ESSCA Corporate Credit Rating PDF

Corporate credit rating Nicolas Deschamps – Corporate Finance Manager H2 2024 1. What is a rating? 2. Why is it important? 3. How do the agencies look at rating? 4. Liquidity analysis 5. Financial adjustments 6. Case study...

Corporate credit rating Nicolas Deschamps – Corporate Finance Manager H2 2024 1. What is a rating? 2. Why is it important? 3. How do the agencies look at rating? 4. Liquidity analysis 5. Financial adjustments 6. Case study 2 1. What is a rating? 3 What is corporate credit rating? ▪ Corporate credit ratings are forward-looking opinions that provide relative rankings of overall creditworthiness and that are expressed by letters ▪ They express an opinion about the ability and willingness of debt issuers to meet their financial obligations on time and in full ▪ They provide a common language for investors and other market participants and are one of several inputs they can consider as part of their decision-making processes ▪ The opinion is not a point in time snapshot but is a long-term view (over the next 12-24 months depending on the rating agency) ▪ Ratings represent a view of the probability of default or expected loss of an instrument or issuer, hence credit ratings are still mapping historical default rates (link to historical global corporate annual default rates by rating category) Outlooks ▪ Outlooks are opinions regarding the likely direction of an issuer’s rating over the medium term (usually 12-18 months) ▪ Outlooks can be positive, negative, stable and developing (contingent upon an event) ▪ There is around 1/3 chance that the outlook materialises into a rating action Rating under review / watch ▪ A rating is placed under review / watch when it is on review for upgrade or downgrade i.e. an event is likely to take place soon and could have a material impact on the rating assigned ▪ There is around 2/3 chance that the watchlist materialises into a rating action Sources: S&P Global Ratings, Moody’s Ratings 4 Rating process 1. An analytical team is assigned upon execution of commercial engagement. Once the rating application is contracted, the analytical team is assigned. 2. Issuer shares company information with analytical team. The issuer prepares their company information and presentation for the first meeting with the analytical team. 3. Management meeting with analytical team. The issuers management team meets with the analytical team to present the company information and discuss the materials. This phase may be accelerated in situations with tighter financing schedules, or for structured finance deals. 4. Analytical team commences analysis and goes to rating committee. The rating committee is a key part of the analytical process and helps to ensure the integrity and consistency of ratings. It reviews, votes and assigns the rating. After the rating committee, a post-committee call is held with the issuer to notify and explain the rating prior to its publication. 5. Ratings and rationale are delivered. The issuer reviews the draft press release. The rating is then delivered through a press release available on the website of the rating agency (unless the rating is private). 6. Ongoing monitoring. Surveillance and dialogue is maintained with organizations for timely and relevant ratings. Source: process as defined by Moody’s Ratings 5 Rating triggers ▪ Once a credit rating is assigned, it is monitored on an ongoing basis ▪ The rating agencies notably monitor some previously-designated key credit factors (which usually contain figures), which are factors that could, individually or collectively, lead to a negative or positive rating action. These factors are summarized in the agency’s report and are known as rating triggers or rating sensitivities ▪ They are good indicators to the outside world (e.g. issuer or investors) to better understand what could trigger a rating action Example of rating triggers: Source: Moody’s Ratings 6 20+ agencies are registered in the EU Source: ESMA supervisory information as per 30 September 2023 7 The main rating agencies Some selected market players A very concentrated market1 Source: ESMA 1 EU-only issued ratings, corporate non-financial 8 Market standards ▪ In Europe, two credit ratings are still favoured: Moody’s and S&P. If one of these 2 ratings is missing, the investor may assume that the outcome was not favourable ▪ In some peer groups and/or for larger issuers, 3 ratings (or more) can also be the norm ▪ For smaller names, where for instance 1 rating is enough, “rating shopping” can happen ▪ However, this is not always possible: S&P and Moody’s have traditionally been the reference agencies for investors, especially for USD debt issuance ▪ Fitch is seen as a specialist in some sub-segments, such as for financial institutions and sovereign ratings ▪ Within the corporate segment, Fitch is most recognised in the real estate and utilities sectors ▪ However, Fitch can be perceived to offer a slightly more flexible approach and can look at a longer forward period. It may therefore also be considered in a rating strategy 9 Long-term rating scales Long-term rating AAA Aaa AAA AA+ Aa1 AA+ AA Aa2 AA AA- Aa3 AA- Investment A+ A1 A+ Grade rating A A2 A A- A3 A- BBB+ Baa1 BBB+ BBB Baa2 BBB BBB- Baa3 BBB- BB+ Ba1 BB+ Probability of Expected default and return of BB Ba2 BB expected loss investors BB- Ba3 BB- B+ B1 B+ Sub-Investment B B2 B Grade rating (also B- B3 B- called High-Yield, CCC+ Caa1 CCC+ Speculative Grade CCC Caa2 CCC or “Junk”) CCC- Caa3 CCC- CC Ca