The Underwriter’s Read has covered a large part of what an underwriter wants to understand before making a credit commitment. This post lists every lesson by layer, with a short note on what each layer establishes. The overview explains why a lender reads a business differently from an equity investor and how the layers fit together.

Situation

The situation layer covers what a lender needs to know before diligence starts: what the money is for, how much is being asked for and in what structure, who already has a claim on the business, when the money has to be in place, and who owns and supports the business. These facts decide which parts of the other layers matter most for a given deal.

- Lesson 01: Use of Proceeds: Why the Need Matters as Much as the Amount

- Lesson 02: Amount and Structure: Defining the Ask

- Lesson 03: Existing Capital: Who Is Already in Line

- Lesson 04: Timeline and Trigger: Setting Expectations for the Process

- Lesson 05: Ownership and Support: Who Is Behind the Business

Model

The model layer breaks the business into nine blocks adapted from the Business Model Canvas and establishes how it makes money: what revenue is contracted and what has to be re-won, why customers pay, which customers the revenue depends on, how much of the cost base is fixed, and what the business relies on to operate. Its findings are the base that the durability and numbers work tests.

- Interlude: The Model Layer: How the Business Makes Money

- Lesson 06: Revenue Streams: What Is Contracted and What Has to Be Re-Won

- Lesson 07: Value Propositions: Why Customers Pay, and Whether They Still Would Under Pressure

- Lesson 08: Customer Segments: Who Pays, and How Much Rests on Too Few of Them

- Lesson 09: Customer Relationships: What Keeps a Customer in Place or Coming Back

- Lesson 10: Cost Structure: How Much of the Cost Base Is Fixed

- Lesson 11: Key Resources: What Produces the Cash, and What Can Be Lent Against

- Lesson 12: Key Partnerships: What the Business Leans On and Does Not Control

- Lesson 13: Key Activities: What the Business Does All Day, and Whether It Can Do More of It

- Lesson 14: Channels: The Route to Market, and Who Sits Between the Borrower and the Cash

Durability

The durability layer tests whether the model holds up against pressure from rivals, customers, suppliers, substitutes and new entrants, following Porter’s five forces, and whether management can carry out the plan. Its findings become specific adjustments to the lender’s cash flow, instead of a flat percentage stress.

- Interlude: The Durability Layer: Testing the Resilience of the Business Model Against Internal and External Pressure

- Lesson 15: Rivalry: Whether the Growth Is Taking Share or Being Bought With Price

- Lesson 16: Buyer Power: What Lets Customers Set the Price

- Lesson 17: Supplier Power: What Lets Suppliers Raise the Borrower’s Costs

- Lesson 18: Substitutes: What Else the Customer Could Use Instead

- Lesson 19: New Entrants: What Keeps Other Companies Out of the Borrower’s Market

- Lesson 20: Execution: Whether Management Can Deliver the Plan and Handle What the Other Forces Bring

Numbers

The numbers layer rebuilds management’s figures from the source documents: how much of EBITDA is cash the debt can be paid from, leverage before and after the new loan, how much cash growth ties up, maintenance spending against growth spending, and how management uses cash when it has a choice. A separate lesson covers borrowers that are not yet profitable, where runway against the next funding milestone replaces coverage.

- Interlude: The Numbers Layer: Turning the Model and Durability Work Into Coverage and Leverage

- Lesson 21: Cash Flow and Coverage: How Much of the Reported EBITDA Is Cash the Debt Can Be Paid From

- Lesson 22: Leverage: The Debt Multiple Before and After the New Loan

- Lesson 23: Liquidity and Working Capital: How Much Cash Growth Ties Up

- Lesson 24: Capital Intensity: Maintenance Spending, Growth Spending, and What Is Left

- Lesson 25: Financial Policy: How Management Uses Cash When It Has a Choice

- Lesson 26: The Cash-Consuming Borrower: How a Lender Underwrites a Business That Is Not Yet Profitable

Repayment

The repayment layer establishes how the loan is repaid and what the lender recovers if the main source fails: which sources of repayment the business has and whether they weaken together, where the loan ranks and which entities hold the assets, what the collateral would recover in a default, and whether a new lender would refinance the loan when it matures.

- Interlude: The Repayment Layer: Sources of Repayment, Claim Priority and Refinancing

- Lesson 27: Sources of Repayment: Operating Cash Flow, Refinancing, and Asset Sales or Owner Support

- Lesson 28: Claim Priority: Where the New Loan Ranks, Which Entities Hold the Assets, and Where They Sit

- Lesson 29: Downside and Recovery: What the Collateral Is, Where It Sits, and How Easily It Converts to Cash to Repay the Loan

- Lesson 30: Refinance Horizon: Whether a New Lender Would Refinance the Loan When It Matures

One borrower through the numbers and repayment

Lessons 21 to 30, apart from the lesson on the cash-consuming borrower, follow the same illustrative specialty distributor. The lender’s EBITDA bridge in cash flow and coverage carries through leverage, liquidity, capital spending and financial policy, and into the repayment, recovery and refinancing schedules. A reader can follow one borrower from management’s figures to the lender’s, from the $33.0mm facility at closing to the $18.5mm the lender expects to be refinanced at maturity.

Applying it to a specific financing

The layers and lessons cover, at a minimum, what an underwriter will want to understand before committing to a loan, and that analysis is the same for every borrower. How a particular lender weighs the findings for a specific deal is not. That depends on the lender type, on the terms comparable credits are getting in the current market, on how lenders have treated similar businesses before, and on which findings the borrower can address before the process starts.

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You can work through these questions for your own business. Knowing how the lenders in your process will weigh the answers, and which of them will set your terms, is the part I do at Synthase Capital Partners.

Most loans are repaid by a refinancing rather than from operating cash flow over the term. The lesson on sources of repayment found that on the lender’s figures, 56 percent of the distributor’s senior facility is left for a refinancing or a sale at maturity. This component models the business as it will look when the loan comes due and tests whether a new lender would refinance it then.

Five probes sit in this component. The first maps when each piece of debt comes due. The second projects the credit metrics at the maturity date. The third tests whether the business will still be durable enough at that date for a lender to want it. The fourth tests whether the business can get through a period when the refinancing market is closed, and the fifth tests whether lenders will still be lending to the sector.

Management’s projection usually shows the loan repaid or reduced to a small balance by maturity, with leverage well below where it started. A lender projects the credit to the maturity date using its own cash flow and repayment figures from earlier components, and compares the amount left to refinance and the leverage at that date with what lenders accept for comparable credits. That lets the lender establish whether the business could raise the debt it will need at maturity, instead of assuming management’s repayment path leaves nothing to refinance.

The five probes, and what validates the answer

When the debt comes due

The first probe maps when each piece of debt comes due. A lender uses the debt schedule from the lesson on leverage and the ranking from the lesson on claim priority, and adds the maturity date of every claim. It then checks whether the maturities are spread across several years or fall in the same year. When several pieces of debt mature together, the borrower has to refinance all of them in one transaction, in whatever market conditions apply that year.

For the distributor, the senior facility matures at the end of year five. The earnout and the deferred purchase price are paid well before then. The $3.0mm seller note is assumed here to mature after the senior facility, which is common for subordinated debt, so a lender confirms from the note itself that it does not fall due first.

