A controversial report from rating agency Fitch Ratings has caused a flutter in the private placement market. The bulletin, entitled US Private Placement Market Overheats – Credit Concerns Arise Over European Issues, concerns the buoyancy of the US private placement market, which saw record issuance of almost $46 billion in 2003. Some market participants have voiced their support for Fitch’s stance but others have dismissed the report as “plain silly”.
The expansion in the market was driven principally by non-US borrowers. Private placements issued by non-US companies accounted for what Fitch describes as a “staggering” two-thirds of the total market in 2003, with the size of individual transactions piercing the $1 billion mark on two occasions. “Weight of demand has led to aggressive pricing,” says the Fitch report, “erasing any illiquidity premium for PPs [private placements], and a softening of financial covenants to the extent that some PPs have been sold without any protection.”
The emergence of this sellers’ market, according to Fitch, has encouraged a number of unnamed banks to abuse the system. In particular, the agency advises that it 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.”
The author of the report, London-based Monica Klingberg Insoll, is unwilling to name any of the specific transactions that alerted Fitch to this particular practice. But she explains that historically, banks leading new issues in the US private placement market would bring their deals to Fitch in advance of marketing them in order to gauge their likely equivalent credit rating. In the event of the agency indicating that a particular issuer would be likely to carry a sub-investment grade rating, she says, the normal practice was for banks to explore alternative financing solutions, such as those available in the high-yield space or in the syndicated lending market. But with investor demand in the US for private placements at such feverish levels, for some banks the temptation to ignore advice about the true likely ratings profile of weaker credits has reputedly become too strong to resist.
In the report Klingberg warns: “Fitch believes the marketing of non-investment grade issuers as investment grade, without independent research, risks ultimately backfiring on the continent’s issuers generally. Increasing credit losses or capital requirements on European portfolios could result in a sharp reduction in USPP investor interest in the region.”
These are weighty allegations. But Klingberg Insoll is eager to play down any suggestion that the report was motivated by a desire to be controversial or confrontational, but to draw attention to an important trend in the market. “At Fitch we are able to look at the market from the perspective of issuers, intermediaries and investors,” she says, “and based on off-the-record conversations with all three we felt that evidence was building up that there was some irrational behaviour going on in the market. Having observed that development, we did not think anybody would thank us for saying nothing.”
Klingberg Insoll also says that the report, which she prepared in consultation with Fitch’s US-based insurance industry analysts, has been widely welcomed by investors. “A number of investors have already called us to say that they thought our analysis was spot-on,” she says.
Nevertheless, the most tantalising aspect of the Fitch report is what it leaves unsaid, presumably for diplomatic reasons. It does not take a huge leap of the imagination to work out that if what Fitch is saying is wholly accurate, it potentially points to lawsuits waiting to happen. After all, if investors in the world’s most litigious society are being misled about the credit quality of the securities that are being marketed to them by some banks, would they simply put any losses down to experience?
For the time being there would appear to be two opposing ways of interpreting Fitch’s controversial report. The first is to view it as a constructive exposure of a potentially very serious weakness in the US private placement market, which, if allowed to continue unchecked, could be very damaging for the future health of the market.
The alternative interpretation is that the report meddles harmfully and unnecessarily in a market that is functioning perfectly well and attracting a growing number of very well-respected European companies. This, at any rate, seems to be the view of bankers who shared their views with Credit on an off-the-record basis. After all, as one says, this is an extremely “delicate” subject and however much bankers may disagree with the rating agency, cordial relations need to be maintained. “I disagree very strongly with the Fitch report,” he says. “I think it was an inappropriate and self-serving piece which is based on opinion rather than facts.”
A question of competence
This banker’s principal gripe is that the Fitch appraisal seems to be casting aspersions on the competence of the investor community in the US private placement market. “Fitch is suggesting that investors are incapable of doing their own credit analysis and are going to get screwed unless they hire a rating agency to secure a public rating and hence take the risk out of the market,” he says.
Historical record, this banker says, flies in the face of Fitch’s argument. “Private placement lenders have been buying unrated deals for decades,” he says. “They are very highly sophisticated institutions which typically have between 30 and 40 people dedicated to credit analysis. Frankly if you compare the insurance companies’ industry specialists with those at the rating agencies, the buy-side credit analysts are much better. That means it would be impossible for an investment bank to try and push the envelope in terms of pricing or covenants or credit quality of an issuer.”
The banker claims that almost all insurance companies that have studied how their private portfolios perform against their publicly rated investments have discovered that over the long term, their private placement assets outperform. Empirical studies, such as those conducted by the Society of Actuaries analysing the performance of the private placement market between 1986 and 1998, would appear to support this assertion.
Admittedly, virtually no private placements find their way into the hands of retail investors via mutual funds, or to the accounts of widows and orphans, with transactions generally distributed among a small clique of very deep-pocketed insurance companies. As Fitch notes in its report, “Investors [in US private placements] are limited in number, typically no more than 10–15 in number.” In other words, the club of private placement investors in the US is probably populated by those institutions that are least in need of overzealous protection.
However, a comparison of the performance and credit quality of historical issuers in the US private placement market with those of companies tapping the market today reveals some disparities. Nowadays, more than half of new issuers are non-US companies. As such, US investors active in the market are facing very different analytical challenges from those that presented themselves in the past. True, there was a flurry of non-domestic issuance at the start of the 1990s, but that was restricted chiefly to borrowers from the UK and Australia.
Nevertheless, bankers don’t agree that the growing internationalisation of the US private placement market justifies the Fitch bulletin. Another banker, again speaking to Credit off the record, thinks that the only entity that will be damaged by the report is Fitch itself. “The report is so transparent in its objective, which is to persuade more companies to get a Fitch rating, that people who have any experience of this market are dismissing it as plain silly,” he says.