An ‘AAA’ move?

THE Malaysian rating agency business is dominated by two distinct and important companies – RAM Holdings Bhd and Malaysian Rating Corp Bhd (MARC).

The key role of both companies, despite being owned by other corporations, is to provide an independent assessment of credit ratings of institutions or corporates that require rating services when new debt instruments are issued.

Rating agencies play a significant role in the development of a vibrant debt capital market, as their services are required even post-issuance to ensure that the rating assigned to the papers that are issued reflects the core fundamental principles in assessing a credit paper.

In addition, rating agencies also provide other auxiliary services, which among others include training, risk analysis and research, as well as bond pricing.

Recently, RAM has been in the news due to changes in the shareholding of the company, as CTOS Digital Bhd, which owns some 19.225% of the company is expected to extend a general offer to acquire the remaining shares it does not already own.

This is made possible as the Securities Commission (SC) has approved “more than one applicant” to hold more than 20% shareholding in a credit rating agency (CRA).

Of course, about two weeks ago, shareholders of RAM also approved the resolution to remove the 20% cap on any individual RAM shareholder.

Presently, CTOS is the second-largest shareholder of RAM, after Oscar Matrix Sdn Bhd (OMSB), which owns 19.9%. Two other largest shareholders are S&P Global Asian Holdings Pte Ltd, with a 19.2% stake, and Dragonline Solutions Sdn Bhd, with 15.65%.

Nine other shareholders own between 0.3% and as much as 5.8% held by Hong Leong Bank. In total, these nine other shareholders own 26.02% of RAM.

Will CTOS obtain control?

With a 19.225% stake, and with the green light obtained for any shareholder to raise their stake above the 20% threshold as well as CTOS’ move to extend a general offer, the question on everyone’s mind is whether CTOS will succeed in gaining majority control or more than a 50% stake.

CTOS has a friendly party among the other shareholders in RAM as OMSB is a company that is owned by a fund, which is also a substantial shareholder of CTOS.

The common shareholding suggests that it is likely that OMSB will cease as a shareholder of RAM, thus allowing CTOS to raise its stake to at least 39.125%.

CTOS would then be just 10.875% plus one share away from gaining a majority control and in all likelihood, this would likely see some of the other nine shareholders agreeing to the general offer.

CTOS would easily gain the 50% threshold if all the minority shareholders with less than a 5% stake presently, which collectively totals 11.7%, accept the offer, giving CTOS a 50.83% stake in RAM.

If the offer price made by CTOS is good enough, even other major shareholders may throw in the towel and pass the baton for CTOS to own an even larger stake in RAM.

RAM valued at RM340mil?

Based on a recent transaction, the 350,000 shares or 3.5% stake acquired by CTOS in February this year was done at RM10.5mil or approximately RM30 per share while an additional 200,000 shares or 2% stake that was purchased after April is believed to have been bought at about RM34 per share, valuing RAM at RM340mil.

This is at about 28.3 times RAM’s financial year 2021 (FY21) normalised earnings and 1.93 times the book value.

While the valuation looks attractive vis-à-vis the premium valuation CTOS itself commands, the real crust of the valuation is whether RAM’s future profits will be earnings accretive to CTOS or otherwise, especially given that CTOS intends to fund the acquisition via borrowings.

The Malaysian CRA industry is an oligopoly with market players.

However, due to RAM’s long history, it has about two-thirds market share of the overall business and is almost three times larger than MARC, with total shareholders’ funds of about RM176.4mil against MARC’s RM62.6mil.

The table summarises the two Malaysian CRA based on the latest financial information extracted from their respective annual reports.

Assuming CTOS emerges as the single largest shareholder with more than 50% equity ownership, the rating industry is expected to be more competitive, as RAM will likely pursue a more aggressive approach to gain further market share of the growing rating agency business.

Niche industry

The capital market, or more specifically, the fixed income market is a very niche industry that requires special skills, especially in research, as well as a robust rating process.

Should RAM expand its business model, it will require a larger and bigger workforce, especially in the areas mentioned above, and without a key platform for new talents to emerge, the salary and wages of existing key personnel will rise and eat into business margins.

Staff cost is the single largest cost factor for CRA as that alone accounted for 63.2% of RAM’s revenue in 2021, down from 69.9% the year before.

In the case of MARC, its staff cost as a percentage of revenue has also been trending to about 48% last year against 54.9% in 2020.

Independence in substance

A CRA must be free from any influence from any parties, especially if the CRA is owned by another corporate with a majority stake.

Hence, CTOS’ public acknowledgement that the independence of RAM in credit assessment and rating as well as not being involved in operations of RAM is most welcome.

The stand that CTOS has taken is rather similar to other globally recognised CRA owned by large corporations, where the rating and operations of the CRA are left to the management of the agencies.

In addition, the SC has said that it is also reviewing the existing framework on rating agency committees to strengthen the independence and objectivity of CRAs as well as allowing companies, including public-listed companies, to be shareholders of CRAs as seen in other markets.

For example, Moody’s Corp, which owns Moody’s Investors’ Services, is a public listed company and its majority shareholders are Berkshire Hathaway with a 13.4% stake, and The Vanguard Group, with a 7% stake, while the rest of the top 10 shareholders own less than 5% each.

S&P Global, which owns S&P Global Ratings, is also a public listed company, having The Vanguard Group as its majority shareholder with an 8.1% stake, while the rest of the shareholders have less than a 5% stake each.

Fitch Ratings is the other CRA that is an unlisted entity and in their books, Hearst Corp is a global media giant.

The SC has also reiterated that given the critical role CRAs play in providing credible credit rating opinions, the independence and objectivity of CRAs’ credit assessment process and rating decisions should never be compromised.

In RAM’s case, independence must not only be seen in form but also in substance.

After all, the rating agencies play a critical role in ensuring that rating exercises are carried out professionally and without interference from any shareholders of the rating agency.

To ensure this, a major shareholder should not have any representation at the board level and all board members must be independent.

This also applies at the rating committee level, which is critical in ensuring the independence of the rating process itself.

Do we need another CRA?

In a related development to CRAs, the SC too is encouraging applications for a third rating agency.

While the SC may have its reasons for opening up the window for new applicants, the Malaysian fixed income market is rather small to accommodate a new player, both in the form of business volume as well as resources, especially human capital.

With the two current rating agencies sharing the market volume of about RM70mil to RM75mil a year, growing at about 15% to 20% annually, the setting up of a third rating agency may sound attractive.

However, the question of capability comes to mind as the industry does not have the in-depth talent to allow a new player to set foot, just yet.

Perhaps a much better approach is to ensure we have the talent pool of capable credit analysts, similar to the equity market analysts, before allowing a new player to set foot into this niche industry.

In addition, the rating industry should also adopt best practices with respect to the poaching of staff and pricing for rating-related work to ensure a healthy industry for the benefit of the capital market as a whole.

Hence, while the deal to acquire RAM by CTOS may be seen as positive in terms of the financial data, mainly due to CTOS’ own rich forward price-earnings multiples, the deal has larger repercussions to the capital market and hence may not be seen as an AAA deal.

Pankaj C Kumar is a long-time investment analyst. The views expressed here are the writer’s own.