• Hedging instruments can generally be procured under competitive conditions. • The presence of a single bank lending to the Contractor does not preclude the use of a competitive process for the execution of swaps or other hedging instruments. • If a competitive process proves to be unavailable, however, then a fall-back of benchmarking the prices of hedging instruments can be considered. • The ITN should set out the Authority's requirements in relation to the execution of hedging instruments. |
The process for achieving best value for money when fixing interest rates at Financial Close is equally as important as the choice of hedging instrument and timing. It is preferable that this procedure be a competitive process, although there is a role for benchmarking where a competitive process has been given full consideration and rejected for sound reasons. The extent to which this is possible will depend on the choice of instrument, which decision itself may be influenced by the extent of available competition.29 In any event, the execution process should be fully transparent to the Authority.
Where interest-rate risk is transferred through the use of a public fixed-rate bond, the price (both the market-wide gilts price and the margin on gilts) is set in the run-up to and at the bond launch. Market practice involves an iterative book-building process and the possibility of having different suppliers/prices to choose from in an explicit way at a single point in time may not arise.
However, for bond issues arranged on a private-placement basis without prior book building in the market by the lead arranger (i.e. generally for the smaller-sized issues, although the judgement on what is 'smaller' will itself depend on prevailing market conditions), there may be scope for competitive offers covering the total interest rate on the bond (i.e. competition on the credit margin over the underlying gilt rate), and this possibility should always be investigated early in the bidding process. It should be noted, in this context, that some 'public' bonds are public only in name and Authorities should establish whether a competitive process for fixing the overall bond interest rate might still be possible, notwithstanding the 'public' label on the bond.30
As discussed in §2.5, interest-rate hedging instruments fall into two groups: those which expose the hedge instrument provider to counter-party credit risk (e.g. interest-rate swaps); and those that do not (e.g. interest-rate caps). Open-market competition should be required where the hedge instrument provider does not assume credit risk on the Contractor, or where the provider's credit risk on the Contractor is covered by third parties, such as monoline insurers.
However, without such credit support, a Contractor is likely to find that there is a limited number of banks (or other hedge providers) which are prepared to offer it instruments such as swaps. It may be too difficult or laborious for a potential hedge provider to assess the credit risk (of the Contractor) unless it is a bank already committed to lend to the Contractor, and thus is already working on its duediligence and credit approval process. Furthermore, complex intercreditor issues arise if a swap is not provided by one or more of the lenders to the Contractor.
This therefore frequently leaves the lending bank(s) as potential monopoly swap provider(s), which is clearly unsatisfactory from a value-for-money point of view. Accordingly, it is important to introduce competition into this process, so far as possible. For example, if a bank lending syndicate is in place at Financial Close, the banks (within the syndicate) can bid against each other to provide part or all of the interest-rate swap. This procedure should be supervised by the Contractor, the Authority, and the Authority's financial adviser. Alternatively, and particularly if the loan is being underwritten by only one bank with any syndication taking place too late to introduce competition on the swap, the under-writer should act as a 'fronting bank', to enable the base swap pricing to be competitively bid.
In the fronting bank structure, the swap market is invited to bid to provide a swap to the fronting bank, which matches the interest-rate swap to be entered into by the fronting bank with the Contractor. The fronting bank charges a separate fronting fee, equivalent to the credit margin it would normally charge on the swap (for which cf. §4). The fronting fee is documented in a separate agreement, will be payable to the fronting bank at the same time as the underlying swap payments, and ceases to become payable upon expiry or earlier termination of the swap. The fronting bank structure is discussed in more detail in Appendix 1.
As a fall-back alternative to a competitive process for producing interest-rate hedges, the Authority can set a benchmark rate, based on recommendations from its financial advisers (suitably supported by markets specialists, as appropriate-cf. §2.5), which the nominated hedge provider chosen by the Contractor must beat or at least match. This benchmarking process may be enhanced by the solicita-tion of check quotes from other hedge market participants. This is clearly a less desirable process than a competition and places heavy responsibility on the Authority's financial adviser to know what specific hedge rate represents good value to its client.
Benchmarking of hedging pricing should be considered a poor substitute for competitive market testing, and it should be borne in mind that 'screen' prices provided by market information suppliers are seldom indicative of the best price that can be achieved at that time under competitive conditions, especially for longer-dated instruments such as those typically used by Contractors entering PFI Contracts.
Authorities and their advisers must consider whether bidder commitment to delivering a competitive process for the execution of hedging instruments is an ITN requirement, or evaluation issue. Either way, the ITN should clearly set out the principles by which hedging is to be undertaken by the Contractor and the approval rights reserved by the Authority in relation to hedging.
________________________________________________________________________
29 As mentioned in §2.5, extra care must be taken when buying option-based instruments to ensure that competitive processes are used. These markets are often relatively illiquid and involve substantial potential for the market to charge a premium.
30 A further issue with bonds is that bond proceeds are fully drawn down at Financial Close, not as and when required as with a bank loan, and have to be redeposited. The interest to be earned on this deposit is itself used to fund the project, and is thus another rate which needs to be hedged, which is normally done through using a Guaranteed Investment Contract (GIC), for which cf. Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance, §2.11. A competitive process should similarly be adopted for the placement of GICs.