The economy of Saudi Arabia is booming. The debt market reveals the truth: as of December 2022, banks in the Kingdom had provided credit facilities totaling more than SAR 2.2 trillion, or $587 billion in US currency, to the private market, with 50% of those facilities being long-term. These figures set records and demonstrate the strength of Saudi Arabia’s remarkable development narrative.
Transactions involving public-private partnerships (PPPs) and the larger project financing sector are essential to this momentum. Such initiatives are growing more quickly thanks to government-prioritized infrastructure projects and mega- and giga-projects nationwide. But, this phenomenal growth has dangers, particularly interest rate risk. The 10-year history of the three-month Saudi Arabian Interbank Offer Rate (SAIBOR) reveals a recent spike and increased volatility. The daily standard deviation has surpassed and doubled to 1.21% during the previous five years from just 0.52% for the preceding five years.
This raises concerns about how the project business and the beneficiary entity—the two main stakeholders in whatsoever project finance transaction—should be divided in terms of interest rate risk. The former, also known as the off-taker or the procurer, compensates the project firm to deliver the agreed-upon scope, whereas the latter is a unique purpose organization founded to perform the project and whose sole asset is the project. How should these two parties distribute the risk of interest rates then?
Local Market Summary
Although the distribution of risk related to interest rates varies for every project, Saudi Arabia’s traditional method burdens off-takers. These beneficiary businesses take on the interest rate risk from the hedge execution date through the winning bidder’s first financial model. Up to the execution of the hedge, any bank rate volatility is protected from the bidder’s profits.
The financial model is modified to preserve the profitability measures if the interest rate is higher than the expected rate at the execution date. The off-taker is responsible for covering the interest rate variation. Yet, the off-taker gains if the interest rate decreases. The stakeholders must decide on the best hedging plan and comprehend how the risk of interest rates is distributed up front to bring this equation into balance.
To accomplish these results, the following actions must be taken at the four crucial phases in the project’s financing process.
1. The Pre-Bid Phase
The project business must develop and provide a hedging plan that details the instrument being considered, the ideal hedging quantum, and other crucial elements. In order for the close-out to go smoothly, the banks and hedge providers must agree. The project business wants to close the project successfully. As a result, it should concentrate on obtaining the funding and completing the necessary paperwork as quickly as feasible. If not carefully designed, the hedging component might cause delays and burden the project business with unfavorable financial conditions.
Before submitting its proposal, the project business must compute the risk associated with interest rate allocation to construct the financial model and projection. For instance, the project business should estimate the impact and factor it into the program economics if long-term financing is anticipated. Still, the financing currencies must be liquid enough to support the entire hedging duration. Would the off-taker still reimburse the project firm for the unhedged portion’s interest rate risk once the hedge is executed? That needs to be said upfront. Will the off-taker share in future profits but not future losses? If so, an evaluation must be done by the project business.
As the project firm pays the expense, any margin the hedging providers make is often not included in the off-taker compensation plan. Due to this, the project business must prepare and consult with the hedge suppliers on the hedging credit spread.
2. The Phase of the Post-Bid Pre-Financial Closure
The project company’s understanding of the pre-bid phase agreement is crucial in the project financing process, and whether it succeeds or fails depends on it. The project firm can prefer that the hedge credit spread be agreed upon by all parties or be the same for all financiers or hedge providers. Nonetheless, there are situations when a credit distance according to the hazards assumed by the lenders may be justified.
The project firm could support competition as hedge providers in the credit spread market. In that circumstance, each lender is entitled to match on a proportionate basis based on the magnitude of the loan. The disadvantage of this strategy is that it can only allow the lender the chance to take part in a transaction that generates money, which might make the transactions less beneficial than anticipated. If long-term financing has a minimum mandated hedging requirement, the project firm can get a closer credit spread again for the following tranches.
Nonetheless, this spread can be superior to the first tranche due to decreased risk throughout the project’s completion or operating phases. The project business accepts — by nature — the first credit spread for the ensuing hedges without an upfront transparent discussion. Early drafting of a hedging protocol that follows the chosen hedging approach is advised. The party that takes on the risk of interest rates often has more freedom to select the protocol’s layout to guarantee fairness, caution, and openness.
The hedge is put through a dry run (practice) to ensure reliable procedure. Yet to evaluate the lowest competitive rate, you need an impartial benchmark. Only sometimes is the lowest rate the best. Transactions involving project financing need intricate financial modeling, and the cash flows vary depending on the hedging rate. Thus, it is essential to coordinate prompt turnarounds with the current cash flow. The hedging protocol’s definitions of how the procedure should be carried out must be followed by the financial/hedge adviser. The assumed floating curves and the actual market rates may have an allowed deviation limit set by some project firms and off-takers. Still, each party must know the risks and establish reasonable limits.
The rules of the derivative trades are outlined in International Swaps and Derivatives Association (ISDA) Agreements and Schedule. The timetable is individualized and arranged from a business and legal standpoint. The commercial factors are covered by the hedging adviser to make sure they are logical, cogent, and sensible. This is especially important for long-dated hedges since interest rates may eventually change to alternative floating rates. To properly understand the effects, the project business must proceed with caution and negotiate any phrase. Once more, this document has to be among the first to be completed at this stage.
3. The Hedge Execution Phase
The big day—the hedge execution—arrives after a successful dry run and after all of the paperwork is finished. The project business should now be fully aware of the financial parameters and the specifics of the hedging. Nevertheless, before executing the hedge, it should do a sanity check on the indicative hedge term sheets from the hedge providers to spot any misalignment to prevent any last-minute shocks. The optimum execution mechanism, which is determined by the anticipated hedge size, currencies, duration, etc., should also be discussed by the stakeholders.
The hedging adviser must ensure that all parties are in agreement on the terms and outlook given the sensitivity of the live hedge quotations and the market dynamics at play in order to prevent slippage expenses and unnecessary hedge execution charges. Each party offers the best exchange rate after bringing all hedge suppliers together for a single call to quote. If the off-taker assumes the interest rate risk after rates have risen first from initial financial model, they must promptly confirm that the optimal rate is acceptable and fair. Always keep in mind that the lowest rate given is not necessarily the best.
4. The Phase of Post-Hedge Execution
The project business should manage future hedging cautiously and maintain the allocation of interest rate risk in mind if a percentage of long-term debt still needs to be hedged. Occasionally, before the first hedge expires, new hedges are only allowed for a brief period of time. The project business should have total choice over when to hedge the entire debt parts following its risk appetite, the hedging approach, and the project covenants since doing otherwise might result in costs to the company if it keeps the interest at risk.
The accounting effect of the financial derivatives is taken into consideration by some project businesses. In order to protect the profit and loss from anticipated volatility, the volunteer IFRS9 hedge accounting guideline has been used more frequently.
Bottom-line
A careful approach results in the best hedging plan for the project firm and off-taker. An early and shared understanding is necessary for success. A checklist can assist the project business in ensuring that every interconnected aspect of the hedge has been considered during design. As every project is different, only a hedging approach works for some of them. The tiniest variance between two programs can result in significant changes to the protocol and hedging approach. Such vast differences highlight how important it is to establish expectations and spell out each stakeholder’s duties at the beginning of any project. This will allow a seamless process of hedging and prevent jobs from overlapping.
