On June 13 2017, Euler Hermes Rating GmbH (EHRG) published its SME Rating Methodology. It is the first in a series of cross-industry, country-specific methodologies to be rolled out in 2017 and onwards. This methodology was developed in collaboration with Moody’s Investors Service (MIS) as part of its previously announced collaboration with Euler Hermes to provide credit ratings for SMEs and MidCaps across Europe. The new rating services based on this methodology are now operated under the TRIBRating brand.
The SME rating methodologies apply to SMEs and MidCaps. We consider an issuer corresponding to the “SME and MidCap” definition to typically have total revenues between €10 and €500 million or financial debt of less than €150 million. SMEs and MidCaps typically exhibit a stronger regional focus, a lower level of product diversification or higher dependencies on customers than we would generally expect for large corporates.
The methodologies do not apply to non-corporate issuers, such as companies operating in the financial sector, which typically exhibit different financial and operational features.
The credit profile and comparison of such companies require different rating considerations and distinct methodologies.
Similarly, public institutions and companies incorporated for less than two years were excluded from the large sample of corporate data used to develop the methodologies, and they are not subject to the SME Rating Methodologies.
The methodologies do not cover large corporates or corporates structured as project financings and are to be used for assigning issuer credit ratings. In addition, these methodologies may also not apply to companies that match the size and debt parameters
for SMEs as defined above but for which Euler Hermes Rating considers important risk characteristics to lend themselves to credit considerations requiring a distinct analytical approach.
The SME Rating Methodologies were calibrated using companies in the non-financial sector (see further under “How were the SME Rating Methodologies developed?”).
Companies operating in the financial sector typically exhibit different financial and operational features.
The credit profile and comparison of such companies require different rating considerations and distinct methodologies. Similarly, public institutions and companies incorporated for less than two years were excluded from the large sample of corporate data used to develop the methodologies, and they are not subject to the SME Rating Methodologies.
The SME Rating methodologies are based on an in-depth analysis of the German and French SME and MidCap sectors and comprehensive experience of assessing credit risk for French and German SMEs and MidCaps. Material elements of these methodologies are built on large amounts of historical information for companies with revenues typically between €10 and €500 million. Specifically, the methodologies were built reviewing:
- About 39,000 German companies over the 2002-15 period, with median/mean revenues of approximately €30 million/€75 million, respectively
- About 45,000 French companies over the 2007-16 period, with median/mean revenues of approximately €18 million/€40 million, respectively.
The large sample of corporate information excludes companies in the financial sector, public institutions and companies incorporated for less than two years.
The methodologies were developed in collaboration with Moody’s Investors Service and Euler Hermes. Both companies are shareholders of Euler Hermes Rating, in which MIS owns a minority stake.
As an independent credit rating agency, Euler Hermes Rating follows its own validation guidelines and processes. While the SME Rating Methodologies were developed in collaboration with MIS, they were and will continue to be subject to validation by Euler Hermes Rating’s validation guidelines and processes. Periodic updates to the SME Rating Methodologies will be done in collaboration with MIS and Euler Hermes.
While SMEs and MidCaps are an extremely diverse population, these companies share some credit characteristics that differentiate them from very large or very small
companies. SMEs and MidCaps typically exhibit a stronger focus on regional sectors, a lower level of product diversification or higher dependencies on customers than we would generally expect for large corporates. At the same time, the credit quality of SMEs and MidCaps is dependent upon variables that may not be as important for companies of a larger size.
The first benefit of the SME Rating Methodologies is that they have robust quantitative foundations, supported by large historical databases evidencing the key drivers of credit quality for companies in this size category. It is exceptional for a methodology development to be able to rely on such deep and broad datasets.
The second benefit of the SME Rating Methodologies is that they show a comprehensive, consistent and transparent framework, with precise and detailed, yet not overly complex, scorecards, as well as guidance for analytical adjustments to the scorecard outcome. The scorecards allow for a consistent application and comparison of credit considerations with respect to SMEs and MidCaps across industries and countries.
The developed methodological framework facilitates a transparent description within issuer reports of the credit considerations that drive Euler Hermes Rating’s assessment and allows for immediate comparability across issuers.
The scorecards will also provide the channel for leveraging the combined knowledge of expert credit analysts at Euler Hermes Rating. While the transparency of this approach allows users to understand each step of the credit assessment approach, it also allows them to compare it with their own view and potentially perform their own analysis using this framework.
Finally, in order to provide a granular credit risk differentiation, the SME Rating Methodologies utilize the same full spectrum global rating scale used to rate all other issuers.
We recognize that market participants do not look at SME and MidCap credit risk in isolation: they need to be able to compare credit risks against their broad portfolio of debt, locally or globally, under a common rating scale. The robust development process of the SME Rating Methodologies allows Euler Hermes Rating to gradate its credit risk opinions across the full spectrum global rating scale, as evidenced in the default statistics for the sample data (based on financial information only) used in the methodology development process. (See Euler Hermes Rating’s latest Validation Study, which can be found on their website at https://www.ehrg.de/en/).
As shown in the charts below, about one third (Germany) and nearly a quarter (France) of a sample of approximately 24,000 (Germany) and nearly 42,000 SMEs and MidCaps (France) whose data was used to develop the new methodologies were scored BBB or higher purely under the financial profile component of the methodology’s scorecard.
This distribution is robust to out-of-sample tests: the financial score distributions by rating categories are very similar for the in-sample and out-of-sample.
The SME Rating Methodologies that were developed in collaboration with Moody’s Investors
Service and Euler Hermes so far apply to companies in Germany and France. SME Rating Methodologies for other countries are under development and will be published sequentially.
SME Rating Methodologies are developed using large amounts of information and knowledge that are country-specific, which drive the relative importance of the different credit considerations, and the standards associated with specific rating categories in each country.
