Companies often ask S&P Credit Ratings' analysts whether financing an equity owner provides will be treated as equity or debt. Here, we examine some of the topical points.

This article accompanies our concurrently published Credit FAQ on financial sponsors, "How We Treat Financial Sponsors In Our Credit Analysis," published Nov. 2, 2023, on RatingsDirect. Or click here to view the report on our Private Markets website.

Frequently Asked Questions

What is non-common equity (NCE), and why does S&P Global Ratings not automatically consider NCE as equity?

Financial sponsors (typically private-equity funds) and strategic owners often use a variety of ways to fund their controlling ownership of companies, in addition to common equity. Examples of these types of NCE include shareholder loans or preference shares. For instruments other than common equity, S&P Global Ratings reviews the instrument's characteristics to understand whether there are sufficient elements to consider it more equity-like than debt-like.

We look at the terms of the instruments, the economic incentives of the owner, and the provision of the funding. This is important because even if the instrument has several equity-like characteristics, we may believe it is a short-term placeholder for future debt or a majority of the financing will be redeemed before the maturity of the longest-dated senior debt.

Our analysis of the NCE may lead to its exclusion from the leverage metrics of an issuer. Nevertheless, the credit metrics will remain in the highly leveraged financial risk category for many speculative-grade issuers, particularly those owned by private-equity sponsors, even when excluding the NCE from debt calculations.

We would only exclude NCE instruments from debt in our leverage and coverage credit metrics when all characteristics required for equity treatment are met. The burden of proof is upon the issuer or its owner to show how the instrument in question meets our criteria requirements. See "The Treatment Of Non-Common Equity Financing In Nonfinancial Corporate Entities," published April 29, 2014, on RatingsDirect. Insufficient disclosure regarding the structure or terms and conditions of the NCE may lead us to include these instruments in our debt metrics.

How the issuer reports these instruments in its audited accounts is not a relevant factor under our criteria. Our methodology for making analytical adjustments to companies' reported financial data is set out in our criteria "Corporate Methodology: Ratios And Adjustments," published April 1, 2019, on RatingsDirect.

What is the rating impact of an NCE instrument being treated as debt?

For many financial-sponsor-owned issuers, irrespective of the NCE treatment, leverage metrics are high and likely to remain so over the rating horizon (typically two to three years). In addition to what the credit metrics indicate, we also consider the owner's approach to financial policy decisions and tolerance levels for operating under elevated leverage conditions. As a result, many financial sponsor-owned issuers will receive an FS-6 or FS-6 (minus) assessment, leading to a financial risk profile assessment of '6' (highly leveraged) under our corporate methodology.

An FS-6 assessment indicates that, in our opinion, the company's forecasted credit ratios in the medium term will likely remain consistent with a '6' financial risk profile based on our assessment of the financial sponsor's financial policy and track record. Issuers with a '6' financial risk profile tend to be clustered around the lower end of the rating scale, depending upon the relative strength of other factors. In the majority of cases, when a financial-sponsor-owned issuer is already highly leveraged, whether we include or exclude the NCE financing from our debt metrics, it does not affect the rating.

What characteristics does an NCE instrument need to qualify for exclusion from our leverage metrics?

These characteristics can include a lack of cross-default or enforcement provisions, no security, nonstapling, or an inability to sell to third parties or redeem the NCE before more senior debt.

A common reason an instrument fails to meet the characteristics of our NCE criteria and qualify for exclusion from our leverage metrics is a lack of alignment of economic incentives between the common equity and the NCE. Among other requirements detailed in our criteria, we expect the NCE provider not to hold any debt instruments; have no fixed payment obligations under the NCE; and have no financial covenants, collateral, or events of default associated with the NCE instrument. Enforcement rights also need to be absent or otherwise deeply subordinated, structurally or contractually, to other, more senior debt so as not to trigger a cross-default mechanism.

NCE instruments often fall short of our NCE criteria due to the lack of a stapling provision. In our view, inclusion of such a provision strengthens the alignment of economic incentives by avoiding the possibility that the company will sell NCE financing to a third party with no interest in the common equity. We expect documentation of the NCE financing to prohibit the sale of the NCE to a third party unless the NCE is stapled to the common equity. That is, the NCE and the common equity must be owned and sold in tandem with the common equity the documents provide for the stapling of the NCE. Absent such explicit statements, we include the NCE financing in our leverage and coverage calculations.

