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Risk: How Lenders Think of Credit Risk and How it is Different From Equity Risk

By Rocky Gor

Virtually every company can use more liquidity, especially when future market stability is uncertain. However, before you approach a lender, you should understand how lenders think of risk and how they distinguish between credit risk—which they take—and equity risk—which they shun. The difference can be quite subtle, but understanding this difference can help you steer your capital raising efforts toward success.

Lending has worked on a very simple premise for thousands of years: a lender rents capital to a borrower, who in return agrees to (1) pay a specific amount of rent on specific dates, and (2) return the rented capital in full on a specific date. The rented capital, of course, is principal (P) and the rent is interest (I).

Many years ago, I was attending a risk management course as a young credit associate at GE Capital, where our chief credit officer effectively summarized our profession in one sentence: “Interest is important, but when there is no P, there is no I.” The probability of not recovering the principal is the risk, and the primary task of a credit professional is to minimize such risk.

Interest is important, but when there is no P, there is no I.

Investment risk has a wide spectrum; U.S. government debt is considered risk free, while investments like currency and commodity futures carry the maximum risk. We can break up the risk spectrum into three categories:

  1. Known risk, known outcome
  2. Known risk, unknown outcome
  3. Unknown risk, unknown outcome

1. Known Risk, Known Outcome

This is the type of risk that a lender can readily understand, predict, and quantify, making it manageable. Let’s assume 40% of a borrower’s revenues come from one take or pay contract. The lender can readily quantify potential reduction in revenues if such a contract was not renewed. They can also predict the timing and resulting impact on borrower’s ability to repay the principal. The lender can manage this risk by making the maturity of their facility contingent on expiration of the contract if not renewed, in addition to liquidity requirements leading up to the cancellation date and over collateralization.

This is credit risk, where the probability of not fully recovering the principal can be quantified and managed. Regulated financial institutions—banks—largely limit themselves to this kind of manageable credit risk.

2. Known Risk, Unknown Outcome

These risks can be conceptually understood but cannot be accurately predicted or quantified. Let’s assume 40% of a borrower’s revenues come from a contract that can be cancelled with a two-day notice. While the possibility of cancellation is obvious, the timing is not. When combined with other business factors, the effect of such cancellation could be disproportionately higher than the loss of 40% of revenues. In other words, the real impact of the cancellation of this contract cannot be predicted with confidence.

If risk cannot be predicted and quantified with confidence, it cannot be managed effectively. In other words, the probability of not fully recovering the principal cannot be quantified or managed. This is equity risk, and it is something that lenders typically avoid.

Conversely, indirect information on this kind of risk can improve predictability. For example, how dependent is this customer on the borrower, the length of the relationship, the quality of other revenue streams, and so on. While not a perfect antidote to inherent unpredictability, additional information can enable a lender to make this risk more manageable, or more credit risk-like. Non-regulated lenders—private debt providers—do take these kinds of risks.

Since 2008, banks have been forced to be more conservative due to new regulations, and as a result the spectrum between the managed predictability of credit risk and the unpredictable outcome of equity risk has seen explosive growth. Today, about 800 private credit funds underwrite riskier deals that banks cannot. Since they take more risk, they need higher compensation compared to banks. We will provide details on the private debt sector, private debt products, and their features in upcoming articles.

3. Unknown Risk, Unknown Outcome

Also known as a “black swan,” unknown risk is posed by events that cannot be foreseen, quantified, or managed. For instance, consider the challenge of underwriting FY 2020 revenues of a borrower in a consumer services business. Because of the COVID-19 crisis the business is closed, and there is no reliable way of predicting when consumer services businesses will reopen or the magnitude of their revenues once they finally do. As there is no way to predict or quantify cash flows of such a borrower, the probability of not getting the principal back is quite high, making this a classic equity risk. In other words, only the equity owners of such businesses may invest additional capital in such businesses if they want to bet on a certain recovery scenario.

To summarize, before approaching financial institutions, think through the predictable aspects of your business, and have a solid explanation for expected cash flows over the next 12-24 months. Also, form a conservative opinion on the valuation of your business and/or assets that you can provide as collateral to a lender. Discuss with potential lenders your plans to safeguard your business when you face unexpected adversity.

While upcoming articles will describe how lenders will assess your cash flows and collateral to determine the amount and structure of capital they can provide, as a rule of thumb, the higher the predictability of cash flows and collateral value, the higher the likelihood of getting capital from banks. As predictability of cash flows decreases, valuation-dependent private debt providers might become more relevant.

Finally, while it is good to understand how lenders perceive the risk of lending to your firm, it is equally important to reduce your risk of not finding the right capital provider quickly by approaching a number of banks and private lenders simultaneously. If you don’t know where to start, visit capx.io to find the right match from 20+ proven capital providers on our platform.