The credit at maturity

The second probe projects the credit metrics at the maturity date. A lender carries its own cash flow from the lesson on cash flow and coverage and its repayment path from sources of repayment forward to maturity. It then compares the amount to refinance and the leverage at that date with the terms lenders are accepting for comparable credits. The new lender will underwrite the business as it is at maturity, so the projection is of that business, not of the business at closing.

On management’s figures the distributor refinances $8.0mm at 0.61x. On the lender’s figures it refinances $18.5mm of senior debt, with funded leverage of 1.68x, or 1.81x if EBITDA is $0.9mm lower as in the downside case. Both are well below the 3.40x funded leverage at closing. The lender’s figure is the one it compares with the market, and the refinancing lender will set its own coverage test on the interest rate that applies at maturity.

These figures assume no distributions. The lesson on financial policy showed distributions becoming permitted in year three on the lender’s figures. Each $1.0mm distributed from then on adds $1.0mm to the amount to refinance. The founder also plans a sale within three to five years, which would repay the facility from the proceeds if it happened before maturity.

Durability at maturity

The third probe tests whether the business will still be durable enough at maturity for a lender to want it. The metrics in the schedule assume the competitive position and the customer base are intact five years out. A lender carries the findings from the durability layer forward to the maturity date: whether rivals are taking share, whether large customers or purchasing groups can push prices down, whether suppliers can raise costs or sell direct, and whether the business still has the management to run it.

For the distributor, the durability findings produced the $0.9mm downside used in the schedule. A lender asks whether the pressures behind that figure are likely to grow over five years, because the refinancing lender will read the business on its competitive position at that date. For a business with little hard collateral, this is the same customer base the lesson on downside and recovery relied on for its going concern value, so one finding affects both the recovery case and the refinancing case.

A closed refinancing market

The fourth probe tests whether the business can get through a period when the refinancing market is closed. A lender models the refinancing delayed by 12 to 24 months and asks whether the business can pay the loan down from its own cash flow, agree an extension with the existing lender, or fund itself through the delay. If it can do none of these, the delay becomes a payment default at maturity.

On the lender’s figures, the distributor’s free cash flow would reduce the senior facility from $18.5mm to $12.0mm over a two-year delay, provided the existing lender agrees to extend and the business performs as projected. The lender also runs the delay on the downside case, because the conditions that close a refinancing market often weaken the business at the same time, as the sources of repayment lesson found for the distributor’s other sources.

Lender appetite for the sector

The fifth probe tests whether lenders will still be lending to the sector at maturity. Lender appetite changes with the credit cycle and with each lender type’s view of a sector. A lender bases its view on actual recent refinancings of comparable credits, such as other specialty distributors of similar size, rather than on general statements about the market. A sector that lenders have stopped lending to can leave a borrower with sound metrics unable to refinance.

For a borrower that is consuming cash, the refinancing test is usually replaced by the next equity round. The lesson on the cash-consuming borrower set out runway against the next funding milestone. At maturity the same probes apply: when the loan comes due relative to that milestone, and whether investors and lenders will still fund the sector then.

What the refinance horizon read produces

At the end of this component a lender has five builds: a maturity profile, a model of the credit at maturity, the durability findings carried forward to that date, a refinancing delay stress, and a view of lender appetite for the sector.

Almost none of it requires new information from the borrower. The component reuses the cash flow and coverage, leverage and durability work and projects it to the maturity date, which makes it the component that draws on every earlier layer of the framework.

A borrower can project its own debt and leverage to the maturity date and map when each piece of debt comes due. Whether lenders will refinance it at that date depends on facts outside the business: which lender types are active in the sector, the terms comparable credits are refinancing on, and how the existing lender has handled extensions before.

You can project your own debt to the date it comes due. Knowing which lenders will be refinancing credits like yours at that date, and on what terms, is the part I do at Synthase Capital Partners.

What a lender recovers in a default depends on where the loan ranks, where the collateral is located, what the collateral consists of, and how easily it can be sold or converted to cash. The lesson on claim priority established the ranking and which entities hold the assets. This component puts a value on those assets in a stress and runs the ranking against that value.

Five probes sit in this component. The first compares the value of the business sold as a going concern with its value in liquidation. The second values the assets in a stress rather than at book. The third establishes what there is to recover when the business holds few hard assets. The fourth runs the ranking against the recovery value, and the fifth estimates how long a recovery would take and what the delay costs.

Management’s projection does not include a default case, and its balance sheet carries receivables and inventory at book value. A lender applies stressed recovery rates to each category of collateral and compares the result with the amount outstanding at the point a default is modeled. That lets the lender establish how much of the loan the collateral would repay if operating cash flow and refinancing both failed, instead of relying on the book value of the assets.

The five probes, and what validates the answer

Going concern or liquidation

The first probe compares two ways creditors could recover. In a going concern sale the business is sold as a whole, with its customers, suppliers and employees. In a liquidation the assets are collected or sold one by one. A lender builds both values from its own inputs and values the credit on the path it expects creditors to take, which is not always the one that produces the higher figure. A going concern sale depends on a buyer being available and on the customers staying through the process.

The distributor’s schedules below model a default in year three on the lender’s figures. By then the lender’s free cash flow has repaid $8.4mm of the senior facility, leaving $24.6mm outstanding. The going concern value applies an illustrative 5.0x multiple to $9.7mm of EBITDA, which is the lender’s $10.6mm less the $0.9mm downside from the lesson on cash flow and coverage.

What the assets are worth in a stress

The second probe values each category of asset at what it would realize in a stress, not at book. A lender asks for the asset register and applies a recovery rate to each category. Receivables are tested for collectability: which customers would still pay a distributor that has defaulted, and how much would be lost to disputes and credits. Inventory and equipment are tested for a forced-sale discount, because they have to be sold quickly and often to buyers other than the usual customers.

How easily each category converts to cash sets its rate. The distributor’s receivables turn into cash as customers pay, on the 45-day collection cycle from the lesson on liquidity and working capital. Its inventory sits in the warehouses and the new branch and has to be sold. The trucks and warehouse equipment sit outside the facility’s security package, so their value goes to other creditors.

The collateral carried at $34.6mm on the balance sheet recovers $22.5mm, or 65 percent of book. Where the collateral sits also affects the value. Inventory held by a subsidiary that does not guarantee the facility, or by a foreign subsidiary whose assets are not pledged, falls outside this figure, which is why the entity map from claim priority comes before the recovery rates.

When there are few hard assets

The third probe establishes what there is to recover when a business holds few hard assets, such as a services firm or a specialty contractor with little equipment. Most of its value is in its contracts and customers. A lender tests whether the contracts could transfer to a buyer and whether customers would stay through a default. That is the same work as the durability layer, and for these businesses the recovery case and the refinancing case depend on the same customer base.

The distributor has hard collateral, but the gap between its $22.5mm liquidation value and its $48.5mm going concern value is mostly the value of its customer relationships and supply agreements. That part is recovered only if those relationships survive the default and transfer to a buyer.

For a borrower that is consuming cash, there is usually little collateral to liquidate, and recovery depends almost entirely on a sale of the company. The lesson on the cash-consuming borrower measured that as loan-to-value against the last round, and showed how the ratio rises if the next buyer pays less.

What reaches the loan

The fourth probe runs the ranking against the recovery value. A lender takes the capital structure from claim priority and pays each claim in order from the value available on each recovery path, until the value runs out. The result shows what is left for the loan once the creditors ahead of it are paid.

