Credit Concerns Arise Over European Issues As US Private Placement Market Overheats

Executive Summary

Strong US demand for private placements (PPs) from European issuers is leading to investments in weaker credits and less protection, increasing the risk of investors incurring losses further down the line and jeopardising future growth. Fitch is concerned that some US investors are storing up potential credit losses without the commensurate reward for taking such risk. Future losses on European portfolios could reduce US interest in private placements from the region, shutting off a useful way for European corporates to extend the maturity of their debt.

Investor demand for diversification and yield led to non-US issuers accounting for two thirds of total volume in the US PP market in 2003, with issuers from across Europe selling deals. Weight of demand has led to aggressive pricing, erasing any illiquidity premium for PPs, and a softening of financial covenants to the extent that some PPs have been sold without any protection.

In addition, Fitch has become aware of unrated deals being marketed as likely to carry a NAIC-2 rating (BBB-range) from industry regulator the National Association of Insurance Commissioners (NAIC), when their credit profiles would indicate a non-investment grade rating. However, NAIC ratings are generally assigned after issuance and consequently after the investment decision. When the NAIC rating is finally assigned, higher capital requirements may be required on certain holdings.

Since January the NAIC has accepted one rating by a credit rating agency as its own, but take-up of this service appears limited to date. From a European viewpoint, Fitch believes the marketing of non-investment grade issuers as investment grade, without independent research, risks ultimately back-firing on the continent’s issuers generally.

With the continuing strong uptake of US PP funding, there may be a refinancing balloon building up for 5-7 years’ time. While arrangers are reporting increased requests by issuers for whole European-invested deals, home-grown PP investors are still too few to meaningfully replace US institutions should the latter retreat. It remains to be seen whether the development of this market can accelerate to achieve meaningful scale within this time period.

A Buoyant Market

The US PP market recorded spectacular volumes in 2003, with nearly USD46bn of new issuance. The 59% increase was boosted by a record amount of funds directed towards this asset class by investors, predominantly US life insurers. These investors have LT liabilities in their core business and the typically long maturities (up to 30 years) in the PP market are particularly attractive. A substantial asset class for US investors, traditional PPs accounted for USD266bn, or 14%, of the USD1.9trn combined US life insurers’ bond portfolios as at FYE03.

US Private Placement Market Historical Private Placement Issuance

Source: IIR Private Placement Forum Jan 2004

Market Growth

While PPs have been around in the US for decades, in the past foreign issuers could only access the market if they had significant subsidiaries or brand names recognised in the US. As investor demand for diversification has increased, the foreign slice of the pie has expanded at the expense of the US portion to a staggering two thirds of total volumes in 2003. Initially, Anglo-Saxon countries such as the UK and Australia were of greatest interest to investors although in the last year issuers from across Europe have joined the PP club.

Reflecting this development, the main UK clearing banks with large corporate lending books such as RBS and Barclays have taken market share from the traditional US arrangers, utilising their existing corporate relationships as well as building more. Continental European banks are also increasingly active. As a fee-earning product, not utilising the bank’s own balance sheet but acting as a broker for investors, PPs are a popular instrument for banks mindful of Basle II restrictions.

The Issuer Approach

European corporates remain largely reliant on banks for their funding needs. A typical development path for funding by a European corporate could be as follows:

However, the rapid increase in supply during 2003 has meant that many sizeable corporates who have already accessed the public debt capital markets have returned to the PP arena to take advantage of keen funding costs. This trend has continued in 2004, in line with a generally more opportunistic approach to funding by corporates.

The Investor Perspective

The low interest-rate environment has resulted in changes of strategy among many investors. For US PP investors, the search for yield has led to increased geographical diversification. The largest investors have credit teams who undertake detailed due diligence and have gradually become more comfortable with issues such as the variation of bankruptcy regimes across jurisdictions. PP portfolios have also benefited from the relative strength of performance versus public debt portfolios in recent years of record bond defaults. Investors report that the larger average size of foreign issuers compared to typical domestic issuers is a positive, along with greater geographical diversity of the corporates’ businesses.

Ratings and Regulation

There is no regulatory requirement for ratings of PPs. However, ratings are increasingly demanded by investors and banks can find placings run more smoothly with the support of independent research and a rating by an international rating agency. Whether market participants desire it or not, the National Association of Insurance Commissioners (NAIC), the industry regulator, will assign ratings through its Securities Valuation Office (SVO). Such ratings are driven by the need to assess asset quality and capital weighting of investors and generally take place after issuance, i.e. after rather than before the investment decision. The SVO has been overwhelmed by increased deal flow and has introduced a new streamlined ratings process, known as the Filing Exempt (FE) process. As from January 2004, one rating from an NRSRO¹ is automatically accepted instead of the SVO also making its own assessment of the credit risk. Ratings must be kept up to date and reviewed at least annually, supported by a private rating letter. As a result, issuers are able to achieve certainty of final rating by obtaining a rating from an agency in advance of the notes being placed with investors. When accessing a new funding market, this approach should ensure that a successful long-term relationship is built with investors. It avoids the potential scenario of an investor purchasing notes on the basis of a bank’s assurance of say, an NAIC-2 credit profile, only to find that the SVO rates the paper NAIC-3 a few months down the line. At the industry’s main annual conference in January 2004, the largest US investors stated publicly that they are firmly in favour of PPs being rated by NRSROs, in line with the FE process.

