It is the prerogative of a company due to business or other considerations as to how it will carry out its business operations. It may prefer to carry out its business as a single legal entity or through various separate entities. These separate entities may be subsidiary companies, associate companies and/or joint ventures. In India, companies have resorted to complex structures while entering into new markets, new geographical territories and so on. Many acquisitions have taken place through special purpose vehicles as well. In case the main company carries out its operations through various separate entities, the mode of operation and the business synergy may be varied. These entities may be in the same line of business as the parent in or few of them may be in the similar line of business with strong/limited operational synergy or without any synergy. Even if the subsidiary companies/associate companies/joint venture entities are having operational synergy among themselves and with the parent company, each entity’s strategic importance in the group and standing & stature may be different.
This paper contains the modality & approach of Infomerics in evaluating an entitiy’s financial profile, after taking due cognisance of the aforesaid factors. At the outset, Infomerics analyses the financials of the entity on a standalone basis to get a perspective of the financial risk profile of the entity concerned. Thereafter, it is necessary to analyse the consolidated financials togetherwith the standalone financials to take a holistic approach. There are instances where a company prefers to isolate its cash flows from those of the new venture and does ring fencing. As there is no sufficient clarity about the obligation of the parent company and there may be possibilities of implications of inter-company transactions on parent company’s financials, it becomes necessary to take an overall view. At times, the parent company acts as a holding company only and the company being rated may be the major company of the group. In such a case, the evaluation of the consolidated financials do not bring much on the table; but even then the evaluation needs to be done. The evaluation of consolidated financials assumes strong significance where there are inter-group transactions for operational linkages or otherwise because the consolidated financials present an overall financial position of the parent and all its group companies as a single economic entity. Infomerics also considers the potential business synergy and the expected fund flows within the group. So what Infomerics considers important is the underlying business & operational linkages which may not always be substantiated through the percentage of equity holding and the entire financial analysis rests on that. Given the above, many a times the rating decisions are based on consolidated financials, among others; while sometime the consolidated financials throw lights over the overall financial position. Needless to make a mention here that the Consolidated financials portrays a meaningful picture of the overall operation & financials such as profitability, debt level & debt mix, resource pattern and asset base of the group. Therefore, in the evaluation process, depending on the significance, approach followed is that of rating the parent as a single economic unit with all subsidiaries, associates and JVs being its various departments.
For the purpose of consolidation, there are three prevalent methods such as, Pooling of Interest Method, Equity Method and Purchase Method, being used depending on the purpose of consolidation and the appropriateness. Infomerics follows Pooling of Interests method to assess the overall financial risk profile of the group and analyse the implications thereof on the company being rated. The Pooling of Interest method cancels out all inter-company assets, liabilities, investments, equity, revenue and expenses for the purpose of consolidation. Under this method, the overall picture of the economic resources under the control of the parent company, its overall obligations and profitability are seen. Infomerics, in line with the IND AS 110, considers control as the basis for consolidation. For this purpose, an investor has control when it is has rights to variable returns from its involvement with the investee, and has the ability to affect the returns, and must present consolidated financial statements, in which assets, liabilities, equity, income, expenses, and cash flow of the parent and subsidiaries are presented as those of a single economic entity. Infomerics believes that the necessity or willingness of one group entity to extend support to another is triggered by the business linkage. Even in a situation where the company being rated is having no major equity stake in a group company, the consolidation is highly necessary if there are inter-group transactions involving cash flow implications. In a situation where the parent company has a significant equity holding in a group company, but there is no business linkage, the necessity of consolidation is inferred from the possibility & extent of cash flow transactions.
Infomerics consolidates all subsidiaries except where the subsidiary does not operate in the same business or sector as the parent and where the activity of the subsidiary is clearly insulated & ring-fenced and where there is no possible/potential cash flow support to the subsidiary. If the subsidiary and parent operate in different sectors, a capital allocation approach is used to determine the rating. In case of a finance subsidiary of a manufacturing parent or an insurance subsidiary of a bank, Infomerics may notch up the rating of the unconsolidated subsidiary on account of a stronger parent. Under this approach, some capital assessed for the level of parent support envisaged is deducted from the parent company’s networth and is allocated to the unconsolidated subsidiary. In this process, the rating of the subsidiary company gets improved. The obvious implication for the same for the purpose of rating of parent company gets captured through deduction from its networth as mentioned above.
