A first approach to financial distress problems -from the regulatory point of view- is to impose controls to the companies' potential indebtedness or requirements to maintain a certain credit level.
These measures -which must ideally be taken when designing the PPP contract- establish ex ante the type of behavior allowed to the company. This reduces the need to monitor the company's specific behavior, since it is assumed that if the company is well rated or its indebtedness is at a certain level, there are no financial distress risks.
As per a recent report of OFWAT - OFGEM in the United Kingdom:
"The regulatory framework includes license conditions that have been put in place to ring fence the regulated business from the activities of the wider group. For many regulated businesses this includes a requirement that they should retain an investment grade issuer credit rating. These arrangements have been designed to reduce the risk of financial distress by constraining the conduct of the company, ensuring its resources are not diverted and that it is not exposed to undue risk. Their presence helps to reassure the regulator that companies remain in a position to finance their functions and consumers interests are not adversely affected by a company's capital structure."174
In the United Kingdom the three main credit rating agencies are FitchRatings, Moody's Investor Services (MIS) and Standard & Poor's (S&P). Categories representing the lower risks are rated as "of investment grade", whereas the higher risk ratings are considered "speculative". In order to define a company's rating (or financial assets), credit rating companies take into account qualitative and quantitative factors including some of the main financial ratios.
As per credit rating companies, imposing a restriction that requires that companies maintain an "investment grade" rating may be seen as a decentralization (or subcontracting) method of the regulatory control function. With this rule, the Regulator delegates in credit rating companies the detailed analysis of the firms' situation and financial prospective175.
It is important to point out that this measure has -at least in its original format- clear applicability limitations in less developed economies. Most developing countries are not considered "of investment grade" by credit rating agencies, thus, it is unlikely that companies carrying out their business in developing markets could reach such rating176.
Other countries impose restrictions on the indebtedness policy through monitoring specific indexes. In some cases, those indexes are accompanied by allowed limit values, while in others only the indexes are set and it is said that such indexes must have reasonable values. Some of these examples are listed in Table 35.
Table 35: Financial Distress Prevention: Indebtedness Ratios Control - Selected Countries
| Country |
| Indicators | Limits |
| UK | Water Electricity | Investment Grade |
|
| Railway | Debt / RAB Investment grade | < 85% > BBB- | |
| Brazil | Electricity | Gross Margin Net Margin ROA Leverage | Not set |
| Colombia | Electricity | Operational Margin EBITDA/Financial expenses Current ratio | > 0 > 1.2 < 1 |
| Australia | AER (Australian Energy Regulator) | Creates an assessment system similar to the one of credit agencies | Table with values for each risk level from AAA to BBB |
| Chile | Water | Leverage Management indicators according to the company's size | Not set |
| Peru | Water | ROE ROA Interest coverage | Not set |
| Electricity | Liquidity Creditworthiness | Not set. Periodic report mentions situations with and without problems. |
Source: Self-made report on the basis of regulators' information
Another measure tending to preserve the companies' financial integrity, which is contemplated in most PPP contracts in infrastructure sectors, is to impose restrictions to carrying out activities that are outside the scope of the concessionaire or licensee company's purpose.
These mechanisms of service "ring fencing" are especially important in the context of a financial distress situation. As discussed, in financial distress situations, managers are encouraged to invest in highly risky projects with expected high profitability hoping to reverse the adverse situation. In order to avoid this type of behavior -which could worsen the company's situation- it is of key importance to prevent companies from developing other activities.
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174 OFWAT - OFGEM 2006 (emphasis added).
175 Note that -when assessing the financial situation of a regulated company, these agencies also indirectly assess the regulator's performance.
176 Tentatively, no company can sustain a higher rating than the country where it is operating, since the country risk of such country constitutes a floor for the company's business risk. The logic behind all this is that the country can "transfer" its potential financial problems to the companies through more restrictions or limitations to transfers abroad. See…