Ratings and Surveillance Process in European Corporate Securitisations
Since 1998, we have assigned public or confidential ratings in more than 50 corporate securitization transactions with a total rated volume of more than £38 billion. Owing to their numerous and often novel features, corporate securitizations tend to require more extensive quantitative, qualitative, and legal analysis than do more traditionally financed transactions. The process for rating potential transactions is intended to be flexible and effective.
Corporate securitizations are also known as corporate entity securitizations, structured finance/corporate hybrid transactions, or, in certain cases, whole-business securitizations. They are hybrid financings that fall along the continuum between classical securitizations (with actuarial pools of financial assets) and unsecured straight corporate bonds rated using traditional ratio-based corporate rating methodologies. These transactions typically benefit from legal and structural enhancements that facilitate a delinkage from the underlying corporate rating on an operating company and mitigate aspects of operating risk. Such financings also allow for tranching of debt obligations.
This article outlines the process we employ in analyzing a corporate securitization in both the initial rating process and subsequent surveillance of the ratings.
The process begins when a banker or corporate operating company contacts us to discuss a proposed transaction. Following the discussion, the banker forwards us a concise transaction book usually containing a preliminary term sheet. This material serves as the basis for a subsequent meeting or conference call with our analysts. The purpose of the initial discussion is to identify the key credit, structural, or legal issues and any additional detail or information required for meeting the targeted ratings objective.
Following this, a team of analysts determines the suitability of analyzing the transaction as a corporate securitization, and at the targeted rating level(s). The team specifies potential issues and concerns. Based on this initial and informal feedback, the banker and operating company then decide whether to proceed.
A decision to proceed is implemented by means of an engagement agreement, wherein the terms and conditions of our appointment and the tasks we commit to carry out are specified.
The agreement includes the names of the lead analysts who will be the daily contact. A team of two or more analysts is assigned as primary contacts, drawing from structured finance and the area of relevant business expertise (for example, corporate finance, public finance, infrastructure finance, and insurance) supported by the legal department. We sometimes draw legal advice from external counsel specialized in specific jurisdictions or industries, in which case we ensure there is no conflict of interest with the legal advisers with other parties in the transaction.
The terms of the agreement include a description of the phased set of tasks to be performed. Some counterparties to the agreement prefer to start with a debt feasibility assessment or a credit assessment, on the basis of which they can decide whether to proceed to the next phase, which is the preliminary rating. Others, in contrast, skip the debt feasibility assessment, and immediately engage us to provide a preliminary rating. The engagement agreement clarifies the phases, which can be the debt feasibility assessment, the preliminary rating, the final rating, and surveillance. The preliminary rating normally, but not always, results in the publication of a presale report, the final rating in a postsale report, and surveillance in a series of transaction updates.
Before conducting the debt feasibility assessment, we prefer to receive all information for performing the analysis. Required information depends on the specific issues on which the banker and his client want us to provide feedback. The information should generally assist the analyst in understanding:
In order to determine the achievable debt amount range, and agree appropriate covenants and liquidity needs, we require the banker to provide a financial model showing the proposed terms, conditions, and structural enhancements, which enable us to perform our own sensitivity analysis.
After receiving all available information, our working team undertakes a preliminary analysis. This is aimed at determining the debt amount range and terms achievable at targeted rating levels, based on key assumptions, which are identified and which would have to be supported in any subsequent and more rigorous analysis, as well as a proposed structure and initial cash flow modeling. The rating analysis and proposed feedback are then presented to a rating committee, normally consisting of members of the Structured Finance and Legal groups, as well as of the Corporate Finance, Public Finance, Infrastructure Finance, or Insurance groups. The proposed feedback reflects the committee’s view. After committee approval, the feedback is presented to the banker. Confirmation of this feedback is usually provided to the transaction’s banker or originator in a letter. This feedback letter typically includes:
The feedback letter is a confidential document which may not be relied upon for financing. In consultation with the client counterparty and possibly others, the banker determines whether the transaction is viable. If so, the counterparty to the engagement letter instructs us to proceed to the preliminary rating phase.
When a decision has been made to proceed, we perform a more in-depth analysis of the transaction. This results first in the assignment of a preliminary rating and production of a presale report. The analysis behind the preliminary ratings is made on the back of information provided to date usually including the draft offering circular and other draft documents.
