The S&P criteria for evaluating investment holding companies (IHC’s) has the potential to move Temasek from a AAA rated credit firm to Greece as the headlines have noted. While this headline does accurately capture the potential impact, too many have focused on the outcome and a misreading of the its implication and not enough effort focusing on how the proposed methodology arrives at the new rating. In fact, the potential outcome of the S&P proposal rests on much more technical reasons than a sudden belief that Temasek is a low credit quality firm.
The biggest proposed change is the importance S&P gives to liquidity in their risk assessment of IHC’s noting that “we propose to give a greater weight to our assessment of asset liquidity than to our assessments of asset diversity and asset credit quality.” S&P stresses the importance of liquidity “…because the ability to sell assets quickly is the ultimate source of debt repayment if an IHC cannot refinance maturing debt. Our assessment reflects how quickly we expect the entity can liquidate assets at a reasonable price.”
There are solid financial reasons, especially for a firm like Temasek, to accept higher liquidity risk by holding lower liquidity assets. Studies have found that asset liquidity is valued so that financial firms, such as hedge funds, willing to hold lower liquidity assets receive a premium for bearing that risk. University endowments have targeted lower liquidity investments given longer investment time horizons and the ability to sell at their discretion.
The second major proposal is to use “spot prices” rather than some “average price over n trading days – to value listed assets.” Related to but also distinctly different from liquidity, this focuses on what price could assets be sold to cover debt payments. This debate has raged for how banks should value their loan portfolios in what is typically called “mark to market” by valuing a bond or loan at the market price the bank could expect to sell it at or at some other less potentially volatile rate such as a long term average or expected stream of cash flow basis.
There is reasonable and straightforward logic as to why spot prices should not be used. Let’s use a simple scenario to illustrate why. Assume the market price of an asset declines and a financial institution reaches a level where they have to sell the asset to cover their debt payment. When they sell an asset this further depresses the market price potentially causing other firms to be forced to sell. It is also possible to recreate this scenario in reverse when prices are going up. Fundamentally, there is a solid argument that using market prices can increase volatility. It should be strongly emphasized that reasonable people have reasonable disagreements on this very tricky issue.
While these two concepts need to be considered separately, they also need to be considered jointly. S&P is proposing that we ask the following about credit risk as it pertains to IHC’s: if an IHC needs to sell assets to repay a debt, how easily can it sell its financial assets and at what price?
How do these concepts apply to Temasek specifically? Temasek can reasonably be considered a somewhat less liquid IHC for two reasons. First, Temasek asset holdings are relatively concentrated. Temasek holdings are concentrated with significant stakes in key firms like Singapore Telecom, DBS, Standard and Chartered, and China Construction Bank. As one article noted, approximately 50% of Temasek assets are concentrated in ten firms. If Temasek needed to sell some of these stakes, given the large size of the holdings, this would reduce the liquidity by pushing down the price if Temasek needed to sell a significant amount or if the market found out Temasek was selling a sizable block. Also, if Temasek ever needed to sell its entire stake in a major holding, this would significantly reduce companies with the ability to finance large acquisitions.
Compare this to Norges Bank Investment Management (NBIM) which manages the Norwegian sovereign wealth fund. They have limited themselves to 2% of outstanding equity of any company they hold. While this essentially turns them into an index fund as they hold 1-2% of most every listed company, this also means that they remain very liquid. NBIM is able to easily sell stakes in entire companies in relatively short periods of time or in many companies when needed. In short, there is elevated liquidity risk due to the concentration of Temasek’s portfolio.
Second, there is what I will term political liquidity risk. Look at the major holdings in Temasek’s portfolio and you will see politically strategic firms like Singapore Telecom, DBS, and Singapore Airlines. Those are for all practical purposes completely illiquid investments where Temasek depends on dividend cash flow for debt repayment. Removing firms from the Temasek portfolio that are for all practical purposes illiquid, reduces Temasek liquidity to cover debt repayment even further. The S&P concern over liquidity risk has a significant impact when focusing on Temasek.
Turning to the question of what price Temasek might be able to secure for its assets under different market conditions returns us to the issue of asset concentration and political risk. Not only is the Temasek portfolio concentrated within its portfolio, it is concentrated by industry and geography with an increasing allocation to higher risk assets like financial and natural resource firms. For example, three of the top four holdings are in financial firms and Temasek remains closely linked to Singapore and surrounding countries. This implies a high degree of correlation among their holdings. If the market is declining, then Temasek would need to price any significant asset sale at an even larger discount. Conversely, in a rising market Temasek might be able to extract a sizable premium for one of its strategic stakes. However, given the concern about debt coverage from asset sales, we should focus on down markets and again there is cause for concern. There would be significant pricing pressures on any significant asset sales by Temasek.
There would also be pricing pressure due to potential political risk. Let’s assume for one moment that Temasek decides to sell a significant stake Singapore Telecom, DBS, or Singapore Airlines. Given the long historical record, key personnel through each firm, and political significance, any buyer would be enormously concerned about undue influence exercised after the sale. The same could also be said about most Asian holdings for instance in China Construction Bank or Bank of China. The Chinese government would most likely have a strong opinion about Temasek selling its holding to anyone else. Political risk is likely to impact the final sales price and not positively.
The primary risks the S&P is proposing to increase in its credit model for IHC’s are the ability to sell and the price it will receive for selling. I believe there is a fair and reasonable case to be made that when Temasek is narrowly analyzed against these two criteria, it does have an elevated risk level. There is good reason to have some concern over liquidity and asset pricing risk should it need to sell assets to cover debt repayment.
As noted at the beginning of this article, while the S&P frameworks does raise the risk profile of Temasek, it is important to note the reasons why. Their reasoning focus on specific and technical issues and not due to a new belief in the underlying quality of Temasek assets.
Note: Part III will cover the Temasek response, whether they should be considered as risky as Greece, and other bigger picture issues.