The Rating Agencies Blow, but We Knew that Already

As Gretchen Morgenson points out in her recent Fair Game column, the overseers are all complicit for the current economic mess. Put in this category the regulators (think SEC, the Fed, etc.), the Boards of these failed financial companies (who didn't understand the products they were pedaling), and the rating agencies. Today lets look at the latter and figure out why anyone cared about their ratings anyway.

Rating agencies rate debt issues. They analyze the risks and assign a grade representing your likelihood of getting your principal and interest back in full. Banks, as lenders and holders of debt make the same calculations when deciding who to lend money. Now, other than the big real estate debacle back in the 80's, lenders to companies have not had the meltdown like now. Why is that? I believe it's because they use more sophisticated devices than the rating agencies. How could this be? It's because they consider the signals from the public equity markets as well as balance sheet analysis.

When I was as banker, we used some type of Z score for our public company relationships. It would measure equity volatility of the target creditor. If the entity's stock was tanking or simply volatile, or low compared to it's competitors, we would stay away from any type of credit exposure, including swaps of any kind. As we have seen with AIG and Lehman Bros, the debt is as exposed as the equity when things go bad.

Lesson, not all is what it seems, only the Gov't is a AAA+ credit because it can tax and print money, so if you want safe try Treasuries, otherwise consider the equity risk of a company who's debt you are investing in, if you want to sleep more soundly.

Gaining Capital without Losing Control

From Forbes

A nice quick read from Jim Casparie, a founding principal of Angel Strategies (the first national organization for angel investors) about convertible notes.

As discussed, this is a great way for newish companies, which need an infusion of capital, to raise funds without having to prove that your growth will actually occur. An investor may be willing to lend money, with a belief in some upside. In the meantime you are paying them are regular debt return in interest. But at their option (in the case of good performance or when a venture capitalist is coming on board) to convert their investment to equity at a favorable price. In effect, you can price the conversion to get the maximum at the conversion date, say in two years when things are singing along! In the meantime the note should have an interest rate below what you would normally pay without this option.

Your CFO should be aware of these types of options as you approach the market for funds.