Rating agencies: Arc sees a gap in emerging-market corporate ratings
Pool of large unrated firms set to grow; Uphill battle to establish market share
Amid calls for a shake-out of the global credit-ratings business, Arc Ratings launched last month in a quest to capture a growing market: mid-sized emerging market corporates with ambitions to access international capital markets.
Citing knowledge of local market dynamics – including implicit government guarantees, bankruptcy norms and regulation – Arc, an alliance of five large domestic agencies from Brazil, India, Malaysia, Portugal and South Africa, hopes to capitalize on its in-the-trenches expertise to grab market share in the growing EM credit-rating business, which is currently under-served by the big three agencies.
Desh Dogra, CEO of Care Rating of India, the country’s second-largest rater, and an Arc network partner, says: "We know Indian corporate balance sheets better than others. Do you think those analysts that are based in Singapore or Hong Kong and fly to Mumbai can really understand local market dynamics? This knowledge will help shape Arc’s international ratings."
Arc chief executive José Poças Esteves adds: "These mid-sized to large corporates are the backbone of their economies. They are currently dependent on the banking system, but have a greater need to access the international capital market, and that’s where Arc comes in."
According to McKinsey research, there are some 8,000 large corporations with $1 billion of revenue, 25% of which are in emerging markets and largely unrated. By 2025, the number of corporations of this scale is expected to grow to 25,000, with some 50% headquartered in emerging markets.
Despite weaker growth in the Brics and Fed-tapering fears, 2013 was another watershed year in emerging market bond issuance, thanks to investor demand for yield and exposure to companies at a different stage of the credit and economic cycles. Primary market issuance in hard currency hit an all-time high of around $500 billion, with a record number of debut issuers.
Emerging market corporate debt is the fastest-growing global fixed-income asset class, with a current market capitalization of $1 trillion (hard currency), comparable to the size of the US high-yield market, underscoring the growing opportunities for credit-opinion providers.
With weaker commodity prices, FX volatility and political risk triggering emerging market corporate downgrades from the big-three agencies last year, investors are paying greater attention to credit analysis and due diligence.
|Uwe Bott, chief ratings officer at Arc|
Uwe Bott, chief ratings officer at Arc, says: "Corporate issuers and investors have been asking about alternative agencies to the incumbents for years. Our local knowledge serves us well. For example, the Brazilian energy market is difficult to understand because of complex local regulation, but our domestic agency understands this better than others." While Arc’s launch triggered much media attention – amid calls to break the monopoly of the established players, given their discredited business model and regulatory bias towards the big three – the agency’s ambitions are initially much more modest in nature.
Arc plans to recruit at least 20 emerging market-focused corporate analysts this year and expand its issuer coverage to structured products and, eventually, sovereigns. Underscoring its potential scale and natural client base, some 10% of the alliance’s 6,000 or so predominantly corporate clients are prospective international issuers.
With as many as 50 new agencies on the scene, catering to different niches, Arc Ratings is the latest firm to challenge Standard & Poor’s, Moody’s and Fitch, which control as much as 97% of the global credit-rating market and who are widely blamed for fuelling the sub-prime mortgage crisis. A December investigation by the European Securities and Markets Authority (Esma) uncovered apparent flaws in the sovereign-ratings process, adding momentum to Esma’s push to boost ratings competition by recognizing new agencies, such as Arc, and encouraging issuers to mandate firms with low market share.
Nevertheless, Arc partners accept that they face an uphill battle to establish market share as new entrants, particularly from emerging markets, face a reputational-risk premium.
David King, head of South African-based Global Credit Rating, an Arc partner, says: "Unfortunately, the perception is the reality in our game. But we are not the easy rating agency. For example, in South Africa, we rated municipalities lower than the other international agencies, such as Moody’s, and we lost business as a result. Now that other agencies have reassessed their opinions on these entities downwards, our credibility has grown. But this process takes time."
Emerging market policymakers are sympathetic to the challenge for pension funds that are mandated to invest in high-grade products, as determined by western-based ratings agencies. Beijing backs Dagong, but the agency remains largely irrelevant outside China. Until there is a shift in the regulatory landscape, analysts say barriers to entry for new agencies are high, capping market adoption and, subsequently, real-money portfolio shifts in favour of emerging market high-yield corporate debt.
Paul McNamara, an emerging markets debt portfolio manager at GAM, says: "Ratings in themselves don’t matter much. They get their importance (and residual credibility) from their institutional role – inclusion in indices, repo haircuts, collateral eligibility, etc. So a new agency is not a game-changer."
Arc currently has no plans to apply to be recognized by the US SEC as a Nationally Recognized Statistical Rating Organization, a status that has thus far also been denied to Dagong.
Arc says its rating methodology will be more narrative-, holistic- and qualitative-based than that of the incumbents, introducing a systemic-risk rating without an investment/non-investment grade dichotomy. In addition, sovereign ratings could be capped by a financial-stability rating akin to the sovereign-ceiling for corporates.