External pressure on private equity funds seems to be mounting daily, despite the continued benevolence of the credit climate. The leveraged buyout (LBO) market, in particular, is under the microscope over public policy issues relating to: the financial strength and viability of pension funds; the role of tax regimes; corporate governance issues; tensions between general and limited partners; information asymmetries between private and public markets; and the overall maturing of the private equity market. Throw in the first signs of a turn in the credit cycle and it is clear that private equity needs to demonstrate that it creates long-term value for the benefit of society as a whole.
Indeed, the industry has recognised the need to consider many of these issues with the creation of Sir David Walker's high-level working group under the auspices of the British Venture Capital Association (BVCA). The terms of reference provide for the creation of a voluntary code that would establish an appropriate level of disclosure of information to investors and other stakeholders as well as reviewing valuation and reporting practices. This initiative is also an opportunity for the rating agencies to step up and offer a partial answer – the provision of unbiased informed credit opinions for public consumption, based on direct interaction with a sponsor and the management team of a portfolio company.
Effectively, ratings provide transparency for investors and other interested parties while maintaining the confidentiality of commercially sensitive information likely to benefit competitors. It is an approach that can be characterised as “regulationlite” – a market-based solution capable of damping the call for reforms and alleviating concerns that any formal regulatory review might result in more onerous reporting requirements for the industry.
In this respect, the ratings agencies already have a head start. We know private equity funds well. For instance, where private equity portfolio companies are raising debt finance for an LBO, the interaction with the agencies is already well established on both a direct and indirect basis. The most usual direct contact is where private equityowned borrowers tap the public highyield bond market. This typically requires a full interactive public rating for both the company and bond issue.
In the US, though less commonly in Europe, private equity-owned companies also raise rated funding from the loan market in the form of senior and subordinated loans. For instance, in 2006, some 75 percent of leveraged loan issuance by volume in the US was publicly rated according to Standard & Poor's Leveraged Commentary & Data (LCD). In Europe, however, the equivalent figure in 2006 was 28 percent of leveraged loan volume, and 12 percent on a deal basis.
However, the tide is moving in the direction of loan ratings in Europe given the growing size and complexity of deals and the increasing proportion of cross-border deals where part of the debt package is carved out for US institutional investors. Also, ratings are often used to support businesses that operate in sectors that have little track record for LBOs, for instance highly cyclical or asset-light service-type businesses – or where a company is looking to re-establish its credentials with the financial markets after negative credit events.
BRIDGING THE DIVIDE
The rationale for ratings, as described above, is long established. Perhaps less well known are the wider potential benefits of ratings. For instance, public ratings are capable of bridging the divide between the private and public markets. Confidential information informs the ratings but is not disclosed externally, allowing ratings to provide a market-based solution to the difficult question of how best to limit the scope for market abuse.
The development of credit derivative and index products such as loan credit default swaps or the iTraxx LevX Senior Index has made this an extremely topical issue in Europe. These products trade on the public market but the problem is that certain trading counterparties may be privy to price-sensitive private information as participants in the underlying loans.
While the penetration of formal ratings for the European leveraged finance market remains relatively low compared to the US, Standard & Poor's is still required to review a large number of LBOs on a private basis with no direct contact with the borrower. This is because institutional lenders including CLOs, credit funds and hedge funds now provide around 50 percent of senior debt funding for European LBOs according to Standard & Poor's LCD. Significantly, Standard & Poor's rates the notes issued by CLOs, which provide about 70 percent of the institutional money. An important part of their due diligence is monitoring the credit quality of the underlying assets going into their portfolios.
This means that, where a public rating is not requested by the company, the CLO manager requests the rating agency to complete an implied rating or credit estimate (also often referred to as a “shadow rating”).
Credit estimates are an estimate of the probability of default for the entity based on an abbreviated analysis derived purely from information provided by the institutional investor. This ensures that the credit quality of the overall portfolio adheres to the requisite covenants and agreed performance tests. These credit estimates are not made public and no write-up is provided to support the letter score descriptor.
The essential point is that these credit estimates are not formal ratings and their use should be limited to portfolio monitoring. Indeed, our concern has been to ensure that, as the market grows, and as more participants receive these estimates, they are not mistaken or misrepresented as formal public ratings and used as inputs into credit decisions. It is for this reason that Standard & Poor's has recently changed its letter score format for implied ratings and credit estimates to lower case on the traditional AAA scale.
In 2006, credit estimates covered around 60 percent of LBO volume – a figure that Standard & Poor's expects over time to convert into public ratings, which will also render them capable of providing market participants with the appropriate level of scrutiny and disclosure of the larger private equity-owned companies in Europe.
The rating agencies, therefore, need to forge even closer links with private equity funds to improve knowledge and understanding as well as to demonstrate the value of the ratings. Nevertheless, an element of tension between the two parties will always remain. For a start, the reputation of a ratings agency hinges on its ability to provide high quality, objective and, above all, independent, research and opinion. Inevitably, this means that the outcome of credit committee deliberations can never be predicted with certainty. This is why it is more efficient to carry out the rating process as early as possible in a transaction timetable, rather than risking throwing syndication off track when, as occasionally happens, a rating comes out slightly below expectations.
This should not put off the sponsors. It is the role of the rating agency to act as an impartial adjudicator condensing relevant business, financial and structural factors into a consistent framework that provides a relatively simple way of comparing the credit quality of companies across industries and geographic regions. Increasingly, our analysis is being extended to quantify the value of the collateral and other protections (if any) that support specific debt issues.
And routine involvement of ratings agencies would go a long way to meet the demands for greater disclosure and transparency for the larger transactions increasingly being funded by investors. It would also avoid the levels of public disclosure that private equity firms might find uncomfortable.
At the end of the day, this is fundamentally the analysis that bank lenders and other investors have to do to ensure that they are making prudent lending decisions. As the penetration of public ratings on LBOs expands the cost of debt funding for private equity borrowers in Europe, it will start to better reflect the differences in underlying credit quality and structure – injecting a self-regulating element into the funding equation for LBOs that does not presently exist.