While investors hold all aces when it comes to sector selection and investment decisions, they approach investment banks (IBs) to understand their target companies. These institutions conduct in-depth credit analysis to gauge the target’s credit risk. Every investor has a different risk appetite and investment mandates. Given the credit risk of the borrower/target, IBs would also approach investors willing to lend to the target company.
IBs use the five Cs of traditional credit analysis to facilitate a deal. They are Capacity, Condition, Character, Collateral, and Covenant. It can be segregated into two sections: credit research and credit risk management.
Credit research enables IBs to gauge a target’s overall creditworthiness or credit risk exposure. Furthermore, if the borrower lacks a recent Credit Rating Agency (CRA) rating, IBs generate a shadow rating for them. For a credit analysis, IBs need to analyze 3Cs – capacity, condition, and character – of the borrower.
Capacity refers to a borrower’s ability to repay debt. Bankers need to extensively analyze the target’s financial and business ability to repay debt. Whether the target has stable and diverse revenue streams can be evaluated from region-wise as well as products and services perspective.
Condition pertains to the target’s industry structure and operating environment. IBs can deploy Porter’s Five Forces analysis to gauge competition in the target industry. To sound out the operating environment, IBs would require a deep-dive analysis to understand macroeconomic factors, prevalent policies, growth prospects, and the industry’s cyclicality.
Character assessment is also essential. IBs should look at the historical financial trend to gain a sense of how responsible the borrower has been and is likely to be in the future. IBs should also pay attention to the target managements’ soundness of strategy and track record from a legal standpoint.
Once IBs gauge the creditworthiness of a borrower based on the 3Cs, they should also analyze 2Cs –collateral and covenants – at the credit instrument level. The 2Cs can also be used as credit risk management tools if the risk appetite of investors and the creditworthiness of the borrower are not at par.
Collateral refers to assets that the borrower pledges as protection against potential losses, in the event that the borrower cannot honor the debt. The quality and value of assets pledged as collateral are important factors. IBs should pay attention to the depreciation expenses on the assets offered as collateral.
Covenant is an agreement that forbids the borrower from participating in certain activities (negative covenants) and demands them to perform certain others (positive covenants). Covenants can be deemed ‘tight/strong’ or ‘loose/weak’, depending on the terms and financial flexibility provided to the borrowing company. While enforcing covenants, IBs have to strike a delicate balance, as being overly restrictive might hinder the target’s cash flow generation abilities, which could hamper timely repayments.
Analyzing all five Cs helps bankers to perfectly match the credit risk of the target company with investors’ risk appetite and facilitate a better deal.