In liquidation, the collateral repays $22.5mm of the $24.6mm outstanding, or 91 percent. The $2.1mm shortfall becomes an unsecured claim and competes with trade creditors and the other unsecured claims for the value of the trucks, the equipment and anything else outside the security package. Under the subordination agreement from claim priority, the seller note receives nothing until the senior facility is repaid in full. In a going concern sale at $48.5mm, the senior facility is repaid in full and the value also covers the $30.1mm of total obligations.

The year of the default also affects the result. The same collateral covers less of the facility in year one, when more of the loan is outstanding, and more of it in year five. Distributions to the owners, which the lesson on financial policy showed becoming permitted as leverage falls, leave more of the facility outstanding at every point.

How long recovery takes

The fifth probe estimates how long a recovery would take and what the delay costs. A lender estimates the duration from comparable processes, then reduces the recovery for the time it takes to receive the cash, for the costs of running the process, and for the value that is lost while the business is in distress, such as customers moving to competitors and inventory ageing in the warehouse.

For the distributor, a recovery is estimated at 12 to 18 months. The categories convert at different speeds: most receivables are collected within the first few months, while inventory takes longer to sell and loses value the longer it sits. The $22.5mm in the schedule is the amount recovered before those reductions.

What the downside and recovery read produces

At the end of this component a lender has five builds: a going concern and a liquidation valuation, a schedule of recovery rates by asset category, an analysis of whether the customer base would transfer to a buyer, a recovery waterfall, and a recovery timeline with its costs.

Most of the inputs already exist. The asset register comes from the lesson on key resources, the ranking and the entity map from claim priority, and the customer analysis from the durability layer. The new work is the valuation, the stress and the waterfall. When there is little hard collateral, the recovery case and the refinancing case rest on the same customer base, which is where the refinance horizon work starts.

A borrower can list its collateral, where it sits and how quickly each category would turn into cash. The recovery rates a particular lender applies, and which recovery path it values the credit on, depend on the lender type, on how it has seen similar collateral realized, and on what buyers are paying for businesses in the sector.

Next in the series

Refinance horizon: whether a new lender would refinance the loan when it matures

The maturity profile, the credit metrics at maturity, and what happens if the refinancing market is closed when the loan comes due.

You can list your collateral and how quickly it would turn into cash. Knowing the recovery rates the lenders in your process will apply, and whether they will value your business as a going concern or on its assets, is the part I do at Synthase Capital Partners.

The lesson on sources of repayment found that the distributor’s sources are likely to weaken together, which gives more weight to where the new loan ranks. This component maps the capital structure from senior to junior, confirms which assets are already pledged, and tests what could rank ahead of the loan later through unencumbered assets, permitted future debt, the group’s legal structure or an intercreditor agreement.

Five probes sit in this component. The first maps the full capital structure. The second confirms what collateral is pledged and to whom. The third tests whether unencumbered assets can stay unencumbered. The fourth tests whether the group’s legal structure puts the loan behind other creditors, and the fifth reads any intercreditor agreement for the enforcement rights behind the stated ranking.

Management and the term sheet usually describe a new facility as senior secured. A lender establishes from the loan documents, the security agreements and a lien search which assets the claim actually reaches, at which entities, and what the documents allow to rank ahead of it during the term. That tells the lender how much of the borrower’s asset base stands behind the amount left outstanding at maturity, instead of accepting the label on the term sheet.

The five probes, and what validates the answer

The full capital structure

The first probe maps every claim on the business from senior to junior. A lender starts from the debt schedule built in the lesson on leverage and adds the seniority, security and maturity of each line. It then reconciles each line to the loan and security documents, because a summary table prepared by management can describe a claim as subordinated or unsecured when the documents say otherwise.

The schedule below continues the specialty distributor. After closing it has the $33.0mm senior facility and three obligations to the sellers of the business it acquired two years ago: a $3.0mm seller note, a $1.5mm earnout and $1.0mm of deferred purchase price.

The senior facility is $33.0mm of the $38.5mm total. The earnout and the deferred purchase price do not appear in funded debt, but they are claims on the same cash. A lender confirms whether the facility permits each payment to the sellers, because a payment to a junior creditor while the senior loan is outstanding reduces the cash available to it.

Pledged collateral

The second probe confirms which assets are already pledged, and to whom. A lender asks for the security agreements and the collateral register, then runs its own lien search, such as a UCC search in the United States, against each borrowing entity. It matches every recorded filing to a line on the debt schedule. A filing with no matching line, such as an equipment lessor’s filing against trucks or a supplier’s filing against inventory it delivered, is an obligation management did not disclose.

For the distributor, the lien search should show the new facility’s filing against receivables and inventory, and the filings of the existing revolver and term loan released at closing. The lender relies on the recorded filings rather than on management’s description of the security.

Unencumbered assets and future debt

The third probe tests whether unencumbered assets can stay unencumbered. A lender asks for a schedule of assets that no creditor holds security over, and reads the negative pledge and debt incurrence terms alongside it. A negative pledge restricts the borrower from granting security over its assets to another creditor. The debt incurrence covenant limits how much further debt the borrower can raise. Together they determine whether the borrower can later raise secured debt that ranks ahead of the loan on assets the lender is counting on.

The distributor’s facility is secured on receivables and inventory. The truck fleet, forklifts, warehouse equipment and systems sit outside that security package unless the security agreement covers them. The lesson on financial policy set debt incurrence at funded leverage below 2.50x, which the lender’s figures reach in year three. From then on the borrower can add debt, and the lender reads the negative pledge and the list of permitted liens to establish whether that debt could be secured on the fleet or on the facility’s own collateral.

Structural subordination

The fourth probe tests whether the group’s legal structure puts the loan behind other creditors. A lender asks for a legal entity chart showing which entity borrows, which entities hold the operating assets and cash, and which entities guarantee the loan. If the loan sits at a parent company and the assets sit in a subsidiary that does not guarantee it, the subsidiary’s own creditors, including its trade creditors, are paid from those assets first. The lender reaches them only through the parent’s ownership of the subsidiary. A guarantee from the subsidiary to the parent’s lender, called an upstream guarantee, gives the lender a direct claim on the subsidiary.

For the distributor, the lender asks whether the business acquired two years ago is held in a separate subsidiary. If it is, the lender confirms that the subsidiary guarantees the facility and that its receivables and inventory are pledged.

Assets held by a foreign subsidiary raise the same question. A lender asks which foreign subsidiaries hold inventory, receivables or cash, whether each one guarantees the facility, and whether its assets are pledged. Where they are not, those assets sit behind the foreign subsidiary’s own creditors, and the lender treats them as outside the collateral that supports the loan.

Intercreditor agreements

The fifth probe reads any intercreditor or subordination agreement for the rights behind the stated ranking. A lender reads three sets of terms. A payment block lets the senior lender stop payments on the junior debt while the borrower is in default. A standstill period stops the junior creditor from enforcing for a set time. The enforcement terms set out which creditor controls the decision to enforce against the collateral. A legal read of these terms establishes what the ranking means when the borrower is in difficulty.

For the distributor, the relevant agreement is the one subordinating the $3.0mm seller note to the senior facility. The lender confirms that it can block payments on the note while the borrower is in default and that the sellers cannot enforce during the standstill period. The same read applies to an existing lender that stays in the structure, using the existing credit agreement reviewed in the lesson on existing capital for any limits it places on a new lender.

