Deal contingent swaps – A Borrower's Holy Grail? | White & Case LLP International Law Firm, Global Law Practice
Deal contingent swaps – A Borrower's Holy Grail?

Deal contingent swaps – A Borrower's Holy Grail?

With signs that the global economy is in the best shape it has been for some time, a number of central banks are raising interest rates. The risk of higher interest rates and corresponding upward trends in forward interest rate markets has prompted project developers and financiers to consider innovative hedging strategies to manage this risk. Deal contingent hedging is a risk solution that has been used in recent project financings in Australia to lock in interest rate protection prior to financial close.

For highly leveraged deals, in particular those with tight equity return parameters, any increase in the base rate that is able to be mitigated through hedging can have a significant impact on equity return. If forward interest rate markets rise during the period prior to financial close, the quantum of debt available to fund the project due to debt sizing constraints, and consequently the equity IRR, can be detrimentally affected - potentially making the project uneconomic for sponsors to pursue. 

In a typical project financing, immediately prior to financial close, the amount of senior debt committed to fund the project will be resized based on the results of certain financial ratios, including a debt service cover ratio (DSCR). The DSCR assesses the project's projected cash flow and debt service obligations using the fixed interest rates that are achieved through hedging being implemented on the date of financial close. At financial close, if the fixed interest rates achieved are higher than the levels assumed by the financial model, the amount of the project's debt service obligations will have increased, and therefore the quantum of senior debt that is able to be committed to the project will need to be reduced (since the project's cash flow available for debt service remains unchanged). This risk has prompted sponsors to use pre financial close hedging strategies to lock in interest rate protection as soon as possible prior to closing so as to ensure that (a) the total amount of equity required to be invested in the project by the sponsors is within a known, tight range and (b) the project economics are protected as early as possible.


Deal contingent swap vs forward start swap vs swaption

A deal contingent swap is a swap that is contingent on a specific event occurring (e.g. financial close is achieved). It is similar to a vanilla forward start swap with three key differences: (a) the ability of the borrower to walk away from the swap if the deal is not consummated without any fee or potential mark to market liability being payable, (b) there is no requirement of the borrower to post any credit support prior to the deal being consummated and (c) its price (pricing is generally less expensive than a swaption but more expensive than a forward start swap).

In the case of deal contingent swaps used for project financing transactions, the swap is activated when financial close is achieved. Given this, deal contingent swaps are very much tailored to the particular transaction and require the parties to assess the risk that financial close will occur by closely analysing any perceived impediments to financial close being achieved. No upfront premium is payable by the borrower, instead the swap margin is increased by an additional ‘contingent margin' to compensate the swap counterparty for the risk it assumes in entering into the transaction (i.e. it must offer the fixed rate at the time the swap is entered into regardless of market movements at financial close). This means the swap counterparty is compensated only if the contingent event is actually achieved and the swap is  activated. If the contingent event is not achieved by a long stop date, the deal contingent swap will usually terminate without the borrower incurring a fee or any mark to market payable.

Since the swap counterparty takes a risk that the contingent event will occur, the swap counterparty will need a high degree of certainty that the transaction will close and it may seek to 'back-off' this risk through other transactions in the market. If the contingent event does not occur, any unwind risk associated with these transactions is borne by the swap counterparty. This is very different to a forward start swap, where if the relevant event does not occur, the borrower will be liable for potential mark to market break costs.  

A swaption is an option to enter into a swap at a fixed rate in the future for a fee. Swaptions can be expensive as the borrower is paying for the benefit of locking in a fixed interest rate upfront without the obligation to utilise the swap if the financing does not reach financial close. The key difference to a deal contingent swap is that typically the swap counterparty is compensated up front through a fee for taking the risk of forward interest rate market movement between the time the swaption is entered into and when the swap is actually executed (the fee is sometimes added to the swap margin if the swaption is utilised). As noted above, under a deal contingent swap, the swap counterparty only benefits if the deal contingent event occurs through payment of the higher swap margin at the time (although there is also a possible indirect benefit in any market movement in the swap counterparty’s favour under transactions which are unwound by the swap counterparty).


Incentives for using a deal contingent swap

Deal contingent swaps are typically not widely used in greenfield project finance transactions.  Hedge counterparties are more accustomed to not taking the risk of market movements and an uncertain contingent outcome (like achieving completion) without receiving appropriate compensation up front (like a swaption) or otherwise being able to close out the transaction on a marked to market basis with appropriate recourse to the counterparty (like a forward start swap). It is therefore interesting to understand the circumstances under which a swap counterparty and sponsor would agree that a deal contingent swap is the best risk mitigant for both parties.

Neoen Australia and Société Générale reached such an agreement when executing the 100MW Hornsdale 2 greenfield wind farm project financing in 2016.  In this case, Société Générale provided a deal contingent swap that locked in the project's interest rates for a period of approximately three months prior to financial close being achieved. Whilst such transactions are common place in Europe and the US for Société Générale, it was a first for Société Générale in Asia Pacific.

Serge Stepanov, Chief Financial Officer of Neoen:

"In the case of Neoen’s Hornsdale 2 project, a contingent swap was a good instrument to reduce the volatility of the economics of the project, as the amount of debt, the amount of equity and the return on investment, were fluctuating with foreign exchange rates and interest rates. As part of its risk management policy, Neoen aims to fix most parameters together, so as to benefit from, or avoid the loss of, correlation between different markets.

The Neoen team was confident in its ability to close the project and therefore willing to book a plain vanilla forward start swap and FX forwards, but the credit risk exposure and associated required credit support for all these instruments together were too high. The contingent swap for the interest rate hedge was a way of resolving that issue."

Simon Scott, Director, Energy & Natural Resources, Société Générale Australia:

"Deal contingent swaps are typically only used in transactions where a final approval is required before financial close can be achieved.  In this case Société Générale transacted the swap prior to the finalisation of due diligence and obtaining credit approval for the financing. The beauty of having locked interest rates ahead of time enabled Neoen to focus on equity negotiations with John Laing and closing out the due diligence process to achieve a smooth financial close."


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