Download DBRS Recovery Ratings for Non-Investment Grade

DBRS Criteria
DBRS Recovery Ratings for
Non-Investment Grade Corporate Issuers
february 2015
previous release: march 2014
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DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers
February 2015
DBRS Recovery Ratings for Non-Investment Grade
Corporate Issuers
TABLE OF CONTENTS
Scope and Limitations
4
Introduction 4
Issuer Ratings, Recovery Ratings and Instrument Ratings
4
Recovery Rating Process 5
Determination of a Path to Default Scenario
5
Valuation of the Issuer upon Emergence from Default
6
Determination of Claims Against the Defaulted Entity
7
Distribution of Value from the Defaulted Entity
8
Assignment of a Recovery Rating and Notching of the Issuer Rating to Determine a
Final Instrument Rating
Ongoing Monitoring
Appendix: Considerations When Evaluating Security
8
10
11
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February 2015
Scope and Limitations
This criteria outlines the current DBRS approach for recovery ratings that are assigned to specific instruments for corporate non-investment-grade issuers. The methods described herein may not be applicable
in all cases; the considerations outlined in DBRS methodologies are not exhaustive and the relative importance of any specific consideration can vary by issuer. Further, this methodology is meant to provide
guidance regarding the DBRS methods used in the sector and should not be interpreted with formulaic
inflexibility, but understood in the context of the dynamic environment in which it is intended to be
applied.
Introduction
• This recovery rating criteria applies only to specific instruments issued by corporate non-investment-grade
issuers; in other words, those issuers with a DBRS issuer rating of BB (high) or lower. DBRS assigns
recovery ratings to instruments of non-investment-grade issuers because non-investment-grade bonds
have a greater likelihood of default, investors have a greater interest in the outcome of a potential
default scenario and an assumed default scenario can be more reliably constructed. This criteria is not
applicable to areas related to ratings on public finance (government and infrastructure) or financial
institutions.
• DBRS does not assign recovery ratings to preferred share securities that are by definition low recovery
instruments (equivalent to RR6, if DBRS were to assign a recovery rating). In addition, recovery ratings
are not used for commercial paper or short-term instruments, which by definition have shorter maturity
durations and a higher reliance on liquidity considerations.
• The recovery rating criteria herein assumes the issuer’s host country supports creditor rights in a manner
broadly consistent with that of a U.S. or Canadian jurisdiction. If not, different criteria may apply.
• While the underlying security impacted by a recovery rating will have a rating trend unless it is on an
under review status, recovery ratings themselves have no trends and are not placed under review.
• In most cases, a recovery rating will not be maintained for very long on a security that has gone to
Default or Selective Default. (For definitions of these terms see “Default Definition” at www.dbrs.com.)
Issuer Ratings, Recovery Ratings and Instrument Ratings
Credit risk is a function of an issuer’s probability of default and the loss given default on a specific debt
instrument. For corporate issuers, DBRS addresses these two components of credit risk separately. A
DBRS issuer rating is DBRS’s assessment of the probability that an issuer will default on its debt. A DBRS
recovery rating, on the other hand, considers the value of assets (or enterprise value) that would be available to an investor for a specific debt instrument, in accordance with its ranking and legal rights, at the
time of an assumed emergence from a reorganization or liquidation process that might occur between,
say, six and 18 months after default. A recovery rating necessarily assumes that a default will occur; the
actual probability of default is addressed solely by the issuer rating.
In this recovery rating criteria for corporate non-investment-grade issuers, DBRS draws a distinction
between companies that have issuer ratings of B (high) or lower and companies with issuer ratings in
the BB range. BB-rated issuers are less likely to default than issuers rated B (high) or lower, which makes
it more difficult to construct a scenario for both a path to default and asset or enterprise values at
default. For BB-range issuers, DBRS is more restrictive in terms of the degree of notching uplift it will
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permit between the issuer rating and the recovery rating, lest non-investment-grade issuers have instruments rated well into investment-grade territory. DBRS sets these tougher recovery standards for BB-rated
issuers in order to smooth the rating scale transition between non-investment-grade issuers (whose instruments are subject to this recovery criteria) and investment-grade issuers.
The final instrument rating, determined by notching up or down a certain number of notches from the
issuer rating in accordance with the recovery rating (see the recovery rating table on page 9), essentially
blends the two elements of credit risk — probability of default and loss given default — giving investors
a better indication of the expected performance of a non-investment-grade bond than would be the case
if only the probability of default were considered.
