There has been a growing trend of corporate issuers selling minority stakes in subsidiaries to financial investors or creating dedicated JVs with a goal of funding multi-year capital expenditure projects, enhancing shareholder returns, or enabling debt repayment without burdening their balance sheet with additional debt. As outlined in our recent commentary, "Corporate Horizons: A Deeper Dive On The Rating Implications Of Structured JV Minority Interest Transactions," published Dec. 10, 2024, we view the minority capital contributed to these JV structures as sitting somewhere between pure equity and pure debt, given there is typically an unequal sharing of downside risk where the financial investor's returns are shielded from underperformance at the JV.

To date, our focus on these transactions has been the business or financial impact of partial disposals on the majority shareholder, and whether we choose to make a potential debt adjustment based on shareholder terms. However, in the following article, we explore another common element of these structures and explain our analytical approach to rating the back-leverage debt instruments financial investors typically use to fund their equity investments in these JVs. It's worth noting that we use the term JV interchangeably in this article, which could either describe a majority owned and controlled subsidiary with a significant minority shareholder, or a more traditional JV where neither shareholder fully controls.

How is back leverage used by minority owners in these JV transactions?

In the context of minority JV transactions, back leverage is the debt raised by financial investors to fully or partially fund their equity investment in the JV. As illustrated in chart 1, this debt is generally issued at a holding company level (Holdco) above the JV, or at the level of the financial investor. Third-party lenders typically receive a pledge of the financial investor's assets, including their equity interest in the JV, as collateral. They may also hold various consent rights, such as protection against priority debt being raised at the JV level. However, lenders of back leverage generally do not receive security over the JV's underlying physical assets.

In these transactions, the "back leverage" is serviced by dividend distributions from the JV to the minority investor. Absent a guarantee by or a contractually agreed upon level of dividends with the majority shareholder, distributions are typically variable in nature and dependent on the operating performance of the JV. For this reason, if the JV materially underperforms base-case expectations, dividend payments may be insufficient to service payments on the back leverage. While a default on back-leverage loans would generally not lead to any cross-defaults on debt at the JV or majority shareholder levels, it could lead to a change in minority ownership, which could incentivize the majority owner to buy out the financial partner.

Chart 1

Under what conditions would S&P Global Ratings apply corporate methodologies to rate back-leverage debt?

Under the example illustrated in chart 1, generally we would envision a five-step process to rate back-leverage debt through corporate-related methodologies.

1. Determine the stand-alone credit profile (SACP) of the JV using "Corporate Methodology".

2. Once an SACP is established for the JV, we assign an issuer credit rating (ICR) to the JV, by applying "Group Rating Methodology" (GRM) and/or "Rating Government-Related Entities: Methodology And Assumptions" (GRE), as relevant.

3. We typically determine the SACP of the entity issuing the back-leverage by applying our "Methodology For Companies With Noncontrolling Equity Interests (NCEI)". NCEI criteria applies to entities, such as the "Holdco" in chart 1, that have noncontrolling equity interests (typically at least 10%, but not more than 50%) in operating companies (e.g., JV Co. in chart 1). Creditors of such entities are deeply subordinated to JV creditors because they rely on subordinated and discretionary dividend payments from an investee company that they do not control. As such, starting with the lower of the SACP or ICR of JV, we notch down to arrive at the NCEI's SACP, according to the methodology provisions detailed the NCEI criteria framework.

4. We then derive the ICR on the NCEI by incorporating any group or government support at the NCEI level (see chart 2).

5. Finally, depending on whether the ICR on the NCEI is rated investment grade or speculative grade, we rate the back-leverage debt issues by applying our Issue and Recovery Rating Methodologies.

Chart 2

What are the major parameters of NCEI criteria?

Once the lower of the JV SACP or ICR is determined, we assign a rating to the subordinated Holdco by assessing four major parameters, as detailed below. Typically, we rate NCEIs at least two notches (and up to seven notches) below the SACP or ICR--whichever is lower--of the JV. We consider:

• The stability of JV cash flows and the robustness of dividend coverage ratios under a stress scenario;
• The JV's corporate governance and financial policy, specifically around incentives to maintain constant or growing dividends per share;
• The robustness of NCEI financial ratios. Given the potential volatility in distributions, a positive assessment of NCEI ratios would require interest coverage >5x and leverage <2x.
• NCEI's ability to liquidate assets (e.g., publicly listed equity stakes) to pay off the back-leverage debt.

NCEI criteria also includes the potential application of a holistic adjustment to fine-tune the SACP, by adjusting it up or down by one notch. The adjustment is based on a holistic review of the company's stand-alone credit characteristics in aggregate. The two- to seven-notch range cited above is inclusive of the holistic adjustment.

