Credit Analysis is the process of evaluating the creditworthiness of a borrower using financial ratios and fundamental diligence (e.g. capital structure).
Often, some of the more important contractual terms in the financing arrangements that lenders pay close attention to include debt covenants and the collateral pledged as part of the signed contract.
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Each lender has its own standardized approach in performing diligence and gauging the credit risk of the borrower. In particular, the inability of the borrower to meet its financial obligations on time, which is known as default risk, represents the most concerning outcome to lenders.
When the downside potential for a borrower is far greater than that of traditional borrowers, the importance of in-depth credit analysis increases because of the uncertainty.
If the lender has determined to extend a financing package, the pricing and debt terms should reflect the level of risk associated with lending to the particular borrower on the other side of the transaction.
The following table contains some of the more common credit analysis ratios used to assess the default risk of borrowers, at the brink of insolvency (i.e. near financial distress).
Note, when a borrower is at risk of default, the metrics used are on a short-term basis, as seen in the working capital metrics and cash conversion cycle. But for non-distressed borrowers, extended time horizons would be used for calculating working capital metrics.
Short-term models are commonly seen in restructuring models, most notably the Thirteen Week Cash Flow Model (TWCF), which is used to identify operational weaknesses in the business model and to measure short-term financing needs.
Credit ratings can also be insightful, but rating agencies require time to adjust ratings, and because of this time lag, rating downgrades can be a bit behind the curve and serve more as a confirmation of existing concerns in the markets.
Leverage ratios place a ceiling on debt levels, whereas coverage ratios set a floor that cash flow relative to interest expense cannot dip below.
While leverage ratios assess whether the borrower has an excess level of leverage on its balance sheet, the coverage ratios confirm whether its cash flows can cover its interest expense payments.
The higher the default risk, the higher the required yield is, as investors require more compensation for the additional risk being undertaken.
Debt covenants represent contractual agreements from a borrower to refrain from certain activities or an obligation to maintain certain financial thresholds.
These legally binding clauses can be found in credit documentation such as loan agreements, credit agreements, and bond indentures, and are requirements and conditions imposed by the lenders that the borrower agrees to abide by until the debt principal and all associated payments are paid.
Intended to protect the interests of lenders, covenants establish parameters that encourage risk-averse decisions through avoidance of activities that could place the timely payment of interest expense and principal on the date of maturity into question.
When banks lend to corporate borrowers, they are looking first for their loan to be repaid with a low risk of not receiving interest or principal amortization payments on time.
Whether structuring a secured senior loan or other forms of debt lower in the capital structure, covenants are negotiations between the borrower and the creditor to facilitate an agreement that is satisfactory to both parties.
If a borrower were to breach a debt covenant in place, this would constitute a default stemming from the violation of the credit agreement (i.e., serving as a restructuring catalyst). But in most cases, there will be a so-called “grace period”, whereby there may be monetary penalties as stipulated in the lending agreement but time for the borrower to fix the breach.
Senior debt lenders prioritize capital preservation above all else, which is accomplished by strict debt covenants and placing liens on the assets of the borrower. As a general rule, strict covenants signify a safer investment for creditors, but at the expense of reduced financial flexibility from the perspective of the borrower.
Covenants to senior lenders (e.g., banks) are crucial factors when structuring a loan to ensure:
In return for this security (and collateral protection), bank debt has the lowest expected return, while unsecured lenders (similar to equity shareholders) demand higher returns as compensation for the additional risk taken on.
The more debt placed on the borrower, the higher the credit risk. In addition, the less collateral that can be pledged; hence, borrowers have to seek riskier debt tranches to raise more debt capital after a certain point. For the lenders that do not require collateral and are lower in the capital structure, collectively these types of creditors will require higher compensation as higher interest (and vice versa).
There are three primary types of covenants found in lending agreements.
Affirmative (or positive) covenants are specified tasks that a borrower must complete throughout the tenor of the debt obligation. In short, affirmative covenants ensure the borrower performs certain actions that sustain the economic value of the business and continue its “good standing” with regulatory bodies.
Many of the requirements listed below are relatively straightforward, such as the maintenance of required licenses and the filing of required reports on time to comply with regulations, but these are signed as standard procedures.
Affirmative Covenant Examples
Failure to pay taxes or to file its financial statements, for example, would certainly harm the economic value of the business from potential legal problems arising.
Negative covenants restrict borrowers from performing actions that might damage their creditworthiness and impair lenders’ ability to recover their initial capital.
Often called restrictive covenants, such provisions place limitations on the borrower’s behavior to protect lender interests. As expected, negative covenants can confine a borrower’s operational flexibility.
Maintenance covenants have generally been associated with senior tranches of debt whereas incurrence covenants are more common for bonds. Financial covenants are designed to track key credit metrics to ensure the borrower can adequately meet interest payments and repay the original principal.
Historically, senior debt has come with strict maintenance covenants while incurrence covenants were more related to bonds. But over the past decade, however, leveraged loan facilities have increasingly become “covenant-lite” – meaning, senior debt lending packages comprise covenants that increasingly resemble bond covenants.
There are two distinct categories of financial covenants:
Maintenance covenants require the borrower to maintain remain in compliance with certain levels of credit metrics and are tested periodically. Typically on a quarterly basis and using trailing twelve months (“TTM”) financials.
Maintenance Covenant Examples
Conversely, incurrence covenants are tested after certain “triggering events” occur to confirm that the borrower still complies with lending terms.
Incurrence Covenant Examples (“Triggering” Events)
Simply put, the borrower may NOT undertake a certain action if it causes the borrower to violate the allowed threshold. This is often through the form of a financial covenant (e.g., Debt / EBITDA).
For example, a company cannot raise debt or complete a debt-funded acquisition if doing so would bring its total leverage ratio above 5.0x.
The existing liens and provisions found in inter-creditor lending terms regarding subordination need to be examined because they are very influential factors in the recoveries of claims.
Similar to distressed investors, lenders of all types should prepare for the worst-case scenario: a liquidation.
The collateral coverage calculates the value of the liquidated collateral to see how far down the claims it can cover.
The collateral of the debtor (i.e., the troubled company) directly affects the rate of recoveries by claim holders, as well as the existing liens placed on the collateral.
Claims held by other creditors and terms in their inter-creditor agreements, especially senior creditors, become an important factor to consider in both out-of-court and in-court restructuring.
But in the case the lender can recover most (or all) of its initial investment even in a liquidation scenario, the riskiness of the borrower could be within an acceptable range.
One requirement in Chapter 11 is the comparison of recoveries under a liquidation versus the plan of reorganization (POR). This directly affects the liquidation value and priority of claims waterfall, which sees how far down the capital structure the asset value can reach down before running out.
The more senior lenders there are, the more difficult it could be for lower priority claims to be paid in full, as senior lenders such as banks are risk-averse; meaning capital preservation is their priority.
For Chapter 11 bankruptcies, the influence of creditor committees can be a useful proxy for the complexity of the reorganization such as legal risks and disagreements among creditors.
But even a higher number of unsecured claims can add to the difficulty of an out-of-court process, as there are more parties to receive approval from (i.e., the “hold-up” problem).
Learn the central considerations and dynamics of both in- and out-of-court restructuring along with major terms, concepts, and common restructuring techniques.