For a borrower that is consuming cash, the capital structure is usually short and receivables and inventory are small. Most of what stands behind the loan is the value of the company to a buyer, which the lesson on the cash-consuming borrower measured as loan-to-value against the last round. The same probes apply: what is pledged, what the documents let the company pledge or borrow later, and which entities hold the assets.

What the claim priority read produces

At the end of this component a lender has the debt schedule reconciled to the documents and four further builds: a lien search, a review of the negative pledge and debt incurrence terms, a structural map of debt and assets by entity, and a review of the intercreditor terms.

The collateral map sets out where the loan ranks, where the collateral is located and what it consists of. It feeds the downside and recovery work, which tests how easily that collateral could be sold or converted to cash to repay the loan. The negative pledge finding feeds back into the structure terms the borrower negotiates for the facility.

A borrower can map its own capital structure, entities and recorded liens. What security package a particular lender requires, and how much room it leaves to pledge assets or add debt later, depend on the lender type, on what terms the market is accepting, and on what existing creditors will agree to.

Next in the series

Downside and recovery: what the collateral is, where it sits, and how easily it converts to cash to repay the loan

Going concern and liquidation values, recovery rates by type of asset, what reaches the loan after the claims ahead of it, and how long a recovery takes.

You can map your own capital structure and the liens recorded against it. Knowing what security the lenders in your process will require, and how much room they will leave you to pledge assets or add debt later, is the part I do at Synthase Capital Partners.

Every loan has three possible sources of repayment: operating cash flow, refinancing, and an asset sale or support from the owners. The introduction to this layer set out why a lender tests each one. This component establishes whether each source is real, whether the three could fail together, and which one the loan actually relies on.

Five probes sit in this component. The first tests whether operating cash flow covers the amortization schedule. The second tests whether refinancing is a real second source. The third establishes whether an asset sale or owner support is committed or only assumed. The fourth tests whether the sources could fail together, and the fifth names the source the deal relies on.

Management’s projection usually shows the debt being paid down from the business’s own cash flow. A lender splits the facility into the part its own free cash flow repays before maturity and the part left outstanding at maturity. That lets the lender establish how much of the loan the borrower can repay from cash it generates, and how much depends on a future lender or a sale, instead of accepting management’s version of the repayment case.

The five probes, and what validates the answer

Operating cash flow

The first probe tests whether operating cash flow covers the amortization schedule. Operating cash flow is the only source fully under the borrower’s control. A lender compares the scheduled principal payments with the free cash flow it validated in the lesson on cash flow and coverage, not with the projection management presented. Any cash left after scheduled principal can repay more of the loan, if the documents require it and the owners do not distribute it.

An illustrative schedule

The schedule below continues the specialty distributor from the numbers layer. Its new senior facility is $33.0mm with a five-year term and $2.0mm of scheduled principal a year. Both columns assume all free cash flow after scheduled principal goes to repaying the facility, which is the assumption behind the leverage paths in the lesson on leverage.

On the lender’s free cash flow, the borrower meets its scheduled principal every year and repays a further $4.5mm over the term. That leaves $18.5mm, or 56 percent of the facility, outstanding at maturity. Management’s projection leaves $8.0mm. In both cases the loan is not repaid in full from operating cash flow, and on the lender’s figures most of it is repaid by whatever comes after. The lesson on financial policy showed the owners taking distributions once leverage falls, and any distribution increases the amount outstanding at maturity.

Refinancing

The second probe tests whether refinancing is a real second source. Most debt is repaid by refinancing rather than amortization, so the $18.5mm in the lender’s column is expected to be repaid by a new lender at maturity. A lender asks for the maturity profile across the capital structure and forms a view of the refinancing market for this credit at that date. The test is whether the next lender would underwrite the business as it will look in five years, not whether today’s lender would. That work is the refinance horizon component, the last in this layer.

Asset sales and owner support

The third probe establishes whether the last source, an asset sale or support from the owners, is committed or assumed. A lender asks for a list of assets that could be sold and any documents that set out owner support, such as an equity commitment letter, a guarantee or a sponsor’s written undertaking to fund. A documented commitment that the lender can call on is different from an owner’s stated intention to support the business. For assets, a lender confirms that each one could be sold and is not already pledged to another creditor.

The distributor’s saleable assets are mainly receivables of $17.3mm and inventory of $17.3mm, both pledged to the senior facility. The founder and his family have not signed any commitment to put more equity into the business. The founder’s plan to sell the business within three to five years would repay the facility from the proceeds, but it is an intention and not a commitment.

Whether the sources fail together

The fourth probe tests whether the sources could fail at the same time. A lender maps each source against a single downside. If a downturn that reduces cash flow also closes the refinancing market and lowers the value of the assets, the borrower has one source of repayment rather than three.

For the distributor, all four sources depend on demand in its end markets. The downturn that uses up the coverage headroom from the lesson on cash flow and coverage would also leave more of the facility outstanding at maturity, reduce what the inventory would sell for, and lower the price a buyer would pay for the business. The lender treats them as sources that are likely to weaken together, and gives more weight to where the loan ranks and what it would recover, which the next two components cover.

Which source the deal relies on

The fifth probe names the source the deal relies on. A lender writes a statement of the repayment case that ties the structure to its main source. For the distributor, on the lender’s figures, the case is scheduled amortization from operating cash flow followed by refinancing of $18.5mm at the end of year five. That makes the refinance horizon work central to the credit, and the lender states that reliance in the credit memo.

For a borrower that is consuming cash, operating cash flow is not yet a source of repayment. The lesson on the cash-consuming borrower replaced the three sources with four: cash on the balance sheet, the next equity raise, a sale of the company, and reaching breakeven. The same probes apply to each: whether it is committed, whether it fails in the same downside as the others, and which one the loan relies on.

What the sources of repayment read produces

At the end of this component a lender has five builds: amortization coverage on its own free cash flow, a refinancing assessment for the amount outstanding at maturity, confirmation of which asset sales and owner support are committed, a scenario testing all the sources against one downside, and a statement of the repayment case.

The analysis draws on the validated cash flow from the numbers layer and the ownership work from the situation layer. When cash flow is thin, more of the weight moves to claim priority and to downside and recovery. When the repayment case is refinancing, it moves to the refinance horizon.

A borrower can work out how much of its own facility its free cash flow repays before maturity. Which source a particular lender treats as the repayment case, and how much it will accept being left for refinancing, depend on the lender type and on how it has seen similar credits refinanced.

Next in the series

Claim priority: where the new loan ranks, which entities hold the assets, and where they sit

Liens, negative pledge terms, assets held by foreign subsidiaries, and intercreditor agreements.

You can work out how much of your facility your own cash flow repays. Knowing which source the lenders in your process will treat as the repayment case, and how much they will leave to refinancing, is the part I do at Synthase Capital Partners.

The earlier layers of the series covered what the borrower is asking for, how the business makes money, what could change that over the term of the loan, and whether the cash flow services the debt. The repayment layer asks whether the lender still gets repaid if the business does not perform to plan, and from what.

Most of the work in this layer reuses findings from earlier lessons. A lender takes its own cash flow, debt schedule, asset register and durability read, and uses them to establish where repayment will come from, where the new loan ranks against other claims, what the lender recovers if the business fails, and whether another lender will refinance the loan at maturity.

