In Practice: Key Hedging Considerations in Negotiating Intercreditor Terms

Hedging: out of sight, out of mind

Sophisticated borrowers often wield significant leverage when negotiating the terms of their financings. However, what is often overlooked in that negotiation is the importance of retaining flexibility for the borrower to be able to offer attractive terms to prospective hedge providers (Hedge Providers).

This can happen because the identity of Hedge Providers as well as the preferred hedging strategy are often unknown at the point of negotiating and signing the terms of the intercreditor agreement (the ICA). As a result, it is not until work begins on the hedging agreements that Hedge Provider feedback on the terms derived from the ICA is obtained. By this point it will likely be too late or costly to amend the terms of the ICA, with the result that it is difficult or impossible for the borrower to implement their preferred hedging strategy.

Flexible hedging terms matter

This situation can be avoided if, when negotiating the ICA, the borrower insists on flexible terms to govern future hedging arrangements. The more flexible the terms, rights and protections that are afforded to Hedge Providers pursuant to the ICA, the more appealing the provision of hedging solutions will be to prospective Hedge Providers. Therefore, flexible ICA terms can provide borrowers with a greater choice of Hedge Providers and more beneficial hedge pricing.

Key hedging considerations

There is, however, a balance to be struck between the rights of Hedge Providers, the rights of borrowers and the protections given to other creditors.

Below are some of the key areas borrowers should consider when negotiating ICAs without the involvement of Hedge Providers, in order to preserve flexibility for future hedging arrangements:

1. Ranking of hedging liabilities

   Subject to any caps or thresholds that are imposed on hedging liabilities, Hedge Providers will normally require that they rank at least pari passu with the most senior class of creditor. This means allowing liabilities under hedging agreements, or at least a portion of those liabilities, to rank super senior if there is already super senior ranking debt or if super senior ranking debt is subsequently introduced.

2. Caps/thresholds on secured hedging

   If borrowers agree with lenders to cap the amount of hedging liabilities that can benefit from the most senior secured ranking, borrowers should be mindful to set any such cap at an appropriate level. Setting the cap too low will result in only a small portion of hedging benefiting from the most senior ranking, with the remaining portion becoming harder or more expensive to obtain due to such Hedge Providers being subordinated to other creditors.

   In addition, borrowers should consider the most appropriate metric for any such cap. The choice is usually between the notional amount of outstanding hedging transactions versus the mark-to-market value of outstanding hedging transactions. The former is easier to calculate and monitor but means that caps will need to be set much higher. The latter is more difficult to monitor, but more accurately reflects the liabilities actually being secured.

   Finally, if possible, borrowers should seek to ensure that all hedging arrangements entered into for the purposes of hedging the debt should benefit from the most senior ranking security, leaving only non-speculative, non-finance linked hedging arrangements open to potential subordination.

3. Portability of hedging

   A common pitfall is the discovery at the time of debt refinancing that the ICA does not permit existing hedging arrangements to survive such refinancing. If the ICA does not permit the existing hedging arrangements to continue to hedge any refinanced liabilities, the borrower may have to crystallise their hedging liabilities and/or enter into new hedging arrangements upon refinancing.

   Again, there is a balance to be struck here because Hedge Providers will also require protection against being forced to participate in a refinancing on new terms.

   From the borrower’s perspective, rather than permitting Hedge Providers to terminate outright upon the occurrence of a refinancing, which leaves the borrower exposed to the risks described above, it would be preferable to include a termination right in the ICA that can be exercised by the relevant borrower group entity to terminate hedging arrangements with a Hedge Provider only if:

   • that Hedge Provider has not consented to the terms of the refinancing because those new terms are materially prejudicial/materially worse for that Hedge Provider (as compared with the terms of the current financing); and/or
   • that Hedge Provider cannot novate its outstanding hedging transactions within a certain prescribed period following the refinancing date.
4. Hedge counterparty voting/entrenched rights

   Voting and entrenched rights form a significant part of a Hedge Provider’s protections under the ICA, particularly in markets where “orphan hedging” (i.e. hedging provided by banks that are not otherwise lenders under the financing) is common.

   Voting rights often differ across markets, with different approaches taken in leveraged, infrastructure, acquisition and project financing transactions. At a minimum, however, Hedge Providers will expect to have a right to vote in respect of, and in an amount equal to, the close-out amount for those trades that have already been terminated at the date of voting.

   Borrowers should also be mindful to ensure that Hedge Providers are afforded reasonable entrenched rights – for example, with respect to material amendments to the finance documents which would materially and adversely impact the ranking, secured status, voting or enforcement rights of Hedge Providers. Hedge Providers are unlikely to agree to drag along rights (i.e. forcing Hedge Providers to accept amendments in which another class of creditor, typically lenders, have agreed to an amendment).

Conclusion

To ensure that borrowers have sufficient flexibility to implement a cost-effective and beneficial hedging strategy, the likely requirements and commercial needs of Hedge Providers should be taken into account when agreeing the terms of an ICA.

Originally published in the February 2025 edition of Butterworths Journal of International Banking and Financial Law.