Hedging adviser of the year: Rothschild

Risk Awards 2021: restructuring effort helped Arqiva to slash its derivatives exposures by 40%

Glen Manning
Glen Manning, head of hedging and derivatives for global advisory

By any measure, restructuring the UK telecoms firm Arqiva’s £1.3 billion derivatives portfolio was a gargantuan task. The Covid-19 pandemic made it immensely more difficult. In the middle of a global lockdown, Rothschild slashed the eye-wateringly complex book of interwoven swap trades by 40% – a “really good job”, according to the client.

Another project saw the firm restructure £4 billion of debt and related hedges following the £11 billion merger between betting firms Flutter Entertainment and the Stars Group. The client says hiring Rothschild was “money very well spent”.

Nor did the pandemic deter Rothschild from steering clients through another pressing concern: benchmark transition. With most Libor rates set to be discontinued at the end of 2021, firms with cash and derivatives products linked to the benchmarks face major uncertainty. Here, Rothschild worked with Southern Water to switch ultra-long Libor exposure on inflation swaps to the sterling successor rate, Sonia. Not just a future-proofing activity, the switch helped unlock £140 million of cash for the client while also providing a ratings cushion. 

Glen Manning, Rothschild’s head of hedging and derivatives for global advisory, had no qualms about taking on such complex assignments in the midst of a pandemic. Time and again, the firm stepped up to the challenge, guiding clients with perplexing problems through the eye of the storm with impressive results.

“When we invest in client relationships, we are there for years and years, through the good and the bad – and we’re able to offer advice around all aspects of what it is they need in order to achieve their financial objectives,” says Manning.

Spaghetti web

Few transactions showcase the breadth of Rothschild’s advisory capabilities better than the restructuring of Arqiva’s swaps portfolio. After raising £2 billion from the sale of telecoms assets to Cellnex in October 2019, the firm set about reducing debt and strengthening its capital structure.

Having never sought hedge accounting treatment for its derivatives, Arqiva had amassed an unfathomable maze of interest rate, cross-currency and inflation-linked swaps. What may have started out as a single interest rate swap in the portfolio could easily have become an inflation-linked exposure through multiple layers of hedging. That meant an entire suite of entangled swaps might have to be unwound just to terminate a single interest rate swap. 

“It really was a great big spaghetti web that the team had to work their way through. To say that this transaction wasn’t straightforward is an understatement,” says Sean West, chief financial officer at Arqiva.

Adding to the headache, some of Arqiva’s swaps included break clauses. A debate ensued around which swaps should be terminated. Eliminating long-dated instruments without breaks should secure a larger upfront termination discount. But eradicating those with break clauses could be more beneficial in the long run, as that would eliminate charges related to valuation adjustments, or XVAs, when contracts are rolled at a future date.

Rothschild’s team set to work, creating a huge spreadsheet of hedging instruments, which it updated almost daily to calculate the best termination prices available and identify the optimal swaps to eliminate.

Securing attractive pricing for a firm known to be sitting on a £2 billion windfall was no easy feat.

“The crux of the transaction was to close out parts of the portfolio that were long-term derivatives in order to achieve an optimum hedging ratio, but one of the issues there was how to get a discount on those terminations when the Street knows you’re getting a large capital inflow,” says Francois Jarrosson, co-founder of derivatives and hedging advisory at Rothschild.

Francois Jarrosson
Francois Jarrosson

“We had to create a situation where there was scarcity around the pot of money that Arqiva was ready to earmark for the swaps, auction that cash somehow to the various counterparties, and make sure that the counterparties with which Arqiva terminated those swaps were able to terminate the right swaps – all at the best possible price,” he continues.

What’s more, with the bulk of the swaps terminations occurring during August, millions of pounds of derivatives needed to be transacted when traders were still acclimatising to kitchen-table trading desks.

“Lockdown definitely created some attrition in terms of the speed at which things could be done,” says Jarrosson. “It also created a lot of volatility within the market, especially for inflation-linked hedges.”

Heightened volatility wasn’t all bad news. As mark-to-market XVA prices became proportionately larger, Arqiva’s hand in attempting to terminate swaps was strengthened.

“In that sense the pandemic created an opportunity for the company to play the volatility to its advantage,” Jarrosson adds.

Longer-term benefits eventually trumped short-term gains as swaps with break clauses were sold via a silent auction process. Thirteen bank counterparties were asked for termination discounts on the relevant instruments.

