Robert Grunewald CEO of Flat Rock Global, LLC

An Innovative Approach to Middle Market Credit : The 5 C’s of Credit

Executive Summary

• Post financial crisis, small to As I’ve traveled the country throughout the past few years speaking at industry middle market companies have conferences, I’ve noticed that as the number of participants in the middle market experienced an increase in the availability of lending sector grows, so does the proliferation of presentations highlighting lender’s “innovative approach” to underwriting the debt of middle-market business. • This increase is correlated with the growing amount of business The “innovative approach” alluded to in these presentations led me to recall the development companies or lessons I learned during 1984 in the credit training program at Citizens & Southern (“BDCs”) which act as sources National Bank (eventually to become Bank of America). The credit program stressed of debt for small to middle that successful lending requires a discipline focus on the 5 C’s of credit—Character, market companies Capacity, Collateral, Capital and Conditions. I believe losses occur when lenders, in their pursuit of a new, innovative approach to underwriting, lose focus on the • As a result, middle market discipline of these 5 C’s of credit. lenders differentiate themselves by developing “innovative Character approaches” to credit underwriting Character refers to the qualitative assessment of a company’s management team. It • These innovative approaches can primarily examines how the business, as well as its principals, have performed with lead middle market lenders to regards to prior debt obligations. A borrower’s character can further be evaluated veer away from fundamental using key factors such as experience, industry knowledge, and trustworthiness. It which is will examine the owner’s ability to manage the business in dynamic market paramount to evaluating a conditions. For example, if a business is going through a leveraged , can the prospective investment owners adequately navigate a levered business with small margin for error? Similarly, it’s paramount to understand management’s experience and track record during economic downturns (Hands on Banking 2017; Hinson, 20041). To appropriately evaluate whether a debtor has quality management, disciplined lenders should utilize some of these essential tools:

• Owner’s resume • A review of management depth • A review of the business plan to include financial projections, risks and opportunities and contingency plans • References • In person interviews

1 Hinson, D. "The" Five C's" of Credit Analysis." (2004). An Innovative Approach to Middle Market Credit Underwriting: The 5 C’s of Credit

Capacity/

Capacity measures the company’s ability to repay a loan; whether the business is solvent. If character forms the bedrock of any loan underwriting, then capacity provides the most important structural component. ‘Global’ cash flow is a particular area of interest when underwriting a loan. Lenders need to examine the broader lending environment. For instance, it is important to analyze a borrower’s ability to satisfy its obligations with related financial institutions like banks, or examine debt held against real estate holdings. A borrower’s capacity is defined as the of the business which provides the primary source of repayment. Without sufficient cash flow, a borrower would need to liquidate assets to repay the loan. Typically, lenders define free cash flow as a company’s plus interest, taxes, and depreciation commonly referred to as EBITDA.

Debt Service = (Net Income + Depreciation & Interest Expense) /Annual Principal and Interest payments on all company debts2

Capacity gauges the debtor’s ability to repay the loan by comparing income versus recurring as well as analyzing debt-to-income ratios. Additionally, lenders investigate the applicant’s cashflow stability over time (Keown, 2013). Lenders generally prefer a ‘debt service coverage ratio’ higher than 1.2x (i.e. there is at least a 20% cushion between earnings and debt service obligations).

Collateral 3

Collateral acts as the for a loan. It is a surety to lenders that their money is safe and that they can recover/repossess these assets in the event of a borrower’s default. Collateral can include hard assets such as accounts receivable, inventory and equipment, however, in today’s increasingly service orientated economy, collateral is often best analyzed by assessing the of the company through various economic cycles. Enterprise value should not be defined by the company’s capitalization structure or the purchase price of the business. An objective analysis of a business using both and comparable company analysis is critical to understanding the collateral value of service orientated businesses.

Collateral is usually thought of as a secondary source of repayment. In reality, collateral is more often used as a lever by the lender to force changes within a faltering business. Those changes may include reducing expenses or an injection of additional , but in some cases, it means encouraging the sale of the business long before a lender would ever take control.

2 Keown, Arthur J. Personal . Pearson, 2013.

3 Brown, Martin, Karolin Kirschenmann, and Steven Ongena. "Bank funding, securitization, and loan terms: Evidence from foreign currency lending." Journal of Money, Credit and Banking 46, no. 7 (2014): 1501-1534. An Innovative Approach to Middle Market Credit Underwriting: The 5 C’s of Credit

For a lender, understanding of the monetary value of the collateral is fundamental. The collateral should be periodically reviewed throughout the life of a loan to ensure that it maintains its value. Lenders usually examine the collateral second to the primary cash flow of the business. Even though collateral enhances credit by giving lenders more security and minimizes risks, it is never the primary source of repayment (Mirovic, Vera, and Dragana Bolesnikov, 2013; Wang, Yihui, and Han Xia, 2014).

Capital

Capital is the ability to sustain a downturn in the economy. A low capital position in a business also raises questions from a lender as to the owner’s commitment to their business. A strong capital base creates an all-important “alignment of interest” between the lender and the borrower. Critical components of capital include the retained earnings of the business, cash invested by sponsors, as well as owner’s roll-over equity or seller notes in the case of a sale of the company. The chances of default are minimized by meaningful contributions made by the borrower. Lenders feel more comfortable in extending credit to borrowers who have made significant capital commitments as this indicates a strong alignment of interest (Wang, Yihui, and Han Xia, 20144).

Conditions Conditions refer to how the loan is intended to be used. Loan conditions such as interest rates and amount of principal amortization affect the desire of lenders to finance the borrower. Evaluating current economic conditions at the time credit is requested, is the final task to determine the feasibility of a loan. Are there specific economic conditions or downturns that would directly affect the capacity of the loan? For example, based upon an assessment of the company’s cyclicality, how will it likely perform in the event of a recession? This is where specific downside case becomes critically important. In today’s environment, it’s also important to evaluate the likely impact on the company to changes in interest rates.5

4 Mirovic, Vera, and Dragana Bolesnikov. "Application of asset securitization in financing agriculture in Serbia." Ekonomika Poljoprivrede 60, no. 3 (2013): 551.

5 Keown, Arthur J. Personal finance. Pearson, 2013.