Time, as they say, moves on relentlessly, and for financial institutions the clock is well and truly ticking down on the transition away from the LIBOR. Indeed, borrowers and lenders are acutely aware that in just months the long-utilized rate will cease to exist.

The need to successfully shift to an alternative rate such as the Secured Overnight Financing Rate (SOFR) is vital. LIBOR is the basis on trillions of dollars of loans and is tied to a multitude of products, such as adjustable-rate mortgages, student loans and corporate loans. Careful transitioning is the key to minimizing large-scale financial impacts, especially in the private debt market[1].

Now, as the deadline looms, it’s essential that we examine the two fundamental questions: what’s the current status of LIBOR transition in the U.S private debt space, and how well prepared are institutions for an orderly transition to the aforementioned new rates?

The impetus for change: LIBOR and the financial crisis

As the dust finally began to settle on the financial crisis, public scrutiny in mid-2012 turned sharply to focus on LIBOR, which had been the standard reference rate for most adjustable-rate products for decades. The market was awash with allegations that during the financial turmoil, banks were misreporting borrowing rates in order to convey financial stability.

Since LIBOR was calculated from self-reported bank submissions, banks could in theory change the submissions and influence the published LIBOR value. In the wake of the allegations, financial regulators around the world urged financial institutions to move away from LIBOR. In 2014, the Alternative Reference Rates Committee (AARC) was created by the Federal Reserve Board and the New York Fed to support the transition away from LIBOR.

In 2017, the AARC then recommended the SOFR, a measure of the cost of borrowing overnight collateralized by Treasury securities[2], as the preferred alternative rate. This is primarily because SOFR is thought to be less susceptible to manipulation and is based on a vast volume of daily transactions (nearly $1 trillion), as opposed to LIBOR (estimated $500 million).

The early struggle to adopt SOFR

While it was helpful to determine an alternative rate, market participants struggled to quickly adopt SOFR, for various reasons. First, SOFR is a risk-free rate since it is backed by the U.S treasury. The LIBOR rate, however, incorporates credit risk (between banks) in the rates, and therefore tends to be higher. If lenders are to adopt SOFR, they need to add this incremental credit risk. To address this issue, the AARC also provided guidance on an additional “credit adjustment spread” to add to the SOFR rate when transitioning away from LIBOR[3].

Moreover, SOFR is an overnight rate, whereas LIBOR contains various terms/tenors (overnight, 1-week, 1 month, 2 month, 3 month, 6 months and 12 months). To address this gap, the AARC suggested the CME Term SOFR in July 2021, which modifies SOFR to have the same terms/tenors as LIBOR[4].

Timeline of transition

Now that lenders/borrowers are equipped with alternative rates that are most consistent with LIBOR, what are the key dates they should have in mind regarding the transition? The 1-week and 2-month LIBOR rates were discontinued in Dec 31, 2021, and loan originations after that date should for the most part be pegged to an alternative rate[7]. The most important deadline is June 30, 2023, which is when all LIBOR rates would irrevocably be discontinued, and every LIBOR rate loan should be moved to an alternative rate.

The state of play: Where do US private debt markets stand?

Bank loan originations tied to SOFR in 20222: On track

New bank loan originations in 2022, which post Dec 31, 2021, should not be pegged to LIBOR, went according to expectations. Based on data from Refinitiv, a large majority of syndicated US loans originated in 2022 were priced to Term SOFR. For the non-regulated direct lending market, however, the share of new originations priced to Term SOFR was closer to 50%[8].

The transition to SOFR was generally smoother than what lenders were expecting, largely in part to AARC’s recommendation of the CME Term SOFR back in July 2021[9], which helped generate a term structure akin to LIBOR.

Transitioning remaining loans to SOFR: long road ahead but room for optimism

So what about the remainder of loans, originated prior to 2022, that still need to transition away from LIBOR? According to the LSTA[10], using data from LevFin Insights, the CS Loan Index, Refinitiv LPC and CLO surveillance reports, roughly 15% of broadly syndicated loans are currently on SOFR. What about the direct lending space? As a proxy, we turned to publicly available BDC data.

From a sample of 12 BDC’s (Business Development Companies) registered with the SEC, all but three BDCs had between 12% to 30% of their books currently pegged to SOFR. In this sample, the average transition rate was 15%, exactly what is estimated for the broadly syndicated loan market.

The general 15% LIBOR transition rate may seem small, considering how near LIBOR cessation is, but to further understand that number we can turn to the Loan Remediation Survey[11][12], recently administered by the ARRC.