Four components, and what each one tests

The lessons publish in the order the builds depend on each other: sources of repayment, claim priority, downside and recovery, refinance horizon. The sources of repayment work names which source the deal relies on. Claim priority produces the ranking of claims that the recovery waterfall runs through. Refinance horizon comes last because it draws on the cash flow, the leverage path and the durability read together.

Where the inputs come from

Each component draws on findings from earlier lessons.

Most of this layer is analysis of material a lender already holds, and it adds few new document requests. The exceptions are legal: a lien search, the security agreements, the legal entity chart with any guarantees, and the intercreditor agreement where one exists.

Which source the deal relies on

Every loan has three possible sources of repayment: operating cash flow, refinancing, and an asset sale or support from the owners. Operating cash flow is the only one fully in the borrower’s control. Most debt is repaid by refinancing rather than amortization, so for many loans the real source of repayment is a lender that has not yet been identified. A lender states which source the deal relies on. If the repayment case is refinancing in year five, the credit depends on the refinance horizon work, and a lender says so in the credit memo.

A lender also tests whether the sources could fail together. A downturn that reduces cash flow can also close the refinancing market and lower the value of the assets, so three sources can behave like one. When cash flow is thin, more of the analysis shifts to where the loan ranks and what it would recover.

Borrowers with few hard assets

For a borrower with few hard assets, such as a services business or a distributor that owns little beyond receivables and inventory, recovery and refinancing depend on the same thing: whether the customer base holds up. A buyer of the business in a downside is paying for contracts and customers that transfer, and a lender refinancing it at maturity is lending against the same base. The durability read from the earlier layer is the main input to both components for these borrowers.

For a borrower that is still consuming cash, the sources of repayment are the four covered in the lesson on the cash-consuming borrower: cash on the balance sheet, the next equity raise, a sale of the company, and reaching breakeven before maturity. Claim priority and recovery apply as written.

What the layer produces

At the end of this layer a lender has a statement of which source repays the loan, a ranking of every claim against the business including any that the documents allow later, an estimate of what it recovers and how long recovery takes, and a view of whether the credit will be refinanceable at maturity. The negative pledge and debt incurrence findings go into the structure terms covered in the situation lesson on amount and structure.

A borrower can list its own sources of repayment and map the liens already recorded against it. Which source a particular lender will treat as the real repayment case, and how it will value the assets in a downside, depend on the lender type and on how it has recovered on similar credits before.

Next in the series

Sources of repayment: operating cash flow, refinancing, and asset sales or owner support

How a lender tests whether each source is real, and whether they could fail at the same time.

You can list your own sources of repayment and map the liens against your business. Knowing which source the lenders in your process will treat as the real repayment case is the part I do at Synthase Capital Partners.

Coverage and leverage both use EBITDA, so neither gives a usable figure for a borrower whose EBITDA is negative. The introduction to this layer set out the alternative: a loan to a cash-consuming borrower is repaid from cash on the balance sheet, the next equity raise, a sale of the company, or the business reaching breakeven before maturity. This lesson takes each of those four sources in turn and shows the build a lender uses to test it.

Most of the work carries over from the five lessons before this one. The monthly sources and uses from the lesson on liquidity and working capital becomes the main schedule. The add-back review from the lesson on cash flow and coverage applies to the burn figure, the debt schedule from the lesson on leverage still sets what ranks ahead of the lender, and committed capex from the lesson on capital intensity is counted in the burn.

Management’s forecast for a cash-consuming borrower usually shows monthly burn falling to breakeven and the next equity raise closing on schedule. A lender rebuilds the burn from the monthly trend the borrower has actually reported, then tests how many months the raise can slip before cash falls to the minimum the covenants require. That lets the lender establish how long the borrower can service the debt from the cash it holds, and how much of the repayment depends on an event the borrower does not control, instead of accepting management’s timetable.

The earlier lessons in this layer followed a specialty distributor with $12.0mm of EBITDA, whose facility was sized on a leverage multiple and tested on coverage. This lesson uses a different borrower: a venture-backed company that makes and sells its own product, with revenue growing and EBITDA still negative. Cash-consuming borrowers are a minority of deals, and the same approach applies to other cases, such as a business partway through a large build-out.

The four sources of repayment

Cash on the balance sheet

Runway is the number of months that cash and committed facilities last at the current rate of burn. The illustrative borrower holds $15.0mm of cash and is borrowing $15.0mm, so it has $30.0mm at closing. At a burn of $1.5mm a month, that is 20 months of runway, against 10 months without the loan. The loan extends runway by the number of months its proceeds cover, and a lender sizes it with that in mind.

A lender builds the burn figure the same way it builds EBITDA for a profitable borrower. It tests each cost that management excludes, because a burn figure with costs left out understates how fast the cash is being used. It adds the working capital a growing product needs, since receivables and inventory use cash on top of operating losses, and it adds the capex that has to be spent before the next milestone. Interest on the new facility is part of the burn.

The next equity raise

For most venture-backed borrowers, the next equity raise is the source a lender expects to extend runway. A lender sets runway against the date of the next funding milestone, such as a product launch, a contract award or the raise itself, and tests how long the raise can be delayed. The schedule below shows the borrower’s cash over 24 months with no raise, on management’s burn and on the lender’s. Management plans to raise $25.0mm in month 12. The proposed facility carries a minimum cash covenant of $5.0mm.

Management’s plan has monthly burn falling from $1.5mm to $0.6mm over two years. The lender’s case holds burn at $1.5mm for the first year, because that is the rate the borrower has reported over the last twelve months, and then lets it fall more slowly. With no raise, management’s cash reaches the $5.0mm minimum in month 24, so the raise can slip by about 11 months. On the lender’s burn, cash reaches the minimum in month 18, which leaves about 5 months.

The raise depends on the investors. A lender reuses the ownership work from the situation layer: how much capital the existing investors have left to deploy, whether they have funded the company through earlier delays, and whether a new investor is expected to lead. The monthly schedule shows how much time the borrower has, and the ownership work indicates whether the investors are likely to fund within that time.

A sale of the company

If the raise does not happen, the loan may be repaid from a sale of the company. A lender sizes the loan against the value of the company using loan-to-value: the loan divided by enterprise value or by the valuation at the last equity round. The borrower’s last round valued it at $150mm, so the $15.0mm loan is 10 percent loan-to-value.

The valuation at the last round was set when investors expected the plan to be met. A sale that follows a missed raise may happen at a lower value, so a lender also reads loan-to-value at lower figures. At $100mm the loan is 15 percent of value, and at $60mm it is 25 percent. The debt schedule still applies: earnouts, deferred payments and other obligations that rank alongside or ahead of the lender are added to the loan before the ratio is read.

Reaching breakeven

The fourth source is the business reaching breakeven before the loan matures, so that operating cash flow repays the debt. The plan to reach breakeven replaces the deleveraging path a lender would build for a profitable borrower. A lender tests it against the burn trend: whether the cash consumed each month has been falling as planned over the months already reported. Management’s plan here reaches breakeven in about month 30. The borrower’s reported burn has held at about $1.5mm a month for a year, which is why the lender’s case assumes a slower decline and does not treat breakeven as a source of repayment within the first two years.

