Rating agencies are eyeing Power Finance Corporation Limited (PFC) and REC Limited (REC) for a possible credit rating downgrade after government approved a proposal to combine two state-run lenders to utilities.

Both Moody's and India-Ratings said that the merger deal has prompted a review of both the companies' credit ratings, warning that the acquisition will increase the leverage of PFC and have an impact on PFC's return on assets and return on equity.

On 6 December 2018, the Cabinet Committee on Economic Affairs (CCEA) gave in-principle approval for the strategic sale of the government of India's (GoI) 52.63 per cent stake in the total paid-up equity capital of REC to PFC. REC is likely to continue to be a separate entity. The acquisition is aimed at achieving the integration of the power financing businesses of REC and PFC, while the disinvestment proceeds will boost the GoI's finances and help reduce the fiscal slippage in FY19.

Global rating agency Moody's Investors Service has placed on review for downgrade the Baa3 issuer ratings of state-owned companies, Power Finance Corporation Limited (PFC) and REC Limited (REC).

At the same time, Moody's has placed on review for downgrade the (P)Baa3 foreign currency senior unsecured MTN program ratings and Baa3 foreign currency senior unsecured ratings of PFC and REC.

Moody's has also placed on review for downgrade PFC and REC's standalone credit profiles of ba3.

According to the rating agency, the review for downgrade is driven by the government's decision to grant approval for PFC acquisition of the government's entire 52.6 per cent stake in REC.

So what are reasons behind the latest downgrade?

PFC's stake buying in REC is credit negative

In Moody's opinion, the acquisition by PFC of the government's stake in REC is credit negative for PFC, because it will materially weaken its consolidated capital ratios. While the transaction could also create some operational synergies, as both PFC and REC operate in the same business segment, Moody's believes that the negative impact from lower capital levels will outweigh any potential synergies.

Acquisition to have impact on PFC's return on assets and equity

India-Rating said that the acquisition will increase the leverage of PFC and have an impact on PFC's return on assets (2QFY19: 1.86%) and return on equity (14.29%); however, the positive liquidity buckets of PFC over October 2018-March 2019 will address the liquidity concerns.

Downgrade of PFC and REC standalone credit profiles will lead to downward pressure on their issuer ratings

Moody's said that with PFC replacing the government as the main controlling shareholder in REC, affiliate support from PFC, rather than government support, would be the main way in which REC's ratings would receive an uplift from its standalone credit profile. Accordingly, negative pressure on PFC's ratings would translate into negative pressures on REC's ratings. At the same time, the support anchor for REC will be PFC's final ratings rather than its standalone credit profile. As PFC's final ratings will continue to benefit from government support, REC's will ratings benefit from implicit government support in this rating architecture. The review for both entities will also focus on any material and tangible evidence of operational synergies created by the transaction.

Edited by Chitranjan Kumar