How do we treat NCE financing partially provided by a controlling shareholder and partially provided by a noncontrolling shareholder?

If the financing is provided through one security and the documents give the controlling shareholder the ability to make decisions that bind all the investors in the NCE, we could exclude the NCE financing from our leverage and coverage calculations, provided all other conditions are met.

If the NCE financing is provided through more than one instrument or through one instrument where the investors can act independently, we would only exclude the portion held by the controlling shareholders from our leverage and coverage calculations, provided all other conditions are met.

How do we treat NCEs provided by joint ventures?

If the NCE financing is provided by several shareholders that exercise control jointly (such as a joint venture), our treatment would depend on whether we view the shareholders' goals and strategy to be aligned, provided all other conditions in the criteria are met.

For example, if a minority holder retains individual veto rights over certain issues, such as financial policy or acquisitions, we are unlikely to exclude the instrument from debt.

How do we treat partial redemption of an NCE tranche?

An important focus of our assessment of prepayment and repurchase clauses is to what extent they undermine the principle that financing provided by controlling shareholders will be outstanding and would act as subordinated loss-absorbing capital if the company experiences credit stress. To exclude NCE financing from debt, we must be comfortable that a majority of the financing will remain outstanding until after the maturity of the longest-dated senior debt. However, limited payments that are akin to dividends are not inconsistent with our excluding an NCE financing from debt.

If partial redemptions are allowed, the circumstances and amount matter for our analysis. However there is a material chance that this may lead us to treat the instrument as debt. The remaining portion of the NCE tranche may remain excluded from our debt calculations if a partial redemption has occurred but we consider the payment to be the equivalent of a dividend. In terms of amount and circumstances, it does not impact the creditworthiness of the issuer, and it does not lower the outstanding amount beyond the principle stated above.

For instance, cash accumulation from previous years' operating cash flows or repayment of accrued interest rather than principal repayment can be supporting factors. Conversely, if our forecast shows that most of the NCE financing will be redeemed, we will include the remaining amount of the instrument in our debt calculation.

How does the criteria differ for NCE instruments provided by strategic owners (as opposed to financial-sponsor owners)?

Several differences are detailed in our criteria, including that stapling is not required. Rather, we believe the alignment of economic incentives with common equity would come from the strategic importance of the issuer for its owner. As a result, to exclude NCE from leverage, we would need to expect that the issuer is at least assessed as a moderately strategic subsidiary as per our Group Rating Methodology and that it is reasonably successful at what it does or has realistic medium-term prospects of success relative to group expectations or earnings norms.

As with financial sponsors, we expect a strategic owner would not be able to trigger an event of default on the instrument or the overall group and the NCE would not have any financial covenant that leads to either a default or acceleration of repayment. We expect the NCE financing to be unsecured, not benefit from any financial guarantees, and be structurally or contractually subordinated to all other debt in the capital structure.

What about instruments where the financial sponsor or strategic investor may own only a minority stake, and most or all of the other requirements are met?

In these circumstances, these criteria do not apply and we evaluate the instrument under our Ratios And Adjustments criteria.

If an instrument with some equity-like characteristics is not provided by a controlling shareholder, how do we evaluate how it is treated for ratio calculation?

If the instrument qualifies as a hybrid under our Hybrid Capital: Methodology And Assumptions criteria (published July 1, 2019, on RatingsDirect), under certain circumstances, it may receive 50% or 100% equity treatment.

If the instrument does not qualify as a hybrid under those criteria, we evaluate it under the Ratios And Adjustments criteria. Specifically, we will not add classes of shares to our adjusted debt measures, regardless of their denomination, if they will never require any cash payments or cause any credit stress and they comply with all of the following conditions:

• No stated coupon or yield;
• No maturity;
• No ability to redeem for cash (but could be converted into common stock);
• No covenants or events of default;
• No security or guarantees; and
• Subordination to all debt.

Further requirements are detailed in the Ratios And Adjustments criteria article.

Related Criteria

• Criteria | Guidance | General Criteria: Hybrid Capital: Methodology And Assumptions, July 1, 2019
• Corporate Methodology: Ratios And Adjustments, April 1, 2019
• The Treatment Of Non-Common Equity Financing In Nonfinancial Corporate Entities, April 29, 2014