50 Terms You Must Know as a Credit Investor
The only way to have a conversation is to know the language
Confused by all the terminology used in the industry, or just looking to sharpen/refresh your knowledge base? Today’s post is a guide and reference point for some of the most common private credit language and terminology used in the industry. Terms that we discuss here will be regularly used in future posts - so if you ever feel lost, think of this as a “cheat sheet” to be referenced to quickly get up to speed. As a credit investor, understanding the terminology and “jargon” used in the industry is critical for effective communication with other members of your deal team (and will keep you engaged during Investment Committee). Plus, there’s no better way to show that you’re a serious contender in the field than being able to engage in a fluid conversation using the same language employed by seniors with 30+ years of experience.
Amortization - The process of gradually paying off debt through regular payments. Most loans issued by direct lending funds include amortization (think Senior and Unitranche financing) although it is typically low, around 1% of principal paid back annually. Amortization payments are typically made on a quarterly basis.
Cash-Flow Lending - A form of lending that evaluates the borrower's ability to generate sufficient cash flow to repay the debt. This is contrary to asset-based lending, where lenders are more concerned with amount and value of collateral (assets) that are used to guarantee the loan.
Covenant - A contractual provision that outlines certain restrictions or requirements a borrower must adhere to. Covenants are how lenders make sure the company doesn’t do anything screwy, and are typically carved up between affirmative covenants (things you must do), negative covenants (things you cannot do), and financial/maintenance covenants (thresholds you must comply with on a predetermined schedule, like maintaining <7.00x leverage tested on a quarterly basis). See ‘Financial Covenants’ for more detail.
Leverage - The use of borrowed funds to amplify potential returns or gain greater exposure to an investment, or the better definition “every millionaire’s favorite invention”. Leverage is one of the only reasons private equity exists, why people can buy a home or car, and why some can pursue higher education. In private credit, leverage is typically referred to as a multiple of EBITDA. For example, if a company is levered to 5.0x, that means they have 5 “turns” of EBITDA in the form of debt on the company. To break it down further, if the company’s EBITDA is $100 million, they have $500 million of debt ($500 / $100 = 5.0x). Lenders typically want leverage to be as low as possible because more debt means more risk. Private equity buyers typically want leverage to be as high as possible (within reason and assuming the company can still operate and meet its financial obligations) because that allows them to write a smaller equity check, which amplifies returns. We will get into leverage in a full post because (not surprisingly!) leverage is one of the fundamental topics to understand in private credit.
Default - The failure to meet the obligations of a loan or debt agreement. This can be as serious as missing interest or principal payments due to cash flow constraints, or even failure to deliver an annual audit/monthly financial statements. Most lenders won’t call a default because of an audit that’s a day or two late, but they will email or call the company to remind them to not f*ck around and find out.
Distressed Debt - Debt instruments issued by companies experiencing financial difficulties or undergoing restructuring. These typically have monster interest rates or are issued at serious OIDs to compensate for the elevated risk. This can also refer to existing loans that were once performing credit, but are now distressed due to performance deterioration at the company. If this is the case, the lender is almost certainly not receiving adequate economics to compensate for the new risk profile - and no one will buy the loan remotely close to par on the secondary markets.
Due Diligence - In short, the process of investigating and evaluating the financial and legal aspects of a potential investment. But this covers a TON of topics and is a core part of the underwriting process. Due diligence is typically carved up between business diligence (do we like the company, is it creditworthy, are there any material risks and how will we get comfortable?) and third-party diligence (quality of earnings report, legal diligence, market studies, etc.) that protect the buyer (and lender) from foul play.
Fixed vs. Floating Rate Pricing - Fixed rate loans are loans with an interest rate that remains constant throughout the term of the loan. It’s not very typical for the direct lending market, but is more common in the junior debt/mezzanine market. Floating rate loans are loans with an interest rate that fluctuates based on a reference benchmark, such as SOFR (or LIBOR historically, although LIBOR is phasing out). Interest rates are typically written as a “spread” over the base rate (i.e. SOFR) which is also referred to as the “margin” or “applicable margin”. So if you see SOFR+550bps, S+500, S+500bps, etc. - these all mean the same thing - pricing on the loan is SOFR + a spread of 5.0%. Not surprisingly, lenders want the interest rate to be as high as possible and borrowers want the interest rate to be as low as possible - where they land is usually dictated by the market.
