Wednesday, January 28, 2009

Investcorp Bank Goes Rating Shopping

Standard & Poor's Ratings Services said today that it lowered its long- and short-term counterparty credit ratings on Bahrain-based Investcorp Bank B.S.C. and related entity Investcorp S.A. to 'BB+/B' from 'BBB/A-2'. At the same time, the long-term counterparty credit ratings remain on CreditWatch with negative implications, where they were originally placed on Nov. 21, 2008. Furthermore, the short-term counterparty credit ratings were removed from CreditWatch where they had been placed with negative implications on Nov. 21, 2008. Additionally, the long- and short-term counterparty credit ratings on Investcorp Bank B.S.C. and Investcorp S.A. were subsequently withdrawn at the company's request.

"The two-notch downgrade reflects our view of the increasingly difficult operating environment for Investcorp's principal business lines of hedge fund investing, private equity, and real estate. We understand that InvestcorpInvestcorp is in the process of significant deleveraging, and we view this and the relatively conservative approach to originating deals in 2008 as positive for creditworthiness," said Standard & Poor's credit analyst Nick Hill.

"However, in our view, global deleveraging, falling equity and real estate prices, and tight credit are combining to lower the value of Investcorp's proprietary investments, strain funding and liquidity, and reduce capitalization," added Mr. Hill. "Moreover, the prospects for higher quality fee income from the core asset management businesses are likely to be constrained by broader weaknesses in economies and financial markets alike, and we expect this to reduce InvestcorpInvestcorp's interest service metrics," continued Mr. Hill.

InvestcorpInvestcorp has five main business lines covering the management of alternative investments, namely private equity, hedge funds, real estate, technology investments, and growth capital in the Gulf. Assets under management were $17.7 billion at June 30, 2008 (of which $3.9 billion represented Investcorp's own investments), but are expected to fall significantly, reflecting weak performance, a reduction in Investcorp's own hedge fund investments, and client redemptions. The management and investment teams are generally longstanding and we view Investcorp's investment and review processes as sound.

Investcorp's business model appears characterized by significant proprietary investments, which it makes in private equity, hedge funds, and real estate in tandem with its clients. This strategy appears designed to align InvestcorpInvestcorp's interests with outside investors. In our opinion, however, the strategy may expose InvestcorpInvestcorp to significant risks as real estate and private equity investments in particular are relatively illiquid. Like all Investcorp's investments, these are marked to market through the income statement. Earnings are therefore volatile and are likely to be especially weak in the near term, reflecting poor performance in hedge funds and declining valuations in real estate and private equity--all of which, in our view, previously benefited from cheap credit. Furthermore, the lack of investor appetite for riskier assets means that fee income could also come under pressure for some time. We understand that Investcorp has no direct or indirect exposure to Madoff funds. In our view, however, the Madoff scandal and weak performance generally could lead to increased hedge fund redemptions across the industry. These factors appear to have necessitated some restructuring to reduce the cost base.

Furthermore, we believe the unfavorable environment for realizing investments and placing more recent deals is likely to reduce cash flow, at the same time as losses on proprietary investments are likely to reduce capital. The concentrated nature of the large exposures within the private equity portfolio may, in our view, pose additional risks.

Prior to withdrawal, the long-term ratings were on CreditWatch with negative implications, where they were originally placed on Nov. 21, 2008. "We believe that earnings, capital, and liquidity are likely to have been adversely affected by market conditions, as indeed has the alternative asset management business model. We expect these factors to be mitigated in part by capital raising and a shift into more liquid assets," added Mr. Hill.

If we continued rating Investcorp, we would see further downside to the ratings arising from a potential failure to improve capitalization and liquidity. In this scenario, we believe that this downside might be more than one notch.

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