Q&A with KBRA

Several months ago I profiled Kroll Bond Rating Agency (KBRA), the new kid on the rating agency block. At the time I concluded that KBRA’s success and its impact on the rating industry remained to be seen and I documented several questions that would likely determine whether KBRA could revolutionize the ratings industry.

Recently, I had an opportunity to pose these questions directly to KBRA’s management: Mr. Jules Kroll, Chairman and CEO, and Mr. James Nadler, President and COO.

Yuval Bar-Or: What do you think would happen (to financial markets, competition, regulation) if the NRSRO designation was abolished?

James Nadler: The issue is that if you abolish the NRSRO designation, what would take its place? … I guess the real sub-question there is: is there something that can easily replace that system and be used that will allow the NRSRO designation to be abolished and for financial markets to continue to move forward.

Yuval Bar-Or: Let’s not worry about predetermining what the replacement would be. Let’s just say that the designation no longer exists … would [there] be market turmoil?

James Nadler: Probably not …

Yuval Bar-Or: Would you support abolishing the NRSRO designation?

James Nadler: I know that Moody’s and S&P and Fitch have historically supported abolishing the NRSRO … I don’t view it as a positive or a negative and we would go about our business whether we had the NRSRO designation or not.

Yuval Bar-Or: How can KBRA displace the incumbent oligopoly and revitalize the industry if it embraces the same embattled and many would say, discredited, issuer pays model?

James Nadler: I certainly understand the notion that in a perfect world it would be great if there were such a thing as an investor pay model because it would remove the conflict … The facts are that the very large complexes that buy fixed income securities don’t need the rating agencies because they do their own work. It is far and away the 80 percent of investors who don’t have the wherewithal to cover all of the various securities that the rating agencies provide that really need rating agencies but also don’t have the wherewithal to pay for the ratings. So it’s a market reality that to have a meaningful platform to talk about issues in the fixed income market to rate bonds in a meaningful way and to really have a meaningful impact and help investors you need to be organized as a rating agency that uses the issuer pays model and I think that that said you need to realize that there are inherent conflicts and you need to organize yourself internally so that you ameliorate those conflicts.

Yuval Bar-Or: Is it physically possible for K2 Global to investigate and monitor enough entities to support KBRA’s intended growth?

James Nadler: K2 global is simply one of the outside groups that we potentially could use on a transaction and so our due diligence capabilities are not limited at all by K2’s capabilities. If for instance K2 didn’t have a particular capability that we needed we would go outside or if they for some reason weren’t staffed to get it done we would go outside so our due diligence capability isn’t limited by K2’s size or growth plan.

Yuval Bar-Or: Would you not then potentially run into problems with inconsistency if different providers use their own techniques or follow their own [investigative] procedures?

James Nadler: You have to have a good idea of how you want the work to be done and guidelines for how you review the output so that you can maintain as much consistency as possible. Now you’re always going to have slight inconsistencies. You’re going to have an inconsistency depending on which analyst you get but hopefully the framework in which you do it ameliorates those inconsistencies and makes them … as small as possible: small enough that they aren’t a big factor in the final output.

Yuval Bar-Or: KBRA insists that once the rating process is set in motion the resulting rating will be published, whether it is favorable or not. Would [issuers] only end up on KBRA’s doorstep if the others provide unsatisfactory ratings? Would KBRA effectively become the rater of last resort?

James Nadler: … you need to spend most of your time working with investors so that they understand your rating criteria. Your rating criteria needs to be transparent and as such it won’t be a surprise to anyone when you come out a certain way but I think the strength the rating agency gets and should get comes from its investors … when you are asked to rate a deal or are bypassed on a particular deal because it’s assumed that you would have a more negative view investors can then make a decision as to whether or not they want to invest in that deal.

Yuval Bar-Or: In the issuer pays model it is the issuers who decide whether to bring business to KBRA. How does catering to investors avoid KBRA becoming the rater of last resort for issuers?

James Nadler: When investors have a strong preference for one particular rating agency it impacts the issuer’s choice as the issuer ultimately needs to sell the bonds to the investors.

Yuval Bar-Or: What do you think of S&P’s recent downgrade of the US Sovereign rating?

Jules Kroll: I have on numerous occasions called into question the ability of these rating agencies to do an effective job on Sovereigns to begin with; whether they really have the capability with the 80 or 90 people that they have … looking at more than 100 countries especially something as complicated as the United States. Specifically regarding S&P I feel that the way they conducted themselves was way out of bounds. For them to take a political position and lay out the ground rules for what had to be done by the US congress and the President in order to maintain the rating was presumptuous, way out of bounds and something that a rating agency has no business doing.

Yuval Bar-Or: Your July 27, 2011 testimony seemed to imply that you feel a rating agency should be able to sniff out fraud.

Jules Kroll: I didn’t mean to imply that we’re going to be sniffing out fraud. What I meant to say was that we are going to conduct certain types of diligence depending on the nature of the corporations that we’re looking at and we’re not going to do it strictly relying on a review of the diligence that is provided to us by issuers but we are going to do some of our own diligence in addition. I didn’t mean to imply that we would look for fraudsters. That level of depth we wouldn’t be going into.

Yuval Bar-Or: In your verbal testimony on July 27th you stated that hiding behind the first amendment is scandalous. What do you view as the correct level of responsibility and accountability that rating agencies should have in future?

Jules Kroll: My view is that the there should be a series of standards, which don’t exist today by the way, that are not all about filling out forms and checklists and the like. There should be a series of standards that rating agencies are expected to do in each of the various categories that they rate. In other words, if you will, standards of care. They don’t have to be in enormous detail and then anybody who does the rating should, just like bankers, auditing firms, lawyers, conduct themselves in a certain way. If they don’t then they should be accountable for that.

Yuval Bar-Or: Your written July 27th testimony indicates significant ownership by 35 pension funds and family offices. How many pension funds and how many family offices have ownership stakes?

Jules Kroll: Our … ownership structure is that our family office and our employees collectively own 60% of the business. The other 40% are owned by other family offices and pension funds. Those pension funds are LPs of several of the Venture Capital firms that invested in this venture. Our co-leads are Bessemer Venture partners and the other co-lead is RRE … and so what you have is public pension funds such as New York State pension fund, New York City pension fund, Michigan pension fund, Pennsylvania, and a number of others and also you actually have … some pension funds outside the United States in a couple of cases. So there are thirty five pension funds who are LPs of the venture capital firms. There’s also a third venture capital firm as well but it’s not one of the leads… in addition we have four other family offices.

Closing Remarks: Having now had the opportunity to communicate directly with KBRA’s management, do I believe the firm will succeed? The answer hinges round one’s definition of success. Mr. Kroll is a very savvy businessman and has surrounded himself with industry insiders. Disenchantment with the incumbents combined with even bigger barriers to entry due to more regulations will likely allow KBRA to carve out a niche and realize success as a commercial venture. Whether the firm’s version of the issuer-pays business model is sufficiently different from the incumbents’ remains an open question. It’s also unclear whether its ownership structure has teeth that will favor rating quality over venture capital profits. So while KBRA may well succeed for its investors, only time will tell whether KBRA will usher in the revolution that will yield a better rating industry.

Note: Space limitations made it necessary to edit the full transcript.

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