The evolution of the syndicated loan market from a private, relationship-oriented credit market to a real securities market has been proceeding steadily for several years. Although the Asian market remains some years behind its US counterpart in terms of development, Standard & Poor's sees evidence of emerging trends that show clear signs of a more investor-driven loan market. The New Basel Capital Accords are expected to accelerate the banking industry's movement toward risk-based and market-driven methods of bank management and supervision.
Reflecting this need for increased efficiency and transparency, loan ratings are increasingly becoming an important factor in the syndicated loan market. The purpose of this article is to focus specifically on Standard & PoorÆs loan and recovery ratings, and in particular to emphasise aspects of the loan rating product and process--such as timing and documentation requirements--that are critically important to rating this unique asset class.
Background
Syndicated loans are more complex instruments than typical public bonds, especially when they have collateral security, complex covenants, and separate tranches with their own discrete levels of creditor protection (e.g., first and second liens). In rating syndicated loans, Standard & Poor's analysts undertake a multistep process. First, they evaluate the issuer's overall risk of default in meeting its financial obligations. That is captured in our corporate credit rating, expressed on our traditional letter scale (AAA, AA, A, BBB, etc.). The analyst then undertakes a deal-specific analysis of the loan itself, which looks beyond the risk of default to factor in the likelihood of ultimate loss and recovery. This analysis not only considers the overall credit-worthiness of the borrower, but also the unique features of the loan instrument, like collateral, covenants, and other structural features, that may determine how much loan investors are ultimately repaid in a post-default scenario. This ultimate loss/recovery analysis is expressed in two ratings:
ò The bank loan rating, which is on the same familiar 'AAA' through 'D' scale as the corporate credit rating, and may be notched up from the corporate credit rating in cases where post-default recovery is expected to be 100%; and
ò The recovery rating, which uses a separate rating scale ('1+' to '5') to focus exclusively on expected loss and recovery. Each recovery rating is defined in terms of an expected recovery range, as outlined below (see Table 1).
Rating Process
Because they incorporate a deal-specific evaluation of the loan's post-default loss and recovery outlook, in addition to the traditional analysis of the risk of default itself, bank loan and recovery ratings typically require a more extensive rating process than that with which many of our issuers and their bankers are familiar. They may also involve intensive dialogue between Standard & Poor's and both the issuer and the issuer's banker (i.e., the lead lender), as analysts attempt to understand and evaluate the likelihood of the issuer defaulting; and how the loan is structured, in terms of collateral, covenants, intercreditor agreements, and other features, to mitigate the effects of default, should it occur, and secure ultimate repayment for the loan holders.
For new clients, the bank loan and recovery rating process involves a meeting between Standard & Poor's and the issuer. Issuers often--but not always--invite their syndicating bank to accompany them to the meeting with us. Indeed, many times it is the banker who introduces the issuer and/or the deal, and arranges the meeting. Some existing clients choose not to meet with us when having a new loan rated, although we recommend it, especially if it is a complex transaction.
Most meetings between Standard & Poor's and an issuer focus on the company's current and future business and financial strategy (including the terms of the proposed financing). In rating loans, it also is important to discuss the downside deal scenario (e.g., what happens if the company defaults; why the lender structured it this way; and what the lender's expectations regarding the default scenario and collateral recovery values may be).
To ensure that Standard & Poor's fully understands the objectives and rationale for structuring the loan as they did, many bankers organise a separate meeting or conference call specifically to discuss loan structure, potential default scenarios, loan documentation, and other issues relating exclusively to the deal. We welcome these meetings with agent banks, and view them as an essential part of the loan rating process. It is obviously to the issuer's advantage to have its banker spend as much time with us as is necessary to fully explore these issues, to ensure the rating captures the full value of any collateral or other lender protections.
Timing
Issuers and their bankers often feel under pressure to get loans rated and sold quickly, and we endeavor to meet our clients' deadlines whenever possible. But rating complicated secured loans and ensuring that the structural and security features are fully evaluated and incorporated into the ratings is a complex process, and often requires several days of analytical work. In many cases, it may also require the efforts and expertise of more than one analyst. Therefore, to ensure that there is ample time for a particular loan's structure to be fully presented by the issuer and its banker; for our analysts to review all the background information on both the company and the loan itself; and for discussion back and forth between analysts and the issuer and bankers, we recommend that agent banks schedule discussions with us early in the loan structuring and syndication process. Our analysts are prepared to rely on preliminary drafts of bank books, offering memoranda and term sheets in starting their loan analysis, with the understanding that any open issues will be addressed as the rating process proceeds.
