a day in the life of an svo analyst - … day in the life of an svo analyst may 26, 2016 jeffrey...

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A Day In The Life Of An SVO Analyst

May 26, 2016

Jeffrey Baskin

Credit Team Leader, Securities Valuation Office


Analyst Backgrounds/Qualifications

• Credit analysts need a firm understanding of finance, economics, legal and accounting issues to properly assessing the business and financial risks in investment securities.

• To the extent that a credit analyst needs additional help interpreting the legal documents, which govern securities, the SVO’s Senior Counsel is consulted.

• Most of the SVO staff are seasoned credit analysts having previously reviewed securities for either Credit Rating Providers (Moody’s, S&P, Fitch et al) or commercial banks.

• The SVO also internally trains staff who have the educational background necessary to become credit analysts.

• At a minimum, SVO credit analysts have a bachelor’s degree in a business related field (economics, finance). Most analysts have a Masters in Business Administration, while some are Certified Financial Analysts.

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Professional Qualifications • Average years of credit analysis experience: 23 years • Masters of Business Administration (MBA): 85% • Bachelors degree: 100% • Chartered Financial Analyst Charterholder (CFA): 19% • Masters degree, other: 15% • Juris Doctorate: 7% • Rating Agency experience: 54% • General Position Requirements (Analyst II/III): Serve as a primary expert in assigned sectors

and industries performing issuer and security credit analysis and research. Analyst is expected to prepare well-reasoned credit analysis reports on their assigned portfolio. Functions include writing credit analysis reports, recommending credit risk designations, security pricing and updating the assigned portfolio of fixed income, equity, hybrid, and private placement securities for inclusion in the NAIC database. Serve as a member of Credit Committee. These duties will be performed under the direct supervision of the Manager, Credit & Valuations Group. Ideal candidates should have related experience of at least 10+ years with 5+ years’ experience of fixed income credit analysis. Experience performing credit analysis at a Nationally Recognized Statistical Rating Organization (NRSRO or “credit rating agency”) is preferred. Master's degree (M.A.), M.B.A. in Finance or equivalent and/or CFA.

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Steps in Assigning a Designation Investment Analytical Framework

• Legal, Structural, & Accounting Considerations • Technical Default • Corporate Credit Analysis Business Risk Assessment Financial Risk Assessment

• Peer Comparison

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Steps in Assigning a Designation Legal/Structural Issues

What Credit Are We Looking At? • Issuer as Obligor: Issuer-Operating Company? Holding Co.?

• Guarantees by Subsidiaries? • Guarantees by Parent? • Guarantees by 3rd Parties? • Implied Support from Parent/Affiliates?

• Collateral: Value of Issuer Assets in a Default Scenario as Compared with Liabilities, Especially Debt

• SVO Designations Measure Likelihood of Timely Payment of Principal & Interest; Notching Up or Down for Relative Position In the Capital Structure and Other Characteristics That Lessen Likelihood Of Default

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Steps in Assigning a Designation Accounting Issues • Acceptable/Unacceptable Accounting Standards • Interest Expense • Capitalized Costs • Qualified/Clean Opinions

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Steps in Assigning a Designation Technical Default

• Multiple Ways To Enter Technical Default Under Loan Agreement • Timely and/or Non-submission of Financial Statements • Material Adverse Change • Unpaid Legal Judgment • Financial Covenants Interest or Fixed Charge Coverage Debt/EBITDA Coverage Minimum EBITDA

• Waivers/Amendments of Technical Defaults by Lenders • Compliance Certificates Required

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Steps in Assigning a Designation Corporate Credit Analysis

BUSINESS POSITION

FINANCIAL POSITION

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Steps in Assigning a Designation Business Risk Assessment

• Industry Dynamics, including barriers to entry, cyclicality, regulatory environment, competition, and other demand and price drivers

• Competitive Position; size versus peers • Profitability; EBITDA margins • Markets Served: geographic, product diversity • Market Share: relative market share, niche served • Growth strategy; dependence on acquisitions versus internal

growth • Management; where management adds value through expertise,

where private owners manage to specific objectives

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Steps in Assigning a Designation Financial Risk Assessment

• Begin with review of historical audited financial statements • Typically would like at least 3 years of audited statements but

not always possible (e.g. LBO) • Would like to see operating performance of issuer’s

businesses over an economic cycle • We request management discussions of past years’ “Results

of Operations” and “Liquidity and Capital Resources”, but sometimes need to piece these together

• Analyze Liquidity; what resources does the company have to meet on-going cash requirements, including debt service, operating costs and capital expenditures

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Steps in Assigning a Designation Financial Risk Assessment – Earnings and Earnings Trends

