Financial Instruments

3 Months Ended

Sep. 30, 2020

Financial Instruments

Financial Instruments

Note 6. Financial Instruments

Fair Value Measurements

FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, FASB ASC Topic 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value, as follows:

Level 1 - Observable inputs such as quoted prices in active markets for identical assets or liabilities;

Level 2 - Observable inputs, other than Level 1 inputs in active markets, that are observable either directly or indirectly; and

Level 3 - Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The Company’s derivative instruments are not traded on a market exchange; therefore, the fair values are determined using valuation models that include assumptions about yield curve at the reporting dates as well as counter-party credit risk. The assumptions are generally derived from market-observable data. The Company has consistently applied these calculation techniques to all periods presented, which are considered Level 2. Derivative instruments measured at fair value and their classification in the consolidated balances sheets and statements of operations are as follows (in thousands):

Derivative – Fair Value (Level 2)
Type of Derivative Contract	Balance Sheet Classification	June 30, 2020		September 30, 2020
Swap Contracts	Trade payables and accrued liabilities	$	3,456	$	3,580
Forward-Exchange Contracts	Trade and other receivables		—		4
	Trade payables and accrued liabilities		258		7
Bifurcated Derivatives	Fair value of bifurcated derivatives in Convertible Note		18,325		19,008

Type of Derivative	Statement of Operations	Quarter Ended		Quarter Ended
Contract	Classification	September 30, 2019		September 30, 2020
Swap Contracts	Unrealized gain (loss) included in “Interest expense”	$	—	$	—
Foreign Exchange Contracts	Unrealized foreign currency exchange gain included in “Foreign exchange and other”		331		267
Bifurcated Derivatives	Change in valuation of bifurcated derivatives in Convertible Note		992		(683)

Interest Rate Swap Contract

The Company’s exposure to market risk for changes in interest rates relates primarily to its senior and other debt obligations. The Company’s policy is to manage its interest expense by using a mix of fixed and variable rate debt.

To manage its exposure to variable interest rates in a cost-efficient manner, the Company has entered into interest rate swaps and interest rate options, in which the Company agreed to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. These swaps and options were designated to hedge changes in the interest rate of a portion of the outstanding borrowings in the Asia-Pacific area. During the year ended June 30, 2017 (“FY 2017”), the Company entered into two interest rate swaps that were designated as cash flow hedges. In January 2018, the Company entered into an interest rate swap contract that was designated as a cash flow hedge. The Company expects this derivative to

remain highly effective during its term; however, any changes in the portion of the hedge considered ineffective would also be recorded in interest expense in the consolidated statement of operations. In April 2019, this interest swap contract was amended and extended. There was no ineffective portion recorded in FY 2020 and FY 2021.

The Company’s interest rate derivative instruments were not traded on a market exchange; therefore, the fair values were determined using valuation models which include assumptions about the interest rate yield curve at the reporting dates (Level 2 fair value measurement). As of June 30, 2020 and September 30, 2020, the open interest rate swap contracts were as follows (dollars in thousands):

	June 30,			September 30,
	2020			2020
Notional amounts	$	68,777		$	71,413
Fixed/Strike Rates		7.17	%		7.17	%
Floating Rates		5.35	%		5.34	%
Fair Value of Combined Contracts	$	(3,456)		$	(3,580)

Foreign Currency Risk

The Company has transactional currency exposures. Such exposure arises from sales or purchases in currencies other than the functional currency. The currency giving rise to this risk is primarily U.S. dollars. Royal Wolf has a bank account denominated in U.S. dollars into which a small number of customers pay their debts. This is a natural hedge against fluctuations in the exchange rate. The funds are then used to pay suppliers, avoiding the need to convert to Australian dollars. Royal Wolf uses forward currency and participating forward contracts to eliminate the currency exposures on the majority of its transactions denominated in foreign currencies, either by transaction if the amount is significant, or on a general cash flow hedge basis. The forward currency and participating forward contracts are always in the same currency as the hedged item. The Company believes that financial instruments designated as foreign currency hedges are highly effective. However documentation of such as required by ASC Topic 815 does not exist. Therefore, all movements in the fair values of these hedges are reported in the statement of operations in the period in which fair values change. As of June 30, 2020, there were 13 open forward exchange contracts that mature between July 2020 and October 2020; and, as of September 30, 2020, there were 35 open forward exchange contracts that mature between October 2020 and February 2021, as follows (dollars in thousands):

	June 30,		September 30,
	2020		2020
Notional amounts	$	3,087	$	12,353
Exchange/Strike Rates (AUD to USD)		0.56516 – 0.68863		0.61689 - 0.72944
Fair Value of Combined Contracts	$	(258)	$	(3)

In FY 2020 and FY 2021, net unrealized and realized foreign exchange gains (losses) totaled $(886,000) and $17,000 and $(3,000) and $51,000, respectively.

Fair Value of Other Financial Instruments

The fair value of the Company’s borrowings under the Senior Notes was determined based on a Level 1 input and for borrowings under its senior credit facilities determined based on Level 3 inputs; including a comparison to a group of comparable industry debt issuances (“Industry Comparable Debt Issuances”) and a study of credit (“Credit Spread Analysis”). Under the Industry Comparable Debt Issuance method, the Company compared the debt facilities to several industry comparable debt issuances. This method consisted of an analysis of the offering yields compared to the current yields on publicly traded debt securities. Under the Credit Spread Analysis, the Company first examined the implied credit spreads, which are based on data published by the United States Federal Reserve. Based on this analysis the Company was able to assess the credit market. The fair value of the Company’s senior credit facilities as of June 30, 2020 was determined to be approximately $366,554,000 (carrying value of $372,697,000, gross

of deferred financing costs of $896,000).The Company also determined that the fair value of its other debt of $7,997,000 at June 30, 2020 approximated or would not vary significantly from their carrying values. The Company believes that market conditions at September 30, 2020 have not changed significantly from June 30, 2020. Therefore, the proportion of the fair value to the carrying value of the Company's senior credit facilities and other debt at September 30, 2020 would not vary significantly from the proportion determined at June 30, 2020.

Under the provisions of FASB ASC Topic 825, Financial Instruments, the carrying value of the Company’s other financial instruments (consisting primarily of cash and cash equivalents, net receivables, trade payables and accrued liabilities) approximate fair value.