The survey ran from August 9 to through September 7, 2022 and is comprised of 73 submissions; lenders and borrowers comprise of roughly 70% and 30% of the responses, respectively. Across all respondents, 89% had a loan remediation plan, which suggests that, even though there doesn’t appear to be much activity, there is significant planning that is yet to manifest. Across all agents or bilateral lenders, 94% have identified all LIBOR loan exposures, 75% have contacted borrowers regarding their remediation plans and 75% have begun to actively transition loans away from LIBOR.

How do lenders and borrowers intent to transition the remaining loans?

It is encouraging to see that there is considerable planning and action taking place to transition away from LIBOR, but what methods are most adopted? 64% agents or bilateral lenders began to remediate contracts by adding “hardwired” fallback language. From the borrowers that were contacted, however, only 13% were receptive to amending “hardwired” fallbacks and 4% wanted to rely on existing fallbacks at cessation.

The most popular response, by 46% of borrowers, was to refinance directly to the replacement rate. In this environment of high inflation and economic uncertainty, getting favorable terms in a refinance may be challenging and could cause a backlog without a backup plan, like an amendment.

What timeline do lenders and borrowers have in mind?

With regards to timing, 86% of agents/lenders expect most of their loans to transition away from LIBOR by the end of 2023Q2, or the last available quarter where LIBOR will be published. At 43%, half the agents/lenders expect to transition in 2023Q1 or earlier, leaving a potential backlog come 2023Q2. The remaining 14% of agents/lenders expect most loans to be transitioned after 2023Q2, which may seem concerning.

However, from those 14%, 70% of lenders report that a vast majority of their loans have hardwired fallback language, which means that loans would automatically revert to an alternative rate at LIBOR cessation.

Alter Domus’ role in the LIBOR transition

As a leading agent in the private debt markets, Alter Domus has proactively reached out to our clients to make sure they were preparing for the transition of their portfolios. Using our recommendations and reporting tools, our clients are prepared for the end of LIBOR in 2023.

The Reasons for Market Optimism

Although the percentage of loans currently transitioned away from LIBOR in the private debt space, 15%, seems rather small, there is reason to be optimistic. Thanks to the Loan Remediation Survey, there is data to support considerable LIBOR remediation plans by 89% of market participants. While the loans might not be transitioned currently, most loans have either AARC hardwired fallbacks (where transition is triggered automatically after LIBOR cessation) or amendment fallbacks, which would mean an amendment would have to be raised.

If action is taken early enough, the private debt market can avoid a costly and risky backlog of amendments. With the end of LIBOR coming within the next six months, we will continue to provide timely updates as warranted, in line with evolving private debt trends.

Footnotes: 

[1] For purposes of this paper, ‘private debt’ refers to broadly syndicated loans and private direct lending markets. See existing Alter Domus report
for further details.
[2] https://www.newyorkfed.org/mar…
[3] https://www.newyorkfed.org/med…
[4] Details of how the Term SOFR is calculated is out of scope for this article 
[5] https://www.newyorkfed.org/arr…
[6] Other alternative rates like SOFR exist in other currencies, such as SONIA in the UK and SONAR in Switzerland.
[7] Some exceptions/gray areas apply, like add-ons of existing deals or originations that were underwritten in 2021. https://www.lsta.org/app/uploa…
[8] https://www.loanconnector.com/… 
[9] https://www.newyorkfed.org/med..
[10] https://www.lsta.org/news-reso…
[11] https://www.newyorkfed.org/med…
[12] https://www.newyorkfed.org/med…

The favorable risk-return characteristics of private debt are attributed to a variety of factors, including compensation to sophisticated investors for accepting limited liquidity and increased complexity relative to the liquid public markets. A contributing factor to the liquidity premium in the private debt market is the cost and related risk of trade settlement.

Trade settlement in the private debt market is a complex process and is often subject to the unique characteristics of the traded facility. At times, trades could take months to settle, exposing buyers and sellers alike to significant risks around volatility, losses and cash flow management. However, there are certain factors that could assist private debt investors to better assess and manage the risks associated with trade settlement.

Loan Trade Settlement – Not a Transitory Consideration

Trading in private loans continues to grow. In just the first half of 2022, $459B has been traded on the LSTA secondary market alone, increasing 12% over the same period in 2021. And as more investors turn to private debt as a viable asset class, we expect trading to continue to grow in tandem.

At Alter Domus, our Loan Trade Settlement group continues to see significant growth in trading volumes, well in excess of the LSTA volumes, as we continue to maximize efficiency, flexibility, and reliability for our clients. With the anticipated continuing growth of the private debt markets, we expect trading volumes to maintain their current upward trajectories, further highlighting the importance for investors to better understand and manage the risks associated with loan trade settlement.

Why Should I Care?

