Interest rates are just like the weather. We can prepare for typical fluctuations, but sudden changes can still surprise us. After the worldwide financial crisis, for instance, we experienced a decade of clear skies and low rates of interest. Even because the winds picked up in 2019 and the economy struggled with the next federal funds rate, the wind gusts soon died down and rates of interest returned to zero.
But within the last two years, the rate of interest has fallen, corresponding to a violent storm. In its desperate fight against inflation, the US Federal Reserve raised funds at an unprecedented pace because the federal funds rate peaked Highest value in greater than 22 years, with a goal range of 5.25% to five.50%. The Fed’s moves caught many off guard.
Think of Saudi Arabia. The private sector has seen remarkable credit expansion lately. The July 2023 monthly statistical bulletin of the Central Bank of Saudi Arabia (SAMA) shows that banks’ credit exposure to the private sector increased at a mean annual rate of 10% from 2018 to 2022. This growth culminated in a record loan volume of SAR 2.4 trillion, or the equivalent of US$0.64 trillion. It is noteworthy that nearly half of those commitments have a term of greater than three years.
Meanwhile, because the introduction of Vision 2030, Saudi Arabia has announced real estate and infrastructure projects price around $1 trillion. Last June, the National Privatization Center & PPP (NPC) declared a pipeline of 200 projects in 17 sectorsthereby strengthening commitment to public-private partnership initiatives.
These initiatives, combined with massive credit expansion within the private sector, mean that many projects have long-term, variable borrowing. And rate of interest volatility has put more pressure on them than ever before. The risk? Tariff changes can’t be planned precisely. The consequences? Rising costs, blown budgets and an uncertain future.
The query is: How can we weather this storm?
The financial model and rate of interest assumptions
Interest rate assumptions are central to leveraged transactions with prolonged exposure. For long-term projects with SAR borrowing, liquidity typically allows coverage for five to seven years. As a result, lender agreements require many projects to insure a significant slice of this borrowing.
But how can we cope with the remaining exposure lifespan? Many projects are based on static, unfounded rate of interest assumptions, particularly for periods longer than 7 to 10 years. These are clearly unsuitable for today’s climate of rising rates of interest. Therefore, models must be recalibrated to reflect increased rates of interest and an appropriate yield curve extrapolated.
Address the present dilemma
Subsequent adjustment of models to the present rate of interest environment will undoubtedly have an effect on key profitability metrics and will even jeopardize the financial viability of a project. The effects grow to be more severe as leverage increases. However, if the issue shouldn’t be addressed, the negative consequences will only worsen.
Projects facing higher rates of interest might want to update models to assume a difficult current environment if the variable debt portion is material. This challenge stays even when the debt is partially secured. Therefore, the project company must examine each the long-term effects on borrowing and the immediate risks. So how should corporations navigate this environment? And is hedging through derivatives the one answer?
The on balance sheet approach
A primary approach must be to take a look at the balance sheet. The financial assessment of a project must have in mind the prevailing rate of interest conditions. If it’s performing higher in its current phase – whether construction or operation – then debt restructuring on more favorable terms could also be an option. In parallel with this review, the project’s arrangements have to be monitored in accordance with industrial and accounting objectives.
However, any refinancing proposal must comply with the agreed terms underlying the underlying financing documents. Project finance lenders typically conform to a soft mini-Permian financing structure. What is a mini perm? This is a kind of loan with a brief to medium-term initial term, during which the borrower pays only interest or a mix of interest and a small principal amount. This creates an incentive for projects to refinance themselves after they are initially due (medium term; five to seven years after utilization). For recent projects, the money sweep, pricing mechanism and other key terms must be fastidiously recalibrated to best impact the underlying project economics for sponsors.
Higher financial performance and creditworthiness could lower the credit spread when refinancing. This can reduce interest expense, strengthen money flow, and otherwise cushion the impact of the next rate of interest environment.
Improved project outcomes also give corporations greater leverage in negotiations, potentially securing them favorable credit terms and fewer stringent contract terms. This allows greater financial and operational flexibility.
A key component of this balance sheet-oriented strategy is the potential of releasing equity value through refinancing on more flexible terms. Replacing a debt capital segment with equity financing can stabilize the project company’s balance sheet and strengthen its financial resilience. Proper refinancing can recalibrate the capital structure to make sure that debt maturity and value align with the project’s money flow capabilities – and strengthen its financial performance.
Ultimately, these advantages can increase investor confidence, especially for publicly traded corporations. Increased confidence can expand the pool of investors and increase the liquidity of debt securities in secondary markets, particularly in public bond/sukuk issuances.
The off-balance sheet approach
The “Combine and expand strategy“I enjoyed my time within the sun through the pandemic. Interest rates presented a chance and lots of sought to increase their higher protection through fixed rate of interest swaps (IRS). This prolonged high-yield hedges beyond their term to profit from lower swap rates, thereby achieving a blended, reduced rate of interest. By merging an existing and recent swap into an extended-dated swap, corporations could immediately reduce money flow burdens and spread the swap’s adversarial liabilities over an extended time frame.
The current scenario offers the alternative opportunity. A project company with an expanded IRS but only partial protection against debt risk can reduce liquidity risk and the specter of contractual breaches. The project company could shorten the term and use the favorable mark-to-market (MTM) to expand short-term hedging coverage.
But what in regards to the prolonged coverage period? Isn’t it much more vulnerable to future tariff fluctuations now? Companies may take drastic measures to keep up financial stability and remain solvent, bordering on financial distress.
If the project’s future performance appears promising, such moves provide short-term advantages and respite while the corporate navigates the complexities ahead. But doesn’t this also mean maintaining long-term exposure? Not necessarily. In particular, multiple hedging strategies those concerned with tail riskcan provide significant coverage.
It is essential that off-balance sheet and on-balance sheet methods usually are not mutually exclusive. The respective benefits will be optimized through sequential or simultaneous implementation.
Final insights
In order to weather the storms of rate of interest fluctuations, we’d like foresight and adaptability. Dealing with price fluctuations even requires foresight before a project begins. Financing documentation along side appropriate hedging agreements should proactively anticipate changes. For example, lenders should avoid imposing rigid “systematic hedging windows” for variable debt risk in order that the project company has sufficient flexibility to adapt to future rate of interest fluctuations.
Care is vital here. Regardless of the financial model’s predictions, the project company must monitor evolving rate of interest dynamics and consider the impact of existing hedges and any risks not yet hedged.
Flexibility can be needed to make the most of potential opportunities. From a balance sheet perspective, improved project performance opens the door to refinancing on more favorable terms. However, this flexibility have to be established prematurely before financial close (FC) is achieved.
Ultimately, an organization’s ideal trajectory aligns with its predefined risk management objectives and KPIs and underpins each on-balance sheet and off-balance sheet decisions. We also must do not forget that while every project is exclusive and there isn’t a universal strategy, it doesn’t hurt to have an umbrella with you when the sky is gray.
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Photo credit: ©Getty Images / Willie B. Thomas
