The Hidden Costs of Non-Zero Interest Rate Floors in European Variable-Rate Debt Facilities

March 2015

 

Floors above zero percent in leveraged finance transactions are not nearly as prevalent in Europe as they have been in the USA, but they have featured in an increasing proportion of European deals in recent years. The rationale for a floor is simple enough: when absolute levels of interest rates are depressed, it provides a targeted minimum yield for lenders without increasing the loan margin.

 


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In practical terms, however, floors impose two sets of burdens on the borrower:
1. Direct and indirect increases to interest expense, with the latter resulting from the time value inherent to options.
2. Considerable accounting complexity for the debt and any interest rate hedging under IFRS.

 

The goal of this paper is to explain the effects of these floors and conclude with a few examples of perhaps more efficient and less burdensome alternate means to satisfy the rationale for non-zero floors in variable-rate facilities. Although borrowers would certainly welcome a reversal of the trend altogether, a few subtle changes to the current market practice for floors could result in a more equitable outcome for all parties.

 

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