A credit rating brings a number of significant benefits to most corporate borrowers: It increases the field of investors who are willing to buy a company’s debt, and by expanding the investor pool, it usually reduces the cost of borrowing. It also increases the level of confidence that the company’s other stakeholders—including derivative counterparties, customers, shareholders, and regulatory bodies—have in the company. However, from the moment a company embarks on the path toward obtaining a credit rating, whether it’s getting a rating for the first time or getting an additional rating, someone needs to carefully tend to the relationship with the rating agencies. That someone is usually the treasurer, and it’s not a job to take lightly.
A credit rating is a very public opinion on the creditworthiness of a company, so it’s vital for the organization to take a systematic and comprehensive approach to managing relationships with the agency or agencies developing those opinions. Even the decision of whether to pursue a rating in the first place is a significant responsibility. Most large companies—especially multinationals—tend to have one or more public ratings in order to access the debt and capital markets, but in some cases the costs of pursuing a credit rating may outweigh the benefits.
Why Get a Credit Rating?
Before starting to pursue a credit rating, a company needs to thoroughly weigh the benefits and costs. Unless the business is very well-established and has very strong brand recognition, it is going to need a credit rating in order to access the bond market. Most investors such as pension funds, insurance companies, and banks can invest only in rated debt. In addition to expanding the group of prospective investors, a credit rating gives a company access to a wider range of debt structures, including those with longer maturities.
However, getting a credit rating has a number of disadvantages as well. The most obvious are the time that staff must dedicate to obtaining and maintaining the rating, and the cost of the rating agency fee. Another consideration is that a credit rating comes with the risk of a rating downgrade, which would bring the company under unpleasant public scrutiny. A particularly weak credit rating may even lead to lower credit scores from bank risk models, and greater public comment, than not having a credit rating at all. Finally, a rated company might find its hands tied in terms of borrowing and other financial decisions if maintaining a certain rating level requires it to adhere to certain limits on financial ratios such as leverage or interest coverage.
An organization should be sure that it wants a credit rating before initiating the process of obtaining one. Although a public rating can be withdrawn, this action could produce negative headlines, especially if the rating is withdrawn soon after it is issued or after a downgrade. And even if a company asks for a rating to be withdrawn, the rating agency usually has the right to carry on rating the company on a ‘non-participatory’ basis if it believes there is sufficient investor interest in the company’s outstanding bonds.
Which Ratings to Pursue?
Once a company has decided to obtain a credit rating, it needs to choose how many ratings it wants to have, and it needs to choose the agencies that will issue them. The credit rating is an important piece of information that investors use in making decisions about purchasing corporate debt; therefore, a company pursuing a rating needs to research how many ratings its prospective investors require, and why. For example, certain funds may be allowed to invest only in companies with two or more ratings.
Along the same lines, the company needs to discover which agencies its prospective investors prefer. This preference varies by geography and by business sector. The company may ask its advisers, such as its relationship banks, for this information. Another factor is whether bonds rated by each rating agency are eligible for inclusion in the common bond indices, and whether eligibility requires a certain rating level from a particular agency.
The company can also evaluate which agencies its peers use and look at the rating levels that they have been assigned. Investors and other market participants may question a company’s selection if it uses a rating agency that is not common among peers in its sector. However, organizations should not use popularity among their peers and investors as their sole criteria for choosing a rating agency. A business’s competitors may have selected a particular agency for reasons that made sense in the past but are no longer valid—for example, some agencies’ rating methodologies may have been opaque in the past but may have become more transparent over the years.
Once it’s narrowed its choices to a shortlist of rating agencies, a company needs to do its due diligence using publicly available information. At the end of this process, the company will meet with each of the rating agencies. The goal should be to uncover as many strengths and weaknesses of each agency as possible prior to meeting with any of the agencies, as well as to investigate the suitability of the rating agencies’ methodologies and processes.
Modeling the Rating
The company should examine the credit rating methodology of each rating agency on its shortlist; the methodology is available on each agency’s website. The company should use the published methodology to model its potential rating with each agency. It should also evaluate the clarity of the methodology.
