A dive into the downside

This article is sponsored by NXT Capital.

Senior debt is considered the safest investment in the capital structure. Yet every loan has potential risks. Before investing with a private credit manager, it is important to understand how the manager evaluates risk and structures transactions accordingly. This is especially important late in the credit cycle when leverage and adjusted earnings may be reaching a peak.

The loan due diligence and approval process is broadly referred to as underwriting, and its rigour can vary by manager. A strong underwriting process should include modelling various downside scenarios that evaluate the borrower’s ability to generate sufficient cashflow to service debt and support ongoing operations, while also maintaining an acceptable loan-to-value ratio. A model is only as good as its assumptions, which means that a manager needs to use its experience to aggressively challenge assumptions and validate cashflows in several possible circumstances.

How do lenders evaluate loans?

Cashflow lenders use qualitative and quantitative analyses to evaluate each loan opportunity and prospective borrower. The qualitative analysis includes assessing the borrower’s competitive positioning, operations and overall market dynamics. The quantitative analysis includes assessing a borrower’s historical performance and the sustainability of prospective cashflows.

A best practice is preparing a detailed financial model that presents multiple scenarios including growth, baseline and downside cases.

Why is the downside case so important?

It is no surprise that credit committees often focus on the downside case. If things go according to plan during the investment horizon, there is generally little concern about loan recovery. If a situation deteriorates due to company-specific events or an overall market shift, recovery risk may increase.

Evaluating downside scenarios also facilitates a constructive discussion about the borrower, the quality of earnings or available information, the industry and an appropriate capital structure based on the level of risk inherent in the transaction.

Further, the combination of credit and structuring decisions that incorporate disciplined modelling and detailed due diligence, as well as active post-closing account management, should result in better recoveries across a private credit manager’s portfolio.

How do lenders build a downside case?

Creating a downside case begins with identifying a variety of potential negative events that could affect a company and/or its industry. Events might include the impact of a recession, loss of a major customer, product obsolescence, emergence of alternative and disruptive business strategies, possible regulatory changes, change in the competitive landscape, lack of expected synergies or run rate assumptions, or a combination of factors that result in the borrower generating less cash. The downside case is customised for each prospective borrower.

Underwriting teams review historical financial data, meet borrower management and review third-party reports. Asking extensive questions provides a better knowledge of the borrower’s business strategy, market dynamics and competitive positioning. A thorough model includes a five-year review of a borrower’s historical financial performance and five years of financial projections. Typical offering memorandums provide only two to three years of historical financials and three to five years of projections.

Many managers will request and review additional detailed historical financial data, including performance through the prior recession, customer or product-level historical trends and other company-specific data to assess the sustainability of a borrower’s anticipated cashflows. A company’s inability to provide detailed historical data can be a red flag.

Based on the results of its due diligence, the underwriting team then determines which critical variables to sensitise a borrower’s performance in the next cycle or a stress scenario. Experienced mid-market lenders also refine downside cases based on the performance of other borrowers in their portfolio and the industry through prior cycles.

Factors considered in a downside case usually include:

• Historical cycle. Review the borrower’s financial performance in a prior down market or the last cycle or two. What happened to revenue, margins and costs? How long did it take to recover? Recognising that the last cycle was 10 years ago, a lender needs to adjust this analysis to account for changes to the underlying business after the last cycle.

• Revenue decline. Evaluate the impact of losing a key customer, a reduction in average selling price or the possible availability of product substitutes.

• Input cost pressures. How do changes in wages, cost of materials (including tariffs), infrastructure needs, freight, etc, affect profitability? How flexible or variable is the company’s cost structure?

• EBITDA adjustments. Are the EBITDA adjustments truly non-recurring? Or are they ongoing cash costs that need to be deducted? Are maturity or run rate assumptions supported?

• Other required capital. What ongoing capital is required to maintain equipment and remain competitive in the market? How old is the fleet? What is the capacity of existing facilities? What other required capital outlays might negatively impact a borrower’s cashflow?

• Working capital changes. Consider liquidity needs caused by less effective management of inventory, payables and receivables. Alternatively, can a borrower free up cash by minimising working capital investment in a downturn?

• Other external factors. How might regulatory changes, technology shifts, software implementation or integrating acquisitions affect cashflow?

• Unfavourable interest rates. What is the impact of the forward LIBOR curve?

How does the downside case affect investment decisions?

Downside case analysis helps lenders determine the appropriate amount of debt that will allow a borrower to support debt service and other liquidity needs in a variety of cycle and stress scenarios. It also allows a manager to proactively structure a transaction for protection.

One key financial metric that lenders use to evaluate debt service is the “fixed charge coverage ratio”, which is typically calculated as EBITDA less capex, divided by interest plus principal payments, taxes and sponsor management fees. FCCR should remain above 1x in the downside case after shutting off subordinate debt interest payments and management fees following a default.

Loan to value is another key factor lenders consider. If the downside case results in increased leverage, the amount of the senior loan should remain below the total expected value of the business. With purchase price multiples at historic highs, it is important to recognise that the expected value will most likely be lower than the entrance valuation.
Modelling is inherently an inexact science, but it does highlight the expected degree of variability in company cashflow. Armed with the understanding of downside scenarios, a private credit manager should propose a capital structure that results in sufficient FCCR and LTV during a period of stress. By recognising these risks, managers can structure transactions to include a higher initial cash equity contribution, or a lower funded senior and total leverage at close that results in an appropriate LTV.

Additionally, private credit managers might require that other debt is structured as unsecured mezzanine versus second lien debt. During periods of stress, unsecured mezzanine debt interest payments can be suspended for a pre-negotiated timeframe to give the borrower additional liquidity, while second lien or unitranche interest payments cannot be shut off.

The commitment to diligence and prudent structuring

Modelling a downside case should always be a component of due diligence, but it is especially critical in later stages of the current economic recovery. The extent to which a manager employs downside modelling and uses it to structure transactions appropriately provides a valuable insight into its commitment to building a diverse, high quality portfolio of loans that are structured to withstand potential stress and cycle scenarios.

Ultimately, a private credit manager’s commitment to detailed underwriting and prudent transaction structuring will help offer investors stable returns as a result of lower defaults and higher recoveries throughout economic cycles and periods of stress.