The relationship between the parent entity and the group company is evaluated mainly on the basis of the extent and likelihood of support from the parent to the group companies. This evaluation depends on many factors like the strategic & economic importance of the group company in the group, the extent of shareholding of the parent in the group company, the nature of management control in the group company by the parent, parent’s track record in extending support to the group company, the possibility of using the cash flow of one by the other and the common logo and/or group name indicating strong bondage. For this purpose, the following factors are looked at:
Exposure of the parent company to the group company in the context of parent company’s networth;
Strategic importance of the group company in the group in terms of business linkage and current & future financial return;
The possibility of cash flow movement among the entities;
Whether any Letter of Guarantee and/or Letter of Comfort has been extended by the parent company to the lenders of group company as a matter of credit enhancement?
Past track record of the parent extending support to the group company in times eventualities;
Extent of shareholding;
Whether any common group name and/or logo is being used to exhibit the bondage?
Infomerics evaluates the impact of group companies on the business and financial risk profile of the parent company being rated. It generally consolidates all subsidiaries of the rated entity through the pooling of interests method for a clear representation of the parent’s operations and liabilities. If a subsidiary company operates in a different sector than the parent or if its operations are explicitly separated and ring-fenced, Infomerics prefers not to consolidate the business and financial risk profiles. However, potential support from the parent to the group company may be considered depending on the extent of linkages.
In evaluating the credit worthiness of a company/entity, the direct and/or tacit support of the group it belongs to or of the parent company assumes significance. While carrying out the credit rating exercise, Infomerics tries to derive comfort from such support, which may be likely, after considering many factors including the demonstrated support in the past. Actually this support goes a long way for the subsidiary/associate/joint venture company in meeting its debt obligation in times of stress. This is more so only when the parent company and/or the group has stronger financials and net cash flow availability.
In case of group support, Infomerics considers large groups with operations in many segments and have complicated shareholding structure. Such groups leverage their brand reputation in raising resources. Most companies in the group may be listed and each will have a professional management and an independent board. But the promoters exercise control over companies in the group, retaining a sizeable stake. In this context, it is important to identify the companies comprising the group. The overall credit profile of the group is evaluated considering the fundamental strength, business model, industry sensitivity and the managerial quality of the major entities of the group.
Infomerics’ attempt is aimed at exploring the possibilities of notching up the credit rating of the subsidiary/associate/joint venture company based on the aforesaid support. Besides the demonstrated support extended by the parent/group in the past, as highlighted above, the other factors considered by Infomerics are moral obligation of the parent/group, stature & standing of the parent/group, strategic position of the company in the group / to the parent company, the commercial benefits to the parent and/or to the group at large due to such association.
Let us discuss below the aforesaid factors in seriatim:
(i) Demonstrated support extended by the parent/group in the past to the company being rated
The support by the parent company and/or by the group may be continuous or situation specific. The parent/group extends support operationally or financially or managerial and on sustained basis or sporadically, as and when the need arises. Operational support may be by way of forward integration, backward integration, marketing support, technology support or infrastructure sharing. Financial support can be by way of infusing equity, extending loans/advances on softer terms, using group or parent’s strength in raising money and/or extending corporate guarantee for raising money. Managerial support may be in the form of sharing services in the areas of corporate finance, legal, representation of eminent people of the parent’s Board in the company being rated. Infomerics also tries to view as to whether this support is on regular basis or in case of eventualities. Prima facie, the operational support is generally on sustained basis; while the financial support may be regular in nature or situation specific.
(ii) Moral obligation of the parent/group
In India, there are groups or companies which are so reputed and have established credentials over decades that association of their name with a company even tacitly imparts high level of comforts to all the counter-parties, including the lender community. While this speaks well for the parent/group, circumstantially it casts a significant obligation on the parent/group to ensure that their images are not adversely impacted due to any deficiency on the part of the subsidiary/associate/joint venture company. This is more so in case of honouring financial obligations such as, vendors payment, payment of statutory liabilities, employee payment and debt servicing, besides all sorts of contractual non-financial obligations. Extent of management control and shared name also reflect the moral obligation of the parent company/group.
(iii) Stature & standing of the group/parent
While the support of the group and/or parent company assumes considerable significance in assessing the creditworthiness of the subsidiary/associate/joint venture company, the weightage on such support also depends on the stature & standing of the group/parent. More precisely, all parent companies/groups cannot command the similar level of acceptability from the market. A listed company or a company accessing capital market frequently has a more obligation to extend support to its group companies.
(iv) Strategic position of the company being rated
A large group has many companies in its portfolio and those may be involved diversified activities. Each company in the group is differently placed in terms of its nature of operations, business model, individual financial strength, scenario & outlook of the industry in which the company operates and past track record. All these determine the strategic position/importance of such company in the group / to the parent company and hence, the support flows accordingly. For captive finance companies, the extent of parent’s business being funded by the captive finance company reflects the level of strategic importance. More candidly, all companies in the same group may not get similar level of support from the group/parent.
