Saudi Arabia’s economy is booming. The debt market tells the story: the banks in the dominion have prolonged greater than SAR 2.2 trillion – that’s $587 billion – in private sector credit facilities, with half of those credit facilities being long-term (as of December 2022). These are record numbers and illustrate the dynamics behind Saudi Arabia’s extraordinary growth story.
Public-private partnerships (PPP) and the broader project finance industry are central to this dynamic. In fact, such projects are increasing at an ever-increasing pace, supported by infrastructure projects prioritized by the federal government in addition to mega and giga projects across the country.
But this remarkable growth comes with risks – particularly rate of interest risk. The three-month Saudi Arabian Interbank Offer Rate (SAIBOR) shows a recent increase and increasing volatility over the past decade. Compared to simply 0.52% in the primary five years, the every day standard deviation has greater than doubled to 1.21% within the last five years.
Historical three-month SAIBOR curve
This raises the query of how rate of interest risk needs to be allocated between the 2 principal players in a project financing transaction: the project company and the beneficiary company. The former is a special purpose company created to implement the project and whose sole asset is the project, while the latter, also often called the customer or procurer, pays the project company for the delivery of the agreed scope.
So how can these two stakeholders best share rate of interest risk?
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The allocation of rate of interest risk varies depending on the project, but the standard approach in Saudi Arabia places the responsibility on the takers. These beneficiary entities will bear the rate of interest risk as outlined within the successful bidder’s initial financial model until the date of hedge execution. The bidder’s profitability is shielded from any rate of interest volatility until the hedge is implemented.
If the rate of interest rises above the assumed rate of interest on the execution date, the financial model is adjusted to take care of the profitability ratios, with the customer paying for the rate of interest deviation. However, if the rate of interest falls, the advantages go to the customer.
To balance this equation, stakeholders must agree on an optimal hedging strategy and understand from the outset how rate of interest risk will likely be distributed.
Here’s what must be done within the 4 key phases of the project financing process to realize these results.
1. The pre-offer phase
The project company must develop and formulate a hedging strategy that specifies, amongst other critical aspects, the hedging period, the optimal hedging scope and the instrument to be considered. The consent of the lenders and protection providers is required for a smooth transaction.
The goal of the project company is a successful conclusion. Therefore, the main focus needs to be on securing financing and executing the relevant documents as quickly as possible. If the hedging element isn’t well planned, it could lead on to delays and impose unfavorable economic conditions on the project company.
In order to create the financial model and forecast, the project company must calculate the rate of interest risk distribution before submitting its offer. For example, if the planned financing is long-term and the financing currency isn’t liquid enough for the whole hedging term, the project company should quantify the consequences and incorporate them into the project economics. Will the customer proceed to compensate the project company for the rate of interest risk of the unhedged portion after the hedging has been accomplished? This should be clear early on. Will the customer share in the next profits but not within the losses? If so, the project company must perform an assessment.
Any margin earned by the hedging providers is often excluded from the customer compensation plan because the project company bears the prices. Therefore, the project company must plan the hedging credit spread and discuss it with the hedging providers.
2. The pre-financial closing phase after the offer
This is the crucial point in project financing, and its success or failure will depend on whether the project company understood the agreement before the tender.
The project company might prefer that every one parties agree on a hedge credit spread or that the spread be uniform across all lenders or hedge providers. But sometimes a credit premium based on the risks borne by the lender could make sense.
At other times it might be that the project company promotes credit spread competition between the protection providers. In this case, each lender has the best to pay proportional compensation depending on the quantity of the debt. The downside to this approach is that it could cost the lender the chance to have interaction in an income-generating trade, which could end in the transactions being less profitable than forecast.
If there may be a minimum hedging obligation for long-term financing, the project company could achieve a narrower credit spread for the next tranches. However, lower risk throughout the project completion or operational phase could mean that this spread is healthier than the primary tranche. Without an open dialogue originally, the project company defaults to accepting the initial credit spread for subsequent hedging.
A hedging protocol needs to be drawn up at an early stage and tailored to the agreed hedging strategy. The party that assumes the rate of interest risk typically has more flexibility in designing the protocol to make sure fairness, prudence and transparency.
A test run of the safety helps to check the reliability of the protocol. However, this requires an independent benchmark that validates the bottom competitive price. The lowest rate isn’t all the time the most effective.
Project financing transactions require complex financial modeling and money flows change depending on the hedging rate. Therefore, coordinating timely turnarounds with updated money flow is critical. The financial/hedging advisor must manage the method as defined within the hedging protocol. Some project corporations and buyers may set a suitable deviation limit between the assumed moving curve and actual market rates, but each party must understand what’s at stake and establish appropriate thresholds.
The International Swaps and Derivatives Association (ISDA) The agreement and schedule specify the terms of the derivative transactions. The schedule is customized and negotiated for each business and legal reasons. The hedging advisor covers the business features to make sure they’re rational, coherent and appropriate. This becomes more vital for long-term hedging where rates of interest may convert to alternative variable rates in the long run. The project company must approach this process rigorously and negotiate each language to totally understand the implications. Again, this document needs to be among the many first to be accomplished on this step.
3. The hedge execution phase
After a satisfactory test run and the completion of the documentation, the large day comes – the execution of the protection. At this point, the project company must have a transparent overview of the economic conditions and details of the hedging. However, to avoid last-minute surprises, the corporate should conduct a sanity check on the hedge providers’ indicative hedge term sheets to discover any discrepancies before executing the hedge. Stakeholders also needs to discuss the most effective execution method, which will likely be determined by the planned hedge size, currency, duration, etc.
Given the sensitivity of the live hedge listing and the market forces at work, the hedge advisor must confirm that every one parties are in agreement with the terms and outlook with a view to avoid slippage costs and excessive fees for executing the hedge. All hedge providers take part in a call to cite; Each party offers the most effective swap rate. If the taker bears the rate of interest risk if rates of interest have increased in comparison with the unique financial model, he should quickly check whether the most effective rate of interest is fair and reasonable. Remember that the bottom rate offered isn’t all the time the most effective.
4. The post-hedge execution phase
If an unhedged portion of long-term debt stays, the project company should rigorously manage future hedging and regulate the distribution of rate of interest risk. Sometimes additional coverage is just permitted for a brief time period before the unique coverage expires. This could end in costs for the project company if it jeopardizes its participation. Therefore, it must have complete freedom to choose when to hedge the remaining debt portions in accordance with its risk appetite, hedging strategy and project agreements.
Some project corporations bear in mind the accounting effects of derivative instruments. As a result, application of the voluntary Hedge accounting based on IFRS9 The standard for shielding profits and losses from potential volatility is becoming increasingly common.
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The optimal hedging strategy for the project company and the customer is the results of a fragile process. Success requires early and mutual understanding. During planning, a checklist may help the project company to make sure that all related security aspects have been taken into consideration.
Of course, every project is exclusive, so there is no such thing as a uniform hedging strategy. The slightest difference between two projects can result in large differences in each the hedging strategy and the protocol.
Such major differences highlight the importance of setting expectations and defining the responsibilities of every participant originally of every project. This helps avoid overlapping tasks and ensures a smooth and seamless assurance process.
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