• Revenues • Components, Growth, Volatility, Cyclicality • Stability, Repetitive Revenue Streams, Contracted Revenue Streams

• EBIT & EBITDA* • Growth, Volatility, Cyclicality, Margins by Products/Divisions

• Separate “Core” Revenues and Profits from Non-Core/Financial Items on the P&L

Example: For an industrial company, exclude investment income, miscellaneous investment gains/losses *Earnings Before Interest, Taxes, and Depreciation/Amortization

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• Ability of operating cash flows to fund recurring requirements- working capital, capital expenditures, dividends

• Predictability of cash flows • Degree of operating leverage • Above must be placed in the context of company growth

• Fundamental growth (e.g. technology/software) • Growth coming out of a recession for cyclical companies (e.g.

construction equipment dealers)

Steps in Assigning a Designation Financial Risk Assessment – Cashflows

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Steps in Assigning a Designation Financial Risk Assessment – Balance Sheet / Financial Flexibility

• Debt Capacity and Debt Structure • Ability to add debt while maintaining credit quality • Ability to add debt under debt covenant restrictions • Short term vs. long term • Fixed rate vs. floating rate e.g. 0.3% LIBOR rates • Refinancing risk

• Balance Sheet Cash Levels; availability under committed credit lines

• Leverageable Assets e.g. long term receivables, ability to factor these

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Steps in Assigning a Designation Financial Risk Assessment – Balance Sheet / Financial Flexibility

• Intangible Assets- potential for impairment • Access To Capital Under Stress

• “Size factors” • Access to equity (private or public) • Access to debt market

• Management Growth Strategies • Organic vs. acquisitions • Distributions to owners/stock repurchase • For private companies, financial policy of owners, potential for

company to be LBO’d

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Steps in Assigning a Designation Financial Risk Assessment –Key Statistics Financial Metrics

Financials are adjusted for • Non-recurring items • Operating leases • Unfunded pension and retirement benefit obligations

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Steps in Assigning a Designation

• Designations are assigned after a credit analyst completes a comprehensive company analysis including the industry in which they operate and a review of peers and an analysis of past audited financial statements.

• An analysis of the legal agreement is also performed as well as the transaction purpose - refinance existing debt, leveraged buyout, dividend distribution, general corporate purposes etc. of the borrowings and place in the capital structure (secured, unsecured, subordinated).

• After reviewing and analyzing the above, the analyst will prepare a written report incorporating key facts from the transaction for presentation to the Credit Committee who collectively will assign a designation.

• Members of the Credit Committee include Senior SVO Members (Director, Senior Counsel, Managers and Team Leaders) as well as Senior Analysts.

• The size and make up of the committee varies depending on the type and/or complexity of a transaction.

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Key Information Used in the Analysis • For certain transactions, such as Project Finance or Credit Tenant Loans, additional

documentation is required to properly assess risk. • Project Finance transactions are generally for newly established entities for which

audited financial statements due not exist. • To assign a designation the analyst would need information pertaining to the

viability of the project, including projected cash flows and third party legal agreements.

• For renewable energy projects we require an independent engineer’s report, which would provide specific details about the project, including project costs, project viability and a review of projections.

• Non-energy projects would require an independent feasibility study. • For Credit Tenant Loans we require the lease agreement binding the tenant to the

obligor and defining the tenant’s lease obligation – covering all costs associated with the leased property (triple net lease – covering all expenses including taxes and insurance) or double net lease (covering operating expenses but not taxes).

• We would also require three years of audited financial statements of the lessee as the lessee will be the source of cash flow needed to meet debt service requirements.

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Key Information Used in the Analysis

• Designations are assigned taking into consideration the issuer’s or obligor’s (they may not be the same) business and industry in which they operate, basis of the transaction, operating performance and financial condition, and legal obligations.

• At a minimum the SVO would require the following information: • For Private Placements detailed information pertaining to the obligor the

industry in which they operate and nature of the transaction can be provided by A Private Placement or Confidential Information Memorandum, and if available an insurance company/filer’s internal memorandum.

• At least three years of audited financial statements are required. • Legal document(s) binding the issuer/obligor to the lender are required. • For transactions heavily dependent upon projected performance, cash flow

projections and supporting rationale would be required.

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Key Information Used in the Analysis

• While various documents are reviewed by credit analysts, it is difficult to weigh or provide the relative importance of each document.

• Documents provided vary by the transaction being analyzed. For example, a project finance transaction generally does not have audited financial statements – at least initially and there is a heavy reliance on projections, while with credit tenant loans there is a heavier reliance on legal documents; companies operating in relatively unique industries (SpaceX – a commercial rocket manufacturer) or one with highly technical or specialized products (a biopharmaceutical company) would require more information on specific business workings.