Interest rate swaps were terminated at a mark-to-market discount of 4% while inflation-linked instruments were eliminated at discounts of up to 6%.

Rothschild estimates the unwind cost came in at just a third of what the client would be required to pay in XVAs had the trades not been terminated.

“Not everyone can achieve something like that, especially when the transaction is public and everybody knew Arqiva would come and close out their swaps,” says Rothschild’s Jarrosson.

The client was impressed. “This particular transaction was incredibly complicated and Rothschild did a really good job in figuring out what the ultimate mix of derivatives was in order for us to meet our hedging requirements,” says Arqiva’s West.

Place your bets

At the time of the Arqiva trade, Rothschild was already well-versed in thrashing out complex problems in the new lockdown environment. In May, the adviser was tasked with optimising an enlarged debt and derivatives portfolio for betting company Flutter Entertainment, following an $11 billion merger with The Stars Group.

This merger threw Flutter’s previously optimal hedging programme into disarray, as the sterling-based funder acquired $5 billion of debt. Roughly half of that was swapped to sterling and euros via cross-currency swaps, with the remainder converted to fixed rates via vanilla interest rate swaps.

Rothschild undertook hefty accounting and risk analysis to select the optimal currency for the newly merged entity’s debt. It also sought the ideal interest rate profile given the currencies involved and the volatility of the earnings.

“This was all being done at a time when Covid had just started to hit the market – when the bond and lending markets had closed – so the refinance strategy and by implication the hedging strategy was uncertain and subject to change,” says Rothschild’s Manning.

“We were also cautious about bank derivative appetite and the capacity of the market to manage risk.”

Reorganising cross-currency swaps to match a new debt profile has a significant foreign exchange impact
Glen Manning, Rothschild

The client ultimately swapped dollar loans and senior debt into euros and sterling via $1 billion of cross currency swaps to reduce cashflow volatility from UK and European operations. An anticipated partial repayment of dollar and euro term loans was pre-hedged with $550 million of FX forwards, while $600 million of interest rate swaps were closed out to reduce the fixed-to-float ratio.

“Reorganising cross-currency swaps to match a new debt profile has a significant foreign exchange impact, as well as an underlying impact on the various interest rate markets that you’re dealing in – and a basis impact. And all of these components were quite volatile at the time because of what was going on with [the] coronavirus,” says Manning.

By getting dealers to agree additional charges including XVAs upfront, the adviser was able to relieve time pressure when it came to implementing those trades.

“We were able to implement the trades using mid-market prices in models that we’d built up at the time. That led to a very efficient execution process, which was absolutely crucial given the constraints of market participants working from home via Zoom calls,” says Rothschild’s Manning.

Mark Irwin, group director of finance at Flutter, was pleased with the outcome. “In terms of execution on the deal, I have no doubt that we ran a very efficient process and we kept the banks very honest and got good pricing,” he says.

“You don’t need to be a derivatives expert to understand that having unhedged positions in excess of £4 billion leads to a significant amount of risk. The numbers were very big so what we paid to Rothschild we consider money very well spent,” he adds.

Sonia switch

Elsewhere, Rothschild helped Southern Water switch a corporate inflation-linked swap to Sonia – the largest such trade to date. The £225 million instrument, which pays inflation and receives Libor in a single cashflow due in 2025, was put in place in 2007 – long before Libor’s demise was envisaged.

“What that meant for our client in practice was that they owe a big inflation-linked payment in the future – which is fine when you’re a regulated business and your business is linked to inflation – but receiving compound Libor until 2055 definitely triggered our attention and highlighted that this legacy trade wasn’t sustainable,” says Jarrosson.

By replacing the Libor leg with a Sonia-based adjustment, Rothschild was able to restructure the payment to deliver £140 million upfront rather than in 2055.

The inflation-linked payment was also downgraded in the capital structure from super senior to senior level – providing a ratings cushion for the issuer’s debt.

“When you have super senior debt ahead of the pari-passu debt, it creates liabilities above the head of lenders. So, downgrading that liability to pari-passu senior debt is more beneficial to Southern Water’s senior debt holders,” says Jarrosson.

Already a leader in derivatives portfolio restructures, inflation hedges and M&A finance advisory, Rothschild is now turning its attention to the realm of environmental, social and governance (ESG) derivatives.

“We’re looking to advise on our first ESG swaps in a way that is innovative,” says Rothschild’s Manning. “We’re actively pursuing one mandate for a client around that, which is something I think we’ll see a lot more of in 2021 and 2022”.

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