In a credit bubble like this one – when the buy-side is chasing yield and debt financing can be readily attained – investors in sub-investment grade debt must be extra careful. Choosing the right business and doing your due diligence is more important than ever.
Debt investing, in the sub-investment grade market, is a due-diligence-intensive business. Yes, slightly less due diligence may be required if the paper is liquid and you can exit your investment within a couple of days or a week: high yield bonds and syndicated leveraged loans, for example, are supposed to be, in most cases, liquid. But even then, in smaller sizes and in certain circumstances, that liquidity may be questionable. When there is less liquidity and likely no way out, debt investors must be absolutely sure of their contractual rights: what restrictions and prohibitions are there on the issuer, such that creditors are protected? Due diligence is critical.
As a first step, a debt investor must be comfortable with the underlying business: the business model, market share, jurisdiction, management, corporate governance, and of course the financials – revenue, expenses, EBITDA, capex, etc. Investors need to consider the cash flow and assets of the business and ask themselves: how sustainable is the cash flow as presented today, and what would my recovery rate be if the business defaulted in the future? Essentially, is this a good business?
Debt investors are looking to invest in solid businesses, but at the same time, the risk-reward balance must be right. In current markets, with this mature bull market in credit and a host of investors chasing yield, it is proving a challenge for some investors to maintain that discipline. At present, the upper hand lies with borrowers and their private equity sponsors, who can be found pushing hard against market-standard clauses in documentation: loosening definitions, lifting restrictions, softening ratio tests, and generally trying to introduce as many off-market or issuer friendly clauses as possible. The financial crisis and wave of ensuing corporate restructuring has shown what happens when documentation starts slipping: a lesson which seem in danger of being forgotten. Right now, due diligence is vital for debt investors to decide whether certain paper – even if it is a good business and offering yield – is actually worth the investment and the risk.
