Private Debt Profiles.

Private market strategies are a crucial part of the financial landscape, encompassing areas such as private real estate, infrastructure, and buyout equity. These strategies often rely on a combination of borrowed capital and equity to develop and operate an asset or restructure a company with the aim of increasing valuation and improving cash flow. Key features of these strategies include the availability and cost of debt, the tenor of the debt, restrictive covenants, contingencies that benefit issuers and investors, and the use of the underlying project or company assets as a secondary source of repayment. The type of debt profile used in these strategies is a distinguishing feature of private markets. Private issuers with less stable cash flows are usually sub-investment grade or unrated and must accept constraints imposed by lenders.

Debt Profile

The composition of a debt profile plays a pivotal role in ensuring sufficient operating flexibility while providing adequate protections for the borrower. It also plays a significant role in valuing these instruments under different credit and economic scenarios. Revolving credit agreements, which are the most common form of short-term bank borrowing facility, may be drawn and repaid as needed until maturity. In leveraged buyout transactions, revolving credit is often secured by a bank based on a pledge of fixed assets, or by private lenders using specific claims to accounts receivable, inventory, or equipment as collateral.

Evaluating Corporate Creditworthiness

Corporate creditworthiness is determined by a combination of qualitative factors, such as a company’s business model, industry, size, and competitive position, and quantitative factors including profitability, debt coverage, and financial leverage. Financial statement modeling and forecasting tools used throughout the CFA curriculum to evaluate future equity and debt performance also apply to private market debt profiles. Estimating expected loss under different scenarios is a key focus, as credit spreads comprise a higher proportion of sub-investment grade and unrated private issuer debt total yield and price.

The Credit Valuation Adjustment (CVA) Framework

The CVA framework is a critical tool in financial analysis, representing the present value of potential credit risk across various financial instruments like loans, bonds, or derivatives. It centers around two primary components:

• Probability of Default (POD): The likelihood that a borrower will not fulfill their debt obligations according to the agreed terms.
• Loss Given Default (LGD): The percentage of the total exposure that is not recoverable after a default occurs.

Together, these components help in estimating the expected loss (EL), which can be viewed as a simple one-period credit spread estimate:

$$\text{Credit spread} \approx \text{LGD} \times \text{POD}$$

Key Financial Ratios

Financial ratios are instrumental in evaluating a company’s creditworthiness. They provide insights into various aspects such as profitability, leverage, and the ability to cover debt obligations.

EBITDA Margin: This measures the company’s operational profitability as a percentage of its revenue, highlighting how much profit is made before accounting for interest, taxes, depreciation, and amortization.

$$\text{EBITDA margin} = \frac{\text{EBITDA}}{\text{Revenue}}$$

Debt to EBITDA: This ratio compares the company’s total debt to its earnings before interest, taxes, depreciation, and amortization, assessing its ability to pay off debt.

$$\text{Debt to EBITDA} = \frac{\text{Total debt}}{\text{EBITDA}}$$

RCF to Net Debt: This shows the proportion of net debt that could be covered by the company’s retained cash flow, indicating its financial flexibility.

$$\text{RCF to net debt} = \frac{\text{Retained cash flow}}{\text{Debt – Cash and Marketable securities}}$$

EBITDA to Interest Expense: This ratio measures the ability of a company to cover its interest payments from its operational earnings.

$$\text{EBITDA to interest expense} = \frac{\text{EBITDA}}{\text{Interest expense}}$$

These ratios collectively provide a comprehensive view of a company’s financial health, operational efficiency, and its capability to meet financial obligations. They are crucial for stakeholders in assessing credit risk and determining investment viability.

Private Debt Valuation and Economic Cycles

Private debt valuation is influenced by a mix of broad economic factors and specific issuer characteristics. These factors interact to affect the level and slope of credit spread curves throughout the economic cycle.

• Early Expansion: During this phase, as profitability begins to improve and default rates remain elevated from the previous downturn, high-yield spreads are relatively high, sitting well above those of investment grade spreads. Often, investment grade spread curves may exhibit a flat to inverted nature, reflecting cautious optimism about future economic growth.
• Mid to Late Expansion: As the expansion matures, default rates decrease, and profitability continues to increase, leading to a steepening of the credit spread curves. This trend persists as the economic expansion approaches its peak, characterized by increased leverage and inflation expectations, signaling growing investor confidence and demand for riskier assets.
• Peak to Early Contraction: As growth reaches its zenith and begins to slow, the economy may start to contract, leading to a recession. This phase sees credit spreads widening and spread curves flattening or even inverting, particularly for high-yield spreads. The changing dynamics reflect deteriorating profitability and an uptick in defaults, increasing the perceived risk of lending.

