Standard & Poor's has developed principles underlying its approach to rating transactions carrying risk that is a hybrid between pure corporate risk and the risk associated with traditional securitizations backed by financial assets or diversified pools of corporates, as in collateralized debt obligation (CDO) transactions. These are generally known as hybrid transactions and sometimes as whole business securitizations.  

Chief Financial Benefits
Hybrid transactions offer a number of financial benefits to corporate borrowers relative to standard corporate secured financing. The benefits arise from the transaction structure's enhanced financial ability to service debt, which in turn is due to features borrowed from asset securitization technology.  

The enhanced capacity to service debt means that hybrid transactions support greater financial leverage. They tend to carry a lower nominal cost of debt, due to higher credit ratings, and they usually have a longer maturity, which reduces pressure on the corporate issuer to plan refinancing.  

The debt tends to be amortizing rather than bullet, in order to provide a continuous signal to noteholders of the transaction's satisfactory financial performance.  

Classification
Hybrid transactions fall within the spectrum bounded by pure corporate risk on one end and commoditized asset-backed securities (ABS) on the other. Since each transaction falls on a unique point within this spectrum, there is no standard blueprint for rating these transactions. Generally, the assets may not be suited to actuarial analysis.  

Individual hybrid transactions are structured on a made-to-measure basis, unlike standard ABS transactions. Whereas hybrid collateral includes a unique set of operating assets in ongoing use, and therefore shares many features of standard corporate ratings, hybrid transactions are reinforced by structural elements normally utilized in asset-backed securitizations.  

The collateral underlying hybrid transactions, however, contrasts with the collateral of structured ABS, such as mortgage-backed or credit card-backed securities, insofar as the former normally lacks an extensive performance track record and may, therefore, be less amenable to statistical analysis. Furthermore, operating assets are often less diversified, less homogeneous, and need to be actively managed in order to generate cash flows. Therefore their revenue-generating characteristics can often be more closely aligned with a specific operator's performance.  

Ratings Objective
Hybrid transactions may be identified by their specifically adapted structure, their debt quantum, the presence of credit enhancement, and performance criteria. Together, these address issues related to the unique assets being used as collateral. Therefore, any ratings criteria will address the principles of analysis of these transactions rather than provide a blueprint for meeting criteria.  

Whereas Standard & Poor's criteria for traditional asset-backed structures involve solving for the level of credit enhancement that supports a given rating, with other variables fixed, this is not the case for hybrid transactions. Instead, the rating of hybrid transactions entails the optimization of a number of variables, including credit enhancement. Standard & Poor's objective is to strike the best balance in the value-added of numerous variables, some of which are more conducive to negotiation during the structuring process than others.  

Relevant Inputs into the Ratings Analysis
The hybrid rating process is essentially a blending of corporate business risk and structured finance analysis that builds on the principles of both with the ultimate goal of maximizing noteholders' control over the cash-generating assets.  

To this end, Standard & Poor's conducts an analysis on the basis of the following information:  

• Business risk assessment;
• Assessment of management and operations;
• Alternative operator/servicer;
• Cash flow structure and modeling;
• Legal and tax structure;
• Credit enhancements and other structural supports; and
• Effectiveness and/or enforceability of mitigants in the form of covenants and third party activities, such as asset valuation, servicing, and audits.

If Standard & Poor's has already provided a corporate (unsecured) credit rating for the relevant business operator, then there is potential to raise the rating for secured creditors, all other factors being equal. This is a result of the risk mitigation generated by isolating the transaction structure from the aforementioned financial risks, via a true sale of the collateral or a favorable secured loan structure (see, for example, Standard & Poor's article "Analyzing English Secured Loans" of Sept. 11, 1997).  

To date, Standard & Poor's has been involved in rating secured corporate debt, which, in the U.K., has benefited from an uplift ranging between one and four notches--and averaging two notches--over the corporate (unsecured) credit rating of the issuer. Thereafter, Standard & Poor's may assess additional benefits to specified debt tranches in response to structural features, such as the ranking of payments under the payments waterfall structure, a variety of credit enhancements, and the quantum and mix of debt and equity.  

This may result in an additional ratings uplift--to date up to six notches, or two ratings categories--over the business risk score. Because of the numerous permutations of such potential benefits, there can be no single formula for arriving at a final rating of hybrid debt tranches. Instead, a broad range of rating solutions follows.  

Key Variables in Assigning Ratings
Standard & Poor's looks at three types of variables in assigning ratings to hybrid transactions. First, there are quantitative variables, whose values tend to be fixed by circumstance or inherent business characteristics. Second, there are qualitative variables whose values likewise tend to be fixed. Third, there are qualitative variables whose values can be negotiated and eventually "tweaked" in order to optimize their respective value-added in respect of the transaction rating.  

Quantitative variables consist primarily of measures of cash flow relevant to the business and incentive "hooks" on the sponsor, such as cash equity and dividend restrictions. The importance of keeping the sponsor motivated to keep the transaction performing cannot be understated. Cash flow measures include line items for each relevant asset, and are not limited to EBITDA. Standard & Poor's typically looks through all relevant line items in a company income statement. The aim of the analysis is to unmask and understand cash flows available for debt service, given that historical cash flows may not always be the best guide to future performance. The range of line items may be narrowed, depending on the importance of any single line item to overall cash flow contribution. An adjustment to the cash flows is made to reflect accounting technicalities that may not apply to this application.  

