Financial Planning & Analysis

The End of LIBOR: Are You Ready?

With all of the happenings at year‐end, thinking about how your company structures its borrowings and contracts in the coming year is probably not at the forefront of discussions. But it should be in relatively short order, given that the end of LIBOR is nigh – and especially if the term SOFR is new to you.

SOFR has become the presumptive replacement for LIBOR by the end of 2021. And yet, there are estimates that only a quarter of companies are ready for the end of LIBOR. This article will explain why the end of LIBOR is coming, why other rates were not chosen, issues with SOFR, and most importantly how this change may impact your company and how to prepare for it.

The End of LIBOR

LIBOR, the London Inter‐bank Offered Rate, came under scrutiny back in 2012, when it was discovered that banks were falsely reporting their rates and in some cases directly requesting rates so as to profit from trades. Oversight was quickly transferred away from the British Bankers’ Association, and tighter regulations were established regarding reporting and recordkeeping.

However, the damage had been done, and finding a more robust replacement rate was deemed necessary. The underlying market for LIBOR were loans between banks, which was quite robust when it first was developed. However, the financial crisis happened in 2008, after which new regulations placed significant capital requirements on financial institutions. As a result, interbank lending slowed to almost a grinding halt.

Now, the LIBOR rate is based on submissions based on an estimated daily volume approximating only $500 million. Comparing this to total LIBOR based contracts valued in the trillions, the question as to the suitability of the LIBOR is understandable.

The ARRC (Alternative Reference Rates Committee) was formed in 2012 by the Federal Reserve to address such needs and finding a new alternative rate is its first task.

Fast forward to 2020. The ARRC has identified SOFR as the expected replacement rate with a long-expected final transition date from LIBOR at the end of 2021. That said, the ARRC recently announced that certain rates will terminate at the end of 2021, but given certain constraints and the need for additional preparation time, some of the more common LIBOR rates may still be published through mid‐2023.

Why SOFR, and When?

SOFR, short for the Secured Overnight Financing Rate, is both similar and distinct from the LIBOR rate. While LIBOR is an unsecured rate with various maturities with an inherent credit risk component, SOFR is a secured overnight rate based on the cost of transactions for overnight repurchase agreements (“Repos”) reflecting effectively no credit risk. Despite these differences, SOFR is based on approximately $750 billion in underlying transactions, making it significantly less prone to manipulation.

While there is significant coalescence around SOFR as the replacement for LIBOR in the US, other countries have their own established replacement rates. The UK has the Sonia rate, and Japan has established the Tonar. And other rates in the US, such as the Ameribor rate, are making inroads as well.

Ameribor, which is an unsecured interest rate benchmark like LIBOR with a credit risk component, may be more reflective of the interbank borrowing costs of medium‐sized and regional financial institutions. However, like SOFR, it does not have a forward-looking term rate structure. And given recent volatility in SOFR rates due to sharp spikes in the underlying repo rates, having more than one replacement rate option may be a conservative option to manage risk.

Other rates, such as the Prime Rate or the Federal Funds Rate, were considered but did not offer the same flexibility in generating developing forward looking rates. The ARRC has been actively promoting the development of a significant underlying derivatives market and trading of SOFR interest‐rate based futures in order to develop a reliable SOFR forward curve.

For now, the Federal Reserve has been publishing 30-, 90-, and 180‐day compound historical rate averages, and government issuers (i.e., Fannie Mae and Freddie Mac) have been active in incorporating SOFR and moving away from LIBOR. Specifically, Fannie and Freddie began to offer ARMs using the 30‐day SOFR in October 2020.

The ARRC hopes to have a full SOFR term market in place by mid‐2021, but it has recently acquiesced to a delay in full termination of LIBOR to mid‐2023. Which may also allow for development of a credit risk component for SOFR to be a true LIBOR replacement rate for commercial loans.

How to Prepare for the End of LIBOR

Knowing that the end of LIBOR is coming is only the first step for most management teams. Making plans for how to incorporate one or more new rates into your Company’s daily operations and contracts are the most critical steps. Outside of standard credit agreements, other significant financial agreements will likely definitely be impacted by the termination of LIBOR.

