Ratings agencies draw fire from CLOs

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Credit rating agencies are drawing fire from investors once again – this time for their anachronistic system of shadow ratings for European leveraged loans. But in this case, the much maligned agencies can share the blame with the clubby network of bankers and private equity sponsors that launched the market early this decade.

Many of those sponsors prefer the private rating system because it keeps the financial state of their portfolio assets hush-hush. That doesn’t sit well with the collateralized loan obligations (CLOs) that bought many of the LBO loans from 2005 on and are compelled to mark to market their positions or even forced to sell if it falls below a certain ratings threshold.

Shadow ratings provide a blurred facsimile of their public counterparts because they are based on information provided by investors rather than from company management or sponsors, according to several CLO managers interviewed by Debtwire.

Because of that imperfect access – and the fact that loan holders pay for the ratings themselves – the agencies review their credit estimates irregularly and communicate them at different times to different lenders, creating confusion and volatility in the market, said a second CLO manager. Public ratings are paid for by corporates themselves, and any changes are telegraphed to the market through a protracted review process.

Separate and unequal

Standard & Poor’s already announced in January that it would provide public ratings of all loan transactions exceeding EUR 500m, but that doesn’t address the bumper crop of deals issued from 2005 to 2007.

Many of the LBO-related loans sold in that era are underperforming and the resulting downgrades of shadow ratings has set off a hue and cry from CLOs. Managers of the structured vehicles argue the agencies are making decisions with incomplete information, but it’s no coincidence that those same CLOs are struggling to keep their bulging CCC buckets from overflowing.

Complaints from loan holders prompted S&P to reverse downgrades of at least two companies in the past month alone. The agency recently upgraded French cable business Numericable’s private rating to B- after downgrading the credit to CCC, said three sources familiar with the matter. Similarly, Standard & Poor’s reverted Springer Science and Business Media’s (Springer) shadow rating to B- following a CCC downgrade.

“We try to manage our deals by selling out of names which we think will drop to CCC, said one CLO manager. “If they drop to CCC then rebound to B3/B- straight away, what is the point?”

Another downgrade U-turn, Gala Coral in May, triggered an outcry for slightly more commercial reasons. Because shadow ratings get delivered annually on different dates specific to the contracts of each CLO customer, some managers found out before others about Moody’s downgrade of Gala to Caa1 from B2. The agency subsequently bounced its rating back to B3 on loan holder pushback.

Investors with early knowledge of the cut sold out of Gala’s loans and the debt traded down three points as a result. Late recipients of the downgrade announcement protested and the ratings agencies have taken steps to improve the dissemination of the downgrades among the subscribers.

“The dissemination of [credit estimate] decisions has improved,” commented another CLO manager. The ratings agencies are now making information available to all lenders at the same time,

Room for improvement?

CLO managers also want more clarity on the methodology used by the agencies, as unlike in the case of public ratings, funds have no access to the credit analyst concerned, said the first and a third CLO manager. Credit estimates are meant to be derived from the same methodology used to produce public ratings, explained the second CLO manager. However, calculations can differ between public and private estimates, he added.

There is also some debate surrounding the inclusion of shareholder loans in debt calculations for credit estimate purposes, noted two CLO managers. Shareholder loans are often equity-type instruments included as subordinated debt in the capital structure for tax efficiency purposes, said the first and second CLO manager.

“If the ratings agency does not know the terms of the shareholder loan, it will be included [in total debt calculations],” said the second manager. “Ultimately the sponsor or company should provide more clarity,” he concluded.

The issue becomes more complex when capital structures are restructured, the first CLO manager noted. “Shareholder loan structures are being used [as quasi-equity] for restructurings, but in many cases they are being treated as debt by the same agencies,” he said. The subsequent effect on credit estimates can be detrimental, adding to CCC burdens despite lender efforts to maintain post-restructured credits at B3/B- levels by converting interest into junior PIK instruments.

Part of the problem rests with the lenders themselves as they are the sole suppliers of information to the agencies for private ratings. There are often delays between lenders receiving monthly accounts and passing the information on to the agencies, noted the second CLO manager. Other investors may choose not to provide private information to the agencies, for fear of triggering a downgrade, the fourth source commented.

Changing tack

A possible solution for addressing the accuracy of credit estimates could be for ratings agencies to liaise directly with companies and sponsors. Shifting to the production of public ratings could present problems for CLO managers. CLO funds must adhere to credit estimates, although public ratings are often considered more robust and timely, said the second CLO manager.

Companies and private equity sponsors are unlikely to support the shift towards public ratings, the CLO managers noted. “I would be surprised whether companies would want that information divulged to the market,” commented the second CLO manager. “At some point borrowers will have to be forced to consider public ratings,” concluded the first CLO manager.

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