As the cash flow data does not normally lend itself to an actuarial analysis because of its limited history, Standard & Poor's undertakes a range of stress flow analyses. "Monte Carlo" simulations can be a useful tool in some cases, but may be inappropriate when insufficient historical data is available to develop the requisite assumptions fully. Determining the stress tests to be applied is the detailed analysis of the business risk inherent in the transaction and the likely quality of the cash flow generated.  

Among the qualitative variables, whose values are largely fixed before the hybrid rating process has commenced, are the business risk assessment, the degree of asset diversity in the collateral stock, the legal structure, and the degree to which continuous supervision of operator performance is feasible.  

With respect to the business risk, Standard & Poor's assesses the degree and scope of operating risk and residual financial risk inherent in the proposed transaction structure, as well as any other relevant aspects of business risk. Key elements in the legal structure are the nature of the security that is proposed and the jurisdiction in which the legal provisions and covenants in the transaction documents are applied. The nature of the security on the collateral stock relates in the first instance to the degree to which a true sale away from the operating sponsor, or equivalent true control of the relevant cash-generating assets, is achieved. In addition, Standard & Poor's looks favorably upon a high degree of delinkage of any proprietary expertise of the business operator from the assets' cash-generating capacity. This is frequently effected through a committed and competent servicer, or back-up servicer. Alternatively, where a committed back-up does not exist initially, the analysis focuses on the ability, cost, and timing implications of sourcing alternative operators or servicers as needed.  

Covenants can serve a number of functions, including preserving repayment capacity; protecting the integrity of the assets and business position; providing signals and triggers to ensure the steady flow of information, introduce early warning signals of credit deterioration, and place the bond trustee in a position of influence should deterioration occur; and purposes that are standard in ABS transactions.  

This leaves a set of variables in respect of which there is quite a bit of scope to improve the risk profile of the securitized debt. Many are structural supports, such as covenants aimed at disciplining the operator or triggering early termination of the debt and/or of the secured loan to allow enforcement of the underlying security when negative signals occur about the business' future cash-generating prospects. Other negotiable variables include the final maturity of the debt, the average life of individual debt tranches, as well as their respective ranking within the payment waterfall, and the degree of debt leverage. Indeed, the scope for leverage and, ultimately, the quantum of total debt that can be raised in a hybrid transaction are positively influenced by the size of the equity contribution, dividend restrictions, provisions for cash reserves, and the senior/subordination structure. Subordinated debt can take the form of traditional securitized debt tranches as well as, for example, preferred stock.  

Taken together, the quantitative and qualitative variables produce a range of potential rating outcomes. Standard & Poor's assesses alternative values of the variables (to the extent that there is scope for their negotiation or "tweaking") in respect of their relevance, capacity to achieve ratings objectives, and consistency across both structured and hybrid transactions.  

Distinguishing Characteristics of Hybrid Ratings
The ratings of hybrid transactions to date have tracked the evolution of this type of transaction as a type of financing tool. Changes can be expected in respect of ratings volatility as experience is gained.  

Volatility
On average, the ratings should turn out to be less variable than corporate ratings but more variable than traditional ratings of asset-backed securitizations. Potential ratings volatility arises because of the likelihood of cash flow volatility within the transaction structure, in reflection of the inherent business risk. Nevertheless, such volatility is partially stemmed by the application of structural supports. Indeed, like corporate ratings, hybrid ratings are far more sensitive to the inherent business risk than are standard ABS ratings. In the case of actual hybrid transactions to date, the business risk has tended to be moderate, representing largely mature, stable businesses scored within a narrow range of 'BBB' to 'BB'. Furthermore, the frequent lack of an historical record for the business operators' performance in these deals exacerbates the level of uncertainty about the future.  

Boundaries
The upper boundary of hybrid ratings, in principle, is the rating level that applies to classical, highly leveraged, highly rated, and commoditized asset-backed securitizations. In practice, however, the highest hybrid rating achieved to date has been 'A' on an unwrapped basis. Standard & Poor's has not as yet rated a hybrid transaction with original business risk scores below 'BB'.  

Operating sponsors whose business risk corresponds to a rating below 'BB' are unlikely to benefit from a hybrid transaction. This is so because their future cash flows are, by definition of the rating, so uncertain that in the opinion of Standard & Poor's they cannot justify stretching the maturity of the debt, nor supporting a larger debt quantum than in a pure corporate risk transaction. Likewise, certain kinds of businesses are unlikely to benefit from a hybrid transaction. These include businesses that are capital intensive, are reliant on unique management skills, or are rapidly evolving (owing to the high degree of technology risk).  

In contrast, there are three types of business operations that are particularly well suited to hybrid transactions. These are:  

• Market value transactions, such as the 2000 Marne et Champagne deal, which involve cash flows generated from the liquidation or turnover of inventories.
• Transactions since 1997 involving a portfolio of fixed assets, such as the public houses (pubs), nursing homes, and motorway service concessions, which involve cash flows generated from rental payments and other business revenues.
• Transactions involving discrete assets, which generate cash flows from revenues in a small number of businesses.