As Europe develops a more investor-driven and liquid secondary loan market, it is following in the footsteps of the US, where rating agencies provide ratings to individual and syndicated loan facilities. Michael Marray reports.

As the European loan market develops into an investor-driven and liquid market similar to that in the US, the rating agencies are playing a more important role, assigning ratings to individual loan facilities in addition to the more traditional corporate and bond ratings.

Loan ratings are most useful in the below investment leveraged loan market but are becoming more common in the lower reaches of investment grade. Few triple A-rated or double A-rated borrowers would bother having an individual loan facility rated but at the border between triple B and double B, lenders will take comfort from having a loan rated to show whether it is investment grade or below.

For borrowers that already have a corporate rating, the difference may be one or two notches up or down. The rating agencies will look closely at covenants, collateral and issues such as to which part of a group the loan is being made (for example, at holding company or operating company level), which may affect the degree of access and control over collateral security.

Driving the trend

The main driver of the loan rating trend is the growing involvement of non-bank investors, such as collateralised debt obligation (CDO) asset managers and insurance companies in the European loan market. “Historically, non-investment grade loans have not been rated in Europe, though an issuer may have had a bond rating and investors could determine what sort of rating it might translate into from a senior debt perspective,” says Kristian Orssten, managing director, co-head of loan capital markets at JP Morgan in London. However, non-bank investors now buy about 25% of all non-investment grade loans and as these investors grow in importance and make a bigger contribution to liquidity in the market, they are becoming powerful enough to demand the rating of loans. Arranging banks are also increasingly asking for ratings.

“The larger the financing exercise, the more you have to satisfy the requirements of many different types of investor. So, on large deals that do rely quite heavily on non-bank investors, we are increasingly having discussions with individual borrowers about having their loans rated,” says Mr Orssten.

Market changes

Dominic Crawley, head of syndicated loan ratings, Europe, at Standard & Poor’s, says some of the key building blocks that brought about the establishment of an efficient, investor-driven loan market in the US are now evident in the European loan market. “In the US, about 65% of money invested in the leveraged loan market comes from non-bank investors, such as CDOs, insurance companies, pension funds and money managers. And these players require ratings on the assets that they buy,” he says. “Because of the growing importance of these non-bank investors in the European leveraged loan market, loan arrangers are increasingly looking to get a rating in order to get a deal away in the market. And a rating also helps liquidity in the secondary market because it widens the range of potential buyers.”

The number of loan ratings continues to grow. At year end 2000, S&P rated 108 loans worth a total of $119bn, but by the end of March 2003 it had rated 200 loans with a volume of $227bn (see table). But Europe still lags far behind the US: Moody’s Investor Services has ratings on $120bn worth of loans for 85 borrowers in Europe yet in the US, it rates $800bn worth of loans for 1200 borrowers. The leveraged loan market in the US is dominated by non-bank investors to a much greater degree than in Europe, where banks still lend quite aggressively in this sector.

“Loan ratings are mainly a non-investment grade product, principally because the capital structure in non-investment grade companies is generally more complex and has a wider variety of debt products, such as mezzanine and deeply subordinated,” says Richard Smith-Morgan, head of business development at Moody’s in London. He says that the need for investors to differentiate across the capital structure is far higher than in investment grade, where there is often just one class of unsecured debt ranking pari passu with unsecured bonds.

“In upper investment-grade land, your loan rating will generally be the same as your bond rating,” says Mr Smith-Morgan. “However, an investor will still take comfort that Moody’s has looked at that loan and is happy with the structure and documentation of various liquidity facilities, such as the Material Adverse Change clause, which may be an issue because liquidity lines from banks may not be available when needed.”

Liquidity concerns

Such concerns about liquidity were previously regarded as more important for highly indebted companies in the leveraged loan sector. However, investors are now asking the same questions of investment grade borrowers and thus investment grade loans are also increasingly being rated.

Among the investment grade loans rated by Standard & Poor’s during 2003 are a Ł650m senior unsecured revolving credit facility for Gallaher Group plc, rated triple B flat, and a E5bn syndicated loan for France Telecom, rated triple B minus. In the below investment grade category, S&P recently assigned a double B rating to the E2.5bn secured syndicated credit facility for Vivendi Universal, forming part of its general restructuring and efforts to improve its tight liquidity situation.

These loans all incorporate rating pricing grids (RPGs) in the loan documentation, which adjust interest rates as upgrades or downgrades take place during the life of the loan. An RPG can also be based on a corporate credit rating but the trend is towards the loan itself to be rated. One advantage is that an RPG requires less negotiation than other traditional financial covenants and the lenders can point to an outside assessment by a third party. This saves banks the trouble of arguing with their clients about whether or not covenants have been triggered when, as one banker points out, the potential loopholes in the documentation are often such “that a truck can be driven through them”.

Aiding trading

Loan documentation is increasingly being worded to facilitate easier trading in the secondary market. Traditionally, borrowers preferred to see small groups of banks keeping loans on their books but they now accept that loans will increasingly be traded in the secondary market.

Bankers are putting pressure on borrowers to get loans rated and not hinder secondary market trading, particularly on large syndicated loans of several billion euros and above. Lead managers know that a rating will help placement across a broader spectrum of investors and that these investors want to see a liquid secondary market.

“Borrowers’ attitudes towards loans being traded in the secondary market will vary depending, for example, on what sort of facility they are looking at and the size of the facility. But I think that, particularly in large event-driven financings, there is a recognition that banks and other investors will often want to trade loans in the secondary market,” says Clare Dawson, executive director at the Loan Market Association, which has produced widely-used standardised documentation that makes loans easier to trade and enhances liquidity.

Where a loan is not rated prior to syndication, non-bank investors such as CDOs are increasingly paying the rating agencies a few thousand pounds to have a piece of a loan rated. CDOs are particularly active buyers of high yielding loans associated with the growing European leveraged buy-out (LBO) market.

“In a European LBO transaction, the issuer concerned may not want a public credit rating or the arranging bank may not feel a public credit rating is needed to get the transaction away,” says Rachel Hardee, director at Fitch Ratings in London. “Therefore, in the absence of public ratings, CDO asset managers are required to request shadow ratings from the rating agencies. These shadow ratings are desktop private ratings that are undertaken based on the information package provided by the CDO asset manager.”

Syndication support

The arranging bank may want to have a loan privately rated to help the syndication process. In such cases, Fitch Ratings completes a Private Letter rating. This is distinct from the shadow rating in that, typically, rating agency analysts will meet the company management. The rating assignment will not be publicly disclosed but may be disclosed within the banking syndicate.

Non-bank investors hope to see more of such ratings initiated by borrowers and arranging banks, not only because it saves them the cost of a desktop rating, but also because it will tend to make pricing more efficient across categories such as double B versus single B-rated loans.

In the US, this pricing differential already exists. “In the US, institutional investors tend to dictate whether a deal gets done or not, whereas in Europe there are still banks that do deals for relationship reasons,” says Simon Hood, managing director at ING Capital Management Ltd, which manages the Copernicus I and II CDOs. “We would encourage the use of ratings to try to ensure that the pricing of individual loans becomes more efficient in the European market.”

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