Lien - A legal claim on an asset, often used as collateral for a loan. This is why certain debt instruments are called First Lien Term Loan or Second Lien Term Loan. The titles delineate the priority order each lender can pursue against the collateral, which is also a way of expressing the risk of the investment. Because Second Lien holders are subordinated to First Lien holders, Second Lien loans come at a premium (think S+8-10% instead of S+4-6%). It’s critical to understand where you rank in terms of liens and how your collateral is defined. You could have a First Lien loan against 20-year old trucks that have basically no value, while another lender has a Second Lien against high quality receivables that are more than enough to pay back both the first and second lien lenders to those assets - who is in a better spot? If you aren’t careful, you could end up getting “First Lien pricing” (think: low) while taking on greater risk than junior debt holders. We’ll cover this in a future post as well given its importance.
Loan-to-Value (LTV) Ratio - The ratio of a loan amount to the appraised value of the underlying asset. If a company raises a $400 million Term Loan and its market value is $1.0 billion, that would be a 40.0% LTV ($400 / $1,000). In the public markets it’s easy enough to determine value because it’s dictated by the market and trades on an exchange. In the private markets, it gets a bit more complicated. If there’s a private equity buyer, the value they are paying for the company is a pretty fair indicator of the value of the company, most of the time. What if there isn’t a buyer involved, and it’s a direct-to-company loan with no private equity backer? Time to whip out your old fashioned valuation techniques and form a view. Most direct lenders target a LTV in the 30-50% range, while junior debt funds can go even higher. Similar to a mortgage, if the market turns and the value of a company drops, LTV can exceed the enterprise value of the company. That’s typically a signal that things are not going well - even if you sell the company tomorrow, there aren’t enough sale proceeds to completely repay the debtholders (sorry equity holders - you’re long gone).
Mezzanine Debt - A hybrid form of financing that combines features of both debt and equity. Mezzanine typically comes into play when a buyer is looking for higher financing than the senior credit markets are willing to provide. If they want 6.5x leverage, but the market will only provide 5.0x, they may turn to the mezzanine market to raise that final 1.5x (at a higher cost, since mezzanine debt will rank junior to senior debt in terms of priority, or could be unsecured).
Maturity Date - The date when a loan or debt instrument becomes due and payable in full. In private credit, typically 5-7 years, which lines up with a private equity firm’s targeted hold period.
Non-Recourse Loan - A loan that limits the lender's recourse to only the collateral provided, protecting the borrower's other assets. If Coca-Cola raises some debt and offers up its accounts receivable balances as collateral, they likely won’t want that lender to be able to enforce against the secret formula if there are challenges collecting its A/R. Non-recourse loans help maintain this flexibility for companies.
Closing Fee - A fee charged by a lender for providing financing. This is typically anywhere between 1-3%, although it can be higher or lower based on where the market is. Closing fees are a key component of returns for private credit funds. In terms of calculating the dollar amount, if a lender commits a $500.0 million Senior Credit Facility and the closing fee is 2.0%, the fee amount would be $10.0 million ($500 * 2.0% = $10).
Par Value - The face value of a bond or debt instrument, representing the amount to be repaid at maturity. If a lender writes a $100.0 million loan, they want to be repaid $100.0 million, plus interest. Seems simple enough. However, the market value of the loan can fluctuate based on company performance, changes in market pricing, etc., but the par value is a constant. Changes in market prices is what caused banks to suffer massive write-downs during the 2008 recession (as well as during the SVB/Signature/First Republic failures). We’ll cover those in the future.