CC - - C D or SD C RD / D Sources: S&P Global Ratings, Moody’s Ratings, Fitch Ratings 10 Definition of default (example with Moody’s) Moody’s definition of default is applicable only to debt or debt-like obligations (e.g., swap agreements). Four events constitute a debt default under Moody’s definition: 1. A missed or delayed disbursement of a contractually-obligated interest or principal payment (excluding missed payments cured within a contractually allowed grace period), as defined in credit agreements and indentures 2. A bankruptcy filing or legal receivership by the debt issuer or obligor that will likely cause a miss or delay in future contractually obligated debt service payments 3. A distressed exchange whereby 1) an issuer offers creditors a new or restructured debt, or a new package of securities, cash or assets, that amount to a diminished value relative to the debt obligation’s original promise and 2) the exchange has the effect of allowing the issuer to avoid a likely eventual default 4. A change in the payment terms of a credit agreement or indenture imposed by the sovereign that results in a diminished financial obligation, such as a forced currency re-denomination (imposed by the debtor, or the debtor’s sovereign) or a forced change in some other aspect of the original promise, such as indexation or maturity Source: Moody’s Ratings 11 What is notching? Notching refers to the relative ratings assigned to different obligations of an economic unit Structural subordination: where a creditor of a parent company does not have access to the assets of the company’s subsidiary until all subsidiary’s creditors have been paid Effective subordination: where an unsecured creditor of company does not have access to the assets of the company that is pledged to secure creditors Contractual subordination: where the ranking of various debt classes are explicitly stated in the borrower’s debt agreement Application of notching in real world is more complicated than it appears Sources: Moody’s Ratings, S&P Global Ratings, Fitch Ratings 12 2. Why it is important? (example of Fresenius) 13 Main goals of Corporate Finance at Fresenius Ensuring financial flexibility ❑ Limiting refinancing risks ❑ Optimizing our cost of capital ❑ Source: Fresenius 14 Ensuring financial flexibility: diversification of funding sources EIB Loan 3% Commercial Paper 1% Equity-neutral convertible bond 3% Other financial liabilities 5% Bonds 63% Schuldschein Loans 11% Total Balance Sheet Debt: ~€15.3bn Corporate bonds are long-term debt obligations with fixed or variable Lease liabilities 14% coupons and a maturity of at least one year Source: Fresenius, data as of June 30, 2023 15  Ensuring financial flexibility: managing our leverage ratio Fresenius Group: Net Debt/EBITDA1,2 5.0 x 4.5 x Net Leverage Ratio 4.2 x = 4.0 x 3 3.7 x 3.6 x 3.6 x 3.5 x 3.4 x 3.5 x 3.9 x Gross Debt – Cash & Cash 3.5 x 3.2 x 3.2 x 3.1 x Equiv. 3.0 x 3.0 x 3.0 x 3.0 x 2.8 x 2.7 x 2.7 x 2.6 x 2.7 x 2.5 x EBITDA 2.7 x 2.5 x 2.6 x 2.6 x 2.0 x 2.3 x 2.3 x 2.2 x 1.5 x 1.0 x 2001 2002 2003 2004 2005 2006 Q1/06 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Q2/23 Pre IFRS 16 Post IFRS 16 FSE excl. FMC 1 At actual FX rates from 2001 to 2010 and at average FX rates from 2011 onwards, for both Net Debt and EBITDA; before special items; pro forma closed acquisitions/divestitures; 2 Pro forma excluding advances made for the acquisition of hospitals from Rhön-Klinikum AG; 3 From 2019 onwards including IFRS 16 Source: Fresenius, data as of June 30, 2023 16 Ensuring financial flexibility: the importance of an IG rating for market access bps 49 52 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 2 5 8 11 14 17 20 23 26 29 32 35 38 41 44 47 1 4 7 10 13 16 19 22 25 28 31 Vol. in bn 700 45 Investment High Yield Grade Volume Volume 40 600 Investment Grade Index High Yield Index 35 500 30 400 25 300 20 15 200 10 100 5 0 0 Dec-20 Feb-21 Apr-21 Jun-21 Aug-21 Oct-21 Dec-21 Feb-22 Apr-22 Jun-22 Aug-22 Oct-22 Dec-22 Feb-23 Apr-23 Jun-23 Aug-23 Source: Fresenius, data as of August 2023 17 Optimizing cost of capital €1,000,000,000 Interest cost €9.25m p.a. €92.5m over 10y 0.925% 10y vs. 5.179% 10y €52m p.a. €520m over 10y Source: Fresenius, data as of June 30, 2023 18 Rating is intermingled with Corporate Finance 1. Advise on financing needs Look at the debt maturities and advise on how much debt is needed, when, with which characteristics (instrument type, maturity, currency, fixed vs floating, etc.) 2. Advise on debt capacity How much debt the company can sustain for M&A, share buy-backs, etc. Decide on optimum mix of debt and equity, especially for M&A 3. Advise on most suitable financing product The higher the amount of debt, the more critical a rating is needed to access the bond markets The smaller the company, the less diversified its capital structure would normally be (but could still be complex) 4. Advise on optimum capital structure Balance between a sound balance sheet and shareholder returns, optimum cost of capital, positioning vs peers of similar rating categories 19 Key skills required from an analyst 1. Analytical thinking 2. Technical skills 3. Structured way of working 4. Productivity 5. Problem-solving skills 6. Initiative 7. Teamwork 8. Communication 9. Relationship management 20 3. How do the agencies look at rating? 