Standard & Poor's (S&P) has released revised criteria for classifying the equity content of hybrid securities, leaving some New Zealand and Australian companies with higher debt to equity ratios overnight. S&P's revised classifications seem to be in response to the flood of hybrid issuances in recent years that benefited from the classification of hybrids as high equity for ratings purposes, but which were structured to have characteristics of debt securities.
Hybrids, having both debt and equity characteristics, will now only be classified as having high equity content (up to 100%) if the issuing company intends to maintain the hybrids as loss-absorbing capital and if the securities are either subordinated to conventional debt (and meet other permanence requirements), are convertible to ordinary equity, or are held strategically by a group entity or government. Hybrids that do not meet high equity content requirements will be classified as having either intermediate equity content (up to 50%) or minimal equity content (0%).
Affected companies now find themselves with unexpected debt or lower ranked equity content for ratings purposes that worsens their overall rating position, while still being left with an instrument that is typically more expensive than conventional debt (due to the high interest rates required to attract unsecured investors). These companies will have to decide whether to redeem hybrids early by virtue of this 'ratings event' (possibly by refinancing with traditional debt or equity, or amending the terms and conditions of the relevant hybrid instruments) or just deal with the change to their balance sheet. Some New Zealand companies like Contact and Genesis have announced through NZX that they are affected by S&P's reclassification and are currently considering redeeming their affected products.
Whether issues of hybrids will reduce as a result of S&P's re-classification is yet to be seen but it is possible that for some issuers traditional equity or debt funding will become more attractive. However, in some sectors, including, for example insurance, which are becoming subject to greater regulatory supervision and specific rules regarding what qualifies towards minimum regulatory capital requirements, hybrids remain a viable option. If properly structured, such instruments can still meet both the regulator's and S&P's requirements and provide a useful alternative in the capital raising tool box.