(v) Commercial/economic benefits to the parent and/or to the group for a particular subsidiary/associate/joint venture company
While the commercial benefits accruing to the parent and/or to the group for a particular company also determines the strategic position of the latter, this factor also plays a significant role in imparting parent/group support. Apart from other factors, if the parent/group feels that extending support to a particular subsidiary/associate/joint venture company is a matter of high level of financial gain in the ensuing years, then the former tries to protect such objective in a reasonable manner. Further, the propensity of the parent company to support a profitable group company in times of stress is generally more, as compared to a loss making entity, to protect decline in economic value of its investment. Extent of parent holding, both current & future, also indicates parent’s level of commitment.
From Infomerics’ perspective, the parent/group support is relevant for credit rating of debt programme of the subsidiary/associate/joint venture company if there is a case of notching up of such credit rating. Infomerics believes that such notching up may be possible only when the parent’s credit rating is stronger than the standalone rating of the subsidiary/associate/joint venture company or when the overall standing of the group is explicitly/implicitly much superior than that of the company being rated. But this notching-up approach is a two-way traffic in the sense that when the credit rating of subsidiary/associate is notched up due to parent support, there is a likely impact on parent company’s credit quality for extending such support. This notching up is not certain and depends on a case to case basis as in case of a independent special purpose vehicles (SPVs), parent company/group support from parent may be limited in meeting debt obligations and hence, is the impact on credit rating. Further, the notching-up approach is applied only when there is no corporate guarantee from the parent. If the debt instrument of a company being rated is unconditionally and irrevocably guaranteed by the parent, and backed by a ring fenced payment mechanism, the rating of the guaranteed instrument is equated with the parent’s rating and rating so assigned carries a suffix ‘SO’ (Structured Obligation).
The ultimate rating of the subsidiary/associate/joint venture company depends upon three factors such as, the standalone rating of the company being rated, the rating of the parent company and to what extent the notch-up is feasible. While the standalone rating is an assessment of the company being rated without factoring parent company support, the parent company rating is after factoring the support being extended by the parent to the company being rated. The extent of notch-up shall depend on five factors mentioned above with the premises as to whether the linkage between the subsidiary/associate company are strong, moderate or weak. In case of strong linkage, the rating of the subsidiary/associate company is made equal to that of the parent. If it is weak, no notching up is done. If the linkage is moderate, then the rating of the subsidiary becomes somewhere between the rating of the subsidiary/associate company and the rating of parent company. However, if support is expected from a number of companies in the group, then it would be difficult to identify a single company for the purpose of measuring support. This causes uncertainty regarding the extent and timeliness of support. Hence, the notch-up gets restricted in such cases.
In case of a joint venture where two or more sponsors have equal shareholding, Infomerics factors the credit worthiness of the sponsor if it provides a written undertaking to provide distress support in servicing the entire/substantial portion of the debt obligation of the joint venture company.
RATING METHODOLOGY FOR GOVERNMENT SUPPORT
The stand-alone rating of government owned entities (GOEs) may be altered by Infomerics based on the extent and probability of support that the government can provide to them. GOEs are generally classified into four categories based on their role and the wider implications that their probable default can have on the government.
Importance in Government policy
Infomerics assesses the importance of a particular GOE in broad policy ambit of the Government. It is assessed through the following factors:
Default and its fallout
The potential fallout of default by a GOE is assessed through the following factors:
Based on the above criteria, Infomerics classifies GOEs into four different categories:
Default Recognition & Post-Default Curing Period
ProposedDefinition of Default
Fund-basedfacilities & Facilities with pre-defined repayment schedule
Adelay of 1 day even of 1 rupee (of principal or interest) from thescheduled repayment date.
WorkingCapital Term Loan
WorkingCapital Demand Loan (WCDL)
Certificateof Deposits (CD)/Fixed Deposits (FD)
PackingCredit (pre-shipment credit)
Overdue/unpaidfor more than 30 days.
Continuouslyoverdrawn for more than 30 days.
BillPurchase/Bill discounting/Foreign bill discounting/Negotiation(BP/BD/FBP/FBDN)
Overdue/unpaidfor more than 30 days.
Fund-basedfacilities & No Pre Defined Repayment Schedule
Continuouslyoverdrawn for more than 30 days.
Continuouslyoverdrawn for more than 30 days.