Recovery Rating Process
There are five stages in the determination of a recovery rating and final instrument rating:
(1) Determination of a path to default scenario,
(2) Valuation of the issuer upon emergence from default,
(3) Determination of claims against the defaulted entity,
(4) Distribution of value from the defaulted entity and
(5) Assignment of a recovery rating and notching of the issuer rating to determine a final instrument rating.
DETERMINATION OF A PATH TO DEFAULT SCENARIO
While a non-investment-grade issuer may not default for several years (if ever), a recovery rating necessarily assumes an eventual default. DBRS considers the types of likely issues that may cause the deterioration
in the business and financial risk factors that might ultimately cause its default. This is a logical extension
of the issuer rating analysis, which draws on the industry and specific company knowledge that DBRS
developed as a result of determining an issuer rating. To the extent DBRS analysts use cash flow forecasting in their issuer rating analysis, various factors may be stressed to create realistic (albeit perhaps
somewhat draconian) default simulations that would be considered in the ultimate construction of the
work DBRS does in stressing for recovery. This analysis can also help address the question of whether
the issuer is likely to eventually emerge from this assumed default as a reorganized operating business or
whether it is more likely to be liquidated.
While this analysis should help DBRS understand the specific factors that might cause default, it is,
nonetheless, difficult to predict both how and when a default might actually occur. Negative free cash
flow (i.e., when operations do not generate sufficient cash to pay for debt servicing, operating expenses
or maintenance capital expenditures) is one early warning sign of potential default. In other cases, consideration might be appropriate for situations where an issuer may pre-emptively file for bankruptcy
protection in order to reorganize its capital structure or gain concessions from labour, suppliers or other
stakeholders. In still other cases, an issuer might raise cash, not from operations, but from asset sales or
an equity injection in order to delay default with the hope that any operating challenges it faces are temporary. The timing of default may be very different in each of these scenarios and the ultimate recovery
value can be different as well. An issuer that defaults pre-emptively may be able to prevent further erosion
of asset value and cash flow. On the other hand, when an issuer tries to delay default and only attempts
to reorganize when business conditions reach a crisis point, enterprise value could be substantially lower
than what it might otherwise have been. DBRS notes that there can be a wide variety of different industry
and company factors to consider when determining a path to default scenario.
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VALUATION OF THE ISSUER UPON EMERGENCE FROM DEFAULT
Once an assumed default scenario has been constructed, DBRS then considers the possible value of the
enterprise (if the business is assumed to be sold as a going concern) or the value of specific assets (in,
for example, the case of an assumed liquidation). DBRS may use one or more of the following methods, as
appropriate, in estimating the enterprise value of an issuer or its assets upon emergence from default. In most
cases, the first approach below (1) would be used. In certain other cases, one of methods (2) or (3) would be more
appropriate. A hybrid approach may also be possible, for example, where certain more marketable operating units
are valued on a going concern basis and other assets are valued on a liquidation basis.
DBRS strives to perform valuations that are conservative and can be maintained over a reasonable time
horizon. Nonetheless, value at the time of default is unlikely to be the same as those valuations at the
time of analysis. While DBRS periodically updates its recovery analysis, the path to default scenario and
accompanying valuations at default would not typically be expected to change significantly year over
year, absent any special factors.
(1) Enterprise valuation (EV) using a multiple of EBITDA approach
In this method, enterprise value would be equal to a forecast baseline annual EBITDA times an appropriate
(stressed) multiple of EBITDA. DBRS typically applies this approach to issuers expected to be reorganized
or sold as ongoing businesses after emergence from default, as opposed to issuers that are expected to be
liquidated. Such issuers often have a viable business with a meaningful market position, reasonably efficient operations and established clientele where default may have been triggered by a cyclical downturn
and/or excessive leverage rather than by any long-term fundamental industry or company weakness.
In determining a baseline annual EBITDA, DBRS may consider performance of the issuer across past
business cycles, the outlook for the industry in general and the possibility that the company that emerges
from restructuring may not have the same strengths it had prior to restructuring (such as key personnel,
suppliers or customers).
In determining the appropriate (stressed) multiple to apply to EBITDA, DBRS will generally examine
companies in similar industries with similar market positions as a reference starting point, recognizing
that potential investors will perceive higher risk in purchasing a company emerging from a reorganization
and therefore may only pay a deeply discounted multiple of EBITDA. While this exercise can involve caseby-case assessments of factors specifically relevant to the issuer concerned and DBRS may also consider a
range of worst-case and best-case valuations before settling on a final EV, the ultimate EBITDA multiple
used will in most cases be a low multiple appropriate for this evaluation (i.e., typically not higher than
five times EBITDA). In certain cases, it may be possible to determine enterprise value using a discounted
cash flow approach, in lieu of the multiple of EBITDA approach discussed above.
