Second-guessing the rating agencies

At Barclays Capital, which has developed its debt capacity advisory service over the past couple of years, “the very existence of the team reflects the extent to which this is a hot, hot issue with clients”, according to the team’s leader, Steve Francis, managing director for financial strategy. “Debt used to be seen as the CFO’s province – now CEOs are getting much more involved.”

The steady stream of ratings downgrades for major corporations has helped to concentrate the minds of senior management on the issue. Similarly, the growth in the volume of debt issuance has helped make the notion of ‘debt capacity’ – which can be defined as a company’s freedom to borrow without provoking a negative change in its rating – of central importance.

As Eirik Winter, head of European corporate debt markets at Schroder Salomon Smith Barney (SSSB) points out: “Companies are increasingly aware that they are sailing close to the wind. They need to know just how close they can sail.”

This is particularly the case for companies that are considering acquisitions. During 2000, when M&A was much more active than in 2001, many ratings changes came from specific events – such as France Telecom’s acquisition of Orange and the earlier Mannesmann-Orange takeover – rather than from a general deterioration in credit quality. A company that may be about to embark on a strategic acquisition wants to know, in Winter’s phrase, how much “headroom” it has to borrow.

This, together with the downgrades resulting from the huge agglomeration of debt from the purchase of 3G licences, has helped put the spotlight on the extent to which companies can borrow without having an adverse effect on their rating. Telecom companies such as KPN and BT have subsequently had to raise fresh equity in order to increase their debt capacity – or at least to ease the pressures on it.

At the same time there is an intellectual debate about ‘optimal capital structure’ and an appreciation that debt is cheaper than equity. No discussion with a banker involved in the debt capacity advisory business is complete without the obligatory reference to business school and theories of the cost of capital.

The drive towards greater shareholder value is part and parcel of this change in thinking, which is encouraging companies to make better use of their equity by increasing their borrowing and either returning funds to shareholders through buybacks or going on the acquisition trail.

This, in turn, throws up the discussion of whether or not a company should be ‘targeting’ a certain rating as part of a thrust to achieve an optimal capital structure.

Unilever is singled out by some as a good example of a company that chose to go out and borrow – to finance the Bestfood acquisition – in the full knowledge that this would lead to a downgrade of its triple-A ratings.

Some are more circumspect about the idea that companies can target particular ratings. “You do not manage a business for the rating agencies but for the providers of capital, the customers and employees,” says John Matthews, head of debt and ratings advisory at Dresdner Kleinwort Wasserstein.

“That said, companies requiring capital from fixed income investors, in particular, certainly need to pay attention to their credit rating, and that in itself can create a useful financial discipline.”

At times it can seem that the whole business of debt capacity advice is caught up in the sometimes tortuous and complex relationships between investment bankers and the rating agencies.

The rating agencies fulfil a crucial role by providing an independent assessment of the long-term creditworthiness of companies, but there is also a desire to control, guide, gently cajole or, as one banker puts it, to “educate” the agencies in arriving at their decisions.

Push debt beyond the limits of its capacity and the agencies will react with a downgrade. That much is clear. But there are also by now some well-publicised doubts about the way in which the rating agencies have on occasion arrived at their decisions and a corresponding desire to steer the agencies’ decision-making.

The junior and middle ranks of the agencies have been plundered repeatedly to fill the ranks of credit research departments over the past few years. Compared with the banks, the agencies’ staffers are covering a much broader range of companies.

And, of late, it has been suggested that the rating agencies have been getting more aggressive as competition intensifies between them, a suggestion that they refute.

At its crudest, debt capacity advice is an elaborate exercise in second-guessing how the agencies will react to a company deciding to take on a certain amount of new debt. That is arguably made more straightforward when the employees of an investment bank are ex-rating agency staffers.

Nonetheless, in private, bankers will admit that sometimes they get it wrong, and naturally, when they do, they suggest it is because of inconsistencies at the rating agencies. One investment banker in Frankfurt complained to Credit about a downgrade that was “hard to understand” – and no doubt especially because the bank had only recently advised the company in question that an acquisition it was undertaking would not have an effect on its ratings.

Whether or not a downgrade was justified in that particular case, it is clear that second-guessing the rating agencies can be a dangerous game, given that they are happy to concede that ratings are more a matter of art than science.

By extension, debt capacity advice provided by banks entails far more than mechanically weighing up ratios, and is bound up with an understanding not only of particular companies, but also of markets and sectors.

At the triple-B level, for instance, there is a considerable divergence among companies in their ability to borrow. “Optimal cost of capital in triple-B territory is particularly complex to determine,” says Matthews at DrKW. Triple-B borrowers that find themselves in a hard-pressed industry may struggle to finance themselves, but profiles vary. One banker cites the Dutch retailer Ahold as an example of a company that has better access to capital than a typical triple-B rated company.

Winter at SSSB adds that the triple-B to single-A range usually leads to an optimal capital structure, but while utilities companies can usually live with triple-B ratings and achieve a low average cost of capital because of their counter-cyclical qualities, autos companies probably do better when they are positioned around single-A.

Whatever business school theory might say, there is no substitute for practical knowledge in evaluating a company’s real debt capacity. This turns, ultimately, on the willingness of the market to absorb paper.

As Antonio Carballo, director and co-head of ratings at Barclays Capital points out: “We have seen times when there was a crazy demand for Russian credits and they were able to call on a tremendous debt capacity.” At times like that, capacity bears little relation to the formulas of the rating agencies.

Juergen Berblinger, managing director at Moody’s in Frankfurt, says: “There is a range of debt-carrying capacities, which are in line with a certain rating. That range is determined by the company’s strategy, the quality of its management and its financial flexibility.”

When they talk about “financial flexibility” the agencies are looking for evidence of alternative sources of funding in difficult times – the ‘hard’ evidence of credit lines as well as other indicators (including existing bond issues which demonstrate an ability to borrow in the debt markets).

“There are a multitude of considerations to look at in relation to debt capacity when making an acquisition,” adds John Wilford, a partner in the M&A practice at Lazards.

“These will include the ability to pay debt interest, the speed of any disposals being made after the acquisition and the timeframe within which a purchase will become cash flow positive.”

Given that the best form of debt capacity advisory service is likely to come from advisers who have an overview of a broad range of factors, where is the best place for the service to sit?

As one banker points out, there is the danger of what could be termed ‘agency capture’ in placing the service in a particular product division of an investment bank. If it goes into the debt division, that may tend to skew advice towards bonds; if it sits in the credit department, that creates another bias, while the equity and corporate finance divisions may want to steer an issuer towards a convertible or some other financing strategy.

At DrKW, debt and ratings advisory is part of the global debt division, and by extension has good links to other divisions such as corporate finance and equity. “This is fundamental so that advice is never given in a ‘silo’,” says Matthews.

At Barclays Capital, the debt capacity team is in the client-focused investment banking division rather than the product-focused side of the organisation, allowing the bank to give “complementary advice” to support M&A advice that comes from elsewhere as well as “a finance and bond market angle so that clients can assemble a rounded portfolio of advice”. One thing is certain: debt capacity advice is unlikely to get significantly more expensive while it remains a loss leader for other kinds of work. “We do not make money directly on this and it is done to capture mandates for debt and equity business. Everyone offers it for a modest fee – it is not like M&A advice,” says one banker.