Credit ratings: helping supply to meet demand

Corporate finance
Author
Christian Leibl	MD and Head of Corporate Capital Structure Advisory at Lloyds Banking Group

Introduction

Credit ratings can act as a powerful enabler to identify and unlock alternative sources of capital. The global universe of rated corporate issuers is displaying two key trends. The first is the significant increase in the number of rated issuers, while the second is the growing concentration of credit ratings in the sub-investment territory. Within Europe, the UK remains at the forefront on both counts. As a result of this trend, the average corporate rating globally has shifted from the high-investment-grade area (triple-B, single-A) to the sub-investment-grade area (double-B) over the past 15 years.

Changing trends in credit ratings

A number of factors are contributing to this shift. The low-interest-rate environment has resulted in capital market (bond) financings, particularly in the sub-investment-grade sphere, achieving very attractive funding rates. Spurred on by this macro-trend, mid-market companies in particular have chosen to diversify their funding sources away from traditional bank financing. This also reflects increased confidence on their part about managing one or more rating agencies as a new stakeholder, and becoming more comfortable with regard to information disclosure and the other reporting requirements that such engagement requires. Also, the low-interest-rate environment has seen a large influx of private equity sponsored deals. This enables them to borrow cheaply in order to fund buyout transactions with a significant proportion of debt capital so that they can achieve acceptable equity returns. From a capital markets perspective, credit ratings can help supply to meet demand. In addition to the investment-grade space, there is also ample liquidity available for sub-investment grade issuers. Investors have become used to investing in sub-investment-grade debt instruments as the search for yield continues. The combination of attractive yields and below-average default rates continues to attract investor demand. These drivers have created what can be labelled as the ‘new normal’. Issuers recognise the benefits of obtaining a public or private credit rating and they are increasingly confident about being associated with a credit rating in the low-investment-grade or sub-investment- grade space.

Not only does a credit rating put a visible (public) stamp of approval on the issuer’s credit quality by an external party, credit ratings also offer ancillary benefits, such as strengthening corporate governance and instilling further discipline in the wider decision-making framework of an organisation. Above all, credit ratings enable the treasury team to unlock different sources of capital, reducing the company’s reliance on traditional bank debt and ensuring that liquidity is available when required.

Preparation is key

When companies are seeking to obtain a credit rating for the first time, preparation is key. They need to prepare for engagement with the rating agencies and ensure that management teams address all of the rating analysts’ requirements. A formal management meeting is an issuer’s opportunity to demonstrate unique characteristics and strengths, while remaining open and transparent about strategic and operational risks, and how management has been effective in mitigating them.

Creating an open dialogue

While all agencies have their own specific assessment methodology in place, the information that the rating analysts are looking for can be broadly divided into three major categories:

1. The business model

• product details;
• profit margins;
• diversification;
• competitive market position; and
• business plan and strategy.

2. Financials

• cash flows;
• debt/equity mix;
• liquidity; and
• hedging policy and strategy.

3. Other information

• shareholder structure;
• management team and expertise;
• government support (if applicable); and
• corporate governance and risk management.

There are three critical factors that ensure the success of a first-time rating process for an issuer. These are the willingness to share confidential information; availability of resources on the side of the issuer; and clarity and awareness among senior managers regarding expectations for the outcome.

Private companies are often seen to be reluctant to disclose information that is not in the public domain, with detailed operational data or business plans being prime examples. In order to work towards the best possible outcome, however, rating agencies should be treated as insiders. The rating analysts and committees that decide on the final outcome are used to handling confidential information appropriately. The issuer always gets a chance to check rating agencies’ publications for potential factual errors that should not be disclosed to the public. So, the issuer remains in control of the information flow. Rating outcome expectations vary widely within organisations. Internal consent about what a realistic rating outcome may look like is important for achieving alignment among senior management team members as they engage with the rating analysts. Natural biases exist with different parties and this can lead to friction during the preparation process. CEOs tend to focus on value creation through (debt-funded) growth, while CFOs prefer a conservative approach to deploying the balance sheet for growth initiatives. It is imperative to find alignment about the pace and magnitude of strategic developments, as well as the funding approach, before presenting the issuer credit story to the rating analysts.

Future rating transitions

While rating stability should be the guiding principle of any issuer, changes over time can be a natural consequence of corporate strategy or macroeconomic events. Common catalysts are changes in an issuer’s business quality (scale, scope of service, product or regional diversification), financial or other factors, such as changes in the regulatory environment or government ownership. Also, as rating agencies may adapt their rating methodologies from time to time, sector-wide rating actions can result.

Arguably, moving down the rating scale is easier than moving up. For an upgrade to occur, an issuer’s business profile must warrant the higher rating level in the first instance. This is particularly true for the transition from a subinvestment-grade rating to investment-grade. In addition, the financial track record of an issuer, and its ability to maintain a relatively more conservative capital structure, is another important factor that rating analysts will consider.

Maintaining an open and honest dialogue remains pivotal as the relationship between the issuer and the rating agencies evolves. As part of the standard review of an issuer’s credit rating, potential changes to either the business or financial proposition throughout the year will be explored. Rating analysts aim to anticipate whether expected strategic actions will fall within the parameters of the assigned ratings, or indeed, whether a change in rating may be necessary.

Credit ratings in a capital structure context

Issuers are frequently concerned with what the ‘best’ credit rating could be for them. Yet, it’s not about landing as high as possible on the scale; rather it’s about achieving the rating that provides the issuer with:

• stability to execute their business strategy without causing short-term rating fluctuations;
• flexibility to issue debt to fund future growth, and/or pay dividends; and
• access to liquidity and a variety of funding instruments.

Clearly, a level of trust underpins the relationship between the rating agency and the company. It is essential that the dialogue is open and transparent if the most appropriate rating is to be secured. If the rating analysts understand an issuer’s future plans, and are kept abreast of changes, they can be the issuer’s advocate in the rating committee. Having the right information is crucial. The worst scenario is where an issuer obtains a rating and then undertakes a corporate action that causes the rating to suddenly deteriorate.