In Europe, S&P Global Ratings publicly rates 55 business and consumer services companies, a number that has grown more than 50% in the past five years. Here, we tackle the top questions we've received from investors about this diverse portfolio, which includes facilities management, customer relationship outsourcing, catering, security, financial and legal services, and staffing. We define business and consumer services companies as organizations that make most of their earnings by offering businesses a more cost-effective way of carrying out their noncore activities or by providing consumers with services.

What does it take to get an investment-grade rating in the sector?

One-third of the companies in our public portfolio currently have an investment-grade rating. Investment-grade issuers are mostly larger in size, more geographically diverse, and offer a wider range of services than their speculative-grade counterparts. In contrast, most speculative-grade names offer a narrower range of services in more fragmented markets or occupy a niche with a relatively small addressable market. They typically lack meaningful diversification outside their core geographies, which often makes them more susceptible to macroeconomic trends in their domestic markets. As such, almost two-thirds of the portfolio currently have business risk profiles in the weaker half of our ratings scale (fair or weaker, see chart 1).

Among investment-grade issuers, almost all of their financial risk profiles currently fall in the stronger half of our ratings scale (intermediate or stronger). For these companies, leverage is typically less than 3x and funds from operation (FFO) to debt is above 30%. By contrast, speculative-grade companies, which are dominated by private-equity owners across a wide range of industries, typically display highly leveraged financial risk profiles (FFO to debt below 12% and leverage above 5x), which drive ratings in the 'B' category across almost two-thirds of the business and consumer services portfolio (see chart 2).

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Another difference is that investment-grade companies across the sector, such as the large contract caterers Compass and Sodexo, typically leverage their superior scale to improve the efficiency of procurement. Route-based specialized services provider (focusing on pest control and hygiene) Rentokil Initial also uses its scale and density of operations to obtain benefits from better optimization of their vehicles and staff than local competitors, while offering a regional or nationwide service that smaller competitors could not offer.

In contrast, many of the speculative-grade issuers we rate hold market-leading positions in niche or local markets. For example, many niche professional service providers such as Capri, Sapphire Midco, and Saphilux have leading positions in fragmented markets and solid customer bases in their core businesses. However, organic growth in these markets is inherently limited, and they rely on bolt-on acquisitions to expand their businesses.

Rated insurance intermediary issuers, operating within the financial services sector, such as Siaci Saint Honore (Acropole Holding), tend to suffer from low geographic diversification and lack the scale to act as a one-stop shop for larger clients, so are rated at the lower end of the ratings scale. Such companies characteristically hold leading positions in smaller, niche broking segments and business lines in their concentrated geographies.

What differentiates 'B' versus 'B-' ratings in the sector?

Most of our ratings on business services companies are in the 'B' category due to their relatively high leverage and financial sponsor backing. Companies with 'B' rather than 'B-' ratings tend to have the potential to generate material free operating cash flow (according to our forecasts) which support adequate cash interest cover ratios and liquidity profiles. Furthermore, companies with 'B-' ratings typically have weaker business risk profiles, combined with debt leverage that is typically very high (see chart 7). Such levels may be sustainable in the short term due to the stability of the contracts the company holds, favorable industry fundamentals and a supportive macroeconomic environment (including low interest rates), but provide limited headroom to weather any operational underperformance.

Sapphire Midco is an example of an issuer that was initially rated 'B', despite very high leverage of about 8x, because of its strong interest coverage and solid market position in corporate services with a highly predictable revenue base and strong margins. However, the high leverage left limited headroom to weather a turn in market conditions. So when margins contracted as a result of regulatory changes in its most profitable jurisdiction, free operating cash flow generation turned negative, which ultimately led to our downgrade to 'B-'.

Why does private equity remain such an important source of capital for the sector and how does this impact ratings?

Private equity owns more than half of our publicly rated companies, with many more privately rated. They find the business and consumer services sector attractive for a variety of reasons, and, as such, private equity remains a major source of capital for the sector:

• The industry is typically relatively predictable as contracts provide recurring revenues, outsourcing trends can often be countercyclical, industrial exposure tends to be low, and organic growth rates typically at least mirror GDP.
• Cost structures are normally variable in nature, and if contracts are not renewed on maturity, then associated costs typically fall away too, so margins tend to be stable, especially where labor profiles are relatively unskilled.
• The sector is asset-light with a low to moderate need for capital expenditure that companies can readily scale back if the macroeconomic outlook slows (see chart 4), leading to strong and sustained cash flow generation.
• Companies can usually quickly increase scale with bolt-on acquisitions (often debt-funded) given the high number of available targets due to the fragmented nature of the industry.