The covenants

The covenants replace the leverage and coverage tests. A minimum cash covenant requires the borrower to hold a set amount of cash at all times, and a lender sets the level so that it is reached while there is still time to act, such as raising equity or selling the company. A performance-to-plan covenant measures results and spending against the plan the lender underwrote, and it is how a lender tracks burn or capex that runs ahead of plan. Lenders to these borrowers often also take warrants, which give the lender a share of any increase in the value of the equity.

What the read produces

At the end of this read a lender has a burn figure rebuilt from reported results, runway to zero and to the minimum cash level, the number of months the next raise can slip in its own case, loan-to-value at the last round and at lower values, and a comparison of the burn trend with the plan to reach breakeven. Those figures set the loan amount, the minimum cash level and the performance-to-plan terms.

The analysis draws on the ownership work from the situation layer and on the five components of this layer. Its output feeds the repayment layer, which covers the sources of repayment for every borrower, what ranks ahead of the lender, and what a lender recovers if the plan does not work.

A borrower can calculate its own runway and loan-to-value before a lender asks. How much time a particular lender needs to see before the next raise, and where it will set the minimum cash level, depend on how it has lent to similar companies and how it expects the borrower’s investors to behave.

Next in the series

The repayment layer: sources of repayment, claim priority and refinancing

Whether the loan is repaid if the plan does not work, and from what.

You can calculate your own runway and loan-to-value. Knowing where the lenders in your process will set the minimum cash level, and how much time they will want before your next raise, is the part I do at Synthase Capital Partners.

Financial policy is how management and the owners use cash when they can choose between paying down debt, paying the owners, and spending on acquisitions. The lessons on cash flow and coverage, leverage, liquidity and working capital and capital intensity measured how much cash the business produces and how much it needs. This component covers what the people who control the business are likely to do with the cash that is left. A lender reads that from the record of past decisions and from the terms of the loan documents.

Four probes sit in this component. The first traces how cash has been used when there was a choice. The second establishes management’s tolerance for leverage and its appetite for acquisitions. The third looks at whose interests the ownership structure favors. The fourth tests whether the loan documents enforce the policy management describes.

Management’s projection usually shows leverage falling as free cash flow repays debt. A lender compares that assumption with the borrower’s record of distributions and acquisitions, and with what the covenants allow. That lets the lender establish how much of the projected free cash flow is likely to go to debt service and repayment, and how much could go to the owners or to the next acquisition instead.

The four probes, and what validates the answer

How cash has been used

The first probe traces how cash has been used when there was a choice. A lender asks for the history of dividends, buybacks and other distributions to owners, and sets it against free cash flow and debt repayment in the same years. Past decisions are the best evidence available of future ones. A borrower that has paid out most of its free cash flow to its owners, or paid distributions in years when debt was rising, is likely to do the same after closing unless the documents prevent it.

Leverage tolerance and acquisitions

The second probe establishes how much leverage management is willing to carry and how often it acquires. A lender asks for the acquisition history, how each acquisition was funded, and management’s stated view on leverage. It reads them against the leverage path from the lesson on leverage, which shows leverage falling as debt is repaid. A borrower that has funded acquisitions with debt may borrow again once leverage comes down, and the path then stops falling.

Ownership and incentives

The third probe looks at whose interests the ownership structure favors. A lender reuses the ownership work from the lesson on ownership and support and reviews the incentives of each owner. A private equity sponsor works to a fund life and a return target, and a sponsor near the end of its hold period may favor a dividend or a sale. A founder or family owner may want regular distributions, may be planning a succession, or may be preparing the business for sale. Each of these can run against a lender’s interest in cash being retained to repay the loan.

An illustrative schedule

The schedule below continues the specialty distributor from the earlier lessons in this layer. The business is owned by its founder and his family. Two years ago it bought a smaller competitor for $13.5mm: $8.0mm in cash, a $3.0mm seller note, a $1.5mm earnout and $1.0mm of deferred purchase price, the obligations set out in the lesson on leverage. Management states a policy of keeping funded leverage at or below 2.50x. The founder has said he plans to sell the business within three to five years.

Over three years the borrower generated $10.0mm of free cash flow, paid $5.2mm to its owners, spent $8.0mm in cash on the acquisition and borrowed a net $3.2mm to cover the difference. The acquisition took funded leverage from 2.10x to 2.90x, above the stated policy of 2.50x. Last year leverage came back down to 2.25x, and distributions rose to $3.0mm, 79 percent of that year’s free cash flow.

Management’s leverage path in the lesson on leverage falls from 3.00x at closing to 1.44x in three years, and about 70 percent of the fall comes from repaying debt. That path assumes free cash flow goes to debt. The record shows the borrower paying out most of its free cash flow once leverage is inside its stated policy. The founder’s plan to sell within three to five years falls inside the term of the new facility, and a lender considers whether distributions are likely to rise ahead of a sale.

What the documents enforce

The fourth probe tests whether the policy management describes is backed by the loan documents. A stated policy on distributions or leverage is not binding. A lender reads the restricted payments covenant, which limits dividends, distributions and buybacks, and the debt incurrence covenant, which limits new borrowing. Both are often written as a condition: the payment or the new debt is permitted only if leverage after it stays below a stated level and no default is outstanding. The lender confirms that the covenants restrict the behavior the record shows, instead of relying on the owners’ goodwill.

The restricted payments test in the proposed facility is set at 2.50x, the same level as management’s stated policy, so the documents turn the policy into a condition of the loan. On management’s figures, leverage passes the test at the end of the first year and distributions would be permitted from then. On the lender’s figures, leverage stays above 2.50x until the end of the third year. Each $1.0mm distributed leaves funded debt $1.0mm higher than the path assumes, about 0.09x of leverage on the lender’s year-one EBITDA.

The debt incurrence test applies the same level to new borrowing, including a seller note. An acquisition of the size management describes, funded mainly with debt, would be limited until leverage falls below 2.50x, or would need more equity from the owners. Which EBITDA figure the tests use is set by the covenant definitions, and the gap between the two paths above comes from the difference between management’s EBITDA and the lender’s.

For a borrower that is consuming cash

For a borrower that is consuming cash, distributions are rarely at issue, because there is no spare cash to distribute. A lender reads financial policy through spending and through the equity: whether management spends to the plan the lender underwrote, and whether the investors will fund the next round before runway runs out. A performance-to-plan covenant measures results and spending against that plan, and a minimum cash covenant sets the cash the borrower must hold at all times. Lenders to these borrowers often take warrants, which give the lender a share of any increase in the value of the equity. The lesson on the cash-consuming borrower covers this case in full.

What the financial policy read produces

At the end of this component a lender has the record of how cash has been used when there was a choice, a view of management’s leverage tolerance and acquisition appetite read against the leverage path, the incentives of each owner, and a read of whether the restricted payments and debt incurrence covenants limit the behavior the record shows.

The analysis draws on the ownership work from the situation layer and on the leverage path. Its output connects to the structure terms covered in the lesson on amount and structure, and to the order in which claims are paid, which the repayment work later in the series covers.

A borrower can assemble its own distribution and acquisition history and compare it with its stated policy before a lender asks. How a particular lender will read that history, and which restricted payments and incurrence tests it will ask for, depend on how it has lent to similar businesses and owners before.

Next in the series

The cash-consuming borrower: how a lender underwrites a business that is not yet profitable

Runway, the burn trend, and the covenants a lender uses instead of coverage.

You can compile your own distribution record and compare it with your stated policy. Knowing how the lenders in your process will read that record, and which restricted payments and incurrence terms they will accept, is the part I do at Synthase Capital Partners.

