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Tuesday, March 31, 2009

"Moody's, we have a problem!"

Last week Moody's announced that it has downgraded and left under review for possible further downgrade its ratings of all classes of notes issued by SVG Diamond Private Equity I and SVG Diamond Private Equity II - deals they should never have rated and should stop rating immediately. (But that's just my opinion.)

Why?

The two deals comprise approximately $717 mm in total. They are CDO transactions, each "referencing a portfolio of shares of private equity funds."

Herein we have problem numero uno: the inherent, obvious lack of diversification by industry. Unlike other CDOs where the rating agencies thought there was diversification, here there never was any such supposition - the underlying are [all or primarily] private equity fund shares (at least according to Moody's press release).

It was diversification and subordination that allowed one to take junk -- it's a technical term, not scathing -- and create investment-grade, or even a AAA. Well, since there's limited diversification here, the junk all acts in tandem, and so the resulting necessity, as we saw above, to downgrade all tranches.

(To be entirely transparent, certain other CDOs, called trust-preferred CDOs or TruPS CDOs, were issued backed wholly by bank or insurance-issued trust preferred securities. These are similarly desirous of diversification, but were rated equipped with the knowledge that banks and insurance companies are heavily regulated and so a lesser default risk. Private equity firms, to say the least, are not heavily regulated.)

From Moody's press release:



SVG Diamond Private Equity is a bankruptcy remote special purpose company incorporated with limited liability in Ireland for the sole purpose of acquiring its interest in the portfolio and certain other assets securing the notes, and issuing the notes.

...

Today's rating actions are primarily a result of the deterioration of the performance of the private equity asset class and the amount of unfunded commitments. The presence of a liquidity facility renders the risk of a default on an interest payment remote.

And now for the juicy stuff:



In reaching its rating decisions, Moody's considered the following important factors:

(1) Cash
The current amount of cash in the structure has been compared to the initial projections. Distributions and drawn-downs have been projected until maturity.

(2) NAV
The Net Asset Value (NAV) of the portfolio as reported by the manager has been compared to the initial projections. Based on the fair value accounting (FASB 157), the NAV presents an aggregated performance metrics.

(3) Public Information Regarding Private Equity
Private-equity funds typically disclose a limited amount of information to the parties involved. Moody's examined the recent disclosure of large publicly quoted buy-out funds with regards to the mark-downs of outstanding Leveraged Buy Outs (LBOs) and Venture Capital (VC) portfolios and used them as guidelines to understand the state of the private equity industry.

(4) Public Equity
Unlike Private Equity, for which historical performance data is available only for the latest 25 years, Public Equity indices provide performance information over a much longer period. As an example, the LPX 50, an index of 50 major publicly traded Private Equity companies, is approximately 67% down since September 2004 (deal inception) and 82% down from its peak in May 2007. In the absence of transparent Private Equity performance data over this time period we can look to Public Equity as a proxy.

(5) Manager's View
The transaction manager has been asked to provide the projected levels of distribution, draw-downs and NAV. Moody's believes that the manager is in a unique position to time the various material elements that impact the cash flow. Moody's applied stressed to the projected levels from managers.

(6) Liquidity Position
By nature, private-equity investors commit capital that will be drawn in the future. Historically, the full amount of committed capital has not been drawn by the Private Equity funds. Moody's believes that the likelihood of a commitment to be drawn during a systemic credit crisis is high.

Moody's has developed a monitoring model for this type of transaction. The model first estimates the cash available over the life of the deal. It also models the liquidity facility dynamically. Based on the factors listed above, Moody's defined three states of future portfolio performance: optimistic, baseline and pessimistic and assessed the probability of losses for each tranche in each of the three states. Haircuts on the projected distributions are in the range between 0% and 40%, depending on the state of the portfolio.


Now we introduce Problems 2 through n:

(2) We're certainly NOT seeing any measure above that takes into account Moody's INDEPENDENT opinion. All we see is "Moody's applied stresse[s] to the projected levels from managers." Sadly, that doesn't take much insight. Nor much investigative research.

(3) These ratings are based on limited historical data: as opposed to the original collateralized bond obligations (CBOs) which were at least supported by corporate bond default rates since at least the early eighties, here Moody's isn't falling back on any substantial historical data.

(4) The limited data they are falling back on isn't even necessarily private equity data: it's public equity and venture capital-type data.

(5) Moody's is relying heavily on the manager's view (!) and projections. Need we say more? This is not entirely dissimilar to a hedge fund investor running in blind despite access to data! Sherlock Holmes would turn in his grave.

