1) I will think like an equity analyst. In order to properly assess the credit risk of a company, you must understand what management is thinking. Since management works for the owners of the company, not its creditors, you must think like an owner. Is there a viable business plan? What is the company’s competitive advantage? What is the company’s plan for growth? How will the company enhance returns to shareholders?
You must understand the pressures management is facing. Is the share price dropping? You can bet that management will do something to push it up, like a share buyback, special dividend, divestiture, or acquisition (or even worse, they will “manage” earnings). Is the owner (whether a private equity shop or a family) interested in selling the company? Perhaps they will defer capital projects (or, once again, “manage” earnings).
2) I will think like a debt analyst. OK, you must understand the owner’s perspective, but you must also keep in mind that what is good for the owner is not always good for creditors. For example, shareholders love high growth companies – they get higher equity valuations (and their managers often get higher compensation). But high growth often means high risk and, perhaps, low or negative cash flow. Remember, a business plan can be good and appropriate for the company, and at the same time, high risk from a credit perspective.
3) I will avoid elevator analysis. No one needs you to tell them if sales (or margins or leverage) went up or down. People can see that themselves by looking at the numbers. Your job is describe why the numbers are changing and, perhaps, give insight into how the company is likely to perform in the future. You have to have an opinion. Tell me if performance is good or bad, not just up or down.
4) I will find the elephant in the room. Too often we see people doing “checklist analysis.” There are certain things they must analyze to fill in all the boxes in their memo. Checklists can be helpful, but you have to remember to look at the big picture. That may mean identifying issues that don’t fit neatly into the boxes. Is there a big issue out there? What does management spend most of their time thinking about? What is the most likely cause of a future decline in the company’s credit quality? This might be an anticipated future sale of the company (for leveraged buyouts), the age of the owners or managers (for privately held companies), a new regulatory framework (for banks), or a new competitor (for everyone!). Don’t be so focussed on the details that you forget to look at the big picture (even if it’s not on your checklist).
5) I won’t leave the structuring to the lawyers. Too often, bankers and credit analysts are focussed on bringing in new transactions, getting them approved internally and/or getting them sold into the market. We leave covenants and other structural issues to the lawyers, or we use a “standard package” of covenants. This is a mistake. The covenants and other structural elements of the deal should be tied to the unique risks of the company. Are you worried the company might grow to fast? Or that they might take on excessive leverage or that the owners will take too much money out of the company? Structural subordination? There are covenants for all of these concerns. The right package of covenants (and the covenant levels) are different for every company.