In the current eventful world, we at Newbrook are finding that the standard knowledge asymmetry between borrowers and lenders is being stretched, making the formation of lender market consensus more difficult, and less reliant on labels. To bridge this widening gap, we posit that the credit story and the lender education process are of growing importance in the context of sound credit analysis.
To illustrate this point, a quick, opening quiz. From a credit standpoint, is opening new points of sale good news for a borrower and their creditors? And investing in a new manufacturing plant? What about having your top client, a 20-years-old commercial relationship, account for 15% of sales? In the interactions that we have had with a long list of lenders with regards to LBO transactions in Europe over the past 18 months, we have witnessed a wide spectrum of reactions to these questions, ranging from support of the business rationale to caution – in some cases unease – about the financial implications, including ramp-up, CAPEX, and concentration risk.
While anecdotal, such reactions have made us pay closer attention to the prevailing mood in credit circles in Europe. In this period, we have observed the emergence of several credit-related themes (defined as a large gap or disconnect between a borrower’s and a lender’s view as it pertains to a topic of the credit analysis in a given transaction). What they all have in common is that the approach each lender followed towards credit analysis and the themes has played a decisive role in the competitiveness of their proposed commercial and legal terms.
In this article, we highlight some of the most frequent themes, reflect upon why they feature in the first place, and share one among many possible ways to look at them from a credit analysis perspective. In this regard, we see the credit story and the lender education process as building blocks of growing importance in debt raising transactions, so we will dig deeper there. Of note: we do not imply that we know better. Our goal is to lay the themes and accompanying ideas in the open for discussion, as these themes deserve more consideration.
Observed themes
For this article, our selection of themes includes those most prominent in relation to market, business model, and revenues. We provide an outline of each theme and the observed implications as a result of both borrower-lender diverging views and broad diversity of lender approaches to credit analysis. The themes are all comparable in relevance and frequency, both ranking high within the credit processes in scope, thus meriting further consideration going forward.
By way of context, these themes have arisen in financing transactions of diverse profile, from primary acquisitions to refinancings to accordions, with opening leverage ratios ranging from 3x to 5x Structuring EBITDA, for total debt packages from €30m to €300m, always involving performing borrowers, both first-time and seasoned issuers.
In our opinion, the positioning of a lender regarding the following themes is not a ‘right or wrong’ discussion, rather a ‘more or less technically sound’ one, hence becoming a differentiating factor for some and a missed opportunity for others.
- Expectation of linear market growth that clashed with real, uneven (not cyclical) yearly results, and ultimately prompted the overthinking of annual rates while failing to recognise the long-term trajectory.
- Treatment of temporary market shocks as structural that translated into a negative sector outlook.
- Oversight of market penetration considerations as it related to a product’s lifecycle and market’s saturation, that produced a simplified assessment of the business plan.
- Distinction between shock-induced stocking decisions in B2B to hedge against supply chain/price disruptions and end-customer demand that resulted in contrasting market growth assessment.
- Differences in business model interpretation that led to an alternative definition of the market and the analysis of a separate set of trends and comparables (and defaults).
- Focus on standard, industry-specific KPIs (e.g. LFL in retail) in lieu of the drivers behind a specific business plan (e.g. M&A or margin improvement) that led to a different understanding of cashflow generation and where sensitivities were most needed.
- Hyperanalysis of revenues (e.g. ‘PxQ’) of a borrower with a broad client base that made trend identification less intuitive, made the bigger picture harder to see, and masked the benefits of diversification at play.
- Eagerness to find large cap-like diversification in revenues and costs together with benefits of scale in borrowers operating in the middle market that led to downplaying the borrower’s existing strengths.
The list above comprises themes of diverse nature. Nevertheless, we have reasons to believe that they all arise as a consequence of a shared set of factors. In the next section, we explore some of the most salient factors that may be contributing to the emergence of the themes.
Contributing factors
Above all, a lender’s structure, values, investment strategy, and liquidity seem to determine the approach and depth of their credit analysis to a large degree, in turn defining what is core or periphery in terms of clients, sectors, and jurisdictions. Interestingly, we have observed substantial differences between banks and funds, generalists and specialists, established players and newcomers, with long and short lists of recent closings, with and without recent defaults (in a similar and distant sector), with preference for business plans built around deleveraging and plans relying on value creation (growth/build-ups), or with a long and short pipeline.
Such lenders’ traits have manifested themselves on multiple occasions throughout transactions, from term sheet to due diligence requirements and Q&A needs. And while these ideas are nothing new, the role they played in the interactions between our direct counterparties –the deal team– and their credit team/investment committee became very apparent. The further the latter were from the deal’s epicentre, the higher the analytical challenge (as one would expect) and the higher the likelihood of resorting to the themes described above (the risk, as in lost opportunity).
