AT30 members discussed how much money banks expect to earn to be in a revolver, how to manage credit rating agencies during deals and more at a gathering sponsored by Chatham Financial in Denver.
The Importance of Managing Rating Agencies in Big M&A Deals
Lesson learned: Find out all you can about the internal dynamics of the agency and take nothing for granted.
Financing a large M&A transaction puts corporate treasury teams squarely in the spotlight as they juggle innumerable moving parts. One of those parts is managing how agencies including Moody’s, S&P and Fitch rate the securities issued to finance a deal. The agencies might not be treasury’s top priority, but as one treasury team learned last year, not grasping how they intend to analyze a transaction can result in a confusing rating outcome.
Ambiguity, confusion. A member of NeuGroup’s Assistant Treasurers’ Group of Thirty speaking at the spring meeting in Denver sponsored by Chatham Financial described a process he said resulted in “rating confusion” after one rating agency gave an “ambiguous” range at the launch of an acquisition. As a result, the company faced a risk that the pool of possible investors would shrink—over fears of a future downgrade—driving up yields. And the same agency wouldn’t definitively rate the deal until it closed, while two others rated the bonds when the issuance was announced.
The member said the company asked the agency, “What are you going to learn between now and closing?” and “What are investors supposed to think?” But the agency did not finalize its ratings until months later when the deal closed.
Another source of potential confusion for investors: Because of certain provisions in the bond issue, one of the agencies con- tinues to rate both the acquirer and the target rather than just one, which means the company has to pay for both ratings.
Forgoing RAS and RES. One possible reason for the less-than-ideal experience: The company did not pay to engage the ratings assessment service (RAS) or rating evaluation service (RES) at the agencies, in part because the analysts seemed to understand the deal well and there were not multiple financing scenarios, which can make such engagements beneficial.
Moody’s says its service allows issuers to request that the agency “considers one or more hypothetical scenarios at a committee-level, and deliver a written response as to how a rating committee would likely rate those scenarios.” S&P’s website says its service “gives you a confidential assessment of the potential credit impact of your proposed strategic initiatives before you implement them, to identify the planned initiatives that potentially could lead to credit outcomes that you would view as more or less favorable.”
Some AT30 members said the price for these engagements is normally about $200,000. The member company indicated that if it were doing the financing again, RAS or RES would probably have been worth the cost.
Understand internal agency dynamics. Another possible factor: silos and internal politics within the agency that played out in the ratings process. Better communication with the analysts covering the acquirer and the target company may have helped the agency come up with one view, especially since the targeted company’s analyst is senior to the analyst covering the acquirer, the member said. While the agency failed to communicate these dynamics, the member said his company should not have relied on the agency for insight into its inner workings. “It falls on us to go beyond what they say,” he said.
The good news. The member company’s imperfect interaction with the rating agency did not have a negative effect on the pricing of the bonds, an indication of the success of the approach taken by the company and its bankers to marketing the bonds. And for all the worry the agency caused the AT30 member, the treasury team learned some valuable lessons about understanding rating agencies’ internal dynamics while juggling due diligence, integration planning, bridge financing, loan syndication, a credit facility phased upsize, the bond structure/guarantee design, rate hedging, the bond proceeds investment strategy and the closing flow of funds.
How Much Money Banks Expect to Make to Be in Your Credit Facility
Calculators to help treasury understand how banks decide what they must earn to be in a revolver.
Treasurers managing share-of-wallet issues with their banks know too well the subtle and unsubtle ways bankers let them know they need to generate more revenue (fees) from the relationship to meet the banks’ internal return targets. And, no surprise, these conversations often take place when treasury is renewing its revolving credit facility. No quid pro quo, of course. But pressure is pressure.
Knowledge is power. To relieve some of that pressure, NeuGroup’s Scott Flieger, a former Wall Street capital markets executive, put together two calculators designed to help arm treasurers with knowledge before they talk to bankers about the fees treasury pays. The calculators provide back-of-the-envelope, ballpark figures of how much banks expect to earn when committing capital to a revolver. Mr. Flieger unveiled the tools at the recent meeting of NeuGroup’s AT30.
Sausage ingredients. Before plugging numbers into the calculator, it helps to know some basics about what’s going into the sausage. The first calculator, shown on the next page, computes return on equity from a core Tier 1 capital (CT1) ratio perspective, the dish we’ll digest today. We’ll discuss the ingredients used to cook up return on equity from a leverage ratio perspective in a future article.
