For several months now ratings agencies have come under a storm of criticism. While agencies' ratings are in theory meant for bondholders, shareholders are clearly attaching greater importance to them, and company managers are often more worried about the impact of a downgrade on their share price than on their bond spread.
When market conditions are difficult and a company is downgraded or even put under surveillance - that tends to get investors' attention. When so-called ratings triggers are involved (which can allow creditors to demand immediate reimbursement) a downgrade can precipitate a liquidity crunch and a crisis of confidence, from which, experience shows, it is very difficult to emerge. Some thought is therefore being given to ways of containing the influence that the ratings agencies seem to have on market movements.
Debt ratings are often said to produce knee-jerk reactions that lack long-term perspective, but, in fact, ratings agencies are closely listened to by investors because they deliver useful news to the market, news that is all the more credible as it comes from independent sources. However, this can only continue to be the case if the agencies improve the quality of their ratings to reflect the growing complexity of companies and markets.

Attentive shareholders

A rating is a subjective opinion on whether an issuer can and will honour its financial obligations. It is therefore meant above all for bankers and bond market operators. In addition to these traditional audiences, shareholders also keep a close eye on ratings (especially downgrades), as they can have a direct impact on share prices. Taken chronologically, agency announcements are first priced in, then integrated by analysts into their forecasts and only then, into the opinions of rating agencies. So a downgrade is partly a response to news that is already integrated into the share price and analyst forecasts.
However, the fact that the market reacts again shows that there is some information that shareholders had not taken into account. This reaction is not necessarily negative, by the way. A downgrade will indeed have a negative impact if it is motivated by a worsening in the company's fundamentals, but it can sometimes have a positive impact if it is due to a transfer in value from creditors to shareholders, e.g. an increase in financial leverage that unlocks greater tax savings, or an exchange of an asset with steady cash flow for a riskier asset.
It is easy to see why shareholders pay so much attention to ratings agencies. An analysis of credit risk is based on factors that are as important for shareholders as for bondholders. There are three such factors: the amount of future cash flow, its volatility, and how it is distributed among shareholders, creditor and managers.

• Assets should be able to produce enough cash flow to pay financing costs and pay down debt, but also to meet shareholders' required rate of return. And when shareholders are happy, creditors are happy, as a fall in the share price would diminish the company's financial flexibility, as well as its growth potential.
• Volatility in cash flow is the second parameter to consider in analysing a company's solvency, as the potential change in expected cash flow can vary significantly. The greater the amplitude, the greater the volatility. Analysing solvency thus consists in assessing risks to cash flow generation. Volatility in cash flow is also very important for shareholders, as the company's value is equal to the sum of its projected cash flow discounted back at a rate that represents its risk.
• The third key to analysing a company's solvency is the way that cash flow is distributed among the various parties: majority shareholders, minority shareholders, creditors, bondholders and top management. First, the rules of distribution must be understood. They are based on the choice of financing and the contracts or commitments that the company has entered into with its partners. But the probability of value transfer between the different parties must also be identified, as these transfers can be the result of decisions that are conscious or unconscious, official or more confidential… This type of analysis involves the company's corporate governance issues.

An observation post with a clear line of sight

A rating generally comes with comments that motivate the agency's position. As they constantly seek out information, shareholders can not help but pay close attention to the agency's position, as it theoretically results from a review of all the elements that constitute the company's value. Who else can provide them with such critical information? Managers have a serious tendency to divulge only the good news and to delay the dissemination of the bad news. They don't want to make promises on future performances. Analysts, meanwhile, often focus on selling the stock.
As for auditors, it is unfortunate that too little attention is paid to their work on risk and that their mission is often reduced to his report to the AGM, i.e. reassuring shareholders on past accounts… whereas investors also need information on prospects and not necessarily financial in nature.
Moreover, agencies have access to privileged information. They have direct access to management and are some of the rare outside players that examine the company's business plan. And, while they are paid by the issuers, agencies are clearly the players that can claim to be the most independent, for several reasons: the bond market is growing so fast they cannot focus on marketing; no single client accounts for more than a small proportion of revenues; and the ultimate rating is decided on by a ratings committee.
But their independence is based above all on their power, which comes from the fact that they are few in number and cannot be ignored, and the fact that they are almost immune from litigation. Their prominence is due to the very specific "NRSRO" status they are granted in the US by the SEC. NRSRO ratings are widely used in financial regulations as a benchmark of security applicable to certain investments by broker-dealers, insurance companies, civil servant pension funds and numerous other financial institutions.