• In general, I would rank the financial statements first, followed by company/industry/transaction information (usually provided together) and then legal documents.

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Key Information Used in the Analysis • Ad-hoc requests can be made upon review of the analyst of documentation

provided, or from questions arising from the Credit Committee. These requests can arise for numerous reasons.

• As an example, in reviewing a transaction the analyst may find repayment is heavily dependent upon a guarantor. (If not provided we would need the guaranty agreement (to detail the guarantor’s specific obligations) as well as three years of audited financial statements of the guarantor to access the guarantor’s ability to generate sufficient cash flow to amortize the subject debt).

• There may be certain events, such as contingent liabilities, which could impact the assigned designation and would call for additional information and or clarification.

• In deriving opinions for designations SVO credit analysts make extensive use of additional resources, mostly Credit Rating Providers and Bloomberg.

• The primary source used are Credit Rating Providers whose reports the SVO use to augment business and industry information, rating methodologies and peers.

• Bloomberg is a valuable tool used in part to obtain peers. • For Municipal Securities we rely heavily on the Electronic Municipal Market Access

(EMMA) website.

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Financials • When analyzing financial statements we analyze numbers and ratios in context

within an industry in which an issuer operates. For example, the same ratios for a regulated utility and a highly cyclical manufacturing company would probably produce significantly different designations if only one set of ratios were used.

• Size in terms of revenue is important as larger companies generally have greater financial flexibility allowing them to raise funds more easily than smaller sized companies. While size is important, the SVO does not place as great an emphasis on size as do most rating agencies.

• Numerous ratios are used by credit analysts (return on capital, free operating cash flow to debt). The focus on most ratios is how much operating cash flow a company generates relative to interest expense (EBIT/Interest) and how much debt is in a company’s capital structure. The higher the debt relative to equity the greater the risk, which can be measured by a debt to capital ratio or a debt to cash flow ratio.

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Steps in Assigning a Designation Financial Performance – Company X

FYE 12/31 : (USD, M's) 2013 2014 2015 3-yr Avg328,124 408,491 500,888 412,50147.96% 48.06% 54.41% 50.60%-11.90% -10.00% -5.90% -8.84%7.58% 7.99% 13.30% 10.03%

270,190 197,758 66,195 178,048

NRSRO/ NRSRO/ NRSRO/ NRSRO/NAIC NAIC NAIC NAIC

0.7x 5-/5- 0.8x 5-/5- 1.0x 5/5 0.8x 5/5-0.8x 6/6 -0.5x 6/6 -0.3x 5/5 -0.5x 5/5--1.4% 5-/5- 0.9% 5-/5- 3.9% 5/5 1.8% 5-/5-

-27.3% 6/ -- -25.9% 6/ -- -5.3% 6/5- -16.5% 6/614.6x 6/6 13.5x 6/6 10.8x 5-/5- 12.3x 6/657.4% 3/4+ 69.0% 4/5+ 91.6% 5/5 74.0% 5+/5+

Revenues

Operating Margin

Shareholder’s Equity

Ratios: 2013

Gross Margin

Adj. EBITDA Margin

Adj. Debt / Capital

2015 3-yr Avg

Adj. EBITDA / Adj. InteresAdj. EBIT / Adj. InterestAdj. FFO / Adj. Debt

Adj. Debt / Adj. EBITDA

2014

Adj. FOCF / Adj. Debt

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Steps in Assigning a Designation Peer Comparison - Satellite/Communication Services

Company

NAIC Baseline

Desig/EquivS&P

Rating

2015 Revenues

($ MM)

Return on capital

(%)

EBIT interest

coverage (x)

EBITDA interest

coverage (x)

FFO/debt (%)

Free oper. cash

flow/debt (%)

Debt /EBITDA

(x)

Debt/debt plus

equity (%)Company X 5+ N/A 500.9 -2.9 -0.3 1.0 3.9 -5.3 10.8 91.6

Company Y 5+ N/A 426.0 0.1 0.1 11.9 29.2 3.2 2.5 21.0

Company Z 4= N/A 411.4 6.4 2.0 2.6 14.3 -17.8 6.9 55.7

ViaSat* 4+ B+ 1,382.5 5.07 1.63 6.89 34.94 -1.3 2.45 49.21

CenturyLink 3= BB 17,900.0 6.1 1.47 4.3 21.2 9.1 3.7 64.7

*Represents 12 months through March 31, 2015

2015 Results

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Financials

• SVO analysts require at least three years of audited financial statements, which is not a “magic” number. The primary purpose of having multiple years of information is to enable the analyst to review a company over a period of time and avoid any year to year anomalies. For example, if debt was issued near year end, or a company had a particularly poor year due to a one time event – storm, factory downtime, performance and financial ratios would be distorted, which if looked at singularly would have an adverse effect on a company’s designation.

