Contingent Interest Rate Hedges

Interest Rate Risk Management

Rate risk arises in an event driven transaction when there is a debt / financing element to the deal. As the steady state financing structure will only be set once the deal has closed, IRDCs can be put in place at signing to immunise against rate rises between signing and closing.

• An IRDC is typically a forward-starting pay fixed, receive floating swap, with a clause that will cause the swap to terminate at zero cost if the conditions precedent in the deal are not met
• If the swap is hedging future fixed-rate financing that will be launched at closing, then the swap will be unwound at launch, and the positive PV will offset the higher coupons of the new debt should rates have risen
• If the buyer on the other hand already has floating rate financing in place and wishes to swap it to fixed for ALM purposes, then the IRDC swap will simply stay in place and act as the ALM hedge

Cross-currency swap DCs can also be used to the extent that the financing is not in the desired currency of debt, due to cost or liquidity considerations.

Risk and Cost Considerations

The level of interest rates will typically be an input into any pricing model that is used to come up with a bid price for a project. If the interest rate is left floating, then the market standard would be to input the current floating rate plus a 25bp buffer. Therefore locking in the interest rate would allow bidders to one less stress factor in the model and ultimately a more compelling bid price. This is why IRDCs are relatively common in long dated infrastructure transactions, where the interest rate becomes an important factor to an already competitive market.

IRDCs are relatively cheap given the lower volatility of interest rates versus foreign exchange. The cost is also applied to a long dated running coupon as opposed to a principle amount so the impact is lesser. Countering this however, is the fact that the conditions precedent to a successful close are often more idiosyncratic, and have longer expected timelines to fulfilment, making the DC riskier for the underwriter. There is also an increased documentation risk as often all documents are signed at closing, meaning  the DC will referenced a draft agreement for the conditions precedent. IRDCs typically trade at around 40% of the ATM option, versus around 20% for a Private Equity FX FXDC.