Outsourcing trends are often countercyclical because as the macro environment deteriorates their clients' urgency to reduce their cost bases often leads to additional outsourcing opportunities. This is appealing to private equity investors. However, private-equity investment usually brings aggressive financial policies, including high tolerance for debt leverage (which typically stands above 5.0x over the rating horizon, see chart 5). It also carries the potential for aggressive shareholder actions, such as high and unpredictable dividend payouts and debt-funded acquisitions, which could lead to further increases in debt on already highly leveraged balance sheets. For example, German car parking operator APCOA Parking has undertaken both material debt-funded acquisitions and paid debt-funded dividends over the last 12 months. Combined with the highly fragmented nature of many subsectors, where many small players typically compete intensively on price, most private equity-owned names in the sector therefore have low ('B' and below) ratings. Despite this, the outlooks are predominantly stable, reflecting the characteristic stability of the sector that supports relatively high leverage and the already low ratings.

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Most companies operating in the industry typically supplement organic growth--that broadly tracks a little above GDP growth as a result of increasing outsourcing trends--with acquisitive growth, to which fragmented markets lend themselves well. Acquisitions can rapidly add service segments and build out regional and national platforms. For example, companies operating in the business process outsourcing sector, which in itself is diverse and includes issuers operating in customer relationship management (such as call centers) are seeking to further capitalize on the growth of e-commerce by making add-on acquisitions in this high-margin area. Indeed, digitalization is an increasingly important strategy for many players; in addition to raising barriers to entry, it can create cross-selling opportunities.

Issuers meaningfully extending their reach geographically and by client sector may enhance our view of their scale, scope, and diversification and therefore enhance their ratings. However, successful integration of acquired businesses is critical, with many debt-funded acquisitions failing to deliver all of the anticipated benefits, such as cross-selling new services to existing clients, benefiting from synergies and keeping integration costs manageable.

How do macroeconomic headwinds affect the sector? Have ratings hit their peak of the cycle?

The industry has shown stability over time because customers are typically focused on cost reduction via outsourcing to companies in the sector. When times get tougher, outsourcing is a way for businesses to save money.

Demand across the diverse range of industry subsectors is generally relatively healthy, particularly for companies with a good track record of service delivery. As revenues are often contracted, the sector reacts later in the cycle to macroeconomic trends than many other industries. The most cyclical of the companies in the sector include consumer services and staffing companies (within the "general support services" bucket). Temporary staffing providers are particularly sensitive to decreases in output, as their customers reduce their use of temporary staff, which can quickly lead to lower revenue growth and falling EBITDA until market confidence returns. For example, Adecco Group's adjusted EBITDA fell by about 50% in 2009 as a result of the cyclical downturn, although credit metrics bounced back quickly the following year.

Outsourcing opportunities are still increasing in most subsectors, leading to opportunities for organic market growth, even during tougher times. This is important given the fragmented nature of the industry, where many small local players compete primarily on price. In segments where scale provides advantages, larger players can readily offer to provide services in additional locations or expand their service offering to reduce such pricing pressure.

After a period of high reinvestment where business service issuers have capitalized on the low interest environment to invest in growth, we forecast that capital expenditure as a proportion of sales will slow as revenue growth declines, in line with deteriorating economic sentiment. However, issuers in our portfolio tend to be asset-light businesses with modest reinvestment needs (averaging about 2%-4% of revenues).

How exposed are companies to the U.K. and will Brexit cause problems for the sector?

The U.K. is one of the leading outsourcing markets globally and, as a result, almost one-half of the companies in the European portfolio are U.K.-headquartered. In our view, the biggest risk Brexit poses to the sector is restricted labor supply in the U.K., which could result in wage inflation. This is important as labor typically represents about one-half to two-thirds of the cost base for companies in the sector. Furthermore, we have observed that Brexit uncertainty has led to a modest slowing in outsourcing decisions--by the U.K. government in particular. That said, most of our rated issuers are not materially exposed to U.K. government contracts and are generally able to pass on inflation through their contracts, so overall we see limited impact on earnings as a result of Brexit.