21 Some key components of credit rating 1 Industry risk 2 Competitive position 3 Operating efficiency ▪ Cyclicality ▪ Scale and scope ▪ Profitability ▪ Predictability of cash flow ▪ Diversification (geographies, ▪ EBITDA margin, return on industries, products, etc.) capital ▪ Supply / demand dynamics ▪ Customer / supplier ▪ Stability of the operating ▪ Barriers to entry concentration performance Management strategy & 4 Financial policy 5 Financial profile 6 corporate governance ▪ Leverage ratios (e.g. Net Debt / ▪ Growth track record EBITDA) ▪ Management experience ▪ Dividend policy ▪ Coverage ratios (e.g. EBITDA / ▪ Growth strategy ▪ Perceived tolerance for financial Interest) ▪ Hedging policy risk ▪ Historical figures and forecast 7 Other factors ▪ Country risk ▪ Liquidity position ▪ ESG (materiality, time horizon, potential financial impact, etc.) ▪ … 22 How do the agencies look at rating? Example of S&P 23 Rating framework applied by S&P Source: S&P Global Ratings 24 Determining the CICRA and BRP (1/2) ▪ Under the framework, the combined assessments for country risk, industry risk, and competitive position determine a company's business risk profile assessment. These strengths and weaknesses determine an issuer's capacity to generate cash flows to service its obligations in a timely fashion. Country risk ▪ Addresses the economic risk, institutional and governance effectiveness risk, financial system risk, and payment culture or rule of law risk in the countries in which a company operates. Industry risk ▪ Addresses the relative health and stability of the markets in which a company operates. Competitive position ▪ Identifies entities that are best positioned to take advantage of key industry drivers or to mitigate associated risks more effectively and achieve a competitive advantage and a stronger business risk profile than that of entities that lack a strong value proposition or are more vulnerable to industry risks. CICRA ▪ The combined assessment for country risk and industry risk is known as the issuer's Corporate Industry and Country Risk Assessment (CICRA). Business Risk Profile ▪ The CICRA is combined with a company's competitive position assessment to create the issuer’s BRP assessment. Source: S&P Global Ratings 25 Determining the CICRA and BRP (2/2) Country Risk Assessment 4 3 Industry Risk Assessment 1 Very Low 2 Low Moderately 5 High 6 Very High Intermediate High 1 Very Low 1 1 1 2 4 5 2 Low 2 2 2 3 4 5 3 Intermediate 3 3 3 3 4 6 4 Moderately High 4 4 4 4 5 6 5 High 5 5 5 5 5 6 6 Very High 6 6 6 6 6 6 CICRA Competitive Position Assessment 1 2 3 4 5 6 1 Excellent 1 1 1 2 3 5 2 Strong 1 2 2 3 4 5 3 Satisfactory 2 3 3 3 4 6 4 Fair 3 4 4 4 5 6 5 Weak 4 5 5 5 5 6 6 Vulnerable 5 6 6 6 6 6 Source: S&P Global Ratings 26 Determining the FRP ▪ Under the framework, cash flow/leverage analysis is the foundation for assessing a company's financial risk profile. ▪ The pattern of cash flow generation, current and future, in relation to cash obligations is often the best indicator of a company's financial risk. The criteria assess a variety of credit ratios, predominately cash flow-based, which complement each other by focusing on the different levels of a company's cash flow waterfall in relation to its obligations (i.e., before and after working capital investment, before and after capital expenditures, before and after dividends), to develop a thorough perspective. ▪ The range of assessments for a company's cash flow/leverage is 1, minimal; 2, modest; 3, intermediate; 4, significant; 5, aggressive; and 6, highly leveraged. ▪ For each company, S&P calculates 2 core credit ratios, funds from operations (FFO) to debt and debt to EBITDA. S&P compares these payback ratios against benchmarks to derive the preliminary cash flow/leverage assessment for a company. ▪ Supplemental ratios are also used to help develop a fuller understanding of a company's financial risk profile and fine- tune S&P’s cash flow/leverage analysis. Supplemental ratios could either confirm or adjust the preliminary cash flow/leverage assessment. ▪ The criteria typically consider 5 standard supplemental ratios, although "Sector-Specific Corporate Methodology" may introduce additional supplemental ratios or focus attention on one or more of the standard supplemental ratios. The standard supplemental ratios include three payback ratios--cash flow from operations (CFO) to debt, free operating cash flow (FOCF) to debt, and discretionary cash flow (DCF) to debt--and two coverage ratios, FFO plus interest paid to cash interest paid and EBITDA to interest. Source: S&P Global Ratings 27 Combining the BRP and FRP Financial Risk Profile (FRP) Business 1 Minimal 2 Modest 3 Intermediate 4 Significant 5 Aggressive 6 Highly Risk Profile (BRP) Leveraged 1 Excellent aaa / aa+ aa a+ / a a- bbb bbb- / bb+ 2 Strong aa / aa- a+ / a a- / bbb+ bbb bb+ bb 3 Satisfactory a / a- bbb+ bbb / bbb- bbb- / bb+ bb b+ 4 Fair bbb / bbb- bbb- bb+ bb bb- b 5 Weak bb+ bb+ bb bb- b+ b / b- 6 Vulnerable bb- bb- bb- / b+ b+ b b- Source: S&P Global Ratings 28 Overview of the modifiers Modifier Impact on the rating Description Diversification / Typically used for conglomerates. S&P assesses the degree of correlation of activities in the event a Neutral / Positive portfolio effect company operates in multiple (at least 3) industry sectors. Capital structure Positive / Neutral / Negative S&P mainly considers interest rate risk, debt maturity risks, FX risks, and investments. S&P considers the sources (A) and uses (B) of cash over the next 6 to 24 months. The level of A/B Liquidity Positive / Neutral / Negative coverage determines the liquidity “level”. S&P evaluates management’s policies with respect to dividends, share