On June 13 2017, Euler Hermes Rating GmbH (EH Rating) 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 methodology applies to SMEs and MidCaps in Germany. 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 methodology does 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 methodology, and they are not subject to the SME Rating Methodology.
The methodology does not cover large corporates or corporates structured as project financings and is used for assigning issuer credit ratings. In addition, this methodology may also not apply to companies that match the size and debt parameters for SMEs as defined above but for which EH Rating considers important risk characteristics to lend themselves to credit considerations that require a distinct analytical approach.
The SME Rating Methodology was calibrated using companies in the non-financial sector (see further under ”How was the SME Rating Methodology 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 methodology, and they are not subject to the SME Rating Methodology.
The SME Rating methodology is based on an in-depth analysis of the German SME and MidCap sector and comprehensive experience of assessing credit risk for German SMEs and MidCaps. Material elements of this methodology are built on large amounts of historical information, covering nearly 40,000 German companies over the 2002-15 period with revenues of typically between €10 and €500 million, with a median/mean of approximately €30 million/€75 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 methodology was developed in collaboration with Moody’s Investors Service and Euler Hermes. Both companies are shareholders of EH Rating, in which MIS owns a minority stake.
As an independent credit rating agency, EH Rating follows its own validation guidelines and processes. While the SME Rating Methodology was developed in collaboration with Moody’s Investors Service, it was and will continue to be subject to validation by EH Rating’s validation guidelines and processes. Periodic updates to the SME Rating Methodology will be done in collaboration with Moody’s Investors Service 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 Methodology is that it has a robust quantitative foundation, supported by a large historical database 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 a deep and broad dataset.
The second benefit of the SME Rating Methodology is that it has a comprehensive, consistent and transparent framework, with a precise and detailed, yet not overly complex, scorecard, as well as guidance for analytical adjustments to the scorecard outcome. The scorecard allows 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 EH Rating’s assessment and allows for immediate comparability across issuers.
The scorecard will also provide the channel for leveraging the combined knowledge of expert credit analysts at EH 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 Methodology uses 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 Methodology allows EH 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 EH Rating’s latest Default Study, which can be found on their website at https://www.ehrg.de/en/ ).
As shown in the charts below, about one third of a sample of approximately 24,000 of the nearly 40,000 SMEs whose data was used to develop the new methodology 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.
Chart 1: Financial Scores Distribution by Broad Rating Categories
Chart 2: Financial Scores Distribution by Broad Rating Categories
The first SME Rating Methodology that was developed in collaboration with Moody’s Investors Service and Euler Hermes applies to companies in Germany. 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.
However, credit ratings are to be expressed on the same scale and to have the same meaning across countries.
EH Rating analysts are to use the SME Rating Methodology to assign credit ratings, or other types of credit assessments under EH Rating’s rating processes and procedures, as documented, filed and reviewed by regulators. EH Rating is a European, independent, regulated credit rating agency.
The SME ratings to be assigned based on the SME Rating Methodology are those of EH Rating. While Moody’s Investors Service is involved in the development of the SME Rating Methodology and its periodic update, it is EH Rating exclusively that validates, assigns and monitors credit ratings and other credit assessments, as applicable. In addition, the SME ratings assigned by EH Rating are expressed on EH Rating’s global scale, not that of Moody’s Investors Service.
While the SME Rating Methodology includes a robust quantitative module, which is based on a broad and deep base of historical data for dozens of thousands of companies in Germany, it also includes 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 Methodology includes 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 Methodology also considers qualitative elements outside the scorecard, such as the quality of the debt structure or the liquidity profile of a company.
The SME Rating Methodology applies across industries (with the exclusion of specific sectors, including the financial industry – see question “Which companies does this methodology 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 Methodology 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 Methodology was calibrated using a large sample of companies in the small, medium and MidCap size range, as explained under ”How was the SME Rating Methodology developed”. The SME Rating Methodology is only applicable to companies with a profile similar to those in the 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 Methodology, 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 Methodology.
Ratings are also based on forward-looking expectations, which may vary from past performance and ratios reflected in historical financial statements. We seek to incorporate all relevant risks into our ratings, whether long term or short term, incorporating appropriate forward-looking views wherever we have appropriate visibility. While ratios included in the financial profile component of the scorecard 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 methodology was developed and extensively back tested across a large sample of companies with historical data and credit performance. The chart below reports the 2-year cumulative default rates by broad rating categories. Default rates generally increase with lower financial profile scores indicating that SME financial profile scores, and by extension SME ratings derived from those scores are a good predictor of default risk. Adding the qualitative layer of the methodology to the financial score is thought to further improve the robustness and discriminatory power of the analysis.
Chart 3: 2Y Cumulative Default Rates by Broad Rating Categories
For more details about the performance of the quantitative part of the methodology, including the average defaulter position, it can be referred to EH Rating’s latest validation study, to be found on EH 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. EH 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 by 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, EH Rating may update its SME Rating Methodology from time to time (in collaboration with Moody’s Investors Service).
 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 default. For more details on the definition of ratings, please see “Basic Principles” on EH Rating’s website at https://www.ehrg.de/en/.
 I.e. scores based on the financial profile component of the scorecard only.
EH Rating’s SME product offering can be accessed on its website. While the SME Rating methodology constitutes the framework for SMEs and MidCaps credit ratings or credit estimates, the quantitative part of the methodology provides 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, EH Rating will also have access to dynamic credit alerts, amongst other sources of information.
Some of Moody’s 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. EH Rating expects its SME ratings or other types of credit assessments to lend themselves to such an analysis and therefore be a potential input for MIS to determine the overall creditworthiness of a portfolio of SME credits backing structured finance debt.