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The 15 companies in our portfolio with investment-grade ratings (see chart 6) are geographically well diversified and are therefore further insulated from any risks related to Brexit. On the other hand, smaller players operating in niche markets are typically more reliant on their domestic markets. For example, warranty service provider Domestic & General (Galaxy Finco) generates over 80% of its revenues in the U.K. For such companies, operating prospects in the sector remain closely tied to slower and more uncertain economic conditions in the U.K. That said, as above, business outsourcing companies may benefit from countercyclical trends, as more companies may outsource to save costs when times get tough.

What do you view as the other key emerging risks for the sector?

Business process outsourcing companies typically store large amounts of sensitive client data and help their clients keep compliant with local regulatory requirements. As such, outsourcing companies face material regulatory, litigation, and cyberrisks. In our view, outsourcers that successfully integrate and leverage digital efficiencies, whether through process automation or increased data security, will increase their likelihood of building a stronger competitive advantage. They can accomplish this by increasing their ability to secure new contracts or by more quickly rolling out new products through modular and scalable digital infrastructure.

Also, issuers that provide services directly to retailers could face continued pricing pressure, given the strain that the retail sector is under at present. Examples include companies engaged in rebate processing, inventory verification, retail merchandising, and janitorial services.

The variable cost structures of service companies largely comprise labor costs, and most contracts include pass-through clauses with minimum time lags to limit the impact of increases in the minimum wage and wage inflation.

Attracting and retaining employees in higher-skilled niche segments, like those in professional services companies such as Sapphire Midco, Intertrust, and ICON, is more expensive and gives less cost flexibility than lower-skilled facilities service providers such as ISS, where employee turnover is high but the cost base is more flexible.

Following several well-publicized issues related to U.K. government contracts in recent years, has anything changed?

Service companies with high exposure to the U.K. government have been under scrutiny in recent years, after the high-profile default of Carillion and the underperformance of prominent names such as Capita and Interserve. For the most part, we believe the defaults of Carillion and other outsourced government partners were related to the construction arms of these companies, with a more limited impact on their business service arms. However, in many cases, bidding wars at the peak of the cycle led to companies entering into low margin contracts with the U.K. government. Companies like G4S PLC have subsequently improved their contract bidding policies and have become more focused on operating margins than sales growth.

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How do you classify business and consumer services companies operating in such a diverse range of industries?

We classify our business and consumer services companies within five broad subsectors: consumer services, distribution services, facilities services, general support services, and professional Services (see "Key Credit Factors For The Business And Consumer Services Industry," published on Nov. 19, 2013. However, within these subsectors are many niches).

• Consumer services: Companies primarily providing services directly to consumers, typically focused on the provision of child care, for-profit education, automated retail, consumer tax and legal, weight management, and funeral and cemetery.
• Distribution services: Companies whose primary function is to distribute products, such as food, beverages, books, pharmaceutical, medical, optical, building products, and automotive products.
• Facilities services: Companies whose primary function is to operate and/or maintain the facilities/premises of other businesses and/or provide staff to carry out these functions. Focus areas may include hospitality (food, catering, concession), uniform and apparel, landscaping, equipment (laundry equipment, medical equipment, heating, air conditioning, plumbing), and cleaning.
• General support services: Companies whose primary function is to provide general support services for businesses that typically have the option to insource the services. Focus areas may include sales and marketing, staffing, manned guarding, inventory and transaction processing, document management, and communications.
• Professional services: Companies whose primary function is to provide complex services for businesses. Businesses outsource to professional services companies because of their scale, expertise, geographical reach, and reputation. Focus areas may include consulting services, information services, insurance brokerage services, financial and audit services, contract research organizations, and background investigative services.

What is the outlook for the sector for 2020?

Our stable outlooks on most companies (see chart 8) factor in our expectations of continuing favorable outsourcing trends, ongoing cost-cutting efforts to preserve margins, typically late or noncyclical mature end markets, and sound liquidity profiles as a result of refinancing over the last couple of years. That being said, 15% of companies have negative outlooks and only 1% positive outlooks. We think that negative rating actions could stem from aggressive financial policies--given the high percentage of private-equity ownership across the portfolio--and operating performances that weaken from levels that we currently expect on a company-specific basis, where stretched financial risk profiles provide limited headroom.

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Note: Data for all charts includes all of the businesses and consumer services companies we rate, that is, those with public, private, and confidential ratings.