Confused ratings: Don’t get lost in the shadows

Credit ratings are a vital tool for corporate debt borrowers and issuers. They should not get mixed up with non-rating opinions, urges Joshua Thompson of law firm Sidley.

Josh Thompson

At best confusing and often misleading, the term “shadow ratings” is often (mistakenly) used to refer to mere estimates or opinions issued by rating agencies that are not credit ratings. The “shadow” analogy fails to capture the distinct characteristics of what non-rating opinions are and erroneously implies that they track the “real” credit ratings as a shadow would track a real object.

Credit ratings are integral to the success of the US corporate borrower/issuer market, providing necessary transparency as well as a simple and identifiable code to facilitate loans and debt securities trading. Importantly, rating agencies carefully tailor non-rating opinion products to address specific market needs.

To avoid getting caught in the so-called shadows, it is important to understand the key characteristics of credit ratings as well as how non-rating opinions – commonly and mistakenly thrown into the bucket of “shadow ratings” – are distinct products.

Credit ratings

As AM Best notes, credit ratings are comprehensive analyses of creditworthiness based on “balance sheet strength, operating performance, business profile and enterprise risk management, or the specific nature and details of a security.”[1] Most importantly, they are essential to investors when assessing a rated entity’s credit health or the creditworthiness of a rated instrument (ie, a bond or loan).

Extensive information collection and analysis

Credit ratings are rigorous products and demand an extensive and interactive information-gathering process. Rating agencies collect a wide variety of quantitative and qualitative information including financial statements, management’s projection models, third-party reports about the entity’s position in key markets compared to its competitors, offering memoranda, regulatory filings, management reports on emerging issues, business plans, internal capital models and so forth.[2]

Rating agencies also commonly conduct sit-down meetings with key executives to further clarify this information and ask questions related to the industry, the entity and the transaction.[3] In these meetings, executives discuss in detail issues such as their areas of responsibilities, strategy, distribution, investments, enterprise risk management and overall financial projections.[4] Analysts process this information in a holistic manner to assess the potential risks to the entity’s overall credit health. Risk analysis involves consideration of factors like underwriting, credit, interest rate, country and market risks, as well as economic and regulatory forces.[5]

Based on this assessment, analysts recommend a rating reflecting the entity’s overall credit strength or weakness. The recommendation is reviewed through a committee process. With public credit ratings, the results are released to the general public; private credit ratings results are delivered to a limited number of parties according to a contractual agreement with the rating agency.[6]

Continued monitoring

Importantly, rating agencies commonly contract to continue to monitor initial ratings on an ongoing basis and make adjustments as necessary.[7] To facilitate the monitoring process, they maintain an open dialogue with the rated entity through regular rating meetings and interim discussions about updated financials, potential transactions and other material events.[8]

Credit ratings are the bread and butter of rating agency operations. Understandably and predictably, the agencies have an interest in protecting their market share for these products. As a result, the cost of credit ratings is generally higher than for non-rating opinion products[9], reflecting the amount of information, the level of analysis and continued monitoring.

Non-rating options

In contrast to credit ratings, non-rating opinions are limited products designed to serve a specific purpose, rather than to opine on the overall creditworthiness of an entity or a security. Most non-rating opinions do not involve the same level of information collection and analysis as credit ratings. Commonly, they are point-in-time opinions that do not involve monitoring after issuance.

Preliminary estimates

A preliminary estimate is essentially a rough estimate of an actual credit rating – an unpublished, unmonitored, point-in-time opinion on what an entity could receive as a credit rating were it to request one. It is typically issued on a confidential basis to unrated entities.[10] Once issued, rating agencies do not maintain ongoing surveillance nor are they required to make any updates.

While a preliminary estimate still speaks to an entity’s general credit strengths and weaknesses, it does not involve the same level of information collection or analysis as a credit rating.[11] The analysis is heavily quantitative because the information provided to rating agencies is based primarily on financial data, without direct input from management or other personnel.[12]

Even where qualitative information is collected, the information is a limited subset, consisting mostly of preliminary business plans or term sheets that are available even for entities in their early stages of development.[13] Due to their limited scope, preliminary estimates allow entities that are wary of the cost and the management time involved in a full credit rating analysis to test the waters with limited effort. That is, entities can examine their credit situation without committing to the more resource-intensive credit rating analysis and identify broad credit issues before receiving an actual credit rating.[14]

Given their scope and lack of continued monitoring, preliminary estimates lack the qualities to be on an equal footing with credit ratings. It is easy to understand why rating agencies themselves explicitly state that preliminary estimates are not credit ratings.