The preliminary rating phase is highly interactive and involves the lead analysts in continuous contact with the originator, transaction banker, and their legal advisors. The analytics undertaken in this phase would include:
As part of the corporate overview, analysts meet on site with the management of the corporate entity originating the operating assets being securitized. They also meet with key third parties that have or could have an important role in the transaction. These might include regulators, equity sponsors, or valuers. The purpose of these visits is to expand our understanding of the business, assets, and industry, focusing on the borrower’s strategic and operational objectives, to selectively view the physical condition of properties and operations and to improve the assessment of transaction risks and their proposed mitigating factors.
We review relevant draft documentation with a number of objectives. One is to ensure that the transaction meets our ratings criteria. Another is to verify whether the credit risk analysis can rely on the proposed structural enhancements, including a covenant package and prescriptive methods of dealing with adverse trends in the underlying business or assets.
When the analysis for preliminary ratings is complete, the analytical team presents the planned transaction to the rating committee. Any issues arising from the committee are passed on to the banker and other parties to be resolved. When all outstanding issues are resolved, a presale report is issued based on the information available at that time and subject to the caveat that any changes prior to the transaction’s settlement could significantly affect the current assessment of risks, debt capacity, ratable debt tranche amounts, and, consequently, the final ratings.
The final rating and rating letter are issued only after all the documentation, including legal opinions and financial model audit, is finalized and no further changes can be made. The rating letter is issued at closing. We request that the issuer disclose in the offering circular that our rating is not a recommendation to purchase, sell, or hold a security, as it does not comment on market price or suitability for a particular investor.
Once ratings are assigned, they are disseminated to the public through various media, including newswires and our Web sites, except when the engagement agreement provides for keeping the ratings confidential. Confidential ratings cannot be disclosed to anyone without the authorization of the rated entity and are subject to our rating disclosure policy.
The approach adopted by us in our surveillance of corporate securitizations is designed to mirror that taken prior to issuance. In practice, this means that the focus is divided between two main areas – the analysis of business risks and the analysis of structural risks. Other potential concerns are also taken into account.
The analyses, supplemented by ongoing input from legal counsel, are conducted simultaneously and typically involve input from at least two of our specialists. An analyst from the Structured Finance group assesses the ongoing structural risks, while an analyst with specialized expertise in the transaction’s underlying business assesses the business risk. The business risk analyst may work in the Corporate Finance group (covering for example, pub securitizations), Public Finance group (for example, in health care transactions), Infrastructure Finance group (for example, in water transactions), or Insurance group (for example, in embedded value transactions).
Surveillance occurs on an ongoing basis in the following layered fashion:
Any change to stress assumptions takes place in the context of a qualitative assessment of the business risk. A material change in the underlying credit is likely to have a rating impact. The transaction review incorporates a commentary on the business environment, operating plans, and strategic challenges facing the business, which should be forward looking. Information requirements tend to be embedded in the transaction covenants.
In order to fully understand the business environment and the challenges facing them, our corporate finance, infrastructure finance, public finance, or insurance analysts maintain a dialogue with the operating company’s management over the transaction’s term. This includes site visits when appropriate to supplement periodic management meetings and conference calls.
Ongoing dialogue allows us to assess the extent to which management can mitigate the risks of the business environment. We therefore ensure that our view on embedded business and management risks is current. Ongoing dialogue also enables us to communicate to the corporate management our views on any material deviation, whether positive or negative, from expected strategy. The policy of communication with management in order to qualify the quantitative analysis already undertaken further enables us to adapt our stress scenario input to sustained and material developments in the transaction’s business risk.
The quantitative and qualitative assessments are incorporated into a wider analytical framework. This includes an assessment of the extent to which available structural mitigants (such as the legal isolation of assets) and any credit, liquidity, equity, or other support can affect the ratings. In addition, in our assessment of any change to the legal framework, we incorporate the analysis provided by internal and external legal counsel. The legal analysis is intended to assess whether ultimately, in a distressed scenario, where deteriorating business risk cannot be hedged by external supports, the legal framework is sufficiently robust to allow noteholders to exercise adequate control over the operating assets to justify the assigned rating.
