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Investment Company Ratings
This summary of Capital Intelligence's (CI) methodology on rating investment companies describes the analytical criteria important in assigning corporate ratings to complex, diversified non-bank financial entities and groups. CI currently rates a significant number of companies which exhibit a diverse mix of financial service operations and which do not fit easily into the traditional categories normally encountered by rating agencies. These entities, in many cases, form part of larger financial groups or are characterised by ownership structures that include a dispersed range of institutional shareholders. The scope of their operations encompasses such wide-ranging non-bank financial services as investment banking, broker-dealer operations, securities trading (client and proprietary), asset management, merchant banking, real estate and consumer finance. The growing presence of Islamic financial instruments and institutions brings added complexity.
CI has developed a specific methodology for assessing the overall creditworthiness of investment companies these entities. The framework we use looks first at the external and internal factors that affect creditworthiness and then at the relationship between a parent and subsidiary. It is important to note, however, that the criteria and analytical procedures contained in this summary may not necessarily apply to all investment companies.
1. External Factors - The external factors that can affect company creditworthiness include what may be termed "market related risks" and cover areas such as the economy, its stability and cyclicality, as well as the political risks inherent in the market from government policies. The extent to which capital markets are mature and the role of the regulatory regime are also considered. This includes a review of current regulatory practices and how they might affect the control of cash flows between entities, restrictions on balance sheets regarding capital requirements, the state of applicable bankruptcy laws and any restraints which may be placed on legal structures. Other key areas in this regard deal with how regulatory bodies respond to market abuse and how transparency is promoted and protected. The culture and legal structure of litigation is also assessed by reviewing historical practices. Finally, it is important to gauge the pace of technological change within the investment industry and the extent to which this provides opportunities or creates obstacles for potential entrants to the market.
2. Internal Factors - The internal factors are company specific and focus on measuring business risk as revealed through the assessment of the firm's management quality, product and market profile, risk policy/management and the financial policy and profile of the company.
Management Assessment - As part of its assessment of management quality, CI looks at the organisational structure of the company, the extent to which departmental functions and responsibilities are clearly defined, and the relationship between the management team and the company's parent or shareholders. In addition, the company's strategy and investment decision-making process are analysed along with its process for defining and implementing those strategies compared to its stated investment goals. The role of its internal support structures is an important factor for review, as is its risk management procedures and guidelines for both regulatory and internal compliance. Finally, governance issues are explored, including an assessment of how effective management is in resolving any conflicting pressures between shareholders and management.
Product & Market Profile - CI evaluates the degree of diversification of the firm's product mix, client base, and assets. The breadth and diversification of a firm's products and services contribute to the growth, reliability, and diversity of earnings while potentially diminishing the firm's exposure to the risk of loss in assets, whether under management or within its own book. At the same time, the firm's product and customer mix influence the firm's profitability. In general, the more diversified the firm's activities, the lower the risk profile. However, it is also important to assess whether diversification places undue stress on the company because of inadequate support structures, knowledge, experience or the absence of suitable market access in order to take full advantage of the expected benefits of that diversification.
Risk Policy & Management - An investment firm's risk appetite and its ability to control these risks are important rating considerations. CI assesses a company's ability to identify the various market risks that are inherent in its business, and to implement systems for reporting and managing those risks, particularly in terms of oversight and compliance.
There are various forms of risk that could impact the quality of a firm's assets and earnings. These include:
- interest risk for earnings sensitive to interest rate movements;
- credit risk for earnings that are sensitive to default;
- liquidity risk, where the absence of market liquidity could impair earnings;
- concentration risk stemming from non-diversified assets;
- extension risk associated with investments that have the potential for early pre-payment;
- derivatives risk, where speculative hedging is improperly used or understood;
- currency risk, where earnings and assets are exposed to unanticipated movements in foreign currency exchange.
All these risks play an important role in the firm's ability to sustain its earnings flow, maintain its financial strength and, ultimately, to service its debt.
How an investment business defines, measures, monitors and controls its risk is very important. CI examines the extent to which the company's risk management unit is truly independent from the trading or other revenue-producing areas of the firm as well as the effectiveness of the systems in place to manage those risks.
Financial Policy & Profile - CI reviews the firm's overall financial profile and the policies it employs to maintain and grow its financial capacity. The assessment of financial fundamentals considers not only the current financial status of the company but also trends in earnings, including cash flow and profitability, asset quality, and capital adequacy. Certain financial ratios are often used in assessing investment management firms, but it should be noted that no single ratio holds more weight than any other, but rather, the entire financial profile of an institution should be taken into consideration.
The most important aspect of a firm's long-term creditworthiness is its ability to sustain profits. Consistent profitability provides not only steady and predictable cash flow to service debt requirements, but also forms capital to support growth. Profits have to cover operating expenses, debt service and credit losses, where financing operations exist, and they must also provide a source of capital for future growth. Strong and predictable earnings generate confidence among investors, which helps companies to secure continuous access to equity and to the debt market.
The principal areas of focus are in identifying the main sources of earnings, the sustainability of those earnings and the firm's cost structure. The current and cash component of those earnings are also assessed, as they may impact future liquidity. An investment management firm's earnings power is determined largely by the level and mix of assets held for trade, dividends from portfolio companies, and assets under management. With most revenues closely tied to the levels of assets held for sale and assets under management, profitability is sensitive to changes in market values and net sales. It is important to identify the proportion of pre-tax earnings derived from less-cyclical activities, such as fee income from management services, and their level in relation to fixed or total costs. The underlying assets that generate those earnings are also carefully assessed in terms of their quality. The quality of those assets, particularly where principal assets are held for investment and trading, are analysed to determine their nature, true value and marketability. It is important to ascertain the quality and quantity of its dividend income, the value and liquidity of assets held for sale, its revenue mix by assets under management and relevant growth projections, and finally, the firm's track record. Any future projections should undergo sensitivity analysis to assess the likely impact by varying economic and market conditions.
The firm's capital adequacy is also addressed. Although important as a measure of solvency and an indication of the firm's ability to withstand temporary distress, capital adequacy ratios are not sufficient proxies for creditworthiness. In the case of investment companies, liquidity is, by far, the key financial measure and a lack of liquidity is often behind a firm's failure. Determining the level of liquidity within a company involves, inter alia, analysing both the maturity profile of the firm's debt relative to its assets and the characteristics of its funding sources, as well as identifying committed bank lines and gauging the amount of unencumbered assets available.
3. Parent/Subsidiary Risk - Critical issues arise when rated entities are part of large diversified groups or where the rating of the group, as a whole, is important. There are two basic approaches to analysing and rating complex groups: the top-down (enterprise) approach and the bottom-up (building block) approach. Determining the economic incentive of a parent to support a subsidiary under stress is common to both. Given a strong economic incentive or an assessment that a subsidiary is of strategic importance to the group, the rating of a weak subsidiary can benefit from the financial strength of its parent. Conversely, a parent company's debt rating could be impaired by a weak subsidiary.
The principal factors that influence a parent's decision to support an ailing subsidiary include the state of the parent's financial health, the relative size of the investment at risk, the amount of control exerted by the parent, and the reputation risk from should the subsidiary fail.