OREANDA-NEWS. Fitch Ratings has affirmed ICAP Plc's (ICAP) Long-term Issuer Default Ratings (IDR) at 'BBB' and Tullett Prebon plc's (Tullett) Long-term IDR at 'BBB-'. The Outlooks are Stable. Fitch has also affirmed ICAP's Short-term IDR at 'F3'. A full list of rating actions is at the end of this rating action commentary.

The affirmations follow the announcement that Tullett has agreed to acquire ICAP's global broking business, the information sales business related to global broking, and i-Swap, ICAP's electronic trading platform for over-the-counter (OTC) interest rate derivatives. ICAP Fusion, an electronic screen which provides access to ICAP's electronic platforms, will also be transferred to Tullett. The transaction will be financed through the issuance of new Tullett shares, both to ICAP and its shareholders. Ultimately, ICAP's shareholders (36% of enlarged Tullett) and ICAP (up to 20%) will own a majority of the enlarged Tullett.

The sale of ICAP's global broking business will simultaneously create one of the largest pure inter-dealer brokers by total revenue in Tullett, and a financial technology-focused firm in ICAP.

The transaction enables both entities to focus on their historical strengths to improve operational efficiency and the resilience of their earnings base. The inter-dealer broker (IDB) sector has seen considerable challenges in recent years, as bank clients have reduced their appetite for trading OTC derivatives, volatility has remained low and yield curves have been flat.

At the same time, a greater push towards central clearing and electronic trading presents opportunities for firms with leading electronic platforms, which include IDBs, exchanges and financial technology firms. Together with the growing importance of non-bank customers, this will push IDBs to compete against firms that provide trading and brokerage services to non-dealer end-users.

KEY RATING DRIVERS
IDRs AND SENIOR DEBT
ICAP
ICAP's ratings primarily reflect our view that the electronic markets and post-trade services, on which the group will focus post-transaction, contain leading businesses which benefit ICAP's company profile. These include an electronic platform for US Treasuries and repos with a strong market share (BrokerTec), and an expanding currency trading venue (EBS). The derivative compression and portfolio reconciliation services have seen strong demand as bank clients deleverage their balance sheets and clearing, reporting and reconciliation requirements for OTC derivatives evolve.

The ratings are also based on our expectation that ICAP's earnings profile will modestly improve in the long term, as the disposal of the voice broking business improves operating profit margins and reduces the likelihood of incurring outsized exceptional costs. The focus on electronic markets and post-trade services should increase the proportion of subscription revenues, supporting earnings stability. We expect operating profit margins to widen to more than 30% after the global broking sale, more than 10 percentage points above ICAP's reported 20% underlying operating margin for FY15.

ICAP incurred GBP151m in exceptional costs in the last two full financial years related to restructuring and legal costs incurred to address global broking's high cost base and to resolve regulatory investigations on the setting of yen Libor. ICAP remains liable for the outcome of the US authorities' investigation into the setting of US dollar ISDAFIX rates after the transaction.

However, these benefits are partly offset by a reduction in earnings diversification. We estimate that EBS alone would represent around 30% of group revenues post-transaction, against an electronic markets contribution of 20% for FY15. While the remaining businesses' earnings volatility has historically been lower than that of voice broking, revenue in electronic markets in part depends on volatile trading volume as only about 29% of electronic markets revenue is recurring in nature.

The ratings also incorporate our expectation that leverage, as measured by gross debt to adjusted EBITDA, should be around 2.0x after the transaction. We view this level as commensurate with ICAP's ratings.

We expect the disposal of the voice broking legal entities to result in lower regulatory capital requirements. As Tullett will repay a GBP330m loan to ICAP Group Holdings Plc (IGHP) on transaction completion, the group will temporarily have a sizeable buffer of available cash. We view this as credit neutral, as we expect that any cash over and above that required for working capital purposes by the remaining divisions will eventually be reinvested in the business or used for acquisitions.

The sale of the global broking business does not change ICAP's low appetite for credit risk, but we expect operational risks to remain high. As ICAP's earnings will increasingly depend on the resilience of its electronic platforms, an appropriate risk control environment and regular investments in infrastructure will be important. The GBP330m loan repayment to the group should at least partly help to fulfil these investment needs.

IGHP is a fully controlled, non-operating subsidiary of ICAP and the obligor of the group's bank facilities, loans and debt, with the exception of the group's retail bond, a EUR15m senior note and European commercial paper. IGHP is covenanted to consolidate at least 85% of the group's EBITDA, supporting the alignment of its ratings with ICAP.

Tullett
Tullett's ratings are based on our expectation that the acquisition of ICAP's global broking business should broaden its franchise to become the world's largest inter-dealer broker by traditional brokerage revenue, which mitigates sector-wide earnings pressure. At completion, the transaction would fall just short of doubling Tullett's prospective revenue base under Fitch's base case, which includes modest revenue attrition from overlapping desks. Greater scale should therefore support our assessment of Tullett's company profile.

