have to consider whether there is an exposure at that long stop date that needs to be covered in the margin rules.”
But while margin rules may increase the work of pre-hedging, they are not an obstacle to the market, says Christina Norland, director, global regulatory solutions at Chatham Financial.
“Recently implemented margin rules and upcoming clearing mandates that affect counterparties in the US and Europe will require in-depth analysis to make sure a trade is compliant,” says Norland. “It will mean a greater compliance burden and heavier lift up front, but won’t stop deal-contingent hedging.”
For more on the impact of MiFID II on the derivative markets click here: Survival of the fittest as MiFID II burdens derivatives market