By John Hintze and Ted Howard
Rating agencies’ nonpublic ratings temper issuer concerns and build trust.
During uncertain times in the capital markets, a company is always wise to get a little advice ahead of issuing debt about how that debt would be treated by rating agencies. This info might be available from various partners but why not tap the source of the ratings themselves? Since rating agencies still pull the strings in the public debt market, pursuing a private rating with them can give a corporate issuer a leg up that will facilitate eventual public-debt issuance as well as the subsequent deleveraging process.
That leg up is the trust that emerges from the ongoing transparency that both private and public ratings require, especially if a company takes on significant leverage and encounters unexpected challenges or opportunities that disrupt its deleveraging plan.
An initial step in the decision on whether to pursue a private rating may be for an issuer to understand its likely credit standing. Although the rating agencies are not permitted to advise or consult with companies on how to manage their credit ratings, they do provide services to inform them about what their credit profile is likely to be upon issuing more debt or otherwise changing their capital structure in a significant way.
“Sometimes, companies may get a private rating just to ensure good corporate hygiene, because a rating also talks about governance—good financial governance generally also reflects good corporate governance.” — Scott Cassie, Fitch Ratings
Moody’s Investors Service’s Ratings Assessment Service (RAS), for example, is aimed at companies “considering transactions that could transform an issuer’s business or financial condition, and which could therefore impact its ratings,” the agency notes in marketing materials. “An RAS allows an issuer to request that Moody’s 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, should they be announced or executed.”
The full assessment
Fitch Ratings provides a similar service, also named Rating Assessment Service. However, Fitch also offers an Indicative Rating, a service that takes a company through the full ratings process, whether it plans to issue debt for the first time or only to consider its current rating status.
“We’ll then provide the [ratings] answer to the company on a confidential basis, and it can determine whether to move forward with us or not,” said Scott Cassie, head of US corporate issuer relationship management at Fitch. “If the company chooses to move forward, it can make the rating public or keep it private, depending on the situation.”
Standard & Poor’s presumably offers a similar menu of rating services, although it did not respond to requests for more information. All three rating agencies also offer private ratings, but only Fitch responded to inquiries into when such ratings are appropriate.
Mr. Cassie said the most common reason for companies to pursue an indicative rating, for a flat fee that he described as “manageable,” is to eliminate fear of the unknown. The rating agencies typically tie their annual surveillance fee to maintain an active private or public rating to the amount of debt outstanding. Often, companies will pursue an indicative rating and then choose to continue with a private rating until they issue public debt, typically within three to nine months.
“They’re saying, ‘We’d like to initiate the relationship now with the rating agencies, when time is not of the essence and executive management is not distracted with roadshows, talking to bankers and getting documentation ready,” Mr. Cassie said. “It also establishes a track record, so when the company does go to market, the only question is the specifics of the transaction.”
Who can benefit?
Technology companies with oodles of cash overseas but insufficient cash in the US to meet domestic needs have been some of the primary new issuers of debt, but pharmaceutical companies, and manufacturers of personal care products and packaged food can also fit that mold. One treasurer of a large technology company noted at a recent NeuGroup peer group meeting that when she joined the firm four years ago, an early goal was to persuade management to approve pursuing a private rating to prepare for the day when substantial new debt may be required.
“Since the company had never been rated, we thought it would be a good idea to go through the motions ahead of time, to build a relationship with the rating agencies, as if we were going to get an inaugural rating,” the treasurer said.
Companies may choose to retain a public rating because it broadens their base of potential institutional investors, whose bylaws may require them to hold higher reserves against unrated debt. They may also choose to maintain a private rating because they can look at rated peers to gauge their cost of capital and determine which investors and bankers to approach.
“Sometimes, companies may get a private rating just to ensure good corporate hygiene, because a rating also talks about governance—good financial governance generally also reflects good corporate governance,” Mr. Cassie said. He added that private companies using professional management may use a private rating to discuss with owners appropriate dividend levels that would ensure the company has sufficient capital for planned growth.
Three years later, the treasurer’s company did in fact need to take on significantly more debt when it pursued a transformative acquisition that required raising more than $15 billion in capital. Going from no debt to leverage of three times EBITDA was a big risk from a credit rating perspective. However, during the three years the company held the private rating, it had regularly reiterated that if it were to pursue a strategic transaction, it would likely lever up significantly and then commit to delevering quickly.
“The more open a company is with the rating agencies, the better off it will be in terms of managing its relationship during the deleveraging process.” — Scott Cassie, Fitch Ratings
“Ideally you want to commit to returning to an investmentgrade profile, or give the agencies a specific amount or range of indebtedness that the company’s financial policies are anchored around,” the treasurer said. “We said we would like to have an investment-grade profile, and we would aim to bring leverage down to 1.5 times [EBITDA], even though at the time of the acquisition we were above 3 times.”
Helpful communicator
The treasurer noted that the rating agencies actually viewed the company’s leverage as closer to four times EBITDA because they typically exclude the impact of anticipated “soft” synergies such as margin and revenue growth until they’re achieved, although they may take a more “wait-and-see” attitude to more achievable synergies such as head-count reduction and contract cancellations.
“We left no doubt in their minds that if the right deal came along, we would lever up, but we would treat the leverage responsibly,” the executive said, adding that a competitor had not taken on excessive debt during its leveraged buyout but it did lever up to pursue a massive share repurchase and dividend. “We told the agencies that we wouldn’t embark on that path in any way, and we’re not going to increase leverage to six times [EBITDA], or something in that range.”
