Posted on: November 20th, 2022
Today’s acquisition financing markets have transitioned from the old LIBOR index to new SOFR (Secured Overnight Financing Rate) index, especially for bank deals. Due to its recent introduction, there are a number of different ways SOFR is quoted by banks and the language used to describe it in the term sheet can be hard to decipher.
As time goes on and the market adjusts to SOFR, the index and pricing methodologies will certainly become more standardized. Nonetheless, the current market can create a level of confusion when two banks are using the same index but quoting it in different ways using completely different approaches. Given the high interest rate environment that corporations are dealing with, it is imperative that you break down the exact approach being used and understand its implications for the actual price of the proposed acquisition financing loan. Each different approach to SOFR must be sorted out and harmonized to be able compare term sheets on an apples-to-apples basis.
SOFR is quoted in two different approaches – one is forward looking and the other is back-ward looking. The backward looking quote averages the daily rate over the last 60 days and creates a moving average index. The forward looking quote uses the forward rate of a 30-, 60- or 90-day future contract. In a rising rate environment, the backward-looking approach will yield a lower index rate than a forward-looking approach, as this approach incrementally increases over time. It is important to review and decipher the language in the term sheet so that you can be sure of the approach you are being quoted. Often in term sheet review, there is an over focus on the actual spread as opposed to the underlying index calculation. This can be a costly oversight and result in an inaccurate calculation of the true interest cost of your acquisition financing loan.
All banks have a spread on top of SOFR, like how LIBOR loans were quoted. Some banks also have an additional mini spread called a credit adjustment spread in addition to the true spread. This mini spread adds more interest cost to the loan. When comparing term sheets, you should be careful to make sure you understand exactly what approach is being used and in what way it is being calculated. Do not hesitate to drill into this with the banker and make sure you completely understand it. SOFR pricing knowledge will enable you to harmonize the true interest cost of each acquisition financing option and allow you to choose the best loan.