The $528 million acquisition of fourth-largest rating agency Duff & Phelps Credit Rating Co. by third-largest Fitch IBCA has sparked speculation on what impact the newly merged company will have on its two top rivals.
While one waggish market analyst called the merger "also meets ran", a solid number of Street players on both sides of the Atlantic argued that the new rating agency could take a bite out of Moody's Investors Service's and Standard & Poor's Ratings Service's market share, especially overseas.
Europe in particular seems to be the battleground of the future for the now three rating agencies. Fitch already had a substantial presence in European ABS ratings, having a near-majority market share in some sectors of that market, according to one analyst. Add Duff & Phelps' strong presence in emerging markets like Eastern Europe, and you have the makings of a Continental ratings powerhouse, sources said.
Indeed, top brass at Fitch have publicly said that creating a European kingpin will be one of their goals. Fitch IBCA Chairman Marc de Lacharriere, who will head the new group, said upon the deal's announcement: "For many years now Fimalac [Fitch's parent company] has been interested in developing a European-owned alternative to the major U.S. agencies. Through the development of Fitch IBCA and with the acquisition of Duff & Phelps, we now have achieved our goal."
The new rating agency, which will have about 1,100 analysts and revenues of $260 million, "could break up the duopoly of Moody's and S&P," one European analyst said. In particular, the new Fitch/Duff (a formal name has yet to be chosen for the new company) could increase the need for European issuers to have more than one rating agency rate their deals. In the past, many issuers have only used either Moody's or S&P.
"It will put more pressure on the big two in terms of increasing competition for market share," added Alexander Batchvarov, head of international ABS research for Merrill Lynch & Co. Among the major European ABS deals Fitch has rated recently include deals from the Turkish Ottoman Bank, the Italian Banca di Roma and Cecchi, and Ocwen UK Ltd.
To be sure, Moody's and S&P are not going to stand by idly and watch their European presence be eroded. Both agencies have had about 15 years experience in the European market, both maintain a network of offices from London to Frankfurt to Milan, and both have seen an increase in business over the last few years. "If it's about creating a European global powerhouse, look around and see who's already there," said one market observer.
"As they have in the past, the markets will decide which ratings will provide the most value," said Bob Becton, vice president at Moody's, which said much of its ABS ratings growth in the last year has come from Europe. "We're confident about our role and growth in these future markets,"
"We're well positioned to compete in this industry," added S&P spokeswoman Christina Pretto. "We have the largest global network of any ratings service."
The Fitch/DCR merger can be seen as an act of survival first, a European powerhouse second, analysts said. "The ratings business is now a global business and if you're going to be in certain markets, you're not going to survive unless you rethink your business model," said one source familiar with the agencies. "This merger allows them to become a long-term player."
The Duff & Phelps acquisition consisted of Fitch making a friendly $100 per share cash offer for Duff. The merger has meant great news for DCR's stock price, which jumped from $79 per share at last Monday's close to $97 per share as of last Thursday's close.
According to sources and Fitch officials, the deal came together quickly and without much fuss over the last two months. Lazard Freres & Co. served as an advisor to Fitch in the acquisition, which will be completed through a cash tender offer, followed by a cash merger. The offer was conditional on Fitch IBCA receiving at least 50 percent of Duff & Phelps shares.
With de Lacharriere serving as chairman of the new company, Robin Monro-Davies has been named CEO and Stephen Joynt as president and COO. Paul McCarthy, chairman and CEO, and Philip Maffei, president, of Duff & Phelps will become directors of the new company.
For the short term, DCR and Fitch will maintain their separate offices in New York and Chicago, as there is of yet no physical room to consolidate the two shops. But expect groups in structured finance to merge soon, and for some employee cuts to occur when there is overlap.
"Investors have told us it's important to offer more comprehensive service," said Chief Executive Officer Joynt. "If we can't grow as fast [right now] as S&P or Moody's, we'll start catching up with them sooner rather than later."
What has some market players intrigued is the potential for pricing wars between the three rating agencies. Currently, with Moody's and S&P having a lock on much of the market, the agencies often get to write their own ticket. One source estimated that in some cases the agencies have as much as 50% profit margins. "There's definitely some room for price competition," he said.
Competition has already been nasty when there were four firms, as recent controversies such as Moody's "shadow" rating of deals and S&P's challenge that Moody's was relaxing its CMBS ratings standards can attest. Expect more of the same going forward, market observers said.
And the new merger could be a small boon for secondary bond investors as well. "It could lead to some real value opportunities in MBS and CMBS which have been rated by only Duff or only Fitch," said Michael Youngblood, head of mortgage research at Banc of America Securities. "Once those obligations are reaffirmed by the new company they could begin to trade at better spreads."
The Securitization Perspective
Securitization market participants, in particular, were taken aback by the announcement of the merger; many wondered how it will affect the market from a securitization standpoint.
A spokeswoman for Standard & Poor's Ratings Service feels that the merger of the two entities will not affect S&P's performance in any way.
"Securitization (structured finance) has long been a market that we are committed to," she said. "We have invested in our structured finance infrastructure and I believe that we are well positioned to continue to compete in this market."
With the acquisition, announced on March 7th and to be completed in four weeks or longer, Fitch said it has achieved its goal in "developing a European-owned alternative to the major U.S. agencies" according to the company's chairman de Lacharriere.
Another obvious reason for the consolidation is to increase the competitiveness in the ever-global rating business.
Fitch Chief Executive Officer Robin Monro-Davies said that by combining with Duff & Phelps, Fitch now can compete more effectively with S&P and Moody's.
The union of Fitch and DCR did not surprise company rivals. A spokeswoman at Moody's described that deal as a logical and strategic move for the two relatively small rating agencies but not enough to shake up the current rating market.
"The market will decide which rating agency is more valuable," she said.
Another source at Moody's shared the opinion of his colleague.
"It's a logical direction for smaller players (rating agencies) to go as they face the issues of globalization in demand for high quality rating services," he said. "We've already experienced this challenge when we began our international expansion back in 1985."
The consolidation will be a "definite boost" for Fitch's loan-rating business, said David Kelson, senior director of the loan products group at the agency. But whether the group will add more staff from DCR, which rates bank loans only occasionally, is still to be decided.
One of the more obvious forseeable changes is that Fitch will broaden the coverage of the insurance sector, a DCR specialization. In addition, Monro-Davies said the combined entity will add depth to its structured finance and corporate finance coverage, which both companies already dealt with extensively.
Monro-Davies hopes that that the new company will break the monopoly enjoyed by S&P and Moody's.
"Corporations need choices when shopping for rating agencies," he said.
And he is hopeful that the acquisition offers them one more serious and strong rating agency - not two weak ones - to choose from.
The $260 million combined revenue of Fitch and DCR is still half the size of either S&P's or Moody's, which is about $600 million and $500 million, respectively.
A source familiar with rating agencies added some insight as to why there may have been a need for this merger.
"Ratings are now global," said the source. "Structured finance is becoming global. It's very big in the US...the growth in Europe is going strong. If you want to be a player as a rating agency, you have to be as global as possible. So what this whole globalization has done, not only to structured finance, is forced smaller rating agencies to rethink their business model."