Practice Questions

Question 1: Corporate creditworthiness is a function of both qualitative and quantitative factors. Among the quantitative factors, key financial ratios are used to evaluate a company’s ability to meet its debt obligations. Which of the following ratios is NOT typically used to assess a company’s creditworthiness?

1. Profitability, as gauged by the EBITDA margin.
2. Leverage, usually comparing total debt to firm resources as gauged by assets, capital, profitability, or cash flow.
3. Market share, comparing the company’s share of the total industry sales to its competitors.

Answer: Choice C is correct.

Market share, comparing the company’s share of the total industry sales to its competitors, is not typically used to assess a company’s creditworthiness. While market share is an important indicator of a company’s competitive position within its industry, it is not a direct measure of a company’s ability to meet its debt obligations. Creditworthiness is primarily assessed based on a company’s financial strength and stability, which is determined by its profitability, leverage, liquidity, and cash flow. These factors are typically measured using financial ratios such as the EBITDA margin and the debt-to-assets ratio. Although a company with a high market share may be more likely to generate stable and predictable cash flows, which could enhance its creditworthiness, market share itself is not a financial ratio and does not provide direct information about a company’s financial health or its ability to service its debt.

Choice A is incorrect. Profitability, as gauged by the EBITDA margin, is indeed used to assess a company’s creditworthiness. The EBITDA margin measures a company’s operating profitability as a percentage of its total revenue. It provides information about a company’s ability to generate profits from its operations, which is a key factor in its ability to meet its debt obligations.

Choice B is incorrect. Leverage, usually comparing total debt to firm resources as gauged by assets, capital, profitability, or cash flow, is also used to assess a company’s creditworthiness. High leverage can indicate a higher risk of default, as it means the company has a large amount of debt relative to its resources.

Question 2: The Credit Valuation Adjustment (CVA) framework is used to represent the present value of credit risk for a loan, bond, or derivative obligation. It comprises two key credit risk components. What are these components and how are they defined in the context of the CVA framework?

1. Probability of default (POD), the likelihood that a borrower fails to make full and timely payments of principal and interest according to debt terms; and loss given default (LGD), the amount a lender fails to recover if a default occurs.
2. Interest rate risk, the potential for investment losses due to a change in interest rates; and market risk, the potential for losses in positions arising from movements in market prices.
3. Credit spread risk, the potential for a change in the spread between the yield on a credit risk bond and the yield on a comparable risk-free bond; and liquidity risk, the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss.

Answer: Choice A is correct.

The Credit Valuation Adjustment (CVA) framework is used to represent the present value of credit risk for a loan, bond, or derivative obligation. It comprises two key credit risk components: Probability of Default (POD) and Loss Given Default (LGD). POD is the likelihood that a borrower fails to make full and timely payments of principal and interest according to debt terms. It is a statistical measure that estimates the likelihood of a default over a particular time horizon. LGD, on the other hand, is the amount a lender fails to recover if a default occurs. It is expressed as a percentage of the exposure at the time of default. Both these components are crucial in the CVA framework as they help in quantifying the credit risk associated with a financial instrument. The CVA is then calculated by multiplying the POD, LGD, and the Exposure at Default (EAD), and discounting this product back to the present using the risk-free rate.

Choice B is incorrect. Interest rate risk and market risk are not components of the CVA framework. Interest rate risk is the potential for investment losses due to a change in interest rates, and market risk is the potential for losses in positions arising from movements in market prices. While these risks can impact the value of a loan, bond, or derivative, they are not directly related to the credit risk that the CVA framework is designed to measure.

Choice C is incorrect. Credit spread risk and liquidity risk are also not components of the CVA framework. Credit spread risk is the potential for a change in the spread between the yield on a credit risk bond and the yield on a comparable risk-free bond, and liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss. These risks can impact the value of a financial instrument, but they are not directly related to the credit risk that the CVA framework is designed to measure.

Glossary

• Private Market Strategies: Investment strategies that involve assets not listed on a public exchange.
• Debt Profile: The composition of a company’s debt, including the types, amounts, and rates of the debt it has issued.
• Corporate Creditworthiness: A measure of a company’s ability to meet its financial obligations.
• Credit Valuation Adjustment (CVA): An adjustment to the market value of derivative contracts to account for counterparty risk.
• Probability of Default (POD): The likelihood that a borrower will default on a loan or other financial obligation.
• Loss Given Default (LGD): The amount of money a bank or other financial institution loses when a borrower defaults on a loan.
• Expected Loss (EL): The anticipated loss on an investment or loan.
• EBITDA Margin: A profitability measure equal to EBITDA divided by total revenue.
• Private Debt Valuation: The process of determining the value of a private debt instrument.

Private Markets Pathway Volume 1: Learning Module 4: Private Debt; LOS 4(d): Analyze private debt profiles and calculate and interpret financial ratios used to value private debt investments