By Bryan Richardson
It’s often said that nobody loves you when you’re down and nowhere is this more true than in the world of credit ratings. Here are some tips for those companies that have fallen from grace and are struggling to get back.
Long an anchor in the world of finance and capital markets, the rating agency space has been a turbulent place since 2008. Having AAA credits default within six weeks of the actual rating can go a long way toward undermining confidence in a rating agency’s value and credibility.
Yet, even though they have stumbled badly, rating agencies continue to wield the same influence and control of a company’s destiny (see related story IT, August 2011). But there are approaches to managing those relationships so as not to be completely at their mercy.
A recent NeuGroup peer group meeting of treasurers included a session on managing rating agency relations and referenced one member’s dramatic fall from rating grace, its long and arduous march back to investment grade, and the tips members discussed to aid in that journey.
The discussion also included input from Jackie Endriss, Director at BNP Paribas’ Ratings Advisory group, which offers complimentary ratings consultations to BNP Paribas clients.
THE FALL IS FASTER
Everyone knows that downgrades happen with much greater speed and severity than do upgrades. No doubt this is one reason many companies do not have ratings nor any plans to acquire them, taking the position that if they are not needed for the business then there is little value in adding that complexity to their operation.
Others will eventually determine they need to be rated, and still others have them and may regret that decision. Following is a checklist of considerations and actions to take whether you are considering pursuing a rating, managing a rating up, or simply want to maintain the rating you have.
Interacting with rating agencies is generally not a huge time investment. Rated companies reported that they expend only a fraction (less than half) of a single FTE toward managing rating agency relationships. The featured member, even in their five-to-seven-year march toward investment grade status, affirmed this.
KNOW WHAT THEY CARE ABOUT
This will vary by industry, but regardless of whether you are looking to acquire, maintain or improve a rating, it is important to know what factors the agencies are most interested in monitoring. Ms. Endriss, a former analyst at S&P, affirmed that the factors are both qualitative and quantitative.
Qualitative factors include:
a. Level and scale of total revenue, EBITDA, and EBITDA margins (diversity and profitability)
b. Level and scale and trend of new orders and sales pipeline (expected performance and competitiveness)
c. Perceived demand/competitive pressures in the market and whether or not the Company is capacity-constrained
d. Risk management (project and enterprise), perceived volatility/cyclicality of the Company’s business and/or end markets
e. Financial policy, as it relates to the Company’s policy toward share repurchase programs, M & A activities, and level of commitment to maintaining conservative credit profile while balancing the interests of creditors and shareholders
Quantitative metrics include:
a. Geographic diversification of revenue
b. Business segment diversification
c. Debt/EBITDA
d. Funds from operations (FFO)/debt
e. EBITA interest coverage
f. Cash & marketable securities/debt
But the factors can be moving targets. Simply measuring these factors by the rating agencies doesn’t go far enough in their minds. Rating agencies will often make adjustments to standard metrics involving debt and EBITDA, specifically adding other liabilities back into the calculations to build in a stronger hurdle.
Examples include operating leases, post-retirement benefit obligations (PBO liabilities), share-based compensation expense and other unusual liabilities that they deem applicable.
The hurdles for achieving upgrades from the agencies become ever higher as companies move further up the credit scale, says Jackie Endriss of BNP
Also, there may be no credit given for positive impacts to the metrics that are outside of the traditional calculation, for example, over-funded pension liabilities. Ms. Endriss pointed out that regardless of the industry, the hurdles for achieving upgrades from the agencies become ever higher as companies move further up the scale. “The bar keeps getting raised,” she said.
EMERGING FROM THE RATING ABYSS
Over the course of the session members noted several things to keep in mind when dealing with rating agencies in general, but particularly when you are lobbying over the long term for a return to investment grade. Here are a few items to remember:
- Keep up the pressure—continue to approach rating agencies regularly with new information. One member noted that “at the point of greatest difference of opinion on what the ratings should be (a difference of four levels) we were meeting with the agencies four times per year.”
- Pursue consistently strong performance and discipline with financial policy and risk management.
- Maintain a conservative capital structure.
- Be patient with new analysts. They turn over due to departures from the company but also due to mandatory rotations to keep them from getting too close to the client. If they are unfamiliar with your industry it can take a while to become proficient.
- Be ready for a long haul. Falling occurs much faster than climbing. Below is the timeline of one company’s return to investment grade after a hard fall.
TREAT THE AGENCIES AS INSIDERS
Several members supported this view and consequently disclose more to the agencies than what is public. It is particularly important to avoid surprising them, which can have negative consequences. Some members recommend contacting them in advance to inform them of negative news, but also to frame the situation in the way they want the agency to view it. This could apply to a poor earnings announcement or to getting their opinion on a potential acquisition. On the flip side, companies/clients don’t like to be surprised either and don’t relish agency announcements without the courtesy of advance notice. This should be expressed to the agencies.
But Do Ratings Matter Anymore?
While the rating agencies have been held largely responsible for the financial crisis—see the results of the Financial Crisis Inquiry Commission—they continue to thrive.
But their influence may be beginning to wane with investors. Witness their latest two big judgments. In late May, Moody’s downgraded several of the biggest Nordic banks. The response? Rising bond and share prices. And then more recently, Moody’s cut the ratings of 15 of the world’s biggest banks, including five US banks. The result? Stocks of those banks rallied. Granted, investors were given several months of warning that the downgrades were coming. Nonetheless, investors are beginning to downplay the rating agencies and possibly viewing them as lagging indicators.
“Moody’s in general is very backward-looking; they are often stating things that are well recognized by the financial community for a long time,” Swedbank Chief Financial Officer Goran Bronner told Bloomberg in May.
BEFORE YOU MAKE THE LEAP
If you are thinking of pursuing a rating there are a number of items to consider before moving forward:
1) How will it benefit the company? If a positive rating will improve your access to affordable capital then it should be investigated.
2) Assess the cost. Costs can be high, and be at least $50,000 to $60,000 per year per agency.
3) Get a rating indication. Many banks, including BNPP, have ratings advisory groups which typically consult with their clients at no charge.
If raters are unfamiliar with your industry it can take awhile to become proficient.
They are able to guide you on how to prepare and approach the agencies. Further, the agency can be engaged to give you an indicative rating based on information provided to them and this should be done as part of the research.
4) Have an exit strategy. Once you are rated, going unrated can be very risky for the business and should only be done if you are certain there will be minimal negative impact. Companies that take this step are generally “pegged” at their last published rating.
INVEST IN THE RELATIONSHIP
Having a credit rating can bring significant benefits to a company’s access to capital. But it comes with a price: investing in the relationship and communication with the rating agencies, not to mention the pressure to maintain the company performance in order to keep a desirable rating.
Certainly the downside of reduced ratings brings the converse impact to capital costs and results in more time invested in the agency relationships. And once you are in this realm it is difficult to exit positively. Careful consideration should be given to the prospect of obtaining ratings and all available resources and support should be utilized in order to make a prudent decision.