repurchases and M&A activity Financial policy Positive / Neutral / Negative as these present event risks that can lead to a steep change in credit metrics. Management / S&P assesses management’s strategic competence, organizational effectiveness, risk management, Positive / Neutral / Negative governance and robustness of governance. Comparable rating S&P uses this modifier to adjust the ratings if they believe (after adjusting for the other modifiers) there Positive / Neutral / Negative analysis are additional credit strengths/weaknesses that may not be fully reflected in the criteria. Source: S&P Global Ratings 29 Diversification / portfolio effect modifier ▪ Multiple earnings streams (which are evaluated within a firm's business risk profile) Assessing diversification / portfolio effect that are less-than-perfectly correlated reduce the risk of default of an issuer. Degree of correlation Number of business lines ▪ This modifier applies to companies that S&P regards as conglomerates. For the of business lines purpose of these criteria, a conglomerate would have at least 3 business lines, each contributing a material source of earnings and cash flow. 3 4 5 or more ▪ S&P defines a conglomerate as a diversified company that is involved in several industry sectors. Usually, the smallest of at least 3 distinct business segments / High Neutral Neutral Neutral lines would contribute at least 10% of either EBITDA or FOCF and the largest would contribute no more than 50% of EBITDA or FOCF. Medium Neutral Moderately diversified Moderately diversified ▪ In rating a conglomerate, S&P first assesses management's commitment to maintain the diversified portfolio over a longer-term horizon. Low Moderately diversified Significantly diversified Significantly diversified ▪ S&P expects the conglomerate's earnings volatility to be much lower through an economic cycle than an undiversified company’s. S&P expects that a conglomerate will also benefit from diversification if its core assets consistently produce positive Notching impact on the anchor rating cash flows (the company diversifies to take advantage of allocating capital among its business lines). Diversification / Business risk profile assessment portfolio effect ▪ There is no rating uplift for an issuer with a small number of business lines that are highly correlated. By contrast, a larger number of business lines that are not 1 Excellent 2 Strong 3 Satisfact. 4 Fair 5 Weak 6 Vulnerable closely correlated provide the maximum rating uplift. ▪ Finally, diversification could mitigate subordination. An issuer's business or 1 Significant +2 notches +2 notches +2 notches +1 notch +1 notch 0 notches diversification geographic diversity may indeed improve the prospect of the residual value remaining for holding company creditors because the company's individual subsidiaries could 2 Moderate +1 notch +1 notch +1 notch +1 notch 0 notches 0 notches retain value differently based on their distinct businesses, some with shortfalls and Diversification others with surpluses. A more liberal priority debt ratio may be applied to reflect the benefit the diversity of assets might provide. For such issuers, S&P may notch down 3 Neutral 0 notches 0 notches 0 notches 0 notches 0 notches 0 notches for subordination risk if the priority debt ratio exceeds 75%. Source: S&P Global Ratings 30 Capital structure modifier ▪ S&P uses its capital structure criteria to assess risks in a company's capital structure First step: preliminary capital structure assessment that may not show up in their standard analysis of cash flow/leverage. ▪ S&P analyses 4 subfactors: Assessment 1. Currency risk associated with debt (Tier 1) Neutral No tier one subfactor is negative 2. Debt maturity profile (Tier 1) One tier one subfactor is negative, and the tier two 3. Interest rate risk associated with debt (Tier 2) Negative subfactor is neutral 4. Investments Both tier one subfactors are negative, or one tier one Very negative ▪ The initial assessment is based on the first 3 subfactors. S&P may then adjust the subfactor is negative, and the tier two subfactor is negative preliminary assessment based on their assessment of the 4 subfactor. ▪ Tier 1 subfactors carry the greatest risks (due to greater likelihood of affecting credit metrics and potentially causing liquidity and refinancing risk). The tier 2 subfactor is Second step: final capital structure assessment important, but typically less so than the tier one subfactors. ▪ The 4th subfactor quantifies the impact of a company's investments on its overall Investment subfactor assessment financial risk profile. Although not directly related to a firm's capital structure decisions, certain investments could provide a degree of asset protection and potential financial Preliminary capital Very flexibility if they are monetized. If the subfactor is assessed as neutral, then the Neutral Positive structure assessment Positive preliminary capital structure assessment will stand. If investments is assessed as positive or very positive, S&P adjusts the preliminary capital structure assessment upward. Very Neutral Neutral Positive Positive Example of the assessment of the investments subfactor: Negative Negative Neutral Positive ▪ Investments in unconsolidated equity affiliates, other assets, where the realisable value is not currently reflected in the cash flows generated from those assets. Very Negative Very Negative Negative Negative ▪ The Investments subfactor quantifies the impact of a company’s investments