1. Credit Risk
Credit risk is the probability that a borrower will fail to make full or timely payments of interest and principal. Private credit is typically unrated by large ratings agencies so the onus is entirely on private credit managers like Montfort to evaluate borrowers for potential investment.
The 5 Cs method of credit analysis incorporates both qualitative and quantitative analysis and is a starting point to examine the borrower’s credit reports, credit scores, income statements, and other documents relevant to the borrower’s financial situation.
The 5 Cs of credit analysis:
This is a borrower’s ability to service their debt. Capacity can be affected by the borrower’s profitability, cash flow measures, and level of existing debt as well as wider industry structure and risk factors.
A company’s mix of debt and equity often includes various layers, each with its own seniority in the capital structure. Seniority refers to the priority of any claim on company assets in the event of default or bankruptcy. In simple terms, debt ranks above equity; secured debt ranks above unsecured debt; and senior debt ranks above subordinate debt.
Higher ranking debt generally receives lower interest rates than lower ranking debt but receives preferred treatment in the event of default or bankruptcy.
In some capital structures, specific assets can be used as collateral for debt. The quality and value of the borrower’s assets that can be liquidated to limit creditor losses in the event of default or company bankruptcy are assessed as part of the credit analysis.
Covenants are the legal terms that spell out obligations and limitations on the actions of a borrower’s management team. They are intended to maintain the credit quality of the borrower and may include requirements that the borrower make regular interest and principal payments, file audited financial statements, and maintain certain financial ratios.
The applicant’s character (i.e., their credit history) is examined as is the nature and intentions of the company’s equity holders, the corporate strategy, the management team’s track record and governance practices at the company board and operating levels as part of the credit risk analysis.
2. Interest Rate Risk
Fixed income securities prices decline as interest rates rise. In the private credit industry, debt is often issued with floating rate payments — fixed rate payments are less common. Floating rate payments adjust up or down based on the level of a pre-set reference interest rate. This means they are less susceptible to capital losses in a rising rate environment than fixed rate credit investments.
3. Valuation Practices
Because private credit is not actively traded, the valuation frequency and methodology of private credit funds can vary. Valuation practices have a significant impact on the price volatility of private credit funds. Investors should expect transparency from their managers and familiarize themselves with the valuation practices of a given private credit manager before investing.
4. Fund Level Leverage
In some cases, managers of private debt funds use borrowed money to provide additional exposure to private debt instruments beyond 100% of their fund’s net asset value. This leverage amplifies both the risk and return characteristics of an unlevered portfolio and comes with its own borrowing cost.
Liquidity refers to the ease and speed with which an investment can be bought or sold in the secondary market.
Managers of private credit funds often originate loans themselves and hold them until they are paid back by the borrowers. The average expected holding period of private credit loans affects investor liquidity so investors should seek to understand the liquidity characteristics of a private credit strategy before investing, as this will affect their ability to redeem units should the need arise. This includes understanding the redemption privileges of any fund they choose to invest in.
6. Rate of Losses
Losses can happen. A good private credit fund will actively monitor its portfolio companies’ performance and take proactive steps to intervene if indicators of loss are uncovered. Montfort uses a proprietary Active Credit Monitoring process to automate the collection of data from its portfolio where it is reviewed monthly by our credit team.
If signs of imminent loss are uncovered, Montfort works with the portfolio company to find a solution to prevent or reduce the loss. As a result, Montfort can better manage credit losses and maximize returns to investors.