There can also be cases where EV is believed to be the most appropriate approach, but the industry is one
where EBITDA levels are volatile and can (or have in the past been) negative. In such situations, DBRS
may reach the baseline EBITDA through an average of past year results, which may include the assessment of such years that are clearly outliers, both positive and negative. Given the long time horizon, some
allowance for past changes at the entity may also need to be considered.
(2) Industry-specific valuation approaches
Many industries have their own accepted metrics for valuing specific assets or entire business franchises.
DBRS may assign, for example, a (stressed) value per hotel room, per subscriber or per unit volume of
certain resources (e.g., oil or gas) in accordance with these industry practices. We may use these industryspecific approaches as our primary evaluation method, or in conjunction with either one of methods (1)
or (3).
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February 2015
(3) Liquidation value approach
This approach is appropriate when the issuer is not expected to be reorganized as a going concern, but
is more likely to be liquidated in whole or in part. Asset value estimations might typically be made for
accounts receivable and inventory, specialized plant and equipment, real estate, marketable brands and
trademarks, and so on. In valuing specific assets, DBRS may refer to third-party appraisals, typical bank
loan-to-value advance rates and similar yardsticks, with discounts or reductions as appropriate. Typical
liquidation value percentages (as a percent of book value) are shown in the table below, although DBRS
may use liquidation value percentages outside of these ranges depending upon the nature and location of
the assets. Where possible, the book value of assets to be liquidated will be forecast at the future presumed
time of default, although in practice, the most recent balance sheet, adjusted for items like an assumed
departure of all cash on hand, is a reasonable starting point.
While valuations depend on many factors, the following table illustrates some general starting points and
other considerations in the liquidation analysis.
Asset
Cash
Typical Liquidation Value
Percentages
(as % of book value)
Comments
0%
In a default scenario, this is assumed to be zero.
60%–80%
A moderately higher level may be appropriate if there is a
substantial government or high-quality corporate obligor
concentration.
0%–75%
Within this wide range, a higher or lower percentage may be
appropriate depending upon whether the inventory is readily
saleable commodities versus perishable or illiquid work in
progress, for example.
Property, plant and equipment
25%–50%
A higher percentage may be appropriate. For example, where
the current appraised market value of owned real estate is
significantly higher than book value.
Intangibles, other than goodwill.
0%–50%
Licenses, trademarks, software, etc. are often of limited
value to a third party, although situations vary and there will
be cases where intangibles will be expected to have value to
certain buyers.
0%
Pure accounting goodwill (i.e., the excess of purchase price
over the book value of assets acquired) is typically given no
value in a liquidation scenario.
0%–100%
This could include prepaid expenses, shares in subsidiaries
(for a holding company), etc. whose potential value covers a
very wide range.
Accounts receivable
Inventory
Goodwill
Other Assets
DETERMINATION OF CLAIMS AGAINST THE DEFAULTED ENTITY
Claims against a defaulted entity include debt of various types and, in certain cases where a liquidation
value approach is being used, debt may also include trade payables, contractual obligations of other types
as appropriate (leases, pensions, guarantees, etc.) and taxes. The costs of reorganization or bankruptcy
(legal and trustee fees, for example) are typically not material relative to the size of claims; however, these
may also be considered where appropriate.
Finally, in the liquidation scenario only, where the entity has a sizeable staff and is thus likely to have a
meaningful level of salary payments within payables, DBRS may consider this to be a priority payment
that ranks ahead of debt obligations if this is supported by applicable laws and regulations.
To arrive at the amount of debt or exposure at default, DBRS will assume that committed credit lines are
drawn down in full prior to default, unless it is very clear that drawdown is restricted by the availability
of collateral (perhaps due to a borrowing base or covenant test). Debt that matures prior to the assumed
time of default is generally assumed to be refinanced, although DBRS may foresee failure to refinance this
debt as a possible cause of default.
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DISTRIBUTION OF VALUE FROM THE DEFAULTED ENTITY
In determining how much each class of creditor will likely receive upon emergence of the company from a
reorganization, DBRS generally uses a typical waterfall analysis. A waterfall analysis is essentially a series
of fractions, with one for each debt class, comparing: (1) the value of assets available to pay that debt
class (the numerator), with (2) the amount of that debt class’s claim (the denominator). At the top of the
waterfall, for the highest-priority claims, the numerator may be larger than the denominator, indicating
that there is sufficient value for the claim to be fully paid. As higher priority claims are paid, fewer assets
remain for the next claimant, and so on, down the line of creditors. In creating the waterfall, DBRS takes
the basic claims and security rights of investors as presented, even though the reality of negotiations in
a corporate reorganization are such that junior creditors and even preferred and common shareholders
may obtain greater economic value than what they might otherwise be contractually entitled to obtain, in
order to get the reorganization done. For more detail on how DBRS evaluates collateral security, please
refer to the Appendix.