• If company has been in existence for at least three years, audited financial statements should be available; if not we would require a Principal and Interest Certificate requesting an NAIC 5* designation – assuming interest and principal are current.

• For startup companies, or companies spun off from larger companies for which consolidating financial are unavailable it is best to check with the SVO analyst before proceeding to file.

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Municipal bonds

• Municipal bonds are issued by: • States, State Authorities, and Multi-State Authorities • Local governments: o Counties, Cities, Towns, Boroughs, School Districts o Special districts with limited taxing authority o Essential utilities such as water, sewer, and electric o County and local agencies and authorities

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Who issues municipal bonds?

• Higher education – Both Public and Private • Not-for-profits: affordable housing, charter schools, cultural,

research, philanthropic, service & advocacy • Public and Private Hospitals

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How are muni bond proceeds used?

• To finance capital projects and aid issuer liquidity • Examples include: o Municipal facilities – main offices, fire, police, first aid o Schools o Hospitals o Prisons o Highway Infrastructure – Toll roads, bridges, etc. o Airports – in the U.S., many foreign are privatized o Ocean Cargo Ports o Liquidity – Tax Anticipation Notes (TANs) and Bond Anticipation

Notes (BANS) o Other: Parking garages, Sports stadiums, Recreational Facilities

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Categories of municipal bonds • General obligation bonds (GO) – usually least risk

o “Full faith and credit” of the issuer backs the bonds o Unlimited Tax vs. Limited Tax o Limited taxes: e.g. property, sales, hotel, car rental

• Appropriation, lease-backed – higher risk o Generally designated 1-2 notches off GO

• Revenue o Pledge of a specific source of revenues to repay bonds o General vs. limited revenue pledge Water and sewer system Airports, Ports, Hospitals, Higher Education Special assessment districts – a limited tax on a specified area Tolls & Fees, tuition and grants

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Key Credit Factors For Municipal Analysis

• National, regional and local economic conditions • State, local or county tax base • For Revenue Bonds – sources of revenue • Financial position • Overlapping debt of other municipal borrowers • Liquidity • Debt profile and legal security – source of payment for the

bonds • Governance and Management • Peer comparison

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Internal Documentation Requirements • Upon receipt of an ATF the analyst assigned to the specific sector will review the

material provided, prepare a report detailing the issuer (what they do and in what industry segment they operate) their historic and or projected operating performance and financial condition, the nature of the transaction (why the borrowing and how will the funds be utilized) and a summary of the key legal features (collateral, subordination, covenants).

• The analysts written report is an internal document. If the SVO is requested to provide a preliminary designation for a security filed under our Regulatory Treatment Analysis Service (RTAS) Application a formal letter will be sent to the filer explaining our preliminary designation and how it was derived.

• Almost exclusively documents used in deriving a designation are stored electronically. Non electronic documents are physically sent to our Kansas City office for storage.

• Legal documents are stored for the life of the transaction. Legal documents supporting securities are held for three years past the latest of maturity or divestiture by the last insurance company holding the security.

• Supporting documents (analysts reports, financial audits) are held for six years.

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Role of Credit Committees

• The role of the credit committee is at a minimum to verify an analysts recommendation and ensure compliance with internal rules and regulations.

• All recommended designations are reviewed by a senior credit committee (with the exception of a security which can qualify as Filing Exempt, however, a filer requests a designation into the VOS database) to ensure comparability, consistency and analytical accuracy.

• Members of a credit committee vary according to transaction complexity. • For example, an RTAS application will be presented to a committee which would

include the SVO Director, Senior Counsel, Credit Managers, Team Leaders and potentially Senior Analysts.

• Transactions for which issuer’s have been reviewed and designated during the year will have a credit committee with substantially fewer members.

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Insurance Company Assistance

• To provide a designation the SVO analyst needs, at a minimum, the documentation referenced in the presentation – three years of audited financial statements, company and industry information, and for new transactions legal agreements.

• Providing the SVO with industry peers would be helpful. In performing an analysis to derive a designation we track the obligor’s historic performance with that of industry participants, particularly ones that are either rated by a Credit Rating Provider or designated by the SVO. In most instances you would expect companies with similar sizes and financial profiles to have the same or close to the same designations. Obtaining financials on the closest industry participants would be very helpful.

• For annual updates in addition to the most recent audit, an internal document providing information explaining drivers of the past year’s performance and financial condition would be helpful, especially for smaller companies that are not required to file documents (10-K’s) with the SEC.

• In addition, if there were any modifications to the lending agreement, or covenant modifications a listing of those would be helpful.

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Q&A

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