Capital intensity is the amount a business has to spend on vehicles, equipment, facilities and systems to keep producing its cash flow. Capital spending, or capex, falls into two kinds. Maintenance capex replaces the assets the business already uses. Growth capex adds capacity the business does not yet have. The free cash flow in the lesson on cash flow and coverage is measured after all capex, and a lender needs to know how much of that capex the business could stop and how much it could not.

Four probes sit in this component. The first separates maintenance capex from growth capex. The second establishes the reinvestment needed to keep the asset base at its current size. The third measures the free cash flow left after the growth plan. The fourth tests how much of the capex plan could be deferred if cash gets tight.

Management’s projection usually shows capex as one line, or labels part of it growth and treats that part as optional. A lender rebuilds the split from the asset register and each asset’s replacement cycle, then runs the cash flow net of the full capex plan. That lets the lender establish how much cash the business generates after the spending needed to keep its current assets, and whether debt service is still covered once the growth plan is paid for.

The four probes, and what validates the answer

Maintenance and growth

The first probe separates the two kinds of capex. A lender asks for the capex history split into maintenance and growth. Only growth capex is discretionary. A business can stop growth capex without affecting the assets it already runs, while maintenance capex can be delayed for a time but is still needed later.

Management’s split often understates maintenance, because a lower maintenance figure makes the free cash flow before growth spending look larger. A lender tests the split against asset lives and replacement cycles. Spending that replaces an asset at the end of its life is maintenance, even where the replacement is larger or newer than the original.

The cost of keeping the current asset base

The second probe establishes the maintenance capex needed to keep the asset base at its current size and condition. A lender reuses the asset register reviewed in the lesson on key resources, which lists each major asset with its age and expected life. The replacement cycle of each asset gives an annual requirement. A lender compares that requirement with actual maintenance spend and with depreciation. Depreciation is an accounting charge based on the historical cost of the assets, so a lender uses it as a reference point and relies on the asset register for what replacement will cost.

Maintenance spend that stays below the requirement for several years moves cost into later years. A lender treats the shortfall as spending still to come.

An illustrative schedule

The schedule below continues the specialty distributor from the lessons on cash flow and coverage, leverage and liquidity and working capital. The borrower spent $2.0mm on capex over the last year, the capex figure in the free cash flow walk. Management classifies $1.2mm of it as maintenance and $0.8mm as growth.

The lender reclassifies $0.5mm of truck purchases from growth to maintenance. The larger trucks replaced vehicles that had reached the end of their lives, and the fleet did not grow. That takes maintenance capex to $1.7mm and leaves $0.3mm of growth capex, the racking for new product lines. Total capex stays at $2.0mm, so the free cash flow in the cash flow lesson does not change.

The asset register gives a maintenance requirement of $1.8mm a year, $0.1mm above the lender’s maintenance figure, so current spending broadly keeps the asset base at its present size. Management’s $1.2mm is $0.6mm below the requirement, which would mean either that the asset base is running down or that the split is wrong. The reclassified trucks account for most of that gap.

Free cash flow after the growth plan

The third probe measures the free cash flow left once the full capex plan is paid for. Growth capex competes with debt service for the same cash. A lender runs the cash flow net of all capex, including any expansion in the plan, and confirms that debt service is covered after reinvestment as well as before it. For the distributor, the growth plan includes the new branch: $5.0mm of fit-out and equipment and $3.0mm of opening inventory, funded by the $8.0mm drawn on the facility between February and August.

Before growth spending, the lender’s free cash flow is $3.0mm against management’s $4.9mm. After the $0.3mm of racking it is $2.7mm, the figure in the cash flow lesson. The branch costs $8.0mm and the facility draw pays for it, so the branch uses no operating cash in the year, but the $8.0mm of debt it adds is serviced from operating cash. After $2.0mm of scheduled principal, the borrower retains $0.7mm of cash in the year on the lender’s figures and $2.1mm on management’s. Those amounts tie to the year-end liquidity in the lesson on liquidity and working capital.

On the lender’s figures, fixed charge coverage is 1.84x before capex, 1.50x after maintenance capex and 1.44x after all ongoing capex, against a covenant minimum of 1.20x. The lender uses the figure after maintenance capex as the coverage the business produces without any growth spending.

What can be deferred

The fourth probe tests how much of the capex plan the borrower could defer if cash gets tight. A lender asks for a schedule that separates committed spending, under signed contracts or already ordered, from discretionary spending that has not been committed. Discretionary growth capex is a lever in a downturn. Committed spending cannot be stopped, and maintenance capex can only be delayed by moving the cost into later years.

For the distributor, the lender counts $0.3mm of ongoing capex as deferrable, against the $0.8mm that management’s split implies. In the lender’s downside case from the cash flow lesson, cash flow sits $0.3mm above the level that breaches the coverage covenant. Deferring $0.3mm of growth capex raises that headroom to $0.6mm; management’s split would suggest $1.1mm. On the branch, $3.5mm of fit-out is under a signed contract at closing. The remaining $4.5mm of equipment and opening inventory could be held back, but deferring it reduces the amount drawn on the facility and leaves liquidity unchanged, because the undrawn commitment can only be used for the branch. The August low point of $1.4mm in the liquidity schedule stays where it is.

For a borrower that is consuming cash

For a borrower that is consuming cash, capex is part of the burn. A lender separates the capex needed to reach the next funding milestone, such as a production line that has to be running before a product launch, from capex that can wait until after it. Runway is calculated with the committed capex included. A performance-to-plan covenant, which measures results and spending against the plan the lender underwrote, is the usual way a lender tracks capex that runs ahead of plan. The lesson on the cash-consuming borrower covers this case in full.

What the capital intensity read produces

At the end of this component a lender has capex split into maintenance and growth on its own classification, a maintenance requirement from the asset register compared with actual spend and depreciation, free cash flow after the full capex plan with coverage measured after reinvestment, and a schedule of committed and deferrable spending.

The analysis draws on the asset register reviewed in the model layer and the cash flow built in the lesson on coverage. Its output is used in three places. The maintenance figure sets the capex line in the free cash flow walk. The free cash flow after the growth plan shows whether the business can fund its growth from its own cash or will need more debt or equity. The deferrable amount is a lever a lender tests in the case where a refinancing takes longer than planned.

A borrower can prepare its own capex split and maintenance requirement from its asset register before a lender asks for them. How a particular lender will classify replacement spending, and how much weight it will give deferrable capex in its downside case, depend on how it has lent to similar businesses before.

Next in the series

Financial policy: how management uses cash when it has a choice

Distributions, acquisitions and leverage tolerance, and what the covenants restrict.

You can split your own capex and tie maintenance to your asset register. Knowing how the lenders in your process will classify your replacement spending, and how much of your capex plan they will treat as deferrable, is the part I do at Synthase Capital Partners.

Liquidity is the cash a borrower can use to meet its obligations as they fall due: cash on hand plus undrawn committed facilities. Working capital is the cash tied up in receivables and inventory, less the amount suppliers finance through payables. A profitable borrower can run short of cash if receivables and inventory grow faster than earnings, or if the cash balance falls during the year to a level the year-end figure does not show. The lessons on cash flow and coverage and leverage measured the business over a full year. A lender measures liquidity month by month.