Within the first year, the issuer had pared down more than $3 billion of debt and diligently following its plan, along with keeping the rating agencies well informed about any changes. This enabled the company to put its deleveraging plan on hold while it considered another unexpected opportunity. Ultimately, the treasurer said, the issue is less about the amount of leverage a company takes on than it is about articulating a plan to bring the leverage down and demonstrating control.
The treasurer said the company decided to first seek a private rating from Fitch. If that agency, perceived as the least conservative of the three main agencies, did not find its debt to be investment grade, then it was probably not worth maintaining a second private rating from Moody’s or S&P.
“Once we got the investment-grade private rating from Fitch, we then chose what we perceived as the tougher of the two remaining agencies, Moody’s, for a second private rating,” the treasurer said.
Developing those relationships with the rating agencies proved critical when, upon issuing the debt, it became clear that the debt issued by the corporate would be rated a notch below investment grade, while its senior secured debt made the investment-grade cut. Understanding the credit agency’s priorities and concerns enabled the company to maximize the amount of less costly senior secured debt in its capital structure. “Having [the agency analysts] meet senior management—the CEO, CFO and myself; we met with them annually for the first couple of years—and explaining our business model to them and getting them comfortable that we say what we mean … That gave us credibility,” the treasurer said.
The executive added that the company annually reinforced its financial policies with the analysts and explained how the company followed them. The consistent message over the three-year period was that it didn’t lever up without a plan to deleverage, or pursue financial engineering that used cash or debt to benefit shareholders excessively.
“That’s the importance of having senior management articulate those financial policies and be committed to them year after year, to build that credibility with the agencies,” the treasurer said. She added that much of that strategic information is available in public filings, but the agencies “want to hear you present it to them.” In addition, the rating agencies want to hear senior management’s views on the industry, since they take input from various companies to publish their industry outlooks.
“In addition to understanding us, they want to make sure they have the dynamics of the industry right,” the treasurer said.
Providing that information to maintain a private rating, which is the same process to maintain a public rating, and developing a rapport with the agencies also gives issuers an opportunity to explain unanticipated events to an analytic team that already understands the company.
“The more open a company is with the rating agencies, the better off it will be in terms of managing its relationship during the deleveraging process,” Mr. Cassie said, adding, “Some companies tell us about important developments an hour before they occur, and some a week before. We respect each company’s concerns regarding confidentiality and work with them accordingly.”
The tech company treasurer mostly agreed.
“It’s very important to answer the agency’s questions as quickly as possible, and to give them a heads-up to anything meaningful. You don’t want them to read about it first in the newspaper,” the treasurer said. “The agencies should never have to call you and say we were surprised by XYZ. There should be no surprises that are in the company’s control.”
But keep some things close to the vest
This doesn’t mean companies must be completely transparent about everything. For example, the treasurer said, her company has pursued smaller acquisitions that it didn’t publicly disclose for strategic reasons. The rating agencies wanted to know the size of the transactions, but rather than providing that level of detail her office simply said the total of the acquisitions was less than a certain amount, or less than a certain percentage of revenue. The agencies’ typically glass-half-empty perspective also can prompt them to question whether management has considered the more extreme scenarios that haunt credit analysts.
“Credit rating analysts are always on the earnings call, because they want to make sure the company is singing the same tune to both sides.” —Tech company treasurer
In such situations, management may nod that it has considered similar scenarios but doesn’t plan to opine on them unduly. Ultimately, the rating agencies issue opinions backed by facts. A relationship with ratings agency analysts won’t change those opinions if they’re factually correct, but it could help temper some of the wording.
“We generally get a preliminary report a day ahead about what will be published, and depending on a company’s relationship with the analyst, it may be able to change the tone or the wording a bit in the nonfactual parts,” she said. “So long as the company is not pushing to change the agency’s view, they’ll work with you.”
Also important to keep in mind after a company has a public rating is to coordinate rating agency presentations with those to equity analysts, since the latter tend to focus on a company’s growth story.
“Credit rating analysts are always on the earnings call, because they want to make sure the company is singing the same tune to both sides,” the treasurer said. They want to make sure the overall message is consistent, and the company isn’t playing a more conservative tune to them and telling the equity analysts something completely different.”
Not a lot of new info
And prepping to obtain a private rating? Mr. Cassie said the rating agencies mostly want the information companies already provide to their banks—historical audited statements going back three years are recommended. Any 10-K filings are also helpful, as is a detailed description of what the company does, especially if it operates in more than one market so the appropriate sector credit analysts can be involved in the process.
During the first meeting, Mr. Cassie said, the company’s CFO and treasurer normally attend, and it’s helpful to bring the CEO as well, to explain the company’s strategy. It is also common to have bankers participating in the meeting, especially at an inaugural meeting or in anticipation of a transformative event.
“It’s the company’s choice, but we would definitely want to hear directly from the company,” Mr. Cassie said about cyber assessment, quantification, mitigation and incident response to protect the organization’s financial statements, which has been really underscored by recent disruptions.”
What private ratings are not
While private ratings can be instructive, rating agencies stress that the private rating exercise is strictly hypothetical and in no way meant to coach companies on their ratings.
Moody’s for one explicitly states that its RAS is not in the business of consulting and provides a comprehensive list of its limitations. For instance, it will “not provide a RAS if the analytical team believes the ratings should be reviewed independently of the hypothetical event,” nor will it “perform a RAS where it considers a situation to be hostile or potentially hostile.” Moody’s says it also does not perform RASs “for third parties to evaluate the impact of a hypothetical transaction on a rated issuer’s debt.” This means those requesting an RAS “must be principals in the transaction for which they are seeking Moody’s feedback.”
Simply put, Moody’s states, a RAS is a “point-in-time, written feedback reflecting a Moody’s rating committee view on the likely rating impact of future hypothetical transactions.”