More perspective needed in debt ratings

Any overall assessment of ratings agencies would have to be positive. Although they have not specifically sought out that status, agencies have become "auxiliary financial information sources" for all investors and, in this capacity, they help narrow the asymmetry of information, which is good for markets. They must now fully assume this responsibility and look at what else they can do to continue fulfilling their role properly, despite considerable disruptions in the business and financial world.
Indeed, elements of credit analysis (cash flows, and their volatility and distribution) are becoming increasingly complex. In response, agencies must integrate new dimensions into their analyses. This will benefit both them and the issuers.
Company cash flow is becoming harder and harder to estimate in terms of the three dimensions above. The competitive edge that makes cash flow generation possible is increasing tenuous, and the exact nature of cash flow and the perimeter under which it is generated are less and less clear.
Analysis shows that major risks are more strategic than financial or operational in nature. There are many risks, but, above all, they are interdependent. Taken separately, two risks that seem relatively insignificant in terms of value creation and, in any case unlikely to occur, can have a fearsome impact when they occur together.
Lastly, how value is distributed among the different participants has become more complex. As companies expand globally and as investors become more willing to buy innovative products, sophisticated legal and tax structures have arisen, along with hybrid securities and managerial practices whose consequences are often hard to assess (e.g. transfer costs or the deconsolidation of certain assets). This complexity allows managers or majority shareholders to make distribution choices that can potentially neglect the interests of minority shareholders or creditors. Good corporate governance practices are meant to ensure that the process of distribution is equitable and consistent. Corporate governance systems is often based on the same recommendations. However, it is worth noting that Enron and Tyco were considered models of corporate governance. That shows that it is not enough to merely adhere to regulations.

Modernisation of ratings is needed

With the environment harder than ever to assess, agencies must adapt their methods or else they will soon be unworkable. One possible improvement would be to better anticipate operating risks by more systematically constructing alternative scenarios. More than the result, it is the approach that is important here, as it requires more in-depth exchanges with management.
A second possible improvement would be to review operating and accounting risks. In this area, the agency must base itself on the work of the company or it auditors. A discussion of risk analysis with the company would ultimately give the ratings agencies a better view of management's maturity in this area. Similarly, agencies should routinely meet with auditors, with audit committee members present, in order to understand the company's accounting choices and control systems.
More generally, agencies must seek to better reflect the quality of corporate governance. In a recent research note, Standard & Poor's mentioned some unusual situations that had a negative impact on issuer solvency (and thus its spread):

• The use of company resources for personal or non-business purposes by a group of dominant shareholders;
• Uncontrolled management compensation;
• Bonus schemes that compromise long-term stability and encourage a focus on short-term profits;
• Insufficient control of the integrity of accounting information, which resulted in increased debt and liquidity risk.

Lastly, agency analyses must better reflect shareholder value concerns. This may seem paradoxical, but, in limiting themselves to dealing with bondholders' concerns, they overlook the fact that bondholders and shareholders' interests are intertwined.

The remedy of competition

In addition to improving and fleshing out the analysis techniques used by ratings agencies, the influence of individual agencies could be limited by offering the market competing sources of information. The important thing is to ensure diversity in analyses, similar to the diversity among investors, to avoid sudden shifts. From this point of view, competition among ratings agencies is, of course, essential. Greater competition must come with stricter professional standards, particularly in how much due diligence should be taken before issuing a rating.
But greater competition will have only a limited impact if there is no "external competition". After all, reducing asymmetry of information is more the business of companies than of ratings agencies. If the impact of ratings on share prices is to be limited, the markets must be better informed, in particular on elements of the company's strategy. To assess a company's value, investors must above all gauge its ability to establish a long-term competitive edge. They can only do so by reviewing non-financial indicators.

Jean-Florent Rérolle

We thank Editions de La Martinière for allowing us to publish this article, which was part of Ernst & Young's Cahier N°6 in June 2003.