The 5 C’s of Credit

By 15 July 2019August 27th, 2020No Comments

The private credit market in Australia is increasingly large and diverse. Given low interest rates and equity dividend yields it is becoming an increasingly relevant source of stable income for investors. An important consideration for investors into private credit funds is the investing thought process the fund manager uses to assess whether lending opportunities are satisfactory from a risk and reward perspective for inclusion in the fund.

We’ve set out in this note a traditional common sense approach to assessing credit risk that we find useful as part of our process to assess lending opportunities for our Stable Income Fund. The so-called 5C’s of credit have been used by credit risk officers in banks and by other credit investors for many years and they form a useful framework for us to explain our investing thought process. They retain their relevance even these days when many believe relying only on credit ratings or mysterious algorithms is sufficient.

Lets start with Character. Simply put, who is the borrower and are they reputationally someone we wish to partner with as a lender? Is the borrower trustworthy and will they do what they say they are going to do? Do management and the shareholders of the borrower have a track record that indicates trustworthiness and capability?  Without this there is not much point in progressing a credit assessment any further.

Two quotes from JP Morgan, arguably the founder of modern corporate banking, are relevant:

  • “The first thing (in credit) is character… before money or anything else. Money cannot buy it;” and:

  • “A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business.”

When funding non-bank lenders, which is a focus of our fund, we extend the character test to both the management and shareholders of the non-bank lender itself and the process they use to assess this issue in the people or corporate’s that they fund.

Then we get to Cashflow (or alternatively, the Capability to repay the loan). This is all about the financial position of the borrower and the borrower’s ability to generate sufficient future cash flow to service the loan and cover their other costs.

Our analysis of the financial statements of the borrower (forecast and historic) focuses on whether the borrower’s profit and loss and cash flow statements show that they have been consistently profitable . We ensure that the real free cashflow the borrower has generated in the past and should do in the future would comfortably service interest and principal on the new loan and all other existing debt – if not, the new debt needs to be considered with caution. Highly leveraged companies always need much more scrutiny in this regard. Working capital and capital expenditure requirements are essential components of the analysis alongside consideration of the real drivers of earnings.

Intensive analysis is required, on both cashflow and character.  When these questions need to be applied to funding non-bank lenders, it is the underwriting guidelines they use to make loans to their clients, and the implementation of these guidelines, that we carefully consider.

Capital relates to the purpose of the borrowing. What are the proceeds of the loan going to be used for and how much shareholder money is at risk? It is essential that borrowers, and their shareholders, have enough “skin in the game” at risk to make sure they pay attention to their lenders. And of course, equity or the “first loss” needs to be sufficient to absorb the losses that can arise in stress scenarios. Covid-19 is certainly providing a realtime opportunity to assess the effect of real stress on businesses and the amount of equity capital genuinely required by borrowers to make it through difficult times and we have  been paying particular attention to this.

Collateral provides lenders with a back-up source of repayment, should a borrower fail to meet its obligations and default on the loan. Collateral is the security offered by the borrower (such as a charge over land and buildings, plant and equipment or guarantees from a creditworthy third party), which can be sold or called on by lenders to recover their capital and any outstanding interest, if the borrower defaults. Loans need to be made based on the cashflow ability of the borrower to repay, not the value of collateral, but collateral does provide a useful underpin given lenders earn a fixed return and do not share in any of the upside of the business. Unsecured lending needs to be short term and only to high quality borrowers.

Conditions (or alternatively Covenants) completes the list. This refers to the terms and conditions attached to the loan. Conditions could include items such as requiring the borrower to maintain a minimum level of capitalisation , interest cover and debt serviceability as well as not exceeding a maximum gearing ratio. The sale and purchase of significant assets may also be restricted or prohibited.

Conditions have the effect of requiring the borrower to engage with the lender either when they wish to embark on an important new initiative or when significant issues have arisen in the business. They give the lender a seat at the table at such times and are an important part of the overall credit package.

Conclusion (the 6th C ?)

Assessing credit risk can be complex and we will explore some of these areas of complexity in future insight notes. But using a common sense approach grounded in the 5C’s provides us with a useful framework to make sure we select loan assets for our Fund that meet our criteria of generating stable income with solid capital preservation.