Project Finance: Beware Interest Rate Miscalculations
Interest rates are like the weather. We can prepare for typical fluctuations, but sudden changes can still catch us by surprise. After the global financial crisis (GFC), for example, we enjoyed a decade of clear skies and low rates. Even as the winds rose in 2019 and the economy struggled with a higher federal funds rate, the gusts soon dissipated and zero interest rates returned.
But in the last two years, the interest rate equivalent of a violent storm has descended. Desperate to battle inflation, the US Federal Reserve has hiked at an unprecedented pace as the federal funds rate hit its highest point in more than 22 years, with a target range of 5.25% to 5.50%. The Fed’s moves have caught many unprepared.
Consider Saudi Arabia. Its private sector has experienced remarkable credit expansion in the last few years. The July 2023 Monthly Statistical Bulletin from the Saudi Central Bank (SAMA) indicates that banks’ credit exposure to the private sector grew at a compounded annual rate of 10% from 2018 to 2022. This growth culminated in a record outstanding credit of SAR 2.4 trillion, or the equivalent to US$0.64 trillion. Notably, almost half of this exposure has a maturity period exceeding three years.
Meanwhile, since the launch of the 2030 Vision, Saudi Arabia has announced around US$1 trillion in real estate and infrastructure projects. Last June, the National Privatization Center & PPP (NPC) declared a pipeline of 200 projects across 17 sectors, reinforcing the commitment to public-private partnership initiatives.
These initiatives, combined with the massive credit expansion in the private sector, mean that many projects have long-dated floating borrowing exposure. And interest rate volatility has put them under more pressure than ever before. The risk? Failing to accurately plan for rate changes. The consequences? Spiraling costs, blown budgets, and an uncertain future.
The question is, How do we navigate this storm?
The Financial Model and Interest Rate Assumptions
Interest rate assumptions are central to leveraged transactions with extended exposure. For long-term projects under SAR borrowing, liquidity typically permits hedging for five to seven years. Consequently, lender covenants require many projects to hedge a substantial portion of this borrowing.
But how do we address the exposure’s remaining lifespan? Many projects apply static, unsubstantiated interest rate assumptions, particularly for periods beyond 7 to 10 years. These are clearly unsuitable for today’s climate of evolving rates. Therefore, the models have to be recalibrated to reflect elevated rates and a reasonable interest rate curve extrapolated.
Addressing the Present Dilemma
Adjusting models to the current interest rate environment after the fact will undoubtedly affect core profitability metrics and may even compromise a project’s financial viability. The ramifications grow more severe with increased leverage. Yet failing to address the problem will only compound the negative consequences.
Projects facing higher interest rates need to update the models to assume a painful current environment if the floating debt portion is material. This challenge remains even when the debt is partially hedged. Therefore, the project company has to examine long-term borrowing implications as well as the immediate exposures. So, how should companies navigate this environment? And is derivative hedging the only answer?
The On-Balance-Sheet Approach
A primary approach should be looking at the balance sheet. The financial evaluation of a project must consider the prevailing interest rate conditions. If it shows enhanced performance in its current phase — whether construction or operation — then debt refinancing for more favorable terms may be an option. Alongside this review, the project’s covenants need to be monitored in line with both commercial and accounting objectives.
Any refinance proposition, however, must correspond to the agreed terms and conditions governing the underlying financing documents. Project finance lenders usually agree to a soft mini perm financing structure. What is a mini perm? It is a type of loan that has a short- to medium-term initial period during which the borrower pays only interest or a combination of interest and a small amount of principal. This incentivizes projects to refinance at initial maturity (medium term; five to seven years post drawdown). For new projects, the cash sweep, pricing mechanism, and other key terms need to be carefully recalibrated to best influence the underlying project economics for the sponsors.
Increased financial performance and creditworthiness could lower the credit spread upon refinancing. This can reduce interest expenses, bolster the cash flow, and otherwise cushion the impact of a higher rate environment.
Improved project outcomes also afford companies increased leverage in negotiations, potentially securing advantageous debt terms and less stringent covenants. This facilitates greater financial and operational latitude.
A vital component of this on-balance-sheet strategy is the potential to release equity value by refinancing on more flexible terms. Replacing a segment of debt with equity financing can sustain the project company’s balance sheet and amplify its financial resiliency. Proper refinancing can recalibrate the capital structure, ensuring that debt maturity and costs correspond with the project’s cash flow capabilities — and strengthen its financial standing.
Ultimately, these benefits can bolster investor trust, particularly for publicly traded entities. Enhanced confidence can widen the investor pool and augment the liquidity of debt securities in secondary markets, especially in instances of public Bond/Sukuk issuance.
The Off-Balance-Sheet Approach
The “Blend and Extend Strategy” enjoyed its time in the sun during the pandemic. Interest rates presented an opportunity, and many sought to prolong their higher fixed interest rate swaps (IRS) hedging. This extended high-rate hedges beyond their maturity to capitalize on reduced swap rates, thereby achieving a blended, diminished rate. By merging an existing swap and a new one into an extended term swap, entities could immediately ease cash flow burdens and spread the swap’s adverse liability over a prolonged period.
The current scenario presents the reverse opportunity. A project company with an extended IRS but only partial hedging against debt exposure can alleviate liquidity risk and looming covenant breaches. The project company might reduce the duration, channeling the favorable mark to market (MTM) to broaden short-term hedge coverage.
But what about the stretched hedge duration? Isn’t it now even more vulnerable to subsequent rate variations? Verging on financial distress, companies may take drastic measures to uphold financial stability and remain solvent.
If the project’s future performance seems promising, such steps provide short-term benefits and a reprieve as the company navigates the complexities ahead. But doesn’t this entail the preservation of long-term exposure? Not necessarily. Several hedging strategies, particularly those addressing tail risk, can provide substantial coverage.
Importantly, off-balance- and on-balance-sheet methods are not mutually exclusive. Implementing them sequentially or in tandem can optimize the advantages of each.
To navigate the storms of interest rate variability, we need foresight and flexibility. Addressing rate fluctuations requires prescience, even before a project begins. Financing documentation, coupled with pertinent hedge covenants, should proactively anticipate shifts. For instance, lenders should avoid imposing rigid “systematic hedge windows” for floating debt exposure so that the project company has enough agility to adjust to future rate variability.
Diligence here is key. Whatever the financial model’s projections, the project company must monitor evolving rate dynamics and consider the implications of any existing hedge and any still unhedged exposures.
It also needs flexibility to capitalize on potential opportunities. Enhanced project performance, viewed from a balance sheet angle, opens the door to refinancing under more favorable conditions. But that flexibility must be established upfront before achieving financial close (FC).
Eventually, a company’s ideal trajectory aligns with its predefined risk management goals and KPIs and underpins both on- and off-balance-sheet determinations. We also must remember that while each project is unique and no universal strategy exists, when gray skies are on the horizon, it doesn’t hurt to carry an umbrella.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Willie B. Thomas
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