Cyclical industries such as Wholesale, Retail, and certain Manufacturing sectors are facing the dual pressures of rising inflation and lagging supply chain disruptions. Current unstable market conditions are prompting many CEOs and CFOs to consider their liquidity options.
If you’re a CEO or CFO of a cyclical business facing market headwinds, you might be thinking about approaching lenders (or perhaps you’ve already started the process). Before you go any further, you need to pause a moment and consider how lenders think about risk.
$277 Billion
– Amount of dry powder in the US Private Credit industry
source: Moody’s
Lending has worked on a very simple premise for thousands of years: a lender rents capital to a borrower, who in return agrees to (1) pay a specific amount of rent on specific dates, and (2) return the rented capital in full on a specific date. The rented capital, of course, is principal (P) and the rent is interest (I).
Many years ago, I was attending a risk management course as a young credit associate at GE Capital, where our Chief Credit Officer effectively summarized our profession in one sentence: “Interest is important, but when there is no P, there is no I.”
The probability of not recovering the principal is the risk that credit professionals fret over most acutely, and their primary task is to issue loans that minimize such risk.
Interest is important, but when there is no P, there is no I.
This is very different from how equity investors think about risk. Equity owners maintain a higher risk tolerance for their investments, because they are often involved in the management of the business, and can take steps to improve the valuation over time. Their investments are also smaller percentages of their overall portfolios as compared to debt investors, hence the downside of a single bad investment isn’t as calamitous.
To better understand how lenders think about risk, it helps to break up the risk spectrum into three categories:
1. Known Risk, Known Outcome
This is the type of risk that a lender can readily understand, predict, and quantify. Thus, it becomes a manageable type of risk.
For example, let’s assume 40% of a borrower’s revenues come from one take or pay contract with a specific maturity date. The lender can readily quantify the potential reduction in revenue if such a contract was not renewed. The lender can also predict the timing and resulting impact on the borrower’s ability to repay the loan’s principal.
The lender can then manage this risk by writing a covenant into the loan agreement that mandates the maturity of the loan, contingent on expiration of said contract. The lender might also introduce liquidity and collateral requirements leading up to the contract renewal date, to ensure that the company maintains enough cash, cash equivalents, or collateral to repay the principal, should the contract fail to renew.
This is a prime example of credit risk, where the probability of not fully recovering the principal can be quantified and managed. Regulated financial institutions—banks—largely limit themselves to this kind of manageable credit risk.
2. Known Risk, Unknown Outcome
This second form of risk can be conceptually understood, but cannot be accurately predicted or quantified.
Let’s again assume 40% of a borrower’s revenue comes from a single contract. But this time, let’s assume the contract can be canceled at any moment—as opposed to having a strict renewal or cancellation date. While the possibility of cancellation is clear (a known risk), the timing of the potential cancellation is unknowable. And because the contract can be canceled at any moment, the cancellation might coincide with other business or market factors (say, a large marketing or R&D expense related to the contract, or a period of cyclicality in the market) which could combine to generate a disproportionately higher loss than 40% of company revenue. So the real impact of the contact’s cancellation cannot be predicted with confidence (unknown outcome).
If risk cannot be predicted and quantified with confidence, it cannot be managed effectively. This is equity risk, and it is something that banks typically avoid.
Direct lenders are more willing to assume equity risk, but not without a ‘credit story’ that highlights key elements of the deal as risk mitigants. Seeing your capital needs from a credit perspective can be difficult, which is why CAPX helps borrowers understand how lenders will think about their business (more on this below).
3. Unknown Risk, Unknown Outcome
Also known as a “black swan,” unknown risk is posed by events that cannot be foreseen, quantified, or managed.
Consider the challenge of underwriting FY 2020 revenues of a borrower in a consumer services business that was forced to shut down during the COVID-19 crisis. At the time, there would have been no reliable way to predict when consumer services businesses would reopen, nor would it have been possible to predict the magnitude of company revenue once services finally resume, given the ‘black swan’ nature of the COVID-inspired lockdowns.
As there was no way to predict or quantify the cash flows of such a borrower, the probability of losing the principal is quite high, making this a classic equity risk. In other words, only the equity owners of such businesses would have invested additional capital, assuming they were willing to bet on a certain recovery scenario.
The Credit Perspective
Before approaching financial institutions, it is critical that CEOs and CFOs think through their business from a credit perspective.
This is more difficult than it sounds, as lenders tend to view businesses in a very different light than those running the day-to-day operations. Many CEOs and CFOs approach the debt capital markets with growth ambitions, assurances of deeper market penetration, and plans for increased customer acquisition. This is all wonderful, but it is the ‘equity story’ of your business. The ‘credit story’ tells a very different tale.
Equity investors are looking at where your business is going. Lenders are looking at where your business has been.
At CAPX, we help borrowers understand their credit story. We partner with CEOs and CFOs to help frame their business from the lender’s point of view. And our end-to-end digital marketplace facilitates a national campaign for your deal, so you can be certain you’re obtaining the best possible terms.
We understand how time-intensive the loan sourcing process can be, so we are offering complimentary credit perspectives to middle-market CEOs and CFOs. If you would like help clarifying your lending options, click the button below and set a time to speak with one of our credit experts.
CAPX will provide a credit overview of your deal, and help walk you through any deal positioning or debt structure questions you may have.
There is no cost for this consultation, and you are under no obligations or commitments to join CAPX. Upon scheduling your free consultation, one of our debt experts will contact you to provide a credit overview of your business.