PIK Interest - Payment-in-kind, a type of interest payment that is accrued onto the loan balance rather than paid in cash. It’s more common in the mezzanine market, and comes up often in distressed investments since cash flow becomes tight and needs to be preserved for more important things, like making payroll. PIK interest increases the balance of the loan and is paid out at maturity (or on a refinancing). A simple way to think about it is as a compounding interest rate - 10.0% PIK on a $1,000 loan is $100 in the first year = now the loan is $1,100. In the second year, the PIK interest is $110 (10.0% of $1,100), and it continues to compound until the loan is repaid. The interesting secondary effect of PIK interest is that it increases cash interest payments as well - since the loan balance is increasing, and cash interest is paid based on the balance of the loan.
Prepayment Penalty - A fee imposed on a borrower who pays off a loan before its scheduled maturity date. This is really meant to protect lenders from short holds, and from undergoing strenuous underwriting processes just to be refinanced in 6-12 months. These penalties are typically written as 102 / 101 / Par - meaning a 2.0% fee in year 1, 1.0% fee in year 2, and no fee thereafter. Certain loans may include a ‘No Call’ provision, the most common of which is ‘interest make-whole’, whereby the borrower would have to pay all of the interest that would have been payable if the loan had been held to maturity. It’s financially not practical, so in effect serves as a no-call provision. No-call provisions are typically written as NC-12 or NC-18, meaning no-call for 12 or 18 months. Fees are assessed on the amount of the loan that is being repaid. And no, prepayment penalties are not assessed on amortization payments that are required under the loan documents (you greedy bastard).
Private Credit - Refers to the financing market where debt financing is provided by non-bank lenders, such as direct lending, mezzanine financing, and distressed debt.
Revolving Credit Facility - A line of credit that allows the borrower to borrow, repay, and re-borrow funds within a specified limit. Also referred to as a Revolver (but not the weapon kind). Some direct lenders include Revolvers in their Credit Facilities, others don’t touch them and prefer they are offered by banks who may or may not already have the cash management function. Revolvers are an easy way for companies to navigate working capital cycles - if they need a lot of cash in order to buy/produce inventory during a certain time period, revolvers allow them to access this cash. Those revolvers can be paid down later, once cash is collected. Revolvers also offer short-term access to cash/liquidity in the event of unexpected one-time costs (revolvers are typically funded within 1-3 business days of a draw request).
Secured vs. Unsecured Debt - Secured Debt is debt that is backed (i.e. secured) by collateral. Unsecured Debt is not backed by collateral, so unsecured debtholders are lending solely against the creditworthiness of the borrower.
Senior Debt - Debt that has priority over other forms of debt in the event of default or bankruptcy, the bread and butter of direct lending funds.
Subordinated Debt - Debt that ranks lower in priority compared to other forms of debt. Typically this is your mezzanine financing, but could include secured financing such as Second Lien loans. Subordinated debt is typically negotiated and subject to a “Subordination Agreement” with senior debtholders that outlines the rights and remedies each lender group has in a bankruptcy or Event of Default (typically a breach of Covenants).
Term Sheet - A document outlining the basic terms and conditions of a proposed loan or investment. Term Sheets are used to signal to buyers or companies that you’ve spent time in diligencing the opportunity upfront, and are comfortable signaling your ability and intent to provide financing. Term Sheets are non-binding, so they won’t hold up in court - but they’re a great way to show your engagement and shouldn’t be sent out carelessly. Private equity buyers may include debt term sheets in their bid package for a business, as a way of signaling that they have the financial means to close on the transaction.
Commitment Papers - Similar to a Term Sheet, but longer form with a greater number of defined terms and already negotiated outcomes. Commitment Papers are a binding commitment to provide financing (with a few get-out-of-jail free cards, such as a Material Adverse Clause) and are typically heavily negotiated between the Borrowers/Lenders. Commitment Papers are a binding commitment, so at this point all due diligence should be completed, and the only outstanding items would be final legal negotiations (and potentially a few straggler third-party diligence reports).
