How private equity can limit risk during switch from LIBOR to new rates

What are the major challenges that PE firms will face?

As the financial industry adopts new benchmark rates, PE firms confront challenges that stem from their structure and purpose:

• Significant reliance on debt. Borrowing is a pillar for private equity. Generally speaking, debt is more important for PE portfolio companies than for their publicly traded counterparts. They seek to obtain or refinance credit and depend on reliable debt funding at stable rates. Turmoil during the sunsetting of LIBOR may be felt to some degree from Wall Street to Main Street. But any instability in credit would especially jar portfolio companies, and the PE firms that own them. Hedged debt is another layer of complexity for risk measurement and accounting.
• Consent needed from multiple stakeholders. Many PE portfolio companies hold a substantial number of LIBOR-indexed credit agreements. Some of the contracts may not be changed without the consent of all stakeholders. Obtaining approval from numerous parties for amending contracts may prove especially difficult because their interests may not align.

A PE firm should consider guiding its portfolio companies through the LIBOR transition while taking a fresh look at its credit policies. For example, a PE firm is usually reluctant to see its portfolio companies renegotiate credit and risk facing disadvantageous changes. The cost of renegotiation alone could undermine returns. Yet fallback language in many current agreements does not account for the outright end of LIBOR and will probably need updating. Depending on their credit profile or loan covenants, some PE portfolio companies could be especially vulnerable to losses in any negotiations. Portfolio companies that take the initiative to begin talks about contract terms may be able to achieve better outcomes than those that delay discussions.

Key steps for a smooth LIBOR transition

PE firms aiming to keep pace with their peers should work with their portfolio companies now to prepare for a smooth LIBOR transition. For many borrowers, steps could include:

• Create a governance structure to execute, manage and monitor the switch to ARRs.
• Inventory contracts that reference LIBOR, such as credit contracts, financial instruments and tax receivable agreements, and determine which terms need alteration. Focus especially on direct and indirect exposures and on fallback language that is ambiguous or that addresses only the temporary unavailability of LIBOR.
• Begin discussions with lenders and derivatives counterparties about fallback language in existing contracts, including selection of an ARR, triggers for a switch to an ARR and calculation of a revised credit spread. (A PE firm may limit costs and promote efficiency by coordinating discussions between its portfolio companies and lenders.) Starting such talks early is essential for renegotiating credit agreements that require approval from all stakeholders for any changes. 
• Plan transition activities with a focus on how to group, organize and sequence the work.
• Clarify accounting and tax implications from modification of debt instruments. A “significant modification” could require an “extinguishment” of a debt security, resulting in a gain or loss.
• Inform directors, employees and other stakeholders about the transition, tailoring discrete messages for each group.
• Ensure that new borrowing and derivative contracts feature clear fallback language aligned with the transition, including selection of the ARR and the calculation for revising the credit spread. 
• Test readiness for a post-LIBOR market by tracking securities and credit agreements tied to alternative rates.

Why it pays to act on LIBOR now

Many PE firms may consider the switch to ARRs a low priority. Some firms hold companies for just three years or less and do not want to pay for a switch to ARRs at companies that they may sell before LIBOR’s end. But the impact from the transition will probably begin to hit long before 2021 and, as the issue gains attention, potential buyers may ask hard questions about how portfolio companies have prepared for the switch.

There are multiple benefits to acting now.

• Identifying and limiting risks
• Promoting efficiency by closely coordinating portfolio companies
• Refining strategies for borrowing, tax and accounting

PwC has been working with banks, insurers, corporates and asset managers to think through how to prepare for the reference rate transition. The same principles apply to PE firms and their portfolio companies, and those that start now to help their holdings prepare for life after LIBOR may avoid a sudden stall in performance and stay ahead of their rivals.

_{[1] Quarles, Randal K. “The Next Stage in the LIBOR Transition,” Federal Reserve, June 3, 2019, accessed Aug. 12, 2019, https://www.federalreserve.gov/newsevents/speech/quarles20190603a.htm}