Under what conditions would S&P Global Ratings apply project finance criteria to rate back-leverage instruments?

Assuming the JV Co. is incorporated and an issuing vehicle such as a Holdco is structured as a project, we would apply our "General Project Finance Rating Methodology" to rate back-leverage instruments. The typical minimal features we would expect to see include:

1. The JV Co. (or other issuing entity in a structure) is a bankruptcy-remote limited purpose entity (LPE) that is legally separated from both the majority shareholder and the minority financial investor.

2. There is a shareholder agreement which sets out the nature of the JV Co. and rights and obligations such as for example voting and step-in rights. It is critical to assess the risk of cash flow interruption to the back-leverage issuing vehicle (Holdco).

3. In a Holdco structure, debt is primarily serviced and repaid using any distributions from the JV Co.'s cash flows that are upstreamed and available to the Holdco, which are outlined under the shareholder agreement and other documents.

4. Back-leverage debtholders would have limited or no recourse to the project sponsors or shareholders.

5. In a project, typical security gives lenders a right to the project's cash flows and assets. This limits the disposal of assets and reduces the incentive for third parties to attempt to file the project for bankruptcy or seize the business. As back leverage is generally issued at a Holdco level above the JV assets, lenders typically would not have any claim on physical assets at the JV Co. In such situations, we would likely view this as a weakness in the security package under our project finance methodology.

6. A controlling stake in the assets via the debt-issuing LPE's majority ownership or via the shareholder agreement described above (or, if the issuer does not have a controlling stake, 100% of its partial ownership is pledged and documentation or legal opinions confirm that the project's lenders have effective step-in rights). Effective step-in rights mean that even if the minority lenders don't have direct access to the physical assets of the JV, they have protections that if exercised would allow the JV to continue producing cash flows to service the minority debt.

7. A set of covenants establishes what the project (e.g., JV Co. or Holdco) can and cannot do during its life, and prevents creditors from being disadvantaged by third parties.

8. Exposure to revenue risk, as well as either construction or operating risk.

Points five and six highlight the two main elements of minority JV Co. transactions that may differ from a typical project finance transaction. Generally, the financial investor in these transactions has a minority non-controlling stake in the JV/project. Additionally, given that back leverage typically sits at a Holdco above the JV Co. project, back-leverage lenders typically have no claim over project assets or cash flows. All else being equal, we typically would assign a lower project SACP if the security package does not include all project assets and cash flow.

Under a project finance approach, we would also consider whether the JV is incorporated or unincorporated (e.g., not established as a separate and distinct legal entity), with the latter requiring increased emphasis on the contractual JV agreement in terms of documented rights, and on the creditworthiness and commitments of the other relevant JV participant.

Under what conditions would S&P Global Ratings apply Principles of Credit Ratings to rate back-leverage debt?

Sometimes transaction structures do not perfectly fit within a criteria framework. On these occasions, we may apply our approach for Rating to Principles, which refers to the process of developing Methodologies and key assumptions to determine a Credit Rating based primarily on the criteria "Principles of Credit Ratings," along with existing criteria such as our project finance or corporate methodologies.

As stated above, the existing scope of our project finance criteria requires a pledge of at least a portion of project assets, agreements, and cash flows. These factors are not always present in minority JV transactions, which could require a Criteria Exception or Rating to Principles, as was the case for Brookfield's JV with Intel Corp. (e.g., Foundry JV Holdco LLC). Similarly, under our corporate approach, we sometimes see extraordinary protections or greater than typical minority investor influence over the JV's dividend policy, which may not be fully contemplated within our existing NCEI criteria, potentially requiring a Criteria Exception or Ratings to Principles process.

What are the considerations in back-leverage debt achieving investment-grade (IG) ratings?

Project Finance

Under our project finance methodology, the back-leverage issue-level ratings will depend on the strength of the contractual framework and creditworthiness of the counterparties, the effectiveness of covenants and security features, and the robustness of cash flow and debt service coverage ratios (DSCRs), among various other factors. Given that project finance offers stronger creditor projections and can be structured to mitigate downside risk, the rating distribution for the project finance sector has been stable over time. As of Oct. 14, 2024, nearly 74% of project finance transactions were rated investment-grade. That said, in the context of minority JV transactions, we believe ratings could skew somewhat lower than traditional project finance transactions, given minority ownership of the financial investor, the distance to the operating assets, and the lack of security over project assets (including physical assets, main contractual agreements, and accounts), in most cases.

Corporate NCEI

In most cases, we would not assign an SACP higher than 'bb+' to an NCEI, reflecting our view that NCEI creditors rely on dividend payments from an entity they don't control. Due to lack of control, NCEI creditors are subject to much greater cash flow volatility compared to creditors at a typical corporate entity or within a project structure.