Unitranche - A type of loan that combines senior and subordinated debt into a single facility, simplifying the capital structure. Unitranche loans are a newer product - in the past, you might lever a business to 5.5x with 4.0x of senior (S+500) and 1.5x of mezzanine (12.0% cash). A unitranche blends the two together, so lenders provide 5.5x of unitranche financing at a blended interest rate (S+650) that is somewhere in the middle. Borrowers like unitranche structures because they only require a single set of loan documents versus a senior/subordinated, which is also more cost effective from a legal perspective. Direct lending firms like unitranche financings because it allows them to balance the portfolio with higher yielding loans that offer better returns for investors - win/win. While rarer in the past, unitranche financing is very common today and is typically offered by both direct lenders as well as mezzanine funds (if priced accordingly).
Working Capital - The capital available for day-to-day operations of a business, calculated by subtracting current liabilities from current assets. It’s a component of cash flow because companies need to convert their working capital into cash in order to then use that cash for other things like interest payments, payroll, etc. which they can’t do if it’s tied up in working capital. For example, the business may sell its goods to a customer at net-30 terms, which means the customer has 30 days to pay the company. For those 30 days, they’ll record an Accounts Receivable balance for that account - but accounts receivable isn’t cash, they still need to collect the balance owed. Working capital can be a non-issue for certain business and a nightmare for others, so it’s important to consider the working capital profile and whether there is seasonality that may skew the assets/liabilities. Last point on this, but you don’t want to lever the company at a working capital low, let the seller sweep cash at closing and then a month later there’s no cash to buy inventory…classic liquidity crunch.
Yield - The expected return on a loan, usually expressed as a percentage. There are a number of components to yield, but the primary ones are the interest rate, amortization rate, and closing fees.
Collateralized Loan Obligation (CLO) - A type of structured credit product that pools together various loans and issues different tranches of securities backed by those loans. A bit more relevant in the syndicated loan market versus the buy-and-hold private credit market that we are oriented toward.
Debt Service Coverage Ratio (DSCR) - A measure of a borrower's ability to meet its debt obligations, calculated by dividing EBITDA by debt payments (interest and amortization). DSCR is a type of liquidity measure used to understand if the debt service burden is too high for a given company. It can also be a financial covenant (i.e. minimum DSCR of 1.5x).
Maturity Extension - An agreement to extend the maturity date of a loan or debt instrument. In private credit, this is typically if the sponsor wants a little more runway to run a sales process, or if a credit is challenged and needs more time to get back on its feet ahead of an exit. Don’t get me wrong - not repaying on the maturity date is an Event of Default, and lenders can exercise their remedies under the loan documents. But sometimes it’s easier to give the sponsor another 6-12 months to position and sell the company in due course. All part of the negotiation.
Pari Passu - A Latin term meaning "equal footing," indicating equal ranking or treatment (also every private credit analyst’s favorite word that they’ll use any chance they get). Most often it’s used to refer to other lenders - if two lenders are pari passu, they have an equal claim to the loan collateral. Co-investors in the same debt tranche or credit facility are also pari passu. Subordinated debt holders are not pari passu to senior, because they rank junior in treatment.
Intercreditor Agreement - An agreement that outlines the rights and priorities of different creditors in the event of default or bankruptcy. Different than a subordination agreement, and intercreditor is typically much more nuanced because it most often deals with split-lien lenders, meaning two different lenders with mixed liens in the collateral. For example, if the collateral consists of Accounts Receivable and Inventory accounts, one lender may have a First LIen in the A/R and a Second Lien in the inventory, while the other lender has the opposite. The Intercreditor Agreement outlines each lender’s rights and actions in a bankruptcy. Typically a lender is looking for equal treatment - if they have to wait 30 days to exercise remedies against their collateral, they’d expect the counterparty to have the same restriction.
Restructuring - The process of renegotiating the terms of a loan or debt instrument to alleviate financial distress and improve the borrower's ability to repay. Private credit firms love it when their borrowers can pay their interest and amortization - but when they can’t, they can’t. It’s time to restructure - maybe switch off some cash interest for PIK or defer amortization. Anything to free up cash so the company can reposition and ideally turn around its financial performance. Lenders don’t want to be too borrower friendly though - they’ll expect some support from the equity holders (an equity contribution, deferral of management fees, etc.) to show that lenders aren’t footing the entire bill and they’re putting additional skin in the game.