on its overall financial risk profile. ▪ It reflects the degree of asset protection and potential financial flexibility that certain investments could provide, if they are monetised. Source: S&P Global Ratings 31 Liquidity modifier Liquidity modifier ▪ S&P’s assessment of liquidity focuses on the monetary flows, the sources and uses of cash, that Liquidity a- and higher bbb+ to bbb- bb+ to bb- b+ and lower are the key indicators of a company's liquidity cushion. ▪ The analysis also assesses the potential for a +1 notch if FP is company to breach covenant tests tied to declines 1 Exceptional 0 notches 0 notches 0 notches positive, neutral, in EBITDA. The methodology incorporates a FS-4, or FS-52 qualitative analysis that addresses such factors as the ability to absorb high-impact, low-probability events, +1 notch if FP is the nature of bank relationships, the level of 2 Strong 0 notches 0 notches 0 notches positive, neutral, standing in credit markets, and how prudent (or not) FS-4, or FS-52 the company's financial risk management is. ▪ A Standalone Credit Profile is capped at bb+ for 3 Adequate 0 notches 0 notches 0 notches 0 notches issuers whose liquidity is less than adequate and b- for issuers whose liquidity is weak, regardless of the assessment of any modifiers or comparable ratings analysis. 4 Less than Not applicable Not applicable -1 notch1 0 notches Adequate ▪ For liquidity to be assessed as at least adequate, appropriate forms of back-up and other sources of liquidity need to be in place to cover at least 100% of intra-year working capital needs and debt 5 Weak Not applicable Not applicable Not applicable b- cap on SACP maturities (including CP) over the following 12 months. Source: S&P Global Ratings 1 No further notching if issuer SACP is bb+ due to cap 2 Additional notch may apply if S&P expects liquidity to remain Exceptional or Strong 32 Financial policy modifier ▪ Financial policy refines the view of a company's risks beyond the Financial policy assessment conclusions arising from the standard assumptions in the cash flow/leverage assessment. Assessment Criteria The importance of a stated financial policy cannot be over-emphasised Indicates that S & P expects management’s financial policy decisions to have a positive impact ▪ Rating analysts will derive significant comfort from a defined financial 1 Positive on credit ratio over the time horizon, beyond what can be reasonably built in their forecasts policy. on the basis of normalize operating and cash flow assumptions. ▪ Rating agencies tend to adopt a longer-term perspective in their rating Indicates that, in S&P’s opinion, future credit ratios won’t differ materially over the time horizon decisions considering a defined financial policy, in particular if such policy beyond their projection, based on their assessment of management’s financial policy, recent 2 Neutral track record, and operating forecasts for the company. A neutral assessment effectively reflects a has been publicly communicated and company has a track record of low probability of event risk in their view. adherence. Indicates S&P’s view of a lower degree of predictability in credit ratios, beyond what can be reasonably built in their forecasts, as a result of management’s financial discipline (or lack of it). It Key points in formulating a financial policy 3 Negative points to high event risk that management’s financial policy decisions may depress credit metrics over the time horizon. ▪ The use of a rating-relevant metric is preferable but not required. S&P defines a financial sponsor as an entity that follows an aggressive financial strategy in using ▪ The level of the chosen ratio has to be realistic both from a historical Financial sponsor (FS-4, FS-5, debt and debt-like instruments to maximize shareholder returns. Typically, these sponsors dispose perspective and in light of future strategy and ambitions. of assets within a short to intermediate timeframe. Accordingly, the financial risk profile S&P FS-6, FS-6 minus) assigns to companies that are controlled by financial sponsors ordinarily reflects S&P’s ▪ Point out potential options available to the company to remedy a potential presumption of some deterioration in credit quality in the medium-term. underperformance against the stated metrics, such as: Financial policy modifier ▪ Focus on restoring financial metrics in line with policy after a significant acquisition Financial policy a- and higher bbb+ to bbb- bb+ to bb- b+ and lower ▪ Potential to reduce / postpone growth-related expenditure +1 notch if liquidity is +1 notch if liquidity is +1 notch if M&G is at +1 notch if M&G is at at least adequate at least adequate and ▪ Use of equity or equity-linked instruments 1 Positive least satisfactory least satisfactory and M&G is at least M&G is at least satisfactory satisfactory ▪ Ensuring the business has adequate liquidity and covenant headroom is also key and should form part of a documented financial policy. 