Update April 2010

DEBT NEGOTIATIONS The Banks’
Perception of the Value of Hedging

When arranging debt financing the subject of interest rate (or currency) hedging will often be viewed by the Sponsor as a sub issue; something to be dangled as a carrot or used as a pawn when negotiations call for its sacrifice. While accepting it is often necessary to lose a battle to win the war, the price of this particular pawn must be known before it is conceded.

It is perhaps a measure of the value banks now attach to hedging – and thus its cost to the Sponsor – that banks are increasingly insisting that the price of using their balance sheet to fund a private equity transaction is ancillary business, and the jewel in the ancillary crown is hedging.

The Value of Hedging Business to Banks

Hedging business is enormously valuable to banks, both directly and indirectly. Directly because the price of hedging instruments, even vanilla ones, is at best opaque and the great majority of clients are ill equipped to judge how an amortisation schedule or a forward start date will affect the price of a straightforward swap. This inequality of knowledge masks, and is thus the source of, a significant income stream for the bank. One basis point on a $250 million three-year interest rate swap has a present value of $73,000.

Indirectly, being armed with the knowledge that a particular transaction is about to enter the market, the bank has a very significant advantage over its peers. Perish the thought that a bank would take a position ahead of putting their client’s position into the market (as that would move the market against the client and in the bank’s favour) but, depending upon the amount being dealt, a bank trader will know how much a given transaction will move the market and deal accordingly. A few $73,000’s and you are soon talking real money!

Recent Trends

One of the more prominent trends we’ve seen is increasingly restrictive hedging letters or covenants that apply, in some cases, to the initial interest rate & currency hedging as well as subsequent hedging. Examples of the uneven playing field issues include banks as hedge coordinators, creating predetermined hedge allocations among banks, setting prearranged credit spreads, allowing a right to match among the bidding banks and requiring cash be used to purchase hedging options. And these don’t even include the increasing use of floors in Libor pricing.

PMC’s Role and Experience

As many know, a significant part of our work stream is provided by financial sponsors. Most of the large and mid market sponsors in the US and in Europe use PMC to advise, negotiate and orchestrate their hedging transactions. Increasingly, these same sponsors are speaking to us at an earlier stage of the process so that they can fully understand the true value of this particular pawn.

PMC Treasury is an independent corporate treasury advisory firm with clients throughout Europe, the US and Asia-Pacific. Started in 1989, PMC consultants advise clients on operational treasury matters such as treasury functions, best practices & controls as well as interest rate, currency & commodity hedging.

 

Back