We believe our clients and their bankers will appreciate the advantages of ensuring that Standard & Poor's has ample opportunity to fully understand and appreciate the loan structures, collateral packages and other features that enhance the likelihood of lenders being fully repaid. Other things being equal, we expect the market to differentiate well-secured loans from poorly secured loans in terms of pricing and spreads. Therefore, we expect that clients and their bankers will want to take the time necessary to allow us to appropriately reflect those differences in our loan and recovery ratings. Although, as mentioned above, Standard & Poor's will make every effort to meet clients' and their bankers' schedules, we believe super-compressed time frames do a disservice to issuers by making it more difficult for the unique features and nuances of their credits to be fully captured in the rating process.
Loan Documentation
Standard & Poor's generally is asked to rate loans early enough in the syndication process that our rating and accompanying write-up can be made available to prospective buyers prior to the loan closing. Our loan and recovery rating analysis is based on the materials presented to us at the time. Besides the typical corporate background documents (annual reports, 10Ks, etc.), we require the same loan-specific documents that generally are presented to the bankers and investors (e.g., the bank book, or offering memorandum; detailed term sheets; cash flow models; descriptions, appraisals, or valuations of collateral; explanations of any unusual structural or intercreditor features, etc.). Our ratings assume the loan that ultimately closes is substantially the same as that originally presented to us. Post-closing, when we receive copies of the closing documents, our analysts review them against that which was described in the original bank book, term sheets, and other materials to verify that the loan as rated and as closed are indeed substantially the same. Standard & Poor's reserves the right to change the rating and/or its write-up if discrepancies between the pro forma rated loan and the loan as ultimately closed so warrant.
Throughout the life of the loan, the issuer is expected to share with Standard & Poor's all of the same information that it shares with investors in the loan (updated corporate reports, covenant compliance certifications, collateral reports, etc.) on a regular basis (usually quarterly, or more often if required by the loan agreement). To ensure that this occurs, we determine with the issuer at the beginning of the rating process who will be sending quarterly update information, and establish a regular e-mail reminder system. Many issuers find it is more convenient to have their agent banks handle this by adding us to the list of investors who routinely are sent updates, either directly from the agent or via IntraLinks.
Surveillance
Surveillance is the term we use to refer to the continual, ongoing review of our ratings. In the case of bank loan and recovery ratings, we review not only the underlying credit rating of the borrower, but also maintain surveillance on the loan and recovery ratings themselves. Although they are related in some ways, the various ratings can move independently of each other. For example, the borrower's business may change in such a way that its credit rating moves up--or down--but in either case, the collateral and other structural features protecting the secured lenders may be unaffected, and the recovery rating does not change. Alternatively, the borrower's credit rating may be stable, but the loan may change. For example, the loan-to-value ratio of a secured loan may improve over time as it amortizes, causing the loan and recovery ratings to be upgraded, even though the underlying credit rating of the borrower remains constant.
Confidentiality
The syndicated loan market is, technically, a private market, and we respect the right of any client to maintain our loan and recovery ratings on a confidential basis. Confidential means, in that case, that Standard & Poor's will not reveal the rating to anyone outside of our rating group without the issuer's authorisation. The response to any inquiries from third parties will be that Standard & Poor's has no rating on the loan. This does not mean, however, that third parties in the loan market (e.g., bankers and investors) that learn about the rating from the issuer or its agent may not mention it to others (including journalists who cover the loan markets), so that the rating de facto ends up being public.
The fact that very few loans remain truly confidential in the loan market is a sign of the greater liquidity in the market, and that large loans - whether confidential or public - get redistributed and traded to an increasingly broad audience of banks and investors that may have little or no relationship with the borrower. It is this broad base of investors - actual and potential - that drives the demand for information in the market, including ratings, data, commentary, news, etc. Most issuers and bankers opt to make their loan and recovery ratings public. They recognise that it is virtually impossible to maintain true confidentiality in a market this hungry for information, and, more important, that it is probably in their own interest to have the rating public so it helps create transparency and liquidity for their loan.
[The article is an extract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]
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