Recent Market Developments

As can be expected in a market benefiting from strong investor demand, pricing has become increasingly keen. The great clamour for assets has driven down spreads to a level where not only has the traditional illiquidity premium disappeared, but instances of privates pricing through publics are becoming increasingly common.

5 Year BBB Credit Spreads

Source: Bloomberg and Bank One Capital Markets

Agents have become more aggressive and the distribution process is now commonly held as an auction. Investors often see their bids scaled back and have taken to up-sizing their original bids in anticipation. Issuers are well placed to obtain competitive pricing.

There are also signs that the shifting balance of bargaining power results in a softening of financial covenants. Recently, a few transactions have even occurred with a complete absence of such documentary protection. However, the most favoured nations (MFN) clause, essentially providing for a pari passu relationship with banks in the event of default, has become more common. A small number of investors have expressed intent on expanding their currently limited non-investment grade portfolios, down to NAIC-3 and NAIC-4. At this level, structures are typically secured and issuers are almost exclusively US domiciled. Fitch has seen some evidence of secured, non-investment grade PPs being tentatively arranged by bankers also for European issuers but is not aware of any such closings to date.

Credit Concerns

In such a seller’s market, it can be expected that the focus on credit quality may slip. Fitch rates many PPs and has a good understanding of the PP market and its drivers. In recent months, Fitch has become aware that a number of Europe-originated unrated transactions are being marketed as “NAIC-2” (BBB-range) despite credit profiles indicating noninvestment grade ratings. Other market participants, both leading arranging banks and investors, have expressed corroborating views to Fitch. However, from the investors’ angle, the weight of the money risks forcing portfolio managers to ignore credit alarm bells in order to achieve short-term objectives such as yearly investment targets and yields. While the SVO’s new Filing Exempt process disposes with the ratings time delay, and hence the potential storing up of unquantified credit problems, in practice the take-up of this service appears limited to date.

With no sign of US investor appetite for European originated PPs abating, Fitch is concerned that some are storing up potential credit losses without the commensurate reward for taking such risk. Once the SVO assigns final ratings, higher capital charges may be required on certain holdings – assuming the SVO’s credit judgement is fully aligned with that of the rating agencies. As shown above, the capital requirement for a BB+ bond is 3.4 times that of a BBB- bond.

From a European viewpoint, Fitch believes the marketing of non-investment grade issuers as investment grade, without independent research, risks ultimately back-firing on the continent’s issuers generally. Increasing credit losses or capital requirements on European portfolios could result in a sharp reduction in US PP investor interest in the region. This would be a set-back, as the US PP has quickly become a useful way of terming out debt for European corporates, especially those in the BBB-range. With the continuing strong uptake of USPP financing, there may be a refinancing balloon building up for 5-7 years’ time. While arrangers are reporting increased requests by issuers for whole European-invested deals, home-grown PP investors are still too few to meaningfully replace US institutions should the latter retreat. It remains to be seen whether the development of this market can accelerate to achieve meaningful scale within this time period.

Trading

Depending on the extent of the discrepancy between expected versus actual SVO ratings as well as on individual investor guidelines, some investors may need to off-load purchased notes if these fall below investment grade. It is important to remember that the US PP market is firmly focused on the investment grade universe, with only some 5% to 20% of market volume pertaining to non-investment grade (NAIC-3 or lower) transactions. The non-investment grade market has to date been reserved for domestic US issuers. As the market is traditionally a buy-and-hold one, trading is very limited. In 2003, approx. USD4bn changed hands, almost exclusively non-investment grade credits. Investors active in the secondary market tend to be hedge funds and other buyers typically more aggressive than primary market players.

Restructuring/Renegotiations

The entrance of short-term focused investors
completely changes the tone and character of the issuer-investor group relationship. While established US PP investors have a reputation for taking the longer term view, standing by their borrowers and working alongside the bank group in any covenant renegotiation or restructuring, hedge funds by definition take a more opportunistic, non-relationship approach. Europe-based restructuring professionals have reportedly already experienced such hardened attitudes in on-going cases and Fitch expects this trend to intensify.

¹ Nationally Recognised Statistical Rating Agency, the main ones of which are Fitch Ratings, Standard & Poor’s and Moody’s.

Note: Julie Burke was co-author of this report which was first published by Fitch on 14 July 2004.

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