Floors, Collars and Guarantees: Managing Revenue Volatility

Lenders do not object to low revenue. They object to unknown revenue. The distinction determines the entire cost of the capital stack.

The volatility premium

A credit assessment is, in essence, a test of whether cash will be present when obligations fall due. Where revenue is contracted with a strong counterparty, the test is easy and the pricing follows. Where revenue is exposed to a market price, the assessment must be run against a downside scenario, and the structure must survive it. Leverage is then set by reference to the worst case rather than the expected case — which is why merchant exposure is expensive out of all proportion to its actuarial cost.

The premium being charged is not a view on the average price. It is a charge for the width of the distribution. Narrow the distribution and the premium falls, even if the mean is unchanged.

The three basic shapes

A floor establishes a minimum realised price or revenue. Above it, the project retains the full benefit of the market. Below it, a counterparty makes up the difference. The economics are those of a put option, and the cost is a premium — payable up front, amortised, or funded out of the upside.

A collar combines a floor with a cap. The project gives away the top of its price range to pay for protection at the bottom. Structured with matched strikes, the arrangement can be arranged at little or no net premium, which is why it is common where the sponsor cannot fund protection from cash.

A minimum price or minimum revenue guarantee achieves a similar economic result through a contractual undertaking rather than a traded instrument. It is typically slower to arrange, more bespoke, and better suited to exposures for which no liquid market exists — which is most of the exposures that actually trouble project lenders.

Design points that decide whether it works

• Match the tenor of the protection to the tenor of the debt, or disclose the mismatch and reserve against it. Protection expiring five years before the loan matures is a refinancing risk, not a mitigant.
• Match the settlement frequency to the debt service dates. Annual settlement against quarterly obligations creates a liquidity gap inside a covered position.
• Match the reference to the actual revenue. A hedge on a national index against revenue earned at a nodal or regional price carries basis risk that can exceed the exposure being hedged.
• Confirm the accounting and covenant treatment before execution. An instrument that produces mark-to-market volatility through the profit and loss account can breach a covenant while the underlying position is performing exactly as designed.
• Establish who owns the collateral obligation. Hedges secured against the project can rank ahead of the debt they were bought to protect.

The effect on the stack

The point of installing a floor is not to improve expected returns; on average it reduces them, by the cost of the premium. The point is to change the character of the credit. A revenue stream with a contractual minimum can support a different quantum of senior debt, at a different margin, over a different tenor, than the same stream unprotected. The right test is therefore not “does the hedge pay for itself against the forward curve” but “does the reduction in the cost and increase in the quantum of debt exceed the cost of the protection”.

Framed that way, protection is frequently accretive to equity returns even where it is expected to expire worthless. That is a conclusion sponsors find counter-intuitive, and it is one of the more reliable sources of value in a structuring exercise.

Certainty is a purchasable commodity. The question is only whether it costs less than the volatility it removes.