Having said that, we could assign an SACP up to 'bbb+' (assuming the JV rating is supportive) if all the below conditions are met, reflecting that the minority investor has a relatively high level of influence over the JV's financial policies, despite its lack of singular control:

• The JV's cash flows are highly stable, leading to robust dividend coverage metrics even under a stress scenario. Additionally, we do not expect covenants or lock-up tests to impact dividend payments.
• There are strong incentives to maintain constant or growing dividends per share. Additionally, the minority investor's vote is required for dividend policy changes.
• The NCEI's interest coverage ratio is greater than 3x and leverage is less than 4x.
• The JV is publicly listed with a deep market for its shares, and we believe the NCEI could liquidate its shares and repay its debt by a factor of at least 3x.
• The NCEI controls a minimum of 40% of the investee company's equity.
• The JV operates in a country and industry with low risk, as measured by a CICRA (Country and Industry Risk Assessment) of 1 or 2.
• There is a shareholders' agreement that requires shared decision-making at the JV on key strategic issues, including dividend policy.
• We assess NCEI's liquidity as at least adequate.

In the context of minority JV transactions, many of the above items are typically incorporated in the structure and terms. In nearly all transactions we have seen to date, the financial investor acquires more than 40% of the JV and retains significant influence over dividend policy through the shareholders' agreement. The one bullet point that is not typically met, however, is with regard to the JV being a publicly traded and easily liquidated entity. Typically, the Class B shares in the JV are privately held by the financial investor and there are restrictions on the sale of these shares for an initial period of time.

Additionally, in cases where the NCEI meets the criteria to be rated as high as 'bbb+', it would still be subject to a two- to seven-notch gap below the JV rating, reflecting subordination and dependence on potentially volatile dividend payments. Accordingly, for the NCEI's SACP to be investment grade, the JV would need to be rated at least 'BBB+/bbb+' (the lower of ICR or SACP). Furthermore, the ICR on the NCEI would still be subject to potential support or negative intervention from a group or government. Finally, we would apply our issue-level recovery-related methodologies to rate the back leverage. This could lead to differences between the issue ratings and the ICR on the NCEI.

How does the back-leverage debt rating relate to any debt adjustments S&P Global Ratings might make at the IG majority shareholder?

Under all the various analytical approaches, the ratings on the back leverage and the ICR of the majority shareholder are indirectly related. They can be thought of as two sides of a pendulum. As discussed in the previous questions, the more ongoing support we expect by the majority shareholder to the JV, the more likely it is that the JV's SACP approaches the level of the ICR on the majority shareholder. This of course indirectly benefits the back-leverage creditors. However, this could also mean that the majority shareholder is on the hook for some sort of payments to the JV that we would view as a debt-like obligation, under our criteria. Put another way, if back-leverage lenders are relying on the majority shareholder for any sort of payment to the JV, we are more likely to make a debt adjustment at the level of the controlling shareholder level--such as adding the net present value of guaranteed payments to debt. This could also be true under a project finance structure, although it will ultimately depend upon the contractual terms.

An additional consideration is the fact that a default of the back-leverage debt may conceivably lead to the majority shareholder buying out the minority investor, either through a buyback clause, or to prevent creditors from owning a minority position in a relatively important JV. If such a buyback clause exists, or if a default on back leverage seemed more likely, we could factor a potential buyout into our base-case forecast for the majority shareholder, raising questions on how such a purchase would be funded.

Under S&P Global Ratings' corporate approach, what are the rating implications for the back leverage if debt also exists at the JV level?

We view back-leverage lenders as subordinated to creditors at the JV. The impact of leverage at the JV level is captured through our ratio analysis at the NCEI, as described above. This is an important consideration because any dividend payments from the JV to the NCEI would only come after debt service at the JV level. Accordingly, the more debt that is placed at the JV level, the weaker the credit metrics would be at the NCEI level, putting it at greater risk of hitting a ratings cap. Under our NCEI criteria, if our forecast interest coverage for the NCEI is below 3x, we cap the SACP at 'b+', while if coverage falls below 1.5x, the SACP is capped at 'b-', regardless of the credit strength of the majority shareholder.

Additionally, the NCEI's SACP cannot exceed the rating that we would assign to the most junior debt or hybrid capital instrument that has been issued by the JV, given that back-leverage creditors are subordinated to all JV creditors, without exception. For example, we would typically rate a hybrid instrument at the JV two notches below the ICR of the JV, while the NCEI rating would have to be at least three notches below the JV rating.

Related Research

• Corporate Horizons: What The Creation Of JVs And Partial Disposal Of Subsidiaries Could Mean For A Group's Credit Quality, Feb. 17, 2025
• Corporate Horizons: A Deeper Dive On The Rating Implications Of Structured JV Minority Interest Transactions, Dec. 10, 2024