Trade settlement exposes buyers and sellers to several risks. Trades could take a relatively long period of time to settle. These longer time periods pose challenges to buyers and sellers to forecast and manage their cash flows – an important consideration for fund managers looking to satisfy, for example, (i) investor redemptions (seller), (ii) commitments to purchase other loans (seller), or (iii) investment objectives (seller and buyer). Delayed settlement could also pose significant incremental administrative challenges and costs to trade counterparties. In a nutshell, delayed and unpredictable trade settlement imposes costs and operational challenges and risks to the front, middle and back offices of sophisticated alternative debt investors.

As already noted, one of the most notable traits of loan trade settlement is the wide variation in times to settle. While public equity and bond traders can confidently expect that the trades initiated on a given day will close in a narrow and predictable time span, private loan traders have no such luxury.

Consider a secondary, non-distressed loan on the LSTA market, the most common loan type traded. A well-behaving trade might close in a little under 20 business days. But things don’t always go so smoothly. Sometimes the process is initiated, but then stalls immediately. Sometimes the process is near completion, only to have the agent point out that the key parts of the signoff are still pending, such as KYC or Borrowers’ Consent. Sometimes these challenges occur as the quarter is nearing its conclusion and the Agent puts all transfers on hold for several days due to scheduled principal or interest activity. At this point, the still open trade is now at 45 days, and may not close for another week or more as the factors contributing to the delay are resolved. As such, even in the secondary LSTA market, loan settlements in the 60-90 days range are not rare.

During a prolonged settlement period, risks could emerge – for example, market conditions could shift, interest rates could change beyond expectations, or the borrower’s risk profile could change.

Similarly, loan managers face additional challenges regarding cashflow management. Anytime a given loan trade settles, cash reserves are affected. Loans committed to be purchased or fund investor redemptions require cash to complete the transaction. Loans sold will lead to an inflow of cash that could be used to meet those commitments. As alternative debt managers continue to gain better insights into the timing of loan settlement, they could further improve their overall fund operations.

Given these potential challenges, it is no surprise that traders would want to factor time to settlement risk into their decision-making process. The good news is that there are several factors that could assist traders to better quantify and manage their trade settlement process. Importantly, while in this paper we share generic observations about the loan trade settlement process, each alternative debt investor will often face unique risks given their portfolio strategy. At Alter Domus, our Loan Trade Settlement team considers these factors and works closely with our clients to provide greater transparency into their unique risks.

What are the Indicators of Loan Settlement Risk?

Loan Facility and Market Characteristics

The most visible factors impacting loan trade settlement are; (i) the trading market (LMA vs. LSTA), (ii) the borrower’s financial condition (‘Par’ loans for financially healthy borrowers and ‘Distressed’ loans for financially stressed borrowers), and (iii) whether the trade is a primary versus secondary market trade. Par LSTA loans are the fastest loan type to close, typically closing in under 25 business days. Par LMA loans take somewhat longer, coming in just under 60 days across both markets. In both the LSTA and LMA Markets, Secondary Par Loans close faster than Primary loans. On the other hand, Distressed loans across both LMA and LSTA are the longest to settle, with distressed LMA loans being the longer of the two.

Cyclicality

Weekly, monthly, and quarterly cyclical elements come into play for determining loan settlement. At the weekly level, all else equal, Mondays often seem to have the lowest trade settlement activity, while the other days of the week close at roughly the same rate.

While at the weekly level the start of the week is where settlement slows the most, the monthly and quarterly patterns are the opposite. As month-end nears, settlement rates decline quite a bit. This pattern appears to be particularly strong, during the last week of the quarter.

Trade Activity for the Loan

The Loan Identifier can indirectly become a quite useful variable to better understand trade settlement risk. By tracking repeat loan trades using the loan identifiers, we have noticed that loans that have traded repeatedly tend to settle much faster than less frequently traded loans. Intuitively, this is not surprising. As a loan facility’s trading activity increases, the administrative process to settle trades improves as kinks in the settlement process are addressed and corrected through repeated activity.

Counterparties, Agents and Others in the Settlement Process Ecosystem

Intuitively, the counterparties and agents involved in a trade would affect how smoothly a given trade settlement process might go. Traders might have an awareness that certain counterparties or agents have been very effective in the past, or vice versa. The data supports such intuition. Counterparties and agents have historic patterns regarding their trade settlement effectiveness.

Conclusion

The factors that affect loan trade settlement times are very relevant for private loan traders. Implications include cash flow management challenges, potential losses, and costs related to delayed trades. These associated challenges are not transitory. The market continues to grow as investors expand their allocations to this appealing asset class.

We’ve identified several factors that could help traders better manage this risk. But we do caution that aggregated market data from industry sources can only tell part of the story. Each client will have their own unique trading profile, and only by exploring the nuanced specific data could traders more precisely quantify their unique risks. Alter Domus will continue to support the loan trade settlement marketplace in our ongoing mission to provide insights to our clients that helps them manage and quantify their trade settlement risk.