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How Midsize Companies Can Achieve Higher Credit Quality

  • By Claire Mauduit-Le Clercq
  • Published: 8/18/2015
emeaA study aiming to offer more transparency into the creditworthiness of EMEA’s mid-market companies shows that many compensate for relatively weak business positions with less aggressive financial policies.

European alternative lending markets are growing at an impressive rate, with as much as €38 billion raised last year through private placements and direct lending. Improving credit risk transparency is key to the development of these markets. This is especially the case for mid-market companies, where credit risk is typically higher and less information is publicly available.

EMEA mid-market businesses tend to inhabit weaker business positions than their larger peers, for which they compensate with more conservative balance sheet and cash management. Nevertheless, a portion of these mid-market companies boast strong niche positions in specific sectors, which allow them, when combined with a conservative financial policy, to reach investment-grade-equivalent credit quality.

A broad spectrum of business

S&P analyzed a sample of 547 mid-market companies in EMEA, which generate maximum revenues of €1.5 billion with maximum total debt of €500 million (or €250 million for companies in the financial sponsor-owned or leveraged buyout (LBO) segment). Although the sample is well spread across industries and sectors, and in terms of revenue size, it is concentrated geographically (80 percent) in the eurozone and the UK.

S&P found that most companies in our survey do not carry the low default probabilities commensurate with investment-grade creditworthiness, but rather feature higher default probabilities covering the full spectrum of creditworthiness from cross-over to high-yield. In fact, mid-market LBOs typically show a credit risk of 'MM5' or 'MM6' on our mid-market scale (which translates to 'B' on our scale for long-term corporate credit ratings). On the other hand, non-LBO companies are spread out more evenly across the credit risk spectrum with a strong representation at 'MM3' on our scale (which corresponds to the more creditworthy 'BB' category on the global rating scale).

However, they can achieve higher credit quality—'MM1', 'MM2' or 'MM3'—through conservative financial policies and, in certain cases, niche business positions. That said, only a small proportion (13 percent) of the non-LBO mid-market companies we assessed fall in the higher credit quality categories, 'MM1' and 'MM2' (9 percent and 4 percent, respectively).

Utilities and tech companies cluster at the top

Those companies reaching the highest rating on the scale, 'MM1', are mainly part of the regulated utilities sector (almost 50 percent of 'MM1' ratings) with an overall concentration in the UK. This mirrors the sector's importance to the British economy, and factors in our positive, “very low” risk assessment of this industry. Midsize regulated utilities are shielded from direct competition, since they are granted exclusive franchises, licenses or concessions, offering public services on a monopolistic basis.

Only 4 percent of the midsize companies have a 'MM2' profile. They operate in the high-tech and capital goods sector, benefiting from conservative financial profiles combined with niche market positioning. All companies in the 'MM2' risk category differentiate themselves from the ones in 'MM1' through weaker business positions, somewhat offset by stronger financial risk profiles. A large proportion of the non-LBO midsize companies (29 percent) fall in the 'MM3' risk category. Those companies carry out a wide range of activities, but mostly fall into the following sectors: capital goods and transportation, healthcare and consumer goods, as well as telecom and tech.

This upper-scale assessment ('MM1-MM3') is mainly reached by midsize companies with a conservative financial profile, including a prudent financial policy and adequate liquidity cushion. In addition to being conservative, some of those midsize companies (11 percent) attain the upper scale ('MM1-MM3') thanks to strong niche positions—mainly in machine and equipment manufacturing, consumer goods, and specialized high-tech sectors. We believe that in these sectors, midsize companies are able to build stronger competitive positions thanks to their ability to differentiate themselves from larger players, either through technological know-how, efficient operating processes, or strong regional brand recognition.

Of course, this kind of information about the creditworthiness of mid-market firms is invaluable for investors, as well as corporate treasury and finance professionals looking for ways to boost their own company’s profile. Even without it, lending to this asset class through alternative markets has grown significantly in recent years. And as studies of this kind increase in frequency and depth, the market’s upward trajectory can only accelerate.

Claire Mauduit-Le Clercq is assistant director for Standard & Poor’s Ratings Services in Paris.

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