Module IV· InterestIntermediate
Question
What is an 'interest rate swap' and why is it used in LBOs?
Answer
Mechanics
Interest rate swap = the sponsor pays a fixed rate and receives a floating rate (typically SOFR). Net effect: variable-rate LBO debt is economically converted to fixed-rate.
Deep diveShow more details
Example
| Position | Before swap | After swap |
|---|---|---|
| TLB coupon | SOFR + 425bps | -- |
| Swap: pay fixed | -- | 4.5% fixed |
| Swap: receive | -- | SOFR |
| Effective fixed rate on TLB | -- | 4.5% + 425bps = 8.75% fixed |
Consequence
The sponsor is protected against rate increases. Typically hedge 50-75% of the TLB volume, leaving the rest floating for optionality.
Common pitfalls
- A mark-to-market swap can create balance-sheet volatility (IFRS 9 hedge accounting required)
- On early repayment, unwinding the swap can have negative or positive cash-flow effects
- Swap counterparty risk (typically ISDA with large banks)
Pitch tip
Question: "When do you hedge the TLB debt?"
Answer: "In high-rate periods a hedge pays off — if the forward curve is falling, staying floating is better. In the current setup (2024) the forward curve is flat, so hedge only 50% of the volume — keep the optionality"