Credit in the time of COVID

Any statement on the level of disruption that 2020 has served up risks being an understatement. In addition to reconsidering personal lives and routines, many investors have been forced to rethink world views on risk and downside – a subject we’ve been spending immense time on over these past 6 months. While GRAPH prides itself on thinking creatively about value gen opportunities for new owners, we are often pulled by clients that are credit investors into deep downside investigations. Synthesizing lessons from this (atypical) experience for the broader sponsor community, a few good “downside practices” stand out that could be helpful for all investors:

  1. Credit investors often do more “sensitizing” the downside: because many of the scenarios that are relevant for sponsors are upside-driven or involve new investments of capital, our traditional sponsor-oriented CDD mandates tend to emphasize value generation opportunities for these. Our credit investor documents wallow in key downside scenarios and ask what creates operational and financial resilience in the business.

  1. Proactively essentializing leading performance metrics: a key outcome of “wallowing” in these downside scenarios is that sophisticated credit investors learn to probe on key performance metrics that will affect the business in downside scenarios – things like churn rates, lines of business with high operating leverage, gross margin concentration in specific accounts become critical discussion topics with the goal of distilling leading indicators that can be tracked going forward. There is power to distilling leading downside indicators that sponsors can benefit from as well – and by “getting in front” of the issues, sponsors impress prospective lenders by proactively attending to this need.

  1. Credit diligence always narrows the focus, “de-templating” the work: GRAPH has done entire (large) projects for credit investors digging solely into topics like churn rates. The effect of this level of focus is to isolate out what really matters from comprehensive business reviews. Some sponsors ask for the same stock diligence coverage on vastly different deals – this is both a waste of resource but also a possibly dangerous distraction from the real issues that will prove to matter. We believe that our strongest equity-side clients do this too: By narrowing focus and taking a phased/methodical approach to threshold questions in priority order, our best sponsor clients actually move faster by building more confidence earlier in the process; and they have the added benefit of equipping themselves to be effective board members – having focused on these issues that matter

Of course, downside scenarios can be overwhelming these days: COVID-19 has created massive uncertainty on both supply and demand issues for many companies. In this environment, choosing the right downside concern can be difficult. Start with the fundamentals – what drives demand and then explore behaviors that develop when that is threatened – regardless of prospective cause. Next, move onto the company’s strengths and determine (with no overstatement) the prospect for the business to influence demand – and the ability of the business to identify and drive commercial activities in the resilient demand pockets. Whatever the scenario, a key lesson we’ve learned is the importance of careful delineation of what changes are more likely to be permanent vs. those that are only temporary. Our savviest clients don’t discuss a “return to normal” post-COVID, but rather a re-envisioning of what the business can look like with the constraints relaxed. This of course does not always need to reflect a lesser future – for some, a “post-COVID” world with the right investments made now may provide greater rewards, rather than diminished opportunities.

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