Credit Underwriting: Your Path to Becoming a Successful Credit Investor
If you ask 10 different credit professionals what underwriting is, you’ll likely receive 10 different answers. It includes evaluating financial statements, understanding trends in customer sales, supplier purchasing, sustainability of margins, operational risks, quality of revenues, accounting practices, forming a realistic view of EBITDA - and that’s just the tip of the iceberg. There’s a lot to cover. So whether you are already working in finance and looking to hone your skills, or seeking to transition into a credit investing role, this post is designed to be an introduction to credit underwriting, and a preview of topics to come.
What is Credit Underwriting?
In one sentence, credit underwriting is a critical aspect of financial analysis that involves evaluating the creditworthiness of borrowers and assessing the risks associated with extending credit. It plays a pivotal role in banking, private credit funds, asset management firms, and private equity funds.
As a credit underwriter, you are responsible for assessing the financial health of potential borrowers, analyzing their credit histories, income statements, balance sheets, and evaluating the probability of repayment. Credit underwriters determine the terms, conditions, and interest rates of loans or credit facilities, ensuring that the lending institution or investor makes informed decisions and is adequately compensated for their level of perceived risk.
The Importance of Credit Underwriting Skills:
Mitigating Risk: Understanding creditworthiness is critical to managing risk. By honing your credit underwriting skills, you will be able to identify potential risks, evaluate borrower profiles, and make informed decisions, thereby minimizing the likelihood of default and ensuring the preservation of capital. There is nothing worse (and less fiduciary) than a “fast-and-loose” private credit professional (yes, they exist) who doesn’t take underwriting seriously and doesn’t dig into obvious risks. The funny thing is, sometimes these investments work out - other times, they are not so lucky. (Sidebar: I recall one investment I had heard about where a company levered up to 6x, only to lose its top customer representing 30% of revenue within 6 months. This was a high-margin customer, so gross profit took a deeper hit. Once the dust settled, EBITDA was comping down 35-40% YoY and leverage was approaching a peak of 9-10x - borderline workout territory, if it wasn’t there already. If only they had respected the underwriting process).
Appropriate Structuring: Effective credit underwriting enables financial professionals to separate high-quality lending opportunities from low-quality, and ensure they are structuring attractive risk-adjusted returns on their investments. The private credit landscape is competitive, and unless you’re working in a junior fund with equity/warrant upside, your ability to generate alpha is limited. Pricing is dictated by the market. You may get repeat business from a private equity sponsor who likes your team, appreciates your flexibility/approach when things go south, but a lot of the time (particularly in the upper middle market) the 6x deal priced at S+650 will lose out to the same deal priced at S+550. A single credit loss can wipe out a meaningful portion of carry - two or three can destroy a fund (read: LPs do not commit to new vintages because the prior funds underperformed, and there are a million credit product alternatives out there for them to allocate).
Career Advancement: Credit underwriting is highly sought after in the finance industry. As someone who understands this process from the ground up, you position yourself as a valuable asset to buyside employers and open doors to a number of career opportunities. It’s more rare than you might think, which is why competition for talent is fierce in the industry.
Future Topics to Cover:
Fundamentals of Credit Analysis: We will delve into the core concepts and principles of credit analysis, including assessing financial statements, evaluating creditworthiness, analyzing industry trends, and understanding key financial ratios.
Loan Structuring and Documentation: Understanding the art of loan structuring is vital to craft credit facilities that align with both borrower needs and risk management objectives. We will explore different loan structures, collateral evaluation, documentation requirements, and legal aspects.
Credit Risk Assessment: We will provide a comprehensive guide to evaluating credit risk, including analyzing borrower profiles, conducting due diligence, and assessing industry risks.
Industry-Specific Credit Analysis: As you might expect, different industries pose different challenges in credit underwriting. We will examine specific sectors, such as real estate, healthcare, technology, and manufacturing, and explore their own unique risk factors.
Credit Portfolio Management: The less spoken of but equally important part of the underwriting process is managing the portfolio once the investment is made. Managing a credit portfolio requires a deep understanding of risk management, diversification, and credit monitoring skills. We will cover topics such as credit monitoring systems, early warning signs, and strategies for mitigating credit losses.
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In Summary…
Remember, credit underwriting is both an art and a science. There is no perfect answer to the question of how to identify and underwrite risk - but there are tried and true strategies and methods used by the best in the industry. And by continuously expanding your knowledge base and refining your skills, you can make informed decisions where even if things move against you, at least you respected the process and can chalk it up to a black swan event. These are billions of dollars at risk in private companies - the least we can do is respect the process and build our skillset.
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-OLB