What LIBOR transition means for family businesses

Since 1986, the London Interbank Offered Rate — commonly known as LIBOR — has been a key benchmark for setting the interest rates charged on adjustable-rate commercial loans and various other debt instruments and mortgages in the US and many other countries around the world. It has also played a big role in pricing debt issued by corporate borrowers.

During the past 35 years, LIBOR has become a key interest rate pricing mechanism for the global financial and credit industry. It is currently the benchmark in more than US$350 trillion in financial contracts worldwide. It is currently being replaced by other, some would say more up-to-date, pricing mechanisms. This summary has been prepared to explain the situation and the steps principal owners, boards and financial officers of private businesses should take to analyze the impact of the LIBOR phase-out that began ramping up in the US on January 1, 2022.

What is LIBOR and how is it calculated?

LIBOR was designed and intended to provide loan issuers (e.g., commercial borrowers issuing notes) or bank lenders providing credit with a standardized pricing benchmark for the interest rates they charge on different financial products. In theory, it was to be reflective of the interest rate at which major international banks would lend funds to one another in the international interbank market for short-term loans. LIBOR has been set each day by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions. These rates have been averaged to provide a range of LIBOR rates or spreads.

LIBOR has been calculated in five currencies: UK pound sterling, the Swiss franc, the euro, Japanese yen, and the US dollar. Each day, 18 international banks submitted their ideas of the rates they estimated would be paid to borrow money from another bank on the interbank lending market in London. To help guard against extreme highs or lows that might skew LIBOR, the Intercontinental Exchange (ICE) Benchmark Administration strips out the four highest submissions and the four lowest submissions before calculating an average. The most commonly quoted rate is the three-month US dollar rate, which is usually referred to as the current LIBOR rate.

The transition away from LIBOR

LIBOR has been replaced as a loan benchmark because of the role it played in the 2008 financial crisis, as well as scandals involving LIBOR manipulation among the rate-setting banks. LIBOR lost its status as the global interest rate benchmark on January 1. LIBOR’s one-week and two-month US dollar rates are no longer published, and US banks are no longer  able to enter into new LIBOR rate transactions, though some rates and existing loan agreements will be honored until mid-2023. 

The new system is designed and intended to replace the conjecture surrounding interest rates that had become predominant under LIBOR. It has been replaced by various alternative reference rates (ARRs). In the US, regulators seem to prefer the Secured Overnight Financing Rate (SOFR), a metric based on overnight market transactions in the U.S. Department of the Treasury repurchase market. There also are alternative rates being offered in the US, such as the Ameribor rates and the Bloomberg Short Term Bank Yield (BSBY). 

Implications for family businesses

While LIBOR will not completely disappear overnight, banks and other lenders will start proposing other ways to set interest rates for your business in 2022. With an adjustable-rate loan, your lender sets regular periods where it makes changes to the rate you are being charged. Historically, most middle-market borrowers’ banks would reference LIBOR when adjusting the interest rate on your business borrowings, changing how much your business would pay each month based upon changes in the underlying base rates.

During this transition, borrowers should review their existing credit agreements to understand what provisions may apply to their rate pricing going forward. Borrowers need to understand the transitional rate pricing mechanism and confirm whether that will be acceptable and how such alternatives to LIBOR may impact their base-rate or interest rate pricing, swap contracts and related borrowing costs.

What are the challenges family businesses will face transitioning to SOFR or another ARR?

If you have an adjustable-rate loan, check to see if it is based on LIBOR. For loans based on LIBOR, find out what alternative index your lender will start using and when. While there may not be a set answer now, keep an eye on the situation. A switch to a different index might mean the lender will wish to negotiate a different credit spread adjustment rate in the future.

While major banks and lenders of large, syndicated loans have begun to utilize SOFR as the replacement for LIBOR, other lenders, including smaller banks, have started to utilize some of the other ARRs to address middle market credit pricing and certain other issues or particular markets.

Also, if your company has “fixed” its floating rate borrowing costs using swaps, it may also be necessary to renegotiate those rates if interest rates under existing or new loan agreements are being priced under a new ARR method, or if they extend beyond June 20, 2023.

Borrowers should be aware of the options available, as well as the benefits and disadvantages of SOFR versus some of the alternative benchmark rates. Often, a one-size-fits-all approach may not work for all loan transactions. However, lenders and borrowers should note that these benchmark rate alternatives currently have lower liquidity than SOFR, and a critical mass of market participants has not rallied around any single alternative to SOFR. Therefore, such factors may impact rate pricing or future increases or extensions of credit.

Tax Considerations

Family businesses also need to consider whether there are any adverse tax consequences triggered by the transactions or financial instrument modifications necessary to implement the transition from LIBOR. Although US Treasury and the US Internal Revenue Service have provided favorable guidance that would treat most of the common debt modifications, derivative modifications, and derivative exchanges that are being implemented to transition from LIBOR as non-taxable events, private family businesses should seek tax advice to confirm that their particular financial instrument modifications or transactions qualify for favorable tax treatment.

What next?

Businesses need to take inventory of their existing commercial loan or lease agreements, contracts, and derivatives to identify LIBOR references and assess their relevant impact and timing. They should also begin discussions ASAP with their lenders to avoid costs associated with renegotiating their contracts later.

Likewise, when renewing credit lines, borrowers at the term sheet stage should consider which alternative interest rate benchmark should be utilized as the replacement rate for LIBOR and the base pricing rate for their new credit facility. This may require discussions and pricing negotiations with a wider range of lenders.