(6) Moody's is relying heavily on the manager's NAV. Okay. But how are they combatting potential mismarkings, especially for NAV-lites? I understand if they can't be expected to spot Ponzi schemes, but some cushion on the NAV interpretation would be swell. "The Net Asset Value (NAV) of the portfolio as reported by the manager has been compared to the initial projections." This unfortunately doesn't seem too useful. More useful would be to analyze the NAVs, especially as we're in an economic environment marked by its unwillingness and inability to evaluate illiquid assets (private equity investments are an ideal, typicaly, problematic example). In a market swamped with scandal, including accounting and valuation scandal, solely trusting the key "interested" party simply does not, can not suffice. Especially as an NRSRO - a nationally recogized statistical rating agency. With power comes responsibility.

(7) "The current amount of cash in the structure has been compared to the initial projections. Distributions and drawn-downs have been projected until maturity." Again, I have no confidence that this approach is worthwhile. Firstly, given the market changes, one can't possibly expect anything to be similar to initial projections. Secondly, projecting drawn-downs through maturity -- out in 2024 -- seems a gargantuan, purely academic task.

(8) We still have no knowledge as to what changed that suddenly demanded all tranches be simultaneously downgraded. These deals were rated 3 and 5 years ago. Isn't there a steady realization -- as with all other CDOs they rate -- that the lower tranches have become a credit concern, followed by the mezzanine, and then the senior-most tranches? Was Moody's simply asleep at the wheel?

We have no reason to believe, based on this announcement, that Moody's has any competitive edge over Joe the Plumber in evaluating the quality of this CDO. Aside, perhaps, for the knowledge that "Moody's has developed a monitoring model for this type of transaction." Given these deals were rated in 2004 and 2006, this seems an odd, retrospective remark. From a psychological perspective, this comment appeals to me as a demonstration of innocence by one not accused of anything. The assumption is naturally that they have a (hopefully accurate)model, given the complexity of the transaction and that they have imposed ratings on the issued tranches. The confession therefore, that they have a model, has the opposite affect of being reassuring: it seems Moody's recognizes that they're walking an unnatural, uncomfortable path here, tip-toeing like a cat on a hot tin roof.

It's sad that they ever chose to rate these transactions in the first place. (Why not simply turn it down until you have sufficient data to support such an analysis?)

It's sad that despite the scarceness of data supporting their ratings, and their ratings' heavy reliance on unreliable data, they continue to rate them.

It's sad that each deal's investors continue to pay monitoring fees to Moody's for its scarce, unreliable, spontaneous monitoring.

4 comments:

Comtesse du Barry said...

Excellent

"Moody's believes that the manager is in a unique position to time the various material elements that impact the cash flow."

Maybe we should have the manager give us the rating!

Datum72 said...

yes this way if they get the rating wrong they can blame the manager. nice

Anonymous said...

These PE funds mightve been somewhat diversified before the crash but yes they have been slaughtered now for over 2 years because they're so highly geared.

And this is exactly what the rating agencies do in corporate M&A, simply dumb their model on top of yours and add some stresses

Anonymous said...

The diversification referred to is at the corporate, industry and geography level rather than the type of security. This broad-nature of this crisis has seriously reduced the value of this diversification. In my view this was sufficiently unexpected to justify the original value of the diversification. It should also be noted that there remains some significant benefit from this diversification.

The more important correlation seems to me analogous to the US housing situation in which the diversification was wiped away by the underlying asset prices.

You are right to question the NAV, but do not get too distracted by this issue as these are strongly cash-flow based. The relevant time period is not 2024 but rather 2012-2015. Still too far out to rey too much on the modeling, but let's not overstate the problem. Also, the problem is not quite as complex as you present as the relevant question is portfolio performance rather than timing, dispersion etc. which would be much more difficult to model.

When might the RAs have begun to downgrade? Look at when the market started revaluing these assets significantly (more than 15% down). Look at Standard Life European Private Equity which is a half decent proxy.
http://www.google.com/finance?q=LON%3ASEP

The market was not substantially discounting these assets until October 2008.

Your other comments about the effectiveness and independence of the RAs seems to me very on the mark, although I'm not sure more data would help or not.

Should these types of transactions been rated in the first place? Interesting question about CDOs overall. While the methodology around reducing risk through seniority tranching is unassailable. The key question to my mind is how to determine the pricing of the tranches. Is the sensitivity of performance of the tranches too high to rely upon for accurate pricing.