What is Credit Analysis?

In the world of finance, credit has always been looked upon as the less-exciting sibling to equity.  This is easy to understand when you consider that finance has always been driven by the principle of risk vs. return.  The risk, as it relates to equity, is quite high given that there is no guarantee of return either in the form of a dividend or return of capital.  The glory, therefore, is in the deal that brings returns of many times (or “X”) the original investment.  Credit’s reputation is rooted in stodgy old bankers reluctantly lending out capital with humble returns to the bank.

Key Learning Points

  • Credit analysis is the process of assessing the ability of the borrower to repay a borrowed amount of money
  • LBO or leveraged buy-out is an acquisition by a financial sponsor, financed using significant amounts of debt
  • Cash flow adequacy is important for credit analysis as cash is used to pay for services and debt and there is less risk involved when lending to companies with strong operating cash flows
  • It has becoming increasingly more important to analyze macro, industrial and corporate level risks when making a loan

The Evolution of Credit

Much has happened in recent times to change this, however.  Many years ago, the LBO was born, and this transaction was not just reliant on debt as many acquisitions are, it was dependent on debt and greater amounts of it than had previously been used in transactions. As a result, the transactions were highly risky. Returns began to creep up, credit product proliferated, and credit bankers, particularly those knowledgeable in high yield finance, were in demand.  The driving force behind this was the need to understand a company’s fundamentals better than most financiers had ever understood them. The earnings or EPS driven approach common in equity-based businesses was not specific enough. Cash was now king on Wall Street and hard-core cash flow analysis was necessary to determine if companies could withstand massive amounts of debt and survive long enough to pay down obligations and deliver a return to the equity holders at the bottom.  Credit analysis does exactly this.

Credit Becomes a Market-based Product

As the demand for credit products proliferated, the market for credit also evolved and became more sophisticated. Loans are now traded in the markets like bonds. This has shifted the pricing of many loans from the banking floors to the trading floors with something called market flex pricing. The expansion of loans as a viable trading product has expanded the number of institutions that are looking for returns in credit products. The increase in hedge funds, credit funds, and other capital funds looking for credit-based returns provides liquidity to the market. The demand for returns from credit products has led to the creation of credit derivatives and special purpose vehicles like collateralized loan obligations, which invest in a large portion of the syndicated high yield loans that are made.

Credit Analysis Now

Credit analysis is, therefore, in demand.  In its purest form, credit analysis is needed at the source of loan origination to ensure that the quality of the loans matches the perceived risk levels.  In two big examples of market breakdowns, the fall of the first high yield loan market of 1987 and the GFC of 2008-9, the underlying credit analysis either failed to accurately detect the growing financial risk of the underlying loans or was ignored in the chase for returns.

With record levels flowing into capital funds, private equity is having its closeup moment. Yet more and more, PE deals involve leverage and with smaller, less established companies that cannot weather a storm the way a BBB+ rated corporation can.  Sound, fundamental analysis of the macro, industrial and corporate level risks are needed for banks with ever tighter capital constraints to make successful and profitable loans to riskier private equity deals. Bankers must not only know how to analyze the financial risk but also understand the complex organizational structures of companies that borrow at different levels as well as the complex capital structures that feature varieties of revolvers, term loans, and mezzanine finance.

Credit analysis is no longer just for old fashioned banks and the rating agencies. Just as the money center lending banks jumped into investment banking and market making activities with the fall of Glass-Steagall, traditional investment banks have opened their balance sheets to making loans, trading loans, investing in loans, and structuring CLOs for investing in loans. The credit skill set, rooted in fundamental analysis, can now be more easily be applied to a wide range of the financial services spectrum.