A rating agency’s reports on similar companies are invaluable in this process, as they explain the competitors’ rating levels and describe how the agency came to its decisions. They include the key financial ratios that the agency uses, along with a commentary on how the ratios impacted the rating decision. The reports will also set out the key ratings drivers for the rated companies, as well as the triggers that could lead to an upgrade or a downgrade. Scrutinizing rating reports reveals how the agencies implement their published methodology and whether they ever depart from the methodology, and why. Published rating methodologies can’t cover every potential corporate structure or profile, so the methodology may need to be adapted on a one-off basis for certain companies.
After examining peer companies’ rating reports, the company pursuing a credit rating can model its own expected rating by comparing its current and projected business and financial profile against those of the rated companies. For example, if the company’s leverage is very similar to that of a peer company, it can use that peer company’s rating report to determine how the agency uses that level of leverage when assigning a rating. If the company does not have similar, peer companies that are rated, then management should still use the published rating methodology to model the rating as best as they can.
This type of modeling exercise provides highly valuable information. First, of course, is the estimate of what a company’s credit rating might be. An estimate developed in this way is not precise; it might be two or three notches away from the final result a company would receive from the rating agency. However, even this rough estimate can indicate whether getting a rating from a particular agency would be likely to reduce the organization’s cost of funds, which in turn helps a company understand whether seeking a rating is likely to be a useful exercise.
Also, assuming a company chooses to continue pursuing a credit rating, it will find great value in understanding the financial profile it would need in order to obtain a particular rating—for example, the typical amount of leverage among companies assigned a specific rating level. Along the same lines, the rating-modeling exercise will highlight which parts of a company’s financial profile reduce its score under each rating agency’s methodology. For example, if one agency’s methodology is more significantly influenced by leverage than other agencies’, then for a company with a high leverage ratio, choosing that agency may lead to a relatively low rating assuming there are no other compensating factors.
A company should work through the modeling exercise prior to meeting with any prospective rating agencies. It should also review the agency’s latest sector reports. For most sectors, rating agencies publish a summary report from time to time setting out their views on the sector and the companies within that sector. A company may also find useful information on each agency’s website, such as how the agency is governed. This entire process should result in a list of questions that the company wants answered prior to selecting a rating agency.
Questions for Prospective Rating Agencies
A company should meet with each of the rating agencies it’s considering before it appoints one or more to provide a credit rating. Although the agencies will bring marketing materials to the meeting and will have their own agenda, the company should prepare its own list of questions. The purpose of the questions should be to clarify the agency’s methodology and its rating process, and the company should send its list to the agency prior to the meeting so that the agency can provide answers with an appropriate level of detail.
Based on its modeling exercise, the company should seek an explanation of the key qualitative and quantitative factors that the agency uses to derive its credit ratings and describe how each factor is weighted. The questions should focus on the particular qualities of the company’s business and financial profile that might disproportionately affect its rating—for example, if the company has large amounts of goodwill on its balance sheet, or if it has a particular target leverage level, the company should ask the agency how its criteria will apply in these circumstances. The company should already have an understanding of how the agency assigns ratings, but its questions can help draw out further detail on how the agency would apply its methodology in practice to the particular organization.
The company should be sure to clarify:
- Which public rating methodology the agency will use to rate the company, and whether it plans to change the methodology anytime soon.
- Potential drivers of the company’s rating: A company can request that each agency identify the company’s potential rating drivers using publicly available data. Additionally, the company should ask the agency about the common rating drivers and themes it is currently observing within the company’s business sector.
- Which organizations are in the peer group that the rating agency will use to benchmark the company.
- How the agency defines and calculates key ratios, such as leverage and interest coverage.
- Details of any in-house models, such as capital models, that the rating agency uses as part of its analysis.
- How the agency would rate bonds issued by the company, including hybrid bonds, and what the relationship looks like between a company’s rating and its bonds’ ratings.
- If the company is part of a group, how its rating might be impacted by the presence of other members of the group and whether other entities in the group would need to be rated.
Rating agency background
- Which analysts will cover the company and maintain communication with the company. The agency should provide details about the analysts’ experience, their current portfolio of clients, and the location of their office.
- Whether the rating agency has the capacity to deal with both the first-time rating process and the ongoing relationship with the company. The agency should specify exactly what information (both current-period and historical) the company will need to provide.