2 Neutral 0 notches 0 notches 0 notches 0 notches ▪ Management's track record and level of commitment to stated 3 Negative -1 to -3 notches -1 to -3 notches -1 to -2 notches -1 notch financial policies are also taken into account. FS-4, FS-5, FS-6, FS-6 minus Not applicable Not applicable Not applicable Not applicable Source: S&P Global Ratings 33 Management and governance modifier ▪ The terms management and governance encompass the broad range of oversight and direction conducted by an entity's owners, board representatives, and executive managers. These activities/practices can impact an entity's creditworthiness and, as such, the M&G modifier is an important component of S&P’s analysis. ▪ S&P determines the M&G modifier by individually assessing 5 distinct subfactors pertinent to credit risk analysis: ▪ Ownership structure (neutral/negative); ▪ Board structure, composition, and effectiveness (positive/neutral/negative); ▪ Risk management, internal controls, and audit (positive/neutral/negative); ▪ Transparency and reporting (neutral/negative); and ▪ Management (positive/neutral/negative). ▪ These assessments are then combined into a preliminary M&G modifier, which can then be adjusted up or down, holistically, to arrive at the final M&G modifier. We assess the final M&G modifier on a four-point scale (positive, neutral, moderately negative, negative). The final rating impact of the M&G modifier is determined by the specific corporate methodologies that use this modifier as an input. Management a- and higher bbb+ to bbb- bb+ to bb- b+ and lower and governance 1 Positive 0 notches 0 notches 0 or +1 notches 0 or +1 notches 2 Neutral 0 notches 0 notches 0 notches 0 notches 3 Moderately negative -1 notches 0 or -1 notches 0 or -1 notches 0 or -1 notches 4 Negative -2 or more notches -2 or more notches -1 or more notches -1 or more notches Source: S&P Global Ratings 34 Comparable rating analysis (CRA) modifier ▪ This is the last step in determining the SACP on a company, after adjusting for the previous 5 modifiers. This analysis can lead S&P to raise or lower its anchor by one notch. The CRA is based on the overall assessment of the issuer's credit characteristics for all subfactors considered in arriving at the SACP. The application of comparable ratings analysis reflects the need to "fine-tune" ratings outcomes, even after the use of each of the other modifiers. A positive or negative assessment is therefore likely to be common rather than exceptional. ▪ S&P considers the assessments of each of the underlying subfactors to be points within a possible range. Consequently, each of these assessments that ultimately generate the SACP can be at the upper or lower end, or at the mid-point, of such a range. E.g. a company receives a positive CRA assessment if S&P believes, in aggregate, its relative ranking across the subfactors typically to be at the higher end of the range. ▪ The most direct application of the comparable ratings analysis is in the following circumstances: ▪ If S&P expects a company to sustain a position at the higher or lower end of the ranges for the business risk category assessment, the company could receive a positive or negative assessment, respectively. ▪ If a company's actual and forecasted metrics are just above (or just below) the financial risk profile range, as indicated in its cash flow/leverage assessment, S&P could assign a positive or negative assessment. ▪ S&P also considers additional factors not already covered, or existing factors not fully captured, in arriving at the SACP. Such factors will generally reflect less frequently observed credit characteristics, may be unique, or may reflect unpredictability or uncertain risk attributes, both positive and negative. Source: S&P Global Ratings 35 How do the agencies look at rating? Example of Moody’s 36 Illustration of the business and consumer service methodology framework (1/3) Source: Moody’s Investors Service * This factor has no sub-factors † Some of the methodological considerations described in one or more cross-sector rating methodologies may be relevant to ratings in this sector 37 Illustration of the business and consumer service methodology framework (2/3) Source: Moody’s Investors Service When debt is zero, the score is Aaa. When debt is positive and EBITDA is negative, the score is Ca When net debt is negative and RCF is positive, the score is Aaa. When net debt is negative and RCF is negative, the score is Ca 38 Illustration of the business and consumer service methodology framework (3/3) Source: Moody’s Investors Service When debt is zero, the score is Aaa. When debt is positive and EBITDA is negative, the score is Ca When net debt is negative and RCF is positive, the score is Aaa. When net debt is negative and RCF is negative, the score is Ca 39 How do the agencies look at rating? Example of Fitch 40 Fitch uses Ratings Navigators ▪ A Ratings Navigator is a visual overview of the key quantitative and qualitative factors Fitch analyzes to arrive at an entity’s credit rating, and embodies Fitch’s commitment to providing clarity to investors and issuers. ▪ Employed as a key part of Fitch Ratings’ own internal rating process, Ratings Navigator is aligned with the agency’s published Rating Criteria and articulates how a rating is constructed. Each report ▪ Shows the relative importance of each rating factor in determining the final ratings, and gauges potential rating sensitivities. ▪ Presents the fundamental trends or outlooks underlying each component of a credit rating, including operating environment, management, company profile, and financial profile in a digestible format. ▪ Assesses each rating factor using the traditional ‘AAA’ scale as well as sector specific rating scales. Link to main Corporate Ratings criteria looked at by Fitch Source: Fitch Ratings 41 4. Liquidity analysis (example of Moody’s) 42 What is liquidity and how is it assessed? ▪ Liquidity can be defined as the magnitude of total cash and readily available cash sources relative to total cash needs for operations, investments, and debt service ▪ Liquidity risk (as view by rating agencies), is the risk on a forward-looking basis that an issuer will not have sufficient cash (or near cash sources) to meet its needs for debt service ▪ The liquidity risk is assessed as part of a broader assessment of an issuer’s risk of default ▪ Credit rating is about capacity and willingness to meet obligations, we are here focusing on the capacity part ▪ The approach to assess liquidity by rating agencies is not only quantitative, but also qualitative as there are many unpredictable variables that affect the balance and timing of future cash sources and uses, including for instance management decisions (e.g. capital allocation strategy) ▪ While liquidity issues are often triggering an event of default, the underlying cause is almost always underperformance of the business or excessive leverage that created an untenable financing structure ▪ The analysis is usually performed every quarter by the rating agencies, with a 12-month horizon Sources: Moody’s Ratings, S&P Global Ratings, Fitch Ratings 43 Analytical frameworks ▪ At Moody’s, 2 main frameworks are used to analyse liquidity (both frameworks have a lot of common points) ▪ The other agencies also have their own frameworks, but with a lot of similarities ▪ Liquidity Risk Assessment (LRA) framework (for investment-grade companies): ▪ Sources and uses of cash ▪ Amount and size of committed credit lines ▪ Conditions to accessing credit lines (covenants, borrowing conditions, MAC clauses, etc.) ▪ Speculative Grade Liquidity (SGL) framework (for sub-investment grade companies): ▪ Internal sources ▪ External sources ▪ Covenant compliance ▪ Alternative sources ▪ It is quite common for rating agencies to assume a shock scenario with no market access over the liquidity period horizon ▪ This is quite unrealistically severe for very highly rated companies which have never lost market access for more than a few weeks ▪ Doing it that way helps ensuring that an automatic access to the market is not assumed (and it helps to ensure that a similar approach is used among peers) Source: Moody’s Ratings 44 LRA: simplified example of S&U ESTIMATED SOURCES ESTIMATED USES Cash ST debt + marketable securities + Maturing LT debt = Total cash & cash equivalents (1) = Total maturing debt (3) FFO Dividends - Change in WC + Share repurchases - Capex = Shareholder payments (4) - Acquisitions / M&A = Operational cash (2) (1) + (2) = Estimated sources (3) + (4) = Estimated uses 45 LRA: other factors to consider A qualitative assessment is also done: ▪ Potential variability or seasonality in FCF generation ▪ Assessment of the reliability of committed credit facilities ▪ Size and maturity ▪ If information on the documentation available: financial covenants and other funding-inhibiting language ▪ Availability timing (how fast can the cash be provided) ▪ Banking relationships ▪ Risk for unexpected use of cash ▪ Potential to raise cash from additional sources (e.g. sales of assets / securitization, debt or equity issuance) ▪ Discretion in using the cash outflows (e.g. capital allocation strategy) Sources: Moody’s Ratings 46 LRA: outcome ▪ The outcome of this analysis is a score (Excellent, Good, Adequate) ▪ This is the base case, but in some cases, the agencies could also do some stress scenarios (e.g. decrease in activity in some BU, higher change in WC, etc.) ▪ Projected shortfall of sources vs uses does not necessarily mean liquidity weakness as an issuer can also take timely action to address any shortfall. It is therefore possible that it will have no rating impact (unless the CRA sees the issuer’s approach as being risky relative to similarly rated peer companies, looking notably at financial policy) ▪ This is an assessment of the likely capacity of issuers to meat short-term obligations on a timely basis, but this analysis does not produce ratings or align with rating levels. Ratings are unlikely to be affected by this assessment of liquidity risk unless there is some substantial liquidity weakness that the CRA does not believe will be remedied quickly, aggressive financial policy vs rated peers. On the other hand, strong liquidity is unlikely to be a rating differentiator for IG companies but becomes increasingly meaningful lower in the rating scale Sources: Moody’s Ratings 47 SGL: general overview ▪ Framework to assess the relative ability of an issuer to generate cash from internal and external sources of committed financing, in relation to cash uses over the next 4 quarters ▪ As per the previous framework, there is no mechanical connection between SGL and debt ratings ▪ There is also no mechanical connection between individual factors from the SGL framework and the final SGL score (some factors may be emphasized depending on the agency’s opinion of key liquidity drivers for a given company at a certain point in time) ▪ Assumption of business as usual (difference with LRA; assumes that the issuer is willing to meet its obligations and does not incorporate M&A activity unless publicly stated) ▪ But assumption of no reliance on non-controlling items (does not anticipate renewal of maturities and covenant amendments) ▪ 4 components: ▪ Internal sources: ability to cover basic cash requirements from cash and cash flow from operations ▪ External sources: reliance on, and size of, available loan commitments ▪ Covenant compliance: elements of conditionality, including covenant cushion and likelihood of compliance ▪ Alternate liquidity: other sources of liquidity, such as asset sales or the