To illustrate this point, let us zoom in on the Q&A phase of the transactions where we have advised in this period. If we had to categorise the lenders who have analysed these transactions based on the intensity and scope of their submitted questions, we would devise the following matrix. Based on our observations, the pragmatic approach of the “Selective verifiers” seemed to translate into faster analysis and approval, and a more ambitious positioning on the terms more relevant to the financing.
Illustration 1
Classification of lenders by approach to Q&A
| Intensity of inquiry
(Defined by number of questions and/or iterations on topics) |
|||
| High | Low | ||
| Scope of inquiry
(Defined by type of questions) |
Focused | Forensic reviewers | Selective verifiers |
| Broad | Comprehensive explorers | General screeners | |
We also see other factors that play a growing role. For example, the industrialisation of the credit process as lenders grow ever larger. In an attempt to do so in an orderly manner, the standardisation of the credit analysis, for instance by using templates, ensures the adoption of risk guidelines, and also raises the question around how flexible they can be to capture a transaction’s unique characteristics. Some lenders may benefit from specialisation here, a strategic choice more prevalent in the U.S. than in Europe, usually found at origination level rather than at credit analysis, and typically built around sectors or macro/business trends, but rarely at the intersection of transaction type, borrower profile, and sector, where a more tailored assessment can be produced in a more systematic way.
Remarkably, we see behavioural factors behind the themes too, with the most common being accelerated analyses and over-reliance on learnings from previous transactions. Their presence seems to be often explained by lack of time due to a rich pipeline, particularly visible depending on the timing of the transaction within the year.
Within the behavioural category, we observe a growing presence of the “event-driven economy” whereby shocks produce an instant (over)reaction and then take an abundant share of voice in discussions and analyses, potentially leading to an overstatement of the impact considering multi-year financings and to an understatement of the fundamental strengths of the borrower.
All of the above were magnified by market conditions, notably the supply of financing transactions. Observations suggest that it is during peak market conditions – notably both ends, booming and dried markets– when the influence of these factors becomes more visible.
In light of these factors, and even if the credit analysis manual has long been well established, flexibility is welcome. In the next section, we will share our views and preferences to be on the “better side” of the themes.
Multiple approaches, one goal
The proliferation of these credit-related themes stems less from financial analysis itself and more from the business analysis that underpins it. From a financial standpoint, a business plan is typically assessed by comparing historical and projected trajectories. Yet the credibility of these trajectories and the business plan as a whole may depend on a lender’s perception of a borrower’s business strength.
There are many ways to think about the business strength of a borrower (and a business plan). One that we like is Bain & Company’s approach to “Sustained Value Creation”, a body of thinking around the core and its full potential, adjacencies, and repeatability. That said, for the purpose of credit analysis in LBO financing, we choose to remain agnostic in terms of frameworks, methodologies, tools, and ratios. For us, the key is how bespoke their use is, and how flexible a lender’s processes and procedures, namely committees, can become to adapt to each and every transaction. This is particularly relevant when a transaction may seem ‘similar to’ another one in the peering process (benchmarking) and the ranking process (in the pipeline).
We like to begin our credit analysis by assessing the relative contribution of market evolution, revenue growth, EBITDA expansion, and cashflow generation to a given business plan. A value creation bridge helps us evaluate upside and downside across market share, price and volume, margin and profitability, and cash conversion factors.
We attempt to decode the business model of the borrower to identify what makes them unique and how the referred business plan fits therein. We follow a simple version of the business model canvas to grasp who buys what and where, how it is made, and what is needed. We find it useful to understand cashflow generation too.
With the business model in mind, we try to see the borrower as a node in a network of suppliers, distributors, and end-customers when ascertaining demand and growth potential. This is probably one of the more complex pieces of the analysis from a quantitative standpoint, and often times we approach it qualitatively.
To assess the market, we seek evidence of the event-driven economy, as there usually is. We try to differentiate temporary shocks from the underlying trends, especially when shocks seem re-occurring. To this end, for example, our focus is on medium term growth rather than on annual rates. For the same reason, we are prudent with the use of multiples. In this context too, we track a basket of indexes such as VIX and iTraxx Xover, which provide useful signals on sentiment and windows.
We also look at the relationship between financial and credit risk for a given transaction with a given borrower. As depicted in Illustration 2, one of the two can be high so long as the other one is low. Our observations suggest that credit risk usually gets most/all of the attention and financial risk considerations can easily be overlooked.