- How long the agency will take to provide the rating after it has been engaged by the company.
- Whether the agency can provide statistics to show the relative stability of its credit ratings.
- How many companies the rating agency covers in the company’s market sector.
- When the agency last updated its rating methodology, and whether it publishes sector reports on a regular basis.
Rating process and documentation
- How the agency will ensure that information which the rated company considers confidential will remain confidential.
- What the agenda will look like for the “management meeting.” During the rating process, the agency will want to meet with senior management of the company it’s rating; agencies usually accomplish this by organizing a one-day visit to corporate headquarters. The agency will send an agenda and a question list to the company in advance, and the company should prepare presentations based on these.
- How the rating committee will make the rating decision. The rating committee is the body within the rating agency that makes the final decision on a company’s rating level. The analysts that interact with the company present their findings to the rating committee after they have gathered all the information they need.
- How the rating agency will make public announcements. The agency should clarify how much time the company will get to review agency press releases and what type of information it will be able to challenge. Usually after a rating committee has provided its opinion, the only things that can change in public announcements are factual inaccuracies or confidential information.
- Circumstances under which the company will be able to appeal the outcome of the rating committee decision, and the process for making an appeal if the company chooses to do so.
- Circumstances under which the company will be able to keep the rating private if it wishes to. Similarly, the company should clarify which circumstances would enable it to provide the private rating to other parties on non-public transactions.
- The process for withdrawing the rating in the future, should the company decide to drop its rating.
- The fees that the agency will charge for rating the company, and for rating the organization’s bonds and loans.
- Whether the rating agency can rate the company under two or more states. For example, if the company is considering a more highly leveraged balance sheet, the rating agency may be able to provide a rating on both its current leverage level and an alternative leverage level. This would likely result in additional fees payable to the agency.
Making the Appointment
After carrying out all this preparatory research and then meeting with its prospective rating agencies, a company will be in a good position to make an informed decision about how many ratings it needs and which agency or agencies should issue them. It will also be well-prepared to work with its rating agencies on an ongoing basis. This process requires time and focus from the organization’s senior management, so the company needs to ensure that it has sufficient resources. The company can reduce the burden on its top executives by assembling a project team and appointing one person as the project leader. The project leader will be responsible for gathering the information required by the rating agencies; preparing the company’s presentation for the management meeting; and managing all communication with the rating agency.
The rating exercise will commence once both parties have signed a rating agency engagement letter, which includes details about fees the agency will charge, confidentiality policies, and how the rated company can withdraw its rating.
This is the point at which the rating agency will want to visit the company and meet with managers. Approximately a week before the management meeting, all the managers who will participate should rehearse their presentations internally to ensure that the company is consistently conveying its key messages to the rating agency. After the company is satisfied with the presentation materials that its managers will deliver during the meeting, it may send the materials to the ratings agency so that the agency’s analysts can prepare for the meeting.
After the meeting, the company being rated should be prepared to answer post-meeting follow-up questions from the agency. Then it will receive its rating, which it can either accept or reject. The company should be under no obligation to get the rating published—the company should confirm that this entitlement is included in the rating agency engagement letter before signing—and it will have the option to appeal the rating decision, subject to the agency’s rules on the appeals process, which should have been clarified during due diligence.
A Systematic Approach Is Key
Deciding to get a credit rating—whether it is a first-time rating for the company or an additional rating—and then making an informed decision about which rating agency or agencies to work with are complicated and time-consuming choices. Moving forward with the rating process will add to the treasury team’s workload. A company can mitigate some of the ongoing effort by setting up procedures that coordinate the delivery of information to rating agencies with delivery of information to other stakeholders, such as equity investors, debt investors, and relationship banks.
For many companies, though, it remains well worth the effort because a credit rating presents opportunities to access debt markets and other funding sources that the organization wouldn’t otherwise be able to access and to increase its public profile. A treasury team that goes into the process using a systematic approach and carrying out detailed preparatory research will have a better chance of getting the rating they need to meet their funding goals.
Gurdip Dhami is a treasury consultant based in London. He advised companies on treasury-related matters (including credit ratings) during his time at RBS, JPMorgan, Cazenove, and Bank of America, and he was the deputy corporate treasurer at Standard Chartered Bank.