Thursday 23 October 2008

IP finance, market disruption and hedging

IP financing often relies upon steady and predictable cashflows derived from the IP assets. Efficient funding structures have been established which use hedging to enable maximum leverage. These structures rely on matching receipts and payments in what are often passive borrowing entities. The credit crunch is having an effect on the market in a way which may even impact existing loans.

The Loan Market Association has published a statement about the number of queries it is receiving from members expressing concerns about their funding costs. Lenders are concerned that the funding costs which are passed to borrowers do not adequately reflect the actual cost of funding some of their loans. This is because funding costs in loan agreements are now generally set by reference to LIBOR (determined by the British Bankers Association) but the lack of liquidity in the market means that there are variations in the real cost of funding available to lenders.

The Loan Market Association form of documents which are widely used in IP financing structures include a clause intended to ensure that a lender's cost of funds are met by the borrower. This clause, known as the market disruption clause, applies when the lender has a cost of funding which is higher than the LIBOR applying to the loan under the loan agreement. The lender may elect to use this clause to charge interest by reference to its cost of funding rather than LIBOR.

If a lender elects to exercise its rights under the market disruption clause, the interest rate will reflect the lender's cost of funding rather than LIBOR and, in practice, will be increased.
Many borrowers have hedged all or part of their loans and have therefore not been exposed to changes in LIBOR during the loan term. Particularly where catalogues of IP rights are financed as a whole by a loan on completion this is likely to be the case. If the market disruption clause is used by a lender, however, the borrower's hedging will no longer provide matched funding with the loan agreement. Under the loan agreement the borrower has the obligation to pay a variable rate; under the hedging documents the borrower has the right to receive a variable rate. In practice, these amounts match giving the economic effect of a fixed rate loan.

However, most hedging documents set the variable rate receivable by the borrower by reference to LIBOR. If the variable rate payable by the borrower in the loan agreement is calculated by reference to LIBOR the borrower will be effectively hedged. If the variable rate payable by the borrower in the loan agreement is calculated by reference to the lender's cost of funds (because of the operation of the market disruption clause) the borrower will not be effectively hedged.

Borrowers should be ready to understand the implications for them if a market disruption clause is used by a lender. Consider the additional cost of borrowing; the effect on testing of interest cover tests (i.e. comparing interest costs to proceeds of the underlying IP assets) and other lender protections.

Written by Charles Kerrigan, posted by Jeremy Phillips

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