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LIN TV is in trouble with lenders, Debtwire reports. The US television broadcaster risks violating terms on one-half billion dollars of loans this year if it can’t cut costs. Management is considering everything from headcount and salary reductions to slashing advertising and dumping non-core assets.
Chief Financial Officer Richard Schmaeling doesn’t like any of those choices, but there’s one expense he found easy to toss overboard – his company’s second credit rating.
“We’re looking to avoid laying people off,” Schmaeling said about the decision not to renew a bond rating from Standard & Poor’s earlier this year. “We turned over about every rock in our cost structure and challenged every item and expense. We talked to banks and others in financial community about dropping the rating and they didn’t think it would be detrimental.”
A growing number of executives are scrutinizing the cost of their debt ratings and reaching the same conclusion – they can go without. Fundamentals-driven investors with robust analytical resources can adapt to the shift, but managers of collateralized loan obligations (CLOs) restricted by obsolete regulations are finding it harder to accommodate.
Ratings devaluation
A spokesperson at S&P declined to comment on rating withdrawal requests from its clients. Executives can take such action for any number of reasons, the spokesperson said, including reduction of debt to a de minimis levels or corporate events like mergers.
A search conducted on S&P’s RatingsDirect website indicates that 28 borrowers requested withdrawals in the first five months of 2009 unassociated with extinguishment of debt, a merger/acquisition or a bankruptcy filing. Eight of those requests coincided with informal debt reorganizations. During the same period in 2008, only 13 companies requested withdrawals under similar circumstances.
Moody’s Investors Service does not break out ratings withdrawals at company request, lumping them into a kitchen-sink category defined as withdrawals for business reasons. A spokesperson for the agency declined to comment on the incidence of borrower-initiated withdrawals. He did disclose that withdrawals of US issuer ratings increased to 10.7% of all ratings this year through April compared to an average of 9.3% from 1999 through 2008.
Rating costs USD 50,000-USD 100,000 for smaller companies but can amount to hundreds of thousands of dollars for larger balance sheets, said several CFOs who jettisoned their ratings in 2009.
While the savings are modest, they do help avoid layoffs. LIN economized USD 75,000, or roughly one-and-a-half average annual salaries, by dropping one of its two ratings, Schmaelig said.
Trimming down on ratings coverage isn’t always about cost – some executives simply dump them to avoid future downgrades. “Why should we pay them to cut [our ratings], said a source at another mid-market company. “[The agencies] have no idea what’s in our pipeline.”
Others, such as gaming operator Buffalo Thunder Development Authority and publisher MediaNews group are restructuring their debt through out-of-court negotiation, rendering ratings a redundant cost.
So far, most companies moving off the ratings grid sit firmly in the middle market, like LIN, Juniper Networks and troubled auto supplier Hilite International. That said, a few larger companies have joined the ranks of the disaffected.
LSI, a semiconductor developer with a USD 2.7bn market capitalization, asked S&P to stop providing a BB rating in April. Highly levered Education Media & Publishing – formerly rated Caa3/CCC – dumped Moody’s and S&P last month ahead of an expected debt exchange. The textbook publishing giant will still carry billions of dollars of debt after its balance sheet overhaul.
Busting baskets
Normally, lenders are all for cutting superfluous costs and executives at all five of the companies interviewed for this article said they consulted with key debt holders before dropping their ratings. Nevertheless, the move has alarmed a number of asset managers with investment mandates that require the imprimatur of one or both agencies.
CLOs, in particular, are pushing back against the trend because they must count all un-rated loans towards limited CCC baskets in their portfolios, said one CLO manager.
Backlash from loan holders has forced at least one borrower – temp placement service On Assignment Inc – to make an about face and re-obtain a rating after cutting back to one rating earlier this year. Another borrower is currently negotiating with investors about the same issue as part of a broader amendment, said a lender involved in the talks.
On Assignment Inc discussed cutting costs by discarding one rating during amendment discussions with principal lenders who made no objection, said CFO Jim Brill. But “some of the [investors] involved in our loan were very troubled by not having two ratings because if they have one rating and that one gets downgraded they have to lower their internal rating,” Brill said. Those loan holders asked the company to go back to two ratings and Brill agreed.
Ratings proved instrumental to the proliferation of CLOs earlier this decade, largely because CLO managers earned fees based on the amount of bonds they sold rather than on the performance of underlying collateral. That dynamic incentivized originators of the deals to structure vehicles exposed to far more loans than they had the resources to cover, outsourcing the tedious business of credit analysis to the ratings agencies.
CLO investors bought into that strategy whole hog, banking on minimum ratings requirements to protect them from downside risk. The seismic shocks from the credit crunch paired with a default spike sharply devalued those assumptions.
Back to the basics
Fixed income investors with sufficient manpower are putting less stock in agency-assigned pedigree and returning to old fashioned number crunching of their own, said Mike Morris, Treasurer of Kulicke & Soffa, a manufacturer of semiconductor assembly line equipment.
The company launched a massive cost cutting campaign this year that entails moving its work force to Israel and doing away with its credit rating. Ratings are still relevant for lesser known issuers and for senior secured debt but “debt investors are increasingly doing their own due diligence,” Morris said.
“We talked to our banks and they all unanimously agreed ratings weren’t something we needed to have,” said Morris.
On the borrower side, executives reacted to tightening financial constraints by engaging their loan and bond holders in unprecedented numbers this year, bypassing the need for ratings intermediation.
After Education Media & Publishing gave the agencies the boot, the publisher sent employees an internal communication explaining the decision, according to a company insider. “As a company without public debt, there is no reason to have a public rating [and] we continue to discuss our balance sheet with key stakeholders,” the memo stated, according to the insider.
Active portfolio managers may be going back to the basics, but CLOs still need ratings to conform with the requirements of their anachronistic indentures. “A CLO has to have a rating,” said a second CLO manager. “If the loan doesn’t [have a rating], then the CLO has to pay agency for private rating. We’d do that rather than sell the loan.”
Private, or “shadow” ratings come relatively cheap at less than USD 5,000 a pop, but they don’t measure up to the real thing, said the second CLO manager. “The agencies don’t really do any analytical work on those – they just get the financial statements and put them in a model and whatever the model spits out is the rating.”
A Moody’s official acknowledged it charges an initial fee to assign a credit estimate to unrated debt that CLO managers wish to add to their portfolios in order to rate the CLO. However, the official clarified that the credit estimates are not ratings and Moody’s will publish a public rating on the debt only at the request of the issuer. Requests for comment on the practice from Standard & Poor’s were not returned.
Absent the leverage provided by amendment negotiations, CLOs face a proliferation of these facsimile ratings as managers continue to cut superfluous expense.
“In this environment, a dollar saved is a dollar you don’t have to worry about finding somewhere else,” said On Assignment’s Brill. “I don’t know many people that haven’t had to deal with layoffs and that’s a very difficult thing to do.”
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