Illustration 2
Classification of a transaction by type of risk
| Financial risk
(Instrument/capital structure risk) |
|||
| High | Low | ||
| Credit risk
(Counterparty risk) |
Low | YES | Corporate lending |
| High | NO | YES | |
We try to have a best-in-class credit story too. We would like to spend some time on this topic in the next section.
Anatomy of the credit story
Ask anyone operating in LBO financing what the credit story is. What you will likely hear are references to the central role that the credit story plays in financing transactions. Surprisingly though, we hardly see a page or section devoted to it. Often times, there is a ‘key investment highlights’ page – ‘key credit considerations’ at best – that lists the reasons why a financing transaction is particularly strong. These points typically draw from an ‘equity story’ –as the ‘investment’ terms suggests–, thus arguing valid points, but ones that are more relevant to depict the upside sellers propose and/or sponsors are after rather than assessing the downside lenders want protection from.
In our view, an adequate credit story describes (i) the type of financing, (ii) the strategy pursued by the borrower, both (iii) in the context of the sector in which it operates, mainly. On top of the headline, it provides a glimpse of what’s happening in the transaction “behind the scenes”, helping to make more educated decisions on initial appetite and priority within the pipeline. The choice of words matters, as they ultimately translate into labels and themes. ‘Corporate development plan’, ‘inorganic growth plan’, ‘international build-up’ point in a similar direction, but are not quite the same. In a similar fashion, ‘financing for the acquisition of the [x] market leader plus undrawn lines to support M&A ambitions’ is not the same as ‘financing for the MBO of the [x] market leader and to support their ongoing build-up in the EU’.
A more robust credit story goes beyond tagging, by highlighting what is unique about these three aspects of a transaction, in other words, how they add value. This is particularly useful when there are – or there have been recently – similar deals in the market. The keyword here is ‘similar’ as pointed out earlier. In most cases, our experience and intuition will serve us well when tagging a transaction ‘comparable’. But such a cognitive bias is a double-edged sword, and we may occasionally stand corrected on the true comparability across transactions upon closer examination. In light of dynamic market liquidity and limited bandwidth of origination teams, the positioning of a transaction cannot be overlooked or delegated to others i.e. left to arbitrary interpretation made in isolation; it needs consistent treatment and careful education to the benefit of lenders’ teams involved in a transaction.
A best-in-class credit story does so without resembling a sales pitch, but a fact-based narrative that lays out in plain terms what really matters. Ultimately, it is not about that one-liner or one-pager per se, but what can be done with it. Credit analysis is a good place to start. A best-in-class credit story signals the relative contribution of the operational/financial levers towards cashflow generation, de facto becoming a sort of map to perform a meaningful, time-efficient credit analysis. Along these lines, if we are dealing with an incremental facility to finance a build-up, chances are that the analysis will benefit from a strong(er) focus on the targets (valuation, synergies, post-merger integration…). That is not to say that other checks on the borrower’s strategic and financial condition need not be performed, but it is worth pondering the time allocated to each, the amount of additional Q&A requested on each, and so on.
A best-in-class credit story embedded in a sound lender education process helps cut through the prevailing noise in today’s markets and stick to ‘trend-driven credit analysis’ in an event-driven economy, focusing on the variables that matter to explain [most of] the variance in the behaviour of a borrower.
Now, we believe the influence of the credit story and lender education process stretch even further, throughout the whole debt raising process. Most important of all, the credit story is the foundation to assess the liquidity available in the market for a given transaction, the end product being a curated list of lenders to approach, and the success KPI being a high hit ratio.
Other cascading impacts of a best-in-class credit story relate to DD, Q&A, and documentation. The credit story informs the decision on how much due diligence is necessary and its scoping. It also helps anticipate and direct the amount and type of Q&A workload. Lastly, it focuses everyone on the clauses of the Senior Facilities Agreement that are most relevant to the borrower.
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Based on our observations, more credit analysis did not necessarily equate to more technically sound decision making. Interestingly, it did not seem to be a matter of quantity, and, frankly, neither of quality alone (understood as depth of analysis), rather one of customisation.
Those lenders ahead in analytical flexibility achieved more advanced understanding of the borrower, sector, and transaction.
Ultimately, the themes are a reminder that sound credit analysis sits at the heart of Leveraged Finance. The playbook may be well established, but striking the right balance between orthodoxy, customisation and materiality remains key. The credit story and the lender education process can be instrumental in achieving this objective.
https://www.bain.com/insights/value-creation-what-it-is-and-why-it-matters/