Letterof credit (LC)
Overduefor more than 30 days from the day of devolvement
Amountremaining unpaid from 30 days from invocation of the facility
Whenrated instrument is rescheduled:
Non-servicingof the debt (principal as well as interest) as per the existingrepayment terms in anticipation of a favourable response from thebanks of accepting their restructuring application/ proposal shallbe considered as a default.
90Days for Default to Speculative Grade and 365 days for Default toInvestment Grade.
Forbank loan ratings, default recognition shall be in line with the RBIguidelines.
Criteria – Complexity Level of Rated Instruments/Facilities
The level of complexity of a debt instrument and/or a debt facility plays a very pivotal role for the various associated parties like, investor/lender, market intermediary and regulatory bodies. It is important for the investor/lender to rightly understand & evaluate the terms & conditions and covenants of each debt instrument/facility, more particularly for innovative ones before deciding on any financial exposure, given the series of developments taken place in the financial market. It may not necessarily be perceived that a debt instrument and/or a debt facility with relatively more complexities has more credit risks; however, all associated parties need to know the level of complexities to take the appropriate call. It may so happen that a simple type of debt instrument/facility may have higher credit risk vis-a- vis the complex one. Keeping the aforesaid in view, Infomerics has classified debt instrument/facility based on complexity to facilitate the investor/lender to take the most informed decision. Infomerics believes that this classification will help the intermediaries to identify the right investor, based on level of complexity. This will also enable all the concerned regulatory bodies to guide the major investors in debt instruments (like insurance companies, provident funds, pension funds, etc.).
For this classification, Infomerics has considered four parameters such as, Premature Redemption, Number of Parties Involved in the Transaction, Certainty of Return and Familiarity of Financial Market with the Debt Instrument/Facility. The aforesaid parameters are elaborated below:
(i) Premature Redemption
Usual debt instruments generally do not have any options and hence, there is no reinvestment risk. But certain bonds/debentures, being in the deep discounting nature, have multiple put/call options. Investors for such instruments should be aware of the same so that they should be prepared for the event of issuer exercising the call option and the consequential reinvestment risk.
(ii) Number of Counterparties Involved in the Transaction
Number of counter- parties involved in a transaction is very important as that has a bearing in understanding/evaluating debt instrument/facility. If the debt instrument/facility is guaranteed, then there is a need to understand the implication of creditworthiness of the guarantor as well, besides the issuer/borrower. The guarantor may be one or more and the nature of guarantee may be full or partial and may be conditional/unconditional.
(iii) Certainty of Return
In case of debt instrument/facility carrying fixed interest rate, there is adequate certainty of receiving the interest on due date. This is so in case of fixed deposits, vanilla type of debentures and fixed rate of loans. However, in case of floating rate paper/debt facility, scenario is different. The rate becomes floating when it is linked to some benchmark rate. Hence, the investor/lender should be fully conversant with the nature of interest rate.
(iv) Familiarity of Financial Market with the Debt Instrument/Facility
The financial market needs to be familiar with the debt instrument per se. Certain debt instruments like non-convertible debentures, fixed deposits, commercial paper are, by and large, known to the market. However, with the gradual developments taken place in the market over the years, there are many sophisticated instruments have come in. Those are Pass Through Certificate (PTC), Perpetual Bond, etc. It is therefore necessary for the investors to
become familiar with the pros and cons of such debt instruments.
Based on the above parameters, to the extent applicable, debt instruments/facilities have been classified in three categories: (a) Simple, (ii) Complex and (iii) Highly Complex.
(a) Debt instruments/facilities are classified as Simple when the same carries a fixed rate of interest, there is a pre-specified tenure, there is one counterparty and there is no prepayment risk. Generally, the market is quite conversant with this type of instrument/facility.
(b) Debt instruments/facilities are classified as Complex when the same carries a floating rate of interest, there is a prepayment risk, tenure may be pre-specified but subject to conditions and the number of counterparties may be more than one. The market may be conversant with this type of debt instrument/facility to a limited extent.
(c) Debt instruments/facilities are classified as Highly Complex when the same carries a floating rate of interest, the maturity profile is varied, there is a prepayment risk and the number of counterparties is more than one. Market is generally not conversant with this type of instrument.
Benefits of Classification
For investor/lender – The aforesaid classification is likely to help the investor/lender to understand the nature of instrument/facility and the level of complexities of the structure.
For Intermediaries - This classification is expected to enable the intermediaries to identify the right investor & target accordingly, based on the level of complexity.
For Regulatory Bodies - This classification may help all the concerned regulatory bodies to prescribe investment criteria for the major investors (like insurance companies, provident funds, pension funds, etc.).