ASSIGNMENT OF A RECOVERY RATING AND NOTCHING OF THE
ISSUER RATING TO DETERMINE A FINAL INSTRUMENT RATING
As noted above, the anticipated recovery percentage for each debt instrument is arrived at by comparing
the expected amount of value available to a specific debt class to the amount of claims within the debt
class. DBRS will then use the appropriate DBRS recovery rating scale in the following table — the righthand column for issuers rated B (high) and lower and the middle column for BB-range issuers — to assign
a recovery rating to each instrument. The resulting instrument rating reflects the issuer rating notched up
or down by an amount that corresponds to the assigned recovery rating, subject to the limitations and
restrictions for certain cases noted in the footnotes to the table and discussed further below. Note that a
recovery rating of RR1 (and, to a somewhat lesser extent, RR2) is unlikely to be assigned unless DBRS
views a high degree of quality and long-term stability in specific assets and/or an enterprise value that
might arise, for example, from regulatory protection or the presence of high-quality real estate.
DBRS makes a distinction between recovery ratings for issuers rated B (high) or lower and issuers in the
BB range for several reasons. First, the assumed default scenario (i.e., timing and cause of default, as well
as the amount of debt outstanding and the valuation of assets upon emergence from default) is more
difficult to forecast the higher the issuer rating (and therefore the lower the probability of default and
the longer the likely time to default). Second, BB-range issuers are more likely to issue debt or otherwise
reorganize their capital structure, which may involve changes in the granting of security, making forecasting of the final capital structure even more difficult. Third, as a general matter, DBRS will tolerate greater
ratings volatility potential for lower-rated issuers; therefore, our criteria becomes more limited the closer
an issuer gets to investment grade.
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DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers
February 2015
DBRS Recovery Rating,
Anticipated Recovery (%) and
Recovery Description
RR1
100% and above2
Outstanding
Notching Versus Issuer Rating
BB Range Issuers
B (high) and Lower Rated Issuers
+2 notches, if the debt is secured1 and
+3 notches, if the debt is secured, subject
+1 notch, if the debt is secured and the
+1 notch, if the debt is unsecured (i.e.,
the issuer rating is BB (low)
issuer rating is BB or BB (high)
to an instrument rating cap of BB
equivalent to the notching for an RR3)
0 notches, if debt is unsecured (i.e.,
equivalent to the notching for an RR3)
RR2
80% to 100%
Substantial
+1 notch, if the debt is secured, subject
to a cap of BB (high)
0 notches, if the debt is unsecured (i.e.,
equivalent to the notching for an RR3)
+2 notches, if the debt is secured
+1 notch, if the debt is unsecured (i.e.,
equivalent to the notching for an RR3)
RR3
60% to 80%
Good
0 notches
+1 notch
RR4
30% to 60%
Average
0 notches
0 notches
-1 notch
-1 notch◦
-2 notches
-2 notches
RR5
10% to 30%
Below Average
RR6
0% to 10%
Poor
1. In all cases, secured debt refers to a first-lien position. Where a secured position results from a second or more subordinate lien,
DBRS will typically deem such subordinate positions to be no better than an unsecured position, for purposes of determining a recovery
rating.
2. Recovery above 100% means that the asset value available for a particular class of debt is greater than, and in some cases, substantially greater than, the face amount of the debt obligation.
Recovery scale for both BB and B areas
When two instruments would both be notched to the same final rating category, the junior instrument is
typically notched down one additional category to reflect the junior ranking of that instrument.
Recovery scale for issuers rated B (high) or lower (right column)
For issuers rated B (high) or lower, an elevation of three notches above the issuer rating is only appropriate in those cases where the debt is secured. Furthermore, three notches of ratings uplift is only given to
instruments of B-rated issuers or lower; in other words, the final instrument rating for these issuers cannot
exceed BB.
Recovery scale for issuers rated in the BB range (middle column)
For reasons noted above, issuers in the BB range are subject to a more restrictive recovery rating approach.
