As part of our corporate finance team at PKF Francis Clark that specialise in company valuations, I often have clients ask difficult and challenging questions on…
The discontinuation of LIBOR at the end of this year represents a fundamental change within the banking and finance industry and will affect a significant proportion of British businesses in some way.
Banks and lenders should be reaching out to coordinate but if you are a business with LIBOR-linked loans then you need to start to work through the ‘how and when’ of transitioning. This might also be an opportune time to consider the overall financing of your business.
What is LIBOR?
London Interbank Offered Rate (LIBOR).
Historically, LIBOR has been an interest rate quoted for borrowing and derivative transactions in UK Pound Sterling and other major currencies (U.S. Dollar, Swiss Franc, Euro, and Japanese Yen) based on rates reported by banks for interbank lending in the London market.
However, issues pertaining to the calculation of LIBOR led regulatory authorities to state that “given consumer protection, litigation, and reputation risks, [they] believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks”.
Hence regulatory authorities and central banks have committed to replace IBORs with alternative rates such as near Risk Free Rates (RFRs) and to this end:
- New financial transactions and products should no longer reference LIBOR rates
- Existing financial transactions and products must transition from LIBOR to alternative rates
Why is this important?
Despite concerns over the LIBOR setting process dating back to 2008, LIBOR continued to be used as a reference for pricing of a range of financial products, including:
- Lending, e.g. terms loans, revolving credit
- Asset-backed securities
- Other sources of rate exposure, e.g. overdrafts, preference shares, leases
So, it is possible that a financial product your business has may have interest that is priced with reference to LIBOR. Taking stock of lending facilities is a good place to start but finding the true extent of a business’s LIBOR exposure can be tricky, as LIBOR can often also be found elsewhere in commercial contracts, intra-group accounts and internal financial analysis. Once identified, there is then the question of if and how these will need to be moved onto a replacement rate ahead of expected LIBOR cessation.
SONIA – an alternative rate
In terms of alternative rates to LIBOR when transitioning existing facilities, there is a risk free rate referred to as SONIA.
The Sterling Overnight Index Average (SONIA) is calculated as “the timed mean of interest rates paid on unsecured overnight sterling denominated wholesale deposit transactions”, i.e. it is backward looking and, as such, the accrued interest for a given period can only be calculated at the end of the interest period.
Options for transitioning your existing LIBOR-based lending facilities
Essentially there are three options:
- Amending of LIBOR base to RFR or Base Rate
- Amending Fixed Rate
As with all financing decisions the preference will be based on a myriad of considerations, including perceptions on future changes to RFR or Base Rate and a business’s appetite for risk – and do not forget other items in the loan agreement being looked at, including covenants and the potential cost of early redemption.
How PKF Francis Clark can help
It has been an exhausting year for most businesses dealing with the impact of the pandemic but given the timelines now left, considering the impact of the end of LIBOR is a serious issue that needs to be evaluated by management.
We are already assisting several clients, specifically those with larger exposures to LIBOR-based facilities, to understand more of the background to the changes and the alternative rates. We are also finding that discussions on interest rates are broadening out to include future plans for the business and the financing of those future plans. These are all areas where I and my colleagues are happy to be engaged as a sounding board and help facilitate a better understanding of the milestones and challenges ahead, so your business is prepared.
For more information or to discuss any of the issues raised here, contact our experienced corporate finance specialists.