A full review of all contracts should be performed to identify the universe of contracts that have at least one financial pricing or fee component that is tied to LIBOR. This list of contracts should then be grouped based on a couple of variables (e.g., type, term length, value of contract, number of counterparties) as this should provide some efficiencies in reviewing and proposing new fallback language.

Some of these agreements may already include fallback language that would determine the rate and terms that would succeed LIBOR, but those terms should be reviewed and potentially renegotiated now that the likely SOFR replacement rate has been identified. Other agreements may not have any fallback language included therein and could become unenforceable in light of this. Either scenario could have unintended consequences if not addressed in the near term.

Debt Agreements and Specific Considerations

Given that many agreements have some temporary fallback language, which is typically to Prime or to a fixed rate, all amendments or new agreements should contemplate the scenario that LIBOR will end and include another successor rate other than Prime. Scenarios that could be documented include:

  1. a new successor rate is preselected and detailed in the contract with priority to Prime
  2. if no successor rate is selected or is not available, language regarding whether the existing fallback rate should become a fixed rate.

And there could be debt agreements that do not have any fallback provisions documented.

Regardless of situation, a permanent fallback structure should be considered. Once identified, it should be renegotiated and documented so that no contract becomes null and void.

Note: any contract renegotiation opens up the contract in its entirety, so review all contracts for areas of improvement at this time as well.

Review Related Agreements, Calculations and Documentation

Other examples of common contracts, calculations and clauses that would be impacted by the change in the reference rate include:

Debt Related

  • Covenants: while language may not be impacted, changes to higher interest could result which may impact certain covenants
  • Interest Rate Hedges: multiple scenarios where discontinuation could be triggered

Reporting and Documentation Related

  • Annual Reports / MD&A Section
  • Operating Agreements
  • Internal Controls: documentation, contract amendments
  • Calculations: goodwill, leases, investments

System and Process Related

  • Accounting Software: updated rates, new rate structures
  • Valuation Models and Other Financial Forecasts
  • Miscellaneous legal, purchase and operating agreements

Control the Outcome at the End of LIBOR

Depending on the size and type of your Company and the number of agreements that need reviewing, the difficulty and time needed to amend the contracts will vary. Contracts may include a multitude of party types from investors, vendors, customers and financial institutions, and may require parent entity sign‐off.

It’s critical to understand at the onset of the process that this will require a cross‐functional team upfront to review, renegotiate and amend all of the contracts. Garnering support from the leadership team will be critical to success.

Other structural factors will impact the ability to amend agreements on a timely basis. For instance, a lease agreement may only have two parties, where a larger syndicated credit agreement will likely have a large number of lenders that all need to agree on new terms and rates.

The end goal should be the successful continuation of the agreement whereby all parties are kept sufficiently whole. While all terms are up for renegotiation once a contract is opened up, and it is tempting to change all terms, the goal should be for economic parity in that no party is made worse off. Using this time to re‐engage your partners could produce more positive outcomes overall for the Company.

We Can Help

The end of the year is a good time to regroup and look forward. If you need support in your financial planning & analysis efforts, we’re here to help. Contact us or click below to learn more about our work:

financial consulting firm california

Categorized in:

similar articles

Learn to think and approach problems like our financial consultants.

Financial Planning & Analysis

CPG Data Insights: Mastering Future Prediction with Six Foundational Tools for CFOs

A CFO’s role involves enhancing transparency in current financial processes while guiding the long-term strategic plan.

June 8, 2023Branden Faust

Financial Systems

Customizing NetSuite Approval Workflows to Meet Unique Requirements 

NetSuite approval workflows can be customized to meet an organization’s unique approval requirements, ensuring that all transactions undergo appropriate scrutiny before they are posted to the system.

June 6, 2023Julian de Luna

Financial Planning & Analysis

3 Stages of Effective Cost Savings Initiatives

Cost cutting – it’s a goal that nearly every company aspires to achieve. However, unlike other areas of business improvement, there is no public playbook on how to accomplish these desired targets. Whether a firm is undergoing a full restructuring plan mandated by a Chapter 11 filing, maximizing the profit and loss statement prior to… View Article

May 31, 2023Aniv Nayar

See All

Back to Insights