The corporate. For the multinational, the relevant variables to use this calculator include the size of the revolver and the notional commitment for the bank. The maturity of the revolver also matters (most are five years) and whether it will be used or “drawn” (most never are). Last are the bank’s internal ratings of the company’s creditworthiness and its sector (some sectors are obviously riskier than others). For this exercise, we’ve assumed a commitment of $100 million for five years and an internal rating of A.
The banks. Banks want to make enough money to meet so-called capital productivity hurdles, often expressed as a return on equity (RoE) objective. We’ve assumed 10% for this exercise. To figure out how much revenue the bank will have to make to justify a $100 million revolver, we start by calculating the impact of the commitment on the bank’s risk-weighted assets (RWA), an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses.
In this example, RWA impact is computed by multiplying the amount of the revolver by a percentage that’s based on that internal credit rating discussed above that is the basis of calculating RWA. In our example, you end up with $15 million in RWA impact; and we’ve tacked on another $5 million in additional RWA.
The context. Banks calculate RWA because of regulatory reforms codified in the Basel III accord following the financial crisis that required them to increase the level and quality of capital they must maintain. RWA is used primarily to calculate a bank’s core Tier 1 capital ratio. Tier 1 capital comprises primarily common stock (equity) and retained earnings. The core Tier 1 capital ratio = CT1/RWA. Our calculator assumes the bank has a CT1 target ratio of 12%.
The upshot. Basel III was designed to ensure that banks maintain an adequate amount of CT1 relative to the risks of their business; so the more CT1 capital a bank needs to maintain, the more revenue it needs to achieve its ROE target. After accounting for the bank’s cost-income ratio (how much it spends to earn every dollar of revenue) and its tax rate, we calculate the bank would expect to generate $1.23 million in gross revenue for the hypothetical company examined here. Some members at the AT30 meeting expressed frustration that the bank’s overall cost structure would affect how much it expects to earn from one relationship.
The caveats. This is a very simple way of understanding how to estimate how much banks need to earn when they commit to a credit facility. As mentioned above, a subsequent article will explore the other way banks approach capital productivity, namely by looking at return on equity from a leverage ratio perspective. That’s the other capital ratio affected significantly by Basel III. To be sure, as Mr. Flieger said at the AT30 meeting, the decision-making process for a bank evaluating a revolving credit facility almost always involves both qualitative and quantitative variables. What’s in this calculator is just part of the possible quantitative piece of the process.
Want to use the calculator? For more information about this calculator and how banks view capital productivity, please contact Mr. Flieger at [email protected].
A Eurobond Deal Pays Off For Medtronic
Significant savings as robust investor demand improves pricing.
Medtronic’s debut eurobond offering this year underscored the significant savings in borrowing costs Europe continues to offer US multinationals.
That takeaway and others emerged from the medical technology company’s presentation about its €7 billion deal at the AT30 spring meeting.
Only two book runners? Medtronic used just two book runners on the transaction, compared to the four or more typically involved in deals of this size. By limiting the book-running group to two institutions, the company ensured that all processes throughout the transaction would be closely coordinated and efficiently executed. The company carefully selected the firms via an extensive interview process to ensure that they worked as one team with the company’s interests as their paramount concern.
Get approval, hit the road. After getting approval to formally engage underwriters, Medtronic spoke with dozens of investors in five European cities during a four-day road show. Investors clearly liked what they heard.
Monster demand. Proof of the road show’s success lies in the numbers. The order book peaked at €34.6 billion, the largest in history.
Rock-bottom rates. Medtronic successfully priced the six-tranche offering in London on March 4. It included €2 billion of two-year fixed and floating-rate notes priced with a 0% coupon or with an implied negative yield.
Bloomberg noted that pricing on the 12- and 20-year tranches tightened 30 basis points between initial price talk and the final terms (coupons of 1.625% and 2.25%, respectively). Medtronic is using proceeds from the deal to fund a USD debt tender and an upcoming maturity, realizing substantial annual savings. Another plus: the deal is leverage-neutral.
Boosting Treasury’s Role in Cyber-Risk Reduction and Policy
Steps to keep finance focused and compliant in the battle against cyberfraud.
The explosion of cybercrime in the digital era has forced finance departments at corporates to up their game in the unending effort to protect the data and financial assets of the company and its customers. NeuGroup members have shared tactics to buttress treasury’s defenses and preparation for the inevitable attacks, including “attacking” their own employees to raise awareness of phishing and other ploys used by bad actors to obtain confidential information.
Beyond tactics, though, treasury benefits from having a seat at the table where practices and policies on cyber-risk are set. That was among the takeaways at the spring meeting of the AT30, where one assistant treasurer described the role of treasury in his organization’s cybersecurity strategy, as well as the department’s attention to a growing number of cyber-related compliance issues.