Debtor-in-Possession (DIP) Financing - Financing provided to a company that is under bankruptcy protection, allowing it to continue operations during the restructuring process. This is the shadow land, and hopefully you never have to visit here. Luckily this is more legal, and no one will expect you to have a solid understanding of bankruptcy negotiations unless you’re interviewing for a distressed debt shop.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) - The holy grail of private credit and private equity. Used as a proxy for cash flow and as a benchmark for valuation. It seems simple enough, but EBITDA can get wildly distorted in the private credit industry because of adjustments (run-rate cost savings, synergies, one-time extraordinary costs, etc.) that are baked into credit agreements. Luckily, these adjustments are typically capped at somewhere between 20-40% of EBITDA. We’ll cover this in more detail in a future post, but forming a reasonable view of EBITDA is a critical component of the underwriting process. If you’ve ever seen a CIM made by an investment banker that includes an $8.0 million adjustment to a $20.0 million EBITDA company for “run-rate cost savings associated with laying off the entire workforce and replacing with AI bots” you’ll start to understand.
Financial Covenants - Discussed briefly in ‘Covenants’, financial covenants are financial targets or metrics that a borrower must meet or maintain throughout the term of the loan. Examples include maximum net leverage of 7.0x, minimum Fixed Charge Coverage of 1.2x, maximum capital expenditures, and minimum EBITDA. Failure to adhere to financial covenants typically results in an Event of Default.
HoldCo Loan - A loan provided to a holding company that owns the equity of operating subsidiaries. This is a spicy element of private credit that will need a longer post, but think of it this way - if you lend to a holding company that owns the operating entities but holds no assets, what is your collateral? The equity, of course, since there’s nothing else to claim from that entity. So if the company assets are held at the operating subsidiaries (OpCo’s), lenders to those subsidiaries will rank senior to the HoldCo loan. You want the borrower to be the entity where the assets are held. This can be a real source of pain for lenders, who think they have a First Lien on assets only to realize they have a First Lien on the HoldCo, which is essentially a lien on equity, which will rank junior to even the most deep-dark subordinated debt held at the OpCo. Do your diligence!
Institutional Investor - An organization or entity that invests large sums of money on behalf of its clients or members, such as pension funds, private equity companies, or insurance companies. It can also be a type of credit risk, if a company has never taken on institutional capital. It can be a culture shock, learning to adhere to a credit agreement, submitting adequate financial reports each month, etc. and can be a headache for lenders to first-time borrowers.
Liquidity - The amount of liquid assets held by a company. Typically cash (the gold standard) but can include revolver availability. Minimum liquidity is often included as a financial covenant to distressed companies during loan restructurings. How do you size the minimum liquidity covenant? Start by looking at payroll - if liquidity falls below the company's bi-monthly payroll requirement, you may be looking at a time bomb. Once payroll isn’t met, bankruptcy risk launches into the stratosphere (before considering potential lawsuits, employee walkouts, and operation shutdowns).
Preferred Equity - An equity investment that has a higher claim on assets and earnings compared to common equity, but lower priority than debt. It typically includes a PIK dividend or a liquidation preference (or both). The most common types of preferred equity in the private equity world are convertible preferred equity (at exit you can receive your initial investment + accrued dividend, or convert into common equity - ideally whichever is higher) or participating preferred equity (a spicy structure where you receive your initial investment + accrued dividend plus equity participation - the financial equivalent of double-dipping your carrot into the ranch bowl with 20+ hungry people waiting behind you).
Secondary Market - The market where previously issued securities or loans are bought and sold among investors, rather than directly from the issuer. It’s highly uncommon to see this in the private credit market, but it does happen on occasion. This is where market value of the loan comes into play, because any buyer wants to ensure the loan is priced according to its risk in the current market environment, not necessarily at the time of issuance.
Event Risk - The risk associated with an event or occurrence that could significantly impact the financial condition or operations of a company, potentially leading to credit risk. Nine times out of ten this is related to an acquisition, which is commonly referred to as integration risk. Even events such as a successful LBO can lead to event risk, as top employees and management team members with options, or owner/operators receive huge paydays from the sale and may not care so much about their jobs moving forward.