As a result, while methodology frameworks are similar and address the same broad credit risk drivers, the scorecards developed for SMEs and MidCaps in different countries may slightly differ in the choice of specific sub-factors for each credit risk consideration, in their relative weights or in the ranges associated with specific risk categories for each of these considerations.
In addition, credit ratings are expressed on the same scale and have the same meaning across countries.
Euler Hermes Rating analysts are to use the SME Rating Methodologies to assign credit ratings, or other types of credit assessments under Euler Hermes Rating’s rating processes and procedures, as documented, filed and reviewed by regulators.
Euler Hermes Rating is a European, independent, regulated credit rating agency.
The SME ratings assigned based on the SME Rating Methodologies are those of Euler Hermes Rating. While MIS is involved in the development of the SME Rating Methodologies and their periodic update, it is Euler Hermes Rating exclusively that validates these, and assigns and monitors credit ratings or other credit assessments, as applicable. In addition, the SME ratings assigned by Euler Hermes Rating are expressed on the global scale used by Euler Hermes Rating, not that of MIS.
While the SME Rating Methodologies include a robust quantitative module, which is based on a broad and deep base of historical data for tens of thousands of companies in Germany and France, they also include a number of key qualitative considerations that are important for assessing an SME’s or MidCap’s creditworthiness.
For transparency and consistency, the SME Rating Methodologies include a detailed scorecard, with a list of considerations, their weights in assessing the credit profile of an SME or MidCap issuer and ranges associated with specific rating categories. Although qualitative considerations have a weight of 30% in the scorecard, the SME Rating Methodologies also consider qualitative elements outside the scorecard, such as the quality of the debt structure or the liquidity profile of a company.
The SME Rating Methodologies apply across industries (with the exclusion of specific sectors, including the financial industry – see question “Which companies do these methodologies apply to?”). Although financial metrics in the scorecard apply to companies in different industries, we may perform analytical adjustments to financial inputs to account for industry specifics (e.g. adjustments for leasing and rental obligations and factoring, or depreciation, amortization and operating expenses).
In addition, the qualitative components of the SME Rating Methodologies generally consider the position of an SME or MidCap against its peers, within a specific industry or an even narrower business segment.
The SME Rating Methodologies were calibrated using a large sample of companies in the small, medium and MidCap size range, as explained under “How were the SME Rating Methodologies developed?”. The SME Rating Methodologies are only applicable to companies with a profile similar to those in their relevant methodology development sample and not for large corporates, for which different credit considerations, and thus, distinct methodologies, apply.
While size is explicitly considered in the SME Rating Methodologies, important drivers of credit risks, such as customer and supplier diversification, market shares, strength of product offering, for which size is sometimes used as a proxy, are instead reflected directly and more precisely in the qualitative considerations of the SME Rating Methodologies.
No. Ratings are also based on forward-looking expectations, which may vary from past performance and ratios reflected in historical financial statements. We seek to reflect all relevant risks into our ratings, whether long- or short-term, incorporating appropriate forward-looking views wherever we have appropriate visibility.
While ratios included in the financial profile component of the scorecards are mainly historical, rating committees may find it analytically useful to incorporate into their credit assessments projected financials over different time periods and scenarios.
The qualitative components of the scorecards are also intended to incorporate forward-looking views, to account for the dynamic nature of a company’s business and industry profiles.
The quantitative part of the methodologies was developed and extensively back tested across large samples of companies with historical data and credit performance.
The chart below reports the 2-year cumulative default rates1 by broad rating categories for German SME in the development sample.
Default rates generally increase with lower financial profile scores indicating that SME financial profile scores2, and by extension SME ratings derived from those scores are a good predictor of default risk.
Adding the qualitative layer of the methodologies to the financial score is thought to further improve the robustness and discriminatory power of the analysis.
1 For the purpose of model development, we have built a default indicator that used information on legal insolvency as well as selected severe payment incidents, which together were thought to best approximate credit. For more details on the definition of ratings, please see “Basic Principles for Assigning Credit Ratings and Other Services” on Euler Hermes Rating’s website at https://www.ehrg.de/en/.
2 I.e. scores based on the financial profile component of the scorecard only.
For more details about the performance of the quantitative part of the methodology, including the average defaulter position, Euler Hermes Rating’s latest validation study can be found on Euler Hermes Rating’s website at https://www.ehrg.de/en/.
However, as with any new methodology, the assessment of the performance of the actual ratings assigned under this methodology will be subject to the existence of a robust statistical track record that will only become available with time.
Euler Hermes Rating will track the performance of the SME ratings it assigns in the future across a wide range of measures. The performance of SME ratings will be reviewed through the agency’s review function periodically, and reported regularly as part of the agency’s annual validation study. In addition, as new information becomes available, Euler Hermes Rating may update its SME Rating Methodologies from time to time, in collaboration with Moody’s Investors Service.
Euler Hermes Rating’s SME product offering can be accessed on its website. While the SME Rating methodologies constitute the framework for SMEs and MidCaps credit ratings or credit estimates, the quantitative part of the methodologies provide the support for scoring products.
Yes, SME credit ratings will be monitored. While information provided by rated issuers should provide the main source of information to be used for monitoring ratings, Euler Hermes Rating will also have access to dynamic credit alerts, amongst other sources of information.
Some of Moody’s Investors Service methodologies for assessing the creditworthiness of portfolios of SME credits, such as SME Asset-Backed Securities (ABS) or Collateralized Loan Obligations (CLOs), provide a framework for the use of third-party ratings or credit scores. SME ratings or other types of credit assessments from Euler Hermes Rating lend themselves to such an analysis and therefore could be a potential input for MIS to determine the overall creditworthiness of a portfolio of SME credits backing structured finance debt.