The purpose of our publications on likely and actual ratings changes is to ensure that all ratings reflect our current view. As a result of the dynamic nature of operating assets, a class of debt’s outstanding rating may have to change over time. During a period of reassessment, we may assign a CreditWatch listing to one or more classes, pending specific clarifications or the receipt of further information. In this regard, an analyst makes a presentation to a ratings committee about the relevant developments. The ratings committee evaluates the issues at hand and arrives at a ratings decision. After notifying the banker of the decision, we publish the revised or affirmed rating and an associated media release.
Rating changes occur when our view of a transaction’s risk profile has changed sufficiently to justify such a move. Our timing is independent of the launch of new debt issues or of our standard annual review cycle.
The surveillance of corporate securitizations is undertaken, at a minimum, on an annual review cycle, usually coinciding with the anniversary of the transaction’s closing, and its results are published on a periodic basis. The surveillance publications are designed to provide detailed insight into how the current rating is being maintained. Unlike rating change publications, these are not event or trend specific.
As more corporate securitizations become seasoned, we have begun to publish transaction updates, which are revisions to the postsale report issued shortly after the transaction’s settlement. Transaction updates report on the application of current data and events to previous ratings analyses. They are our benchmark publication for familiarizing the market on a periodic basis with the key strengths, risks, and concerns relating to a transaction’s rating. They may be helpful to potential and first-time investors as well as to investors seeking an update to an existing holding.
The transaction update report provides a review of the business-risk assessment and transaction performance, including covenant compliance, and the status of key structural features, such as the use and availability of liquidity.
The analysis in transaction updates focuses on the transaction’s hedged and unhedged risks, which embed the package of risk mitigants applied by means of structural features. The bulk of the analysis centers on developments in the transaction’s underlying business risk. The transaction updates highlight the elements of business risk that are not, and possibly cannot be, fully hedged, and comment on the ratings implications.
Most corporate securitizations are still too young to be affected by principal amortization. In due course, however, we will assess and comment on how transaction risk profiles may have evolved. The transaction update will become increasingly valuable as amortization occurs while stable levels of credit enhancement in the form of subordinated debt, equity, and cash-funded first-loss pieces have a positive effect on a transaction’s credit risk profile.
Our ratings, and the views on which they are based, reflect both publicly available information and confidential information provided either voluntarily or in accordance with contractual reporting requirements. Transactions are rated with varying degrees of visibility into the future.
As visibility may change and the elements in a transaction’s overall business risk, as well as other risks, may likewise change as a transaction seasons, current and comprehensive information flows are critical to our surveillance. That is why we require transaction documents to provide for periodic reports and look favorably on those transactions where documentation provides for comprehensive reporting. Even after transaction documents have been finalized and a securitization is becoming seasoned, we may require additional and specific information in order to continue assigning any rating. In the absence of adequate information, we reserve the right to downgrade, suspend, or withdraw current ratings.
We require reports containing data that may be confidential on at least a quarterly basis, with allowance for greater frequency on demand. The current values of all variables in the historical cash flow model of a transaction are to be reported, both in terms of the operating cash flows and the borrower- and issuer-level cash flows. The definition of variables employed in reports to us must be consistent with those applied to the cash flow model and to the transaction’s legal documents. All actual and contingent liabilities of the corporate borrower and the securitization issuer are to be reported. These include obligations incurred via sale and leaseback financing, rents, or the creation of subsidiaries or other group companies, along with a clear definition of each.
In parallel with our original analysis at the time of the initial rating, cash movements must be periodically reported as well as the conditions under which they have occurred. This information is used to verify enforcement of covenanted restrictions on cash payouts as well as unforeseen cash leakage. Reports should include details of current insurance coverage and any waivers or exclusions. Such information, whether or not provided to us on a confidential basis, serves more than one purpose. It bolsters the evidence on which ratings are based and updated. It also raises operating companies’ own awareness of risk issues embodied in the information and can thereby increase management’s inclination and accountability to manage the relevant risks. In numerous corporate securitizations, a significant portion of the information has become available to company management as a direct result of preparing the securitization for launch. An operating company’s commitment to provide periodic reports and reports on demand also enhances the transparency of current ratings and facilitates a solution when credit issues arise.