The ratings also incorporate our view that some cost synergies are achievable, as support functions are consolidated and IT systems are rationalised. While a reduction in operating expenses should improve EBITDA margins in the long term, front-loaded costs to achieve these savings are likely to put pressure on margins in the short term. We expect Tullett to have greater discretion in adjusting its fixed costs post acquisition, which should enable it to respond to challenging market conditions more flexibly.

In Fitch's view, revenue from voice broking supported by electronic screens are likely to remain under pressure, reflecting cyclical and structural factors. The latter include more stringent capital requirements for banks, which reduces their appetite for trading OTC derivatives. We expect that this negative trend will largely offset any benefits of greater scale following the transaction. While we view Tullett's diversification into oil broking positively, we expect Tullett to remain largely reliant on traditional broking asset classes.

We expect Tullett's leverage, as measured by gross debt to adjusted EBITDA, to increase in the medium term, as costs to achieve savings are incurred prior to the savings being realised. Under our base case, gross debt should not exceed 2.5x adjusted EBITDA if revenue does not fall by more than 7% per year in the three years following completion, assuming revenue loss from overlapping desks is small. We view leverage under 2.5x as commensurate with Tullett's ratings.

As part of the transaction, Tullett will enter into a GBP470m bridge facility maturing at end-2017 aiming to help it repay the GBP141m senior notes maturing in July 2016 and the additional GBP330m it agreed to pay ICAP on transaction completion. The bridge facility will be gradually replaced by bond issuance, but we do not expect gross debt levels to increase above GBP550m (GBP80m retail notes and the bridge facility).

Tullett operates with an investment firm consolidation waiver, which requires it to meet consolidated capital requirements at waiver expiry. We expect the terms of the new waiver (necessary following the transaction) to include similar requirements to reduce a wider capital deficit, defined as the shortfall between its capital resources and its consolidated capital requirements ("excess goodwill"). We view the requirement to reduce the shortfall as positive for creditors as it will require the firm to improve the quality and size of its capital base. If earnings pressure were to result in a material obstacle to the elimination of excess goodwill, we would expect Tullett to review its dividend policy.

As the acquired broking businesses engage in matched principal, name give-up and execution only transactions, we expect the nature of credit risk exposures undertaken by the group to remain unchanged, although higher volumes will marginally increase risks. In line with peers, we view operational risk, including the risk of litigation, as significant for Tullett. The transaction with ICAP includes a warranty from the latter that covers the potential exposure to the outcome of the US authorities' investigation into the setting of US dollar ISDAFIX rates.

RATING SENSITIVITIES
IDRs AND SENIOR DEBT
ICAP
ICAP's ratings are based on our expectation that gross debt will remain well below 2.5x adjusted EBITDA on a sustained basis. Higher than anticipated earnings volatility, a loss of franchise resulting from increased competition or an unexpected increase in gross debt which would cause leverage to exceed this threshold would put pressure on ratings.

The ratings are also sensitive to the outcome of the Commodity Futures Trading Commission's investigation into the setting of USD ISDAFIX rates. Should any regulatory investigation result in an outsized financial penalty or in business restrictions, the ratings would be reviewed.

Given its reliance on electronic platforms, upside ratings potential is limited, but could result from a meaningful increase in post trade services' earnings contribution, materially lower leverage or a long track record of sustained profitability.

Tullett
Fitch's base case assumes that revenue loss arising from overlapping desks will be modest, and that revenue will not decline by more than 7% per annum. Higher than expected revenue declines would put ratings under pressure as gross debt to EBITDA would likely come close to 2.5x, which Fitch views as the upper bound on leverage for investment grade rated securities firms.

Should restructuring charges materially exceed plans, or should regulatory or legal investigations result in outsized financial costs, the ratings would also be reviewed. Tullett's ratings are also sensitive to the planned cost synergies not materialising.

We would also review Tullett's ratings if the company's liquidity came under pressure or if interest expenses on new bonds issued increased materially. This is not our base case but could arise in the context of Tullett having to access the bond market to replace the GBP470m bridge facility, which represents refinancing risk.

Given our view of continued pressure on the voice broking industry, upside ratings potential is limited in the absence of substantial further diversification towards products and clients less correlated with banks' trading appetite.

The rating actions are as follows:

ICAP Plc
Long-term IDR affirmed at 'BBB'; Outlook Stable
Short-term IDR and commercial paper programme affirmed at 'F3'
Senior debt affirmed at 'BBB'

ICAP Group Holdings plc
Long-term IDR affirmed at 'BBB'; Outlook Stable
Short-term IDR affirmed at 'F3'
Senior debt affirmed at 'BBB'

Tullett Prebon plc
Long-term IDR affirmed at 'BBB-'; Outlook Stable
Senior debt affirmed at 'BBB-'