presence of unencumbered assets that may be used to secure new external financing Sources: Moody’s Ratings 48 SGL: assessment of internal sources Sources: Moody’s Ratings 49 SGL: assessment of external sources Sources: Moody’s Ratings 50 SGL: assessment of covenant compliance Sources: Moody’s Ratings 51 SGL: assessment of alternate liquidity Sources: Moody’s Ratings 52 SGL: outcome SGL-1: Very good liquidity ▪ Issuers with a very good liquidity are most likely to have the capacity to meet their obligations over the coming 12 months through internal resources without relying on external sources of committed financing SGL-2: Good liquidity ▪ Issuers rated SGL-2 possess good liquidity. They are likely to meet their obligations over the coming 12 months through internal resources but may rely on external sources of committed financing. The issuer’s ability to access committed financing is highly likely based on Moody’s evaluation of near-term covenant compliance. SGL-3: Adequate liquidity ▪ Issuers rated SGL-3 possess adequate liquidity. They are expected to rely on external sources of committed financing. Based on its evaluation of near-term covenant compliance, Moody’s believes there is only a modest cushion, and the issuer may require covenant relief to maintain orderly access to funding lines SGL-4: Weak liquidity ▪ Issuers rated SGL-4 possess weak liquidity. They rely on external sources of financing and the availability of that financing is, in Moody’s opinion, highly uncertain Sources: Moody’s Ratings 53 SGL: internal sources example 1 In €m Q3 2024 Q4 2024 Q1 2025 Q2 2025 LTM Q2’25 EBITDA - Cash interest - Cash taxes - Change in WC - Cash dividends - Maintenance capex +- Scheduled debt maturities = CF after basic cash obligations Cash at the beginning of the period + CF after basic cash obligations = Cash at the end of the period 54 SGL: internal sources example 1 In €m Q3 2024 Q4 2024 Q1 2025 Q2 2025 LTM Q2’25 EBITDA 108 51 132 116 407 - Cash interest (11) (10) (9) (9) (40) - Cash taxes (20) (20) - Change in WC 10 16 (23) 7 9 - Cash dividends (70) (70) - Maintenance capex (20) (20) (20) (20) (80) +- Scheduled debt maturities (60) (60) = CF after basic cash obligations 27 37 79 3 147 Cash at the beginning of the period 15 42 79 159 15 + CF after basic cash obligations 27 37 79 3 147 = Cash at the end of the period 42 79 159 162 162 55 SGL: internal sources example 2 In €m Q1 2025 Q2 2025 Q3 2025 Q4 2025 LTM Q4’25 EBITDA - Cash interest - Cash taxes - Change in WC - Cash dividends - Maintenance capex +- Scheduled debt maturities = CF after basic cash obligations - Project-based capex - Investments in subsidiaries and JVs = CF before extraordinary items - Extraordinary capex - Share repurchases = Internally generated CF Cash at the beginning of the period + Internally generated CF = Cash at the end of the period 56 SGL: internal sources example 2 In €m Q1 2025 Q2 2025 Q3 2025 Q4 2025 LTM Q4’25 EBITDA 80 85 90 80 335 - Cash interest (25) (25) (25) (25) (100) - Cash taxes (10) (10) - Change in WC 5 (5) (5) (5) - Cash dividends (10) (10) (10) (10) (40) - Maintenance capex (20) (20) (20) (20) (80) +- Scheduled debt maturities = CF after basic cash obligations 30 15 30 25 100 - Project-based capex (30) (50) (60) (40) (180) - Investments in subsidiaries and JVs (10) = CF before extraordinary items 0 (35) (40) (15) (90) - Extraordinary capex (40) (40) - Share repurchases = Internally generated CF 0 (35) (80) (15) (130) Cash at the beginning of the period 40 40 5 (75) 40 + Internally generated CF 0 (35) (80) (15) (130) = Cash at the end of the period 40 5 (75) (90) (90) 57 5. Financial adjustments (example of Moody’s) 58 Why do rating agencies adjust financial metrics? ▪ The rating agencies adjust reported financial statements to better reflect the underlying economics of transactions and events and to improve the comparability of financial data. They calculate credit-relevant ratios using adjusted data and consider these ratios when determining ratings. Example of Moody’s ▪ For instance, Moody’s adjustments do not imply that a financial institution’s financial statements fail to comply with applicable accounting rules. Their goal is to enhance the analytical value of financial data for credit analysis. ▪ Moody’s recognizes that achieving full comparability of financial statements on a global basis is impossible due to different measurement, recognition, presentation and disclosure practices that exist within and across various countries, regions and accounting regimes. However, where their key metrics may be significantly affected by different accounting treatments that are generally well disclosed, they make adjustments to improve the quality and comparability of the data. ▪ Certain adjustments are considered standard adjustments by Moody’s and are designed to encapsulate adjustments across all nonfinancial corporates, where applicable and where disclosure permits. In addition to the standard adjustments, Moody’s may also make non-standard adjustments to financial statements for other matters to better reflect underlying economics and improve comparability with peer companies. Non-standard adjustments tend to involve a higher degree of analytic judgment. ▪ Moody’s may not make standard or non-standard adjustments that would apply to a non-financial corporation in situations where the amounts involved are immaterial. ▪ Link to Moody’s Rating Methodology on financial statement adjustments for nonfinancial corporates Sources: Moody’s Ratings 59 6. Case study 60