Third-party estimates

Provided at the request of a third party, these estimates are unpublished, unmonitored, point-in-time opinions on an unrated entity’s likely credit rating. For example, third-party businesses and financial institutions can use these estimates to supplement their credit analysis on unrated customers, suppliers, partners, lessees, borrowers and other counterparties.[15] In the financial markets, the estimates are also used to support the ratings on collateralised debt obligations (CDOs). In cases where the underlying asset/collateral is unrated, CDO portfolio managers can request a third-party estimate to better understand the credit risk and to categorise the collateral.[16]

For these estimates, information is collected without the unrated entity’s involvement and the analysis is based solely on information provided by the third party or information available to rating agencies from other public sources.[17] As a result, the analysis for third-party estimates is limited in scope and does not include all aspects of a credit rating analysis.[18] Rating agencies acknowledge this limitation and make it clear that the analysis involved is “abbreviated” compared to credit ratings.[19]

Third-party estimates do not involve ongoing monitoring. Unless specifically requested, rating agencies are not required to make updates.[20]

In essence, third-party estimates are second opinions supplementing assessments of unrated counterparties. As acknowledged by rating agencies, third-party estimates are not intended to be a direct substitute for credit ratings.[21]

Hypothetical estimates

A hypothetical estimate is an opinion of the possible credit impact of a hypothetical transaction or scenario. They are unpublished, unmonitored, point-in-time opinions. They are also analytical tools to allow entities to evaluate various financial and strategic changes that may affect overall creditworthiness.[22] Examples include mergers and acquisitions, divestitures, restructurings, recapitalisations, changes to corporate structures and so forth. Hypothetical estimates are used to weigh the merits of different strategic actions before implementation and typically offered both to rated and unrated entities.[23]

Compared to preliminary estimates or third-party estimates, hypothetical estimates are often based on a more interactive process involving collection of both qualitative and quantitative information. Rating agencies communicate directly with the requesting entity to collect information, such as financial projections and other details related to the hypothetical transactions.[24] For some rating agencies, hypothetical estimates involve a committee process similar to a credit ratings committee process.[25]

While the level of analysis is more thorough compared with the other two types of non-rating opinions, hypothetical estimates still remain unmonitored; the opinion is a snapshot based on the current credit situation and does not take into account material changes that may occur in the future.[26]

Because a standard credit rating captures an entity’s go-forward creditworthiness, a hypothetical estimate cannot be considered on par with a credit rating. While these estimates involve some degree of deeper analysis, their main focus is on the hypothetical occurrence’s effect and is largely silent on the “as is” state of creditworthiness. By design, a hypothetical estimate is more of a decision-making tool rather than a holistic summary of overall creditworthiness.

Unsolicited ratings

Rule 17g-5(a)(3) of the Securities Exchange Act was developed to encourage unsolicited ratings for structured finance products. As an outgrowth of a policy concern to discourage ratings “shopping” for these and other complex instruments (and related conflict of interest concerns arising from “pay-to-play” situations), this rule facilitates ratings agencies providing ratings even though not retained by the issuer (or arranger) to do so. These are also not “shadow ratings”.

Joshua Thompson is a partner in law firm Sidley’s Global Finance practice

Works cited

[1] AM Best, Understanding Best’s Credit Ratings, pg. 11.

[2] Moody’s, How to Get Rated (Corporate Finance), pg. 7.

[3] Moody’s, How to Get Rated (Corporate Finance), pg. 8; AM Best, Understanding Best’s Credit Ratings, pg. 6,7.

[4] AM Best, Understanding Best’s Credit Ratings, pg. 7.

[5] AM Best, Understanding Best’s Credit Ratings, pg. 8.

[6] AM Best, Understanding Best’s Credit Ratings, pg. 11.

[7] AM Best, Understanding Best’s Credit Ratings, pg. 10,11.

[8] AM Best, Understanding Best’s Credit Ratings, pg. 6; Moody’s, How to Get Rated (Corporate Finance), pg. 10.

[9] S&P, Credit Estimates,; Moody’s, How to Get Rated (Corporate Finance), pg. 4-5.

[10] S&P, Credit Estimates,; Moody’s, How to Get Rated (Corporate Finance), pg. 5; Fitch Ratings, Fitch Ratings Product Overview.

[11] S&P, Credit Assessments,

[12] AM Best, Understanding Best’s Credit Ratings, pg. 13.

[13] AM Best, Understanding Best’s Credit Ratings, pg. 12.

[14]S&P, Credit Assessments,

[15] S&P, Private Credit Analysis: Changing the Unknown to the Known,

[16] S&P, Credit Estimates,

[17] S&P, Credit Estimates,; S&P, Private Credit Analysis: Changing the Unknown to the Known,

[18] S&P, Credit Estimates,

[19] S&P, Credit Estimates,

[20] S&P, Credit Estimates,; S&P, Private Credit Analysis: Changing the Unknown to the Known,

[21] S&P, Credit Estimates,

[22] AM Best, Understanding Best’s Credit Ratings, pg. 11-12; S&P, Rating Evaluation Service,

[23] S&P, Rating Evaluation Service,

[24] AM Best, Understanding Best’s Credit Ratings, pg. 12.

[25] AM Best, Understanding Best’s Credit Ratings, pg. 12.

[26] AM Best, Understanding Best’s Credit Ratings, pg. 11-12; S&P, Rating Evaluation Service,