Modeling the Downside Case
By Linda Chaffin, Guest Contributor
Senior debt is considered the safest investment in the capital structure. Yet every loan has potential risks. Before investing with a private debt manager, it is important to understand how the manager evaluates risk and structures transactions, especially later in the credit cycle.
The loan due diligence process is known as “underwriting,” and its rigor can vary by manager. A strong underwriting process should include modeling downside scenarios to evaluate whether the borrower can generate sufficient cash flow to service debt, support ongoing operations and maintain an acceptable loan-to-value ratio.
How do lenders evaluate loans?
Cash flow lenders use qualitative and quantitative analyses to evaluate each loan opportunity. The qualitative analysis includes assessing the borrower’s competitive positioning, operations and market dynamics. The quantitative analysis includes assessing historical performance and the sustainability of prospective cash flows. As part of this, a best practice is preparing a detailed financial model with multiple scenarios including growth, baseline and downside cases.
Credit committees often focus on the downside case. If things go according to plan, there is generally little concern about loan recovery. If a situation deteriorates, recovery risk may increase.
Evaluating downside scenarios facilitates a constructive discussion about the borrower, quality of earnings, industry and an appropriate capital structure based on the risks inherent in the transaction.
Building a downside case
Creating a downside model begins with identifying a variety of negative events that could affect a company and/or its industry and result in the borrower generating less cash. These might include a recession, loss of a major customer, product obsolescence, new regulations, change in the competitive landscape or lack of expected synergies.
A thorough model includes a five-year review of a borrower’s historical financial performance and five years of projections. A company’s inability to provide this data can be a red flag.
The downside case and investment decisions
Downside 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 (“FCCR”), which is typically calculated as EBITDA less capex, divided by interest + principal payments + taxes + sponsor management fees. FCCR should remain above 1.0x in the downside case after shutting off subordinate debt interest payments and management fees following a default. Changes in loan to value (“LTV”) is another metric that lenders consider.
Armed with an 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. This might involve structuring a transaction to include a higher initial cash equity contribution or a lower funded leverage.
Ultimately, a private credit manager’s commitment to detailed underwriting and prudent transaction structuring should result in lower defaults and higher recoveries, which can help offer investors stable returns throughout economic cycles or periods of stress.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of NXT Capital or TEXPERS.
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| Linda Chaffin |
Linda Chaffin oversees NXT Capital’s investor relations activities and fundraising efforts. She is actively involved developing and maintaining investor relationships across the institutional LP community, including insurance companies, public and corporate pension plans, foundations, endowments and consultants. Chaffin brings over 20 years of investor relations, fundraising, private equity, and M&A investment banking experience to NXT.
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