Secure a seat on the risk committee. Treasury at the presenter’s company plays an active role on a corporate risk committee that’s facilitated by the enterprise risk management (ERM) team and provides a forum for identifying, communicating and escalating risks, including cyberthreats. The committee uses a score sheet to grade how “owners of risk” are protecting the company. The committee is involved in decisions on funding risk reduction projects.
Hire a compliance officer. To evaluate cybersecurity and other practices at the company, treasury hired a compliance manager who reports to the assistant treasurer. The manager’s purview includes nonregulatory payment industry compliance, Sarbanes-Oxley, policies and procedures, and audits. Among the issues examined for best practices are positive pay vs. payee positive pay, bank account validation for vendor banking changes, bank account validation software and services, and focused cybersecurity training. No other companies attending the meeting have a dedicated compliance person.
Coping with regulation inflation. The financial industry’s focus on cybersecurity is leading to what the member company describes as a “noticeable increase in nongovernmental cybersecurity and data security compliance regulations.” The presenter described these areas where the company needed to take additional steps:
Payment Card Industry Data Security Standard (PCI DSS). These standards apply to all entities that store, process or transmit cardholder data. Treasury at the presenting company, along with IT and ERM, implemented an action plan that among other steps tokenized all customer credit card data, developed PCI DSS web training and hired a qualified security assessor to evaluate global compliance. The presenter said his company’s APAC business is decentralized and some areas said their country standards were sufficient, making it hard to convince them they had to be PCI-compliant.
SWIFT customer security program. SWIFT members must attest to mandatory controls on an annual basis. This includes a security baseline that must be implemented on locally hosted SWIFT infrastructure, something another member said is “onerous.” The member’s company implemented an action plan, with treasury collaborating with IT and ERM. It includes a new SWIFT transmission server in a firewall environment in a data center and multifactor authentication security controls on payment platforms.
National Automated Clearing House Association (NACHA) security rule. Third-party senders must soon protect beneficiary account numbers by rendering them unreadable when stored electronically. NACHA is neutral about the methodology, e.g., encryption, truncation or tokenization. The presenter said the possibility of needing to attest to being noncompliant made his company realize it had to take action.
What’s your role? Another concept that surfaced at the meeting that will serve treasury’s efforts to prevent the theft or misuse of data is role-based access control (RBAC). This limits what digital information an employee can access based on the person’s role within the company. The presenting member endorsed it as a way to prevent people from “moving within the company with data they don’t need.”
What Multinationals Need to Know About SA-CCR
Changing how banks measure counterparty credit risk exposure may raise hedging costs for corporates.
Last December, the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. commenced the comment period for a proposed rule updating how banks calibrate counterparty credit exposure for their derivative contracts. The proposal provides a “standardized approach for measuring counterparty credit risk” and is known by market participants as “SA-CCR” (pronounced “soccer”). It would replace the current exposure method (CEM).
Why corporates should care. At the AT30 meeting, experts from host and sponsor Chatham Financial highlighted how SA-CCR could effectively increase the capital requirements for banks entering into commercial hedging transactions with corporates by increasing the counterparty credit risk exposure of these transactions. Under Basel III, if derivative transactions under SA-CCR are deemed riskier than under CEM, the result will be an increase in risk-weighted assets (RWA) for banks. So it’s logical to assume that banks would need to increase their profit margins to generate acceptable returns on their capital—most likely at the expense of corporate clients.
Unintended consequences. Chatham noted that several unintended consequences could result if SA-CCR is enacted. Banks might need to widen their bid-ask spreads to generate higher revenues, resulting in higher hedging costs for corporates. Corporates might also experience lower liquidity levels if banks choose to either exit or simply reduce their commitment to the market. One participant at the meeting noted that a “second order” consequence could be banks reducing their balance sheet commitments in other areas, such as letters of credit or revolving credit facilities, to rationalize the increased capital requirements under SA-CCR.
State of play. The comment period deadline was extended from Feb. 15 to March 18 after regulators saw a significant volume of reactions from market participants. Among the groups that submitted comments to regulators were Chatham Financial and the Coalition for Derivatives End-Users. The International Swaps and Derivatives Association, the American Bankers Association, the Bank Policy Institute, the Securities Industry and Financial Markets Association and the Futures Industry Association responded jointly.
At this point, the market awaits an update from the prudential regulators. Most market participants would agree that the CEM needs revision but they are concerned that however well-intended SA-CCR is designed to be, it may have some significantly negative consequences for corporates.