Fixed Charge Coverage Ratio - A ratio that measures a company's ability to cover its fixed charges (interest expenses, amortization, lease payments) with its available earnings. It can be tested in a number of ways, but the most common is (EBITDA - CapEx - Taxes - Management Fees) / (Interest Expense + Amortization). FCCR is typically annualized in the first three quarters following close, then switches to an actual trailing figure (LTM or last twelve months).
Solvency - The ability of a company to meet its long-term financial obligations and continue operations, typically assessed by evaluating its assets and liabilities.
Warrant - A derivative security that gives the holder the right to purchase underlying securities (such as shares) at a specific price within a certain time frame. Most common as part of mezzanine debt and almost nonexistent in the senior/unitranche market. Comes with its own host of considerations (including dilution protects, exercise mechanics, put rights, etc).
Strategic vs. Financial Buyer - Strategic buyers are companies that are looking to acquire others for synergies. Think Amazon buying Whole Foods to foray into grocery delivery/Amazon Fresh, or L’Oreal buying Aesop to access a new customer base/business segment. Financial buyers typically refer to investment firms such as private equity buyers, who are looking to acquire a business, grow it, and sell it for profit within a certain timeframe. Strategic buyers are often more attractive to sellers as they can afford to pay a higher price, since the synergies allow them to underwrite a higher EBITDA figure.
Asset-Based Lending - A type of lending where the borrower's assets, such as accounts receivable or inventory, are used as collateral.
Bridge Loan - A short-term loan used to provide immediate financing until long-term funding is secured. Due to its short-term nature, bridge loans typically carry high interest rates as they also bear market risk (i.e. the risk that a replacement loan is not closed within a reasonable timeframe to pay back the bridge lender).
Event of Default - When a borrower breaches the terms of its loan agreement. Maybe it breached a covenant, missed a payment, didn’t pay its taxes, didn’t keep its legal entities in good standing with the government, or maybe it raised additional debt secured by your collateral without telling you, or paid a fat equity dividend. There’s a lot of things lenders don’t want their borrowers to do because it adversely affects the risk profile of their investment. If an Event of Default is called, equity holders typically have a cure period to right the wrong. If the EoD is not cured, lenders can exercise remedies. “Exercise remedies” is credit language for f*cking sh*t up and more or less means ability to foreclose on and sell underlying collateral. If the loan benefits from a pledge of equity, foreclosing on collateral would mean lenders can in effect become owners of the company - leaving the private equity buyer with nothing. It’s safe to say that if lenders went this extreme of a route, they probably won’t see another deal from that sponsor. Remember, lenders don’t want to own the collateral - it’s just a safety net (like how the bank doesn’t want to own your home, they want you to make mortgage payments.
Senior-Stretch – The sweet spot between senior and unitranche leverage profiles. For example if senior is only willing to provide financing up to 4.0x of leverage, and unitranche is willing to provide 5.0x-6.0x, a single senior loan at 4.5x or 4.75x could be considered a “senior-stretch” – not quite unitranche, not quite senior. This one is more of an art than a science, and I like to imagine portfolio teams arguing deep into the night over drinks on why a 4.9x loan is “totally a senior-stretch” and a 5.0x loan is a “unitranche, hands down”.
Annnnd deep breath out – you made it to the end! That was exhausting – but like all good study guides, it’s meant to be referenced, not read in full or memorized. Hopefully this sets a foundation that you can refer to whenever needed.
If you liked this post, let us know in the comments. There will likely be more of these in the future, simply because the universe of private credit and finance language is so broad and we could have stretched to 75 or even 100 (we didn’t want to write a novel).
One last thing - as you can probably tell, this post took a lot of time and thought to make it both accessible and engaging. If you found value in today’s post, consider upgrading to paid, which helps support the OLB team create more educational content. This cheat sheet will be free to all, but certain posts in the future will be limited to our paid subscriber base.
Best of luck and happy hunting.
-OLB
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