(Bloomberg) -- Lenders and borrowers have just a few months to negotiate how they're going to ditch the disgraced Libor benchmark in the leveraged loan market, and time is of the essence, said KKR & Co.'s Tal Reback.
Reback is overseeing KKR's transition from the London interbank offered rate globally, including for companies that the private equity firm has bought out and for loans that its funds own. The fight in the loan market often boils down to how much of a "credit spread adjustment," or extra interest, investors should get to compensate them for moving to the Secured Overnight Financing Rate, which is typically lower than Libor. Liquidity in Libor is falling, and the benchmark could move steeply in the coming months.
Reback, who is also a member of the Alternative Reference Rates Committee, spoke to Bloomberg's Paula Seligson on Feb. 7. Comments have been edited and condensed.
About 75% of the $1.4 trillion US leverage loan market still needs to transition away from Libor and there are about five months left to make the switch. What are the risks?
Number one is just overall budgeting enough time to effectuate all of these amendments that need to get done while managing deteriorating liquidity in Libor.
As we get closer to June, Libor is becoming more and more illiquid. SOFR is where the liquidity is. The potential gapping out of Libor on these floating rate assets is a real risk.
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It needs to be a productive next five months where we're working together across the market. We're proactively managing ALM (asset-liability management), we're proactively managing credit risk, but we're also making sure, by virtue of not stalling, that we're not giving rise to any type of potential systemic risk.
We always knew the loan market would be more complex to transition than other segments of the market. Because you're not clearing through the DTCC (Depository Trust & Clearing Corp.). It's not a one-size-fits-all process. This is credit by credit, credit agreement by credit agreement.
The loan market is complex, it's nuanced and it can be opaque. It does not move the same way the equity markets do. But it's equity linked, and there's a lot of macroeconomic factors at play here.
Some Libor amendments are being rejected after CLO investors organized in January to demand higher credit spread adjustments. What do you make of this development?
We're at a critical point of the transition where I think all market participants really need to take a step and zoom out to understand: what's the goal at hand? What are potential downside and tail risks if loans do not transition in time?
Amendments are a key process to getting the transition done and I encourage everybody to proactively try to remediate those contracts in the interest of their fiduciary duties.
If you don't zoom out to see the full picture to understand how it all comes together, you may be missing broader risks that should be considered in your value proposition.
How are private equity firms are thinking about this transition?
It's about the health of our companies. We're acting in the best fiduciary way that is best for our portfolio companies. If we think about what makes sense, it's not just about what's the lowest basis point CSA that you can get.
If you look at both sides, whether you're a sponsor or just a lender, everyone has ingested this cost of capital rising. If you net that out, what are we really talking about here? Just a few basis points. We're not talking about much.
What happens to companies starting in July that haven't transitioned to Libor? What risks do they face?
If the transition is hardwired in their lending agreements, they're going to move over to the fall-back specified in that document, which is probably 11, 26, and 43 basis points (for one-, three-, and six-month term SOFR), or it could be pursuant to market conventions.
Where the risk is larger is if the document is not hardwired. It's going to be very credit agreement specific, depending how things are defined, and when that credit agreement was drafted. Loans that don't have a hardwired transition could fall back to the base rate, which is typically defined as Prime, which is at 7.75% now. We think that would be quite devastating for cash flow.
Nothing good comes when you wait till the last minute.
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