The BB range is a transitional range between B (high) or lower-rated issuers (who are subject to the full
recovery rating methodology) and investment-grade-rated issuers (who are not subject to any specific
recovery analysis). While DBRS will start with an economic analysis of the value of assets and/or enterprise value of issuers with issuer ratings in the BB range, as it does with issuers rated B (high) or lower,
constructing a likely path to default, capital structure at default, or valuation at default for BB-range
issuers is very subjective.
To compensate for this forecasting difficulty associated with issuers in the BB range, it will be harder for
issuers in this rating category to achieve any ratings uplift at all; only one or two notches of ratings uplift
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DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers
February 2015
(not three) will be permitted. A two-notch rating uplift is only available to those issuers with an issuer
rating of BB (low); in other words, no issuer with an issuer rating in the BB range can have an instrument
rating that exceeds BBB (low). To be clear, for two notches of uplift to be given to instruments of an issuer
with a BB (low) issuer rating, DBRS will expect to see secured debt, forecasted enterprise or asset value
at least equal to (and in most cases, much greater than) the fully drawn debt of that instrument class, as
well as stable asset values that might arise from, for example, regulatory protection or very high-quality
real estate collateral.
ONGOING MONITORING
After assigning a recovery rating, DBRS will continue to monitor the issuer and its debt instruments for
material changes that might affect recovery and other ratings including, for example:
• Changes in the amount of debt outstanding per interim financial statements.
• Changes in debt structure (including bank facilities) or collateral provisions.
• Changes in factors or assumptions that might affect DBRS’s estimates of enterprise value or the value
of assets.
• Changes in the organization (mergers and acquisitions activity, recapitalizations, etc.).
• Changes in intercreditor relationships.
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DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers
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Appendix: Considerations When Evaluating Security
There are a number of potential issues that analysts may consider when evaluating the security provisions
of a specific instrument.
• Overlapping security claims: Often secured lenders will have a security interest in “all assets,” or words
to that effect. This often means “all assets that have not already been pledged to someone else.” It may
also mean “all assets within a certain geographic region or legal jurisdiction, for example, the United
States,” or otherwise cover fewer assets than the total shown on firm’s consolidated financial statements.
Some analytical work may therefore be required to determine what percentage of the company’s assets
and total cash flow is actually represented by the lenders’ collateral security.
• Higher-priority claims: In cases where certain creditors have higher-priority claims on specific assets, an
analyst would have to reduce the estimate of enterprise value available to other creditors to account for
satisfying the claims of the priority creditors first.
• Holding company and structural subordination issues: Each corporate entity can only give a lender a
security interest in assets it actually owns. A holding company generally only owns stock, so a pledge of
all assets from a holding company is only a pledge of the stock in its subsidiaries. For the security interest
to include the operating assets of the company — which is what generates the cash flow — then the pledge
must be from the operating subsidiaries that actually own those assets. For that asset pledge to be enforceable, there generally has to be a guarantee from each of these subsidiaries pledging assets to the secured
debt, as well as valid legal consideration for the granting of the guarantee and pledge. In the event that
structural subordination of the holding company’s debt is mitigated by guarantees from the operating
subsidiaries but not secured by any pledge of the subsidiaries’ operating assets, the creditors could only
expect to have claims ranked pari passu as the unsecured creditors of the operating subsidiaries in the
event of default.
• Collateral sharing issues: Different lending groups will often share collateral; for example, one group
may have a first lien on current assets and a second lien on plant and equipment, and the other may have
a first lien on plant and equipment and a second lien on current assets.
• Excesses and deficiencies: Secured creditors who come up short from the proceeds of their specific collateral generally file claims as unsecured creditors for the deficiency. Similarly, any excess from pledged
collateral security over and above what the secured creditors are owed becomes available to pay unsecured creditors.
• Intercreditor negotiation and accommodation: Bankruptcy can be a long, expensive and highly complex
process. Depending on the perceived strength of various parties to the proceeding and their desire for
speedy resolution and other factors, out-of-court settlements and compromises sometimes result, with
different distribution of valuation proceeds than what would be achieved via the theoretical waterfall
allocation. Typically, these may involve higher-priority claimants agreeing to receive less than their full
claim in order to provide a minimal payment to certain junior claimants, so as to obtain their cooperation
and avoid a lengthy court battle. In some cases, in anticipation of such intercreditor negotiation, creditors would enter into an intercreditor agreement to predetermine in an orderly fashion the mechanism or
framework of such resolution to facilitate recovery, should default occur. It is important to highlight here
that while DBRS’s recovery analysis is based on the security arrangements and priority ranking as they
are under the various contractual agreements (including such predetermined intercreditor agreements),
it does not (and could not possibly) anticipate any renegotiated arrangements between the issuer and the
various claimants at, or close to, default.
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