Five probes sit in this component. The first measures the cash conversion cycle and its trend. The second sizes the working capital that growth consumes. The third establishes the liquidity available today. The fourth tests whether sources of cash cover uses over the next 12 to 24 months. The fifth finds the lowest point in the cash balance during the year.

Management’s projection usually shows cash at each year end, with working capital growing in line with revenue. A lender rebuilds working capital from the historical days of receivables, inventory and payables, and rebuilds the cash balance month by month from its own cash flow figure. That lets the lender establish whether the forecast includes the cash that growth will tie up, and whether the borrower can service the debt in the lowest month of the year as well as at year end.

The five probes, and what validates the answer

The cash conversion cycle

The first probe measures the cash conversion cycle, the number of days between paying suppliers and collecting from customers. It has three parts. Days sales outstanding is how long customers take to pay. Days inventory outstanding is how long stock sits before it is sold. Days payables outstanding is how long the business takes to pay its suppliers. The cycle is the first two added together, less the third. A lender asks for each over the trailing 24 months and reconciles them to the receivables and payables agings and to the balance sheet.

A lender looks at the trend in each part as well as the total. A cycle that shortens because payables have stretched from 30 to 35 days may mean the borrower is paying suppliers later than agreed. A lender checks whether suppliers agreed to the longer terms. If they did not, the cash that stretched payables provide can reverse, and suppliers can tighten terms or credit limits.

What growth ties up

The second probe sizes the working capital that growth consumes. A lender takes working capital as a percentage of revenue from the history and applies it to the growth plan. At 17.5 percent, each $10.0mm of new revenue ties up about $1.75mm of cash in receivables and inventory, net of payables, before that revenue is collected. A borrower growing quickly can put more cash into working capital than it earns in the year. The lender checks that the projection uses a percentage consistent with the history.

Liquidity available today

The third probe establishes total available liquidity: cash on hand, the undrawn part of the revolver, and any other committed facility. A lender adjusts each for restrictions. Cash held in a foreign subsidiary, or pledged against a letter of credit, may not be available to service the debt. Revolver availability is limited by the financial covenants and, for an asset-based revolver, by the borrowing base, which lends against a percentage of eligible receivables and inventory. An undrawn commitment set aside for a specific purpose, such as a capital project, is available only for that purpose.

An illustrative schedule

The schedule below continues the specialty distributor from the lessons on cash flow and coverage and leverage. The borrower has revenue of $140.0mm and cost of goods sold of $105.0mm. Over the last 24 months, customers have gone from paying in 42 days to 45 days, inventory has improved from 62 days to 60, and payables have stretched from 30 days to 35.

The cash conversion cycle has shortened by four days, and all of the improvement comes from paying suppliers later, while customers have slowed. Working capital is 17.5 percent of revenue today, and would be 18.1 percent on the payable terms of two years ago. Management plans revenue growth of $8.5mm next year, which at 17.5 percent ties up about $1.5mm, the working capital figure used in the cash flow lesson. The lender accepts that figure for its base case. If suppliers return the business to 30-day terms, the borrower pays out about $1.4mm once, on top of the growth figure.

Sources and uses over the next 12 to 24 months

The fourth probe builds sources and uses of cash over the next 12 to 24 months. Sources are cash from operations and available facilities. Uses are working capital, capital spending, debt service and other committed payments, such as an earnout or deferred purchase price. For the distributor, the $1.0mm of deferred purchase price falls due in month 18, inside the 24-month window. A lender rebuilds management’s schedule on its own cash flow figure and then stresses it for slower collections and faster spending, separately and together.

The lowest month

The fifth probe looks at the cash balance within the year. Management usually presents cash at quarter ends, and a quarter-end figure can sit above the lowest point in the quarter. A seasonal business builds receivables and inventory ahead of its peak and collects afterwards, so the low point usually falls just before collections come in. A lender asks for a monthly cash profile and identifies the peak borrowing need across all 12 months.

For the distributor, the $33.0mm facility repays $24.0mm of existing debt and pays $1.0mm of fees at closing. The remaining $8.0mm is drawn as the new branch is built and stocked between February and August. Liquidity at closing is $10.0mm: $2.0mm of cash and $8.0mm of undrawn commitment, all of it set aside for the branch. The facility has no other availability, so the seasonal build in receivables and inventory is funded from cash and from operations. The schedule uses the lender’s figures: $10.6mm of EBITDA less capex, cash taxes and cash interest gives $4.2mm of cash from operations for the year.

Liquidity falls to $1.4mm in August. The branch is complete by then, and receivables and inventory are at their seasonal high. Most of the peak-season receivables are collected in September, which takes liquidity back to $2.6mm at the quarter end. Management presents liquidity at each quarter end on its own EBITDA figure, and the lowest figure it shows is $3.7mm, at September. The lender’s August figure is $2.3mm lower. About $1.1mm of that comes from the lower EBITDA and $1.2mm from measuring monthly instead of at quarter end.

The lender then applies the two stresses from the working capital schedule to the August figure. Receivables slowing by another three days, as they did over the last two years, ties up about $1.2mm and leaves $0.2mm. Suppliers returning to 30-day terms takes out about $1.4mm and leaves nothing. Together they take August liquidity to $1.2mm below zero, so the facility as proposed leaves almost no room for either stress and does not cover both at once.

For a borrower that is consuming cash

For a borrower that is consuming cash, liquidity is the main measure. A lender calculates runway, the number of months that cash and committed facilities last at the current burn rate, and compares it with the date of the next funding milestone, such as a product launch or the next equity round. A borrower burning $1.5mm a month with $30.0mm of liquidity has 20 months of runway. A lender also tracks the burn trend, whether monthly burn is rising or falling. Working capital still counts, because receivables and inventory for a growing product use cash on top of operating losses. The usual covenant is a minimum cash covenant, which requires the borrower to hold a set amount of cash at all times. The lesson on the cash-consuming borrower covers this case in full.

What the liquidity read produces

At the end of this component a lender has the cash conversion cycle and its trend, working capital as a percentage of revenue applied to the growth plan, available liquidity net of restrictions, sources and uses over the next 12 to 24 months in its base and stress cases, and a monthly cash profile with the lowest month identified.

The analysis draws on the customer payment terms and supplier terms reviewed in the model layer. Its output is used in two places. The working capital figure feeds the free cash flow walk behind coverage. The lowest month and the stress cases show how much availability the structure needs after closing.

A borrower can build its own monthly cash profile and working capital trend before a lender asks for them. How a particular lender will treat stretched payables, how much availability it will want above the lowest month, and how it will size a revolver around the seasonal build depend on how it has lent to similar businesses before.

Next in the series

Capital intensity: maintenance spending, growth spending, and what is left

Maintenance and growth capex, and the free cash flow left after the growth plan.

You can build your own monthly cash profile and working capital trend. Knowing how the lenders in your process will treat stretched payables, and how much availability they will want above your lowest month, is the part I do at Synthase Capital Partners.

Leverage is total debt divided by EBITDA. A lender rebuilds both parts before accepting the figure a borrower presents. The debt figure often leaves out obligations that will have to be paid, such as an earnout on a prior acquisition or a deferred purchase price. The EBITDA figure depends on which add-backs are accepted, which was the subject of the lesson on cash flow and coverage. A lender then measures leverage twice: as it stands today, and pro forma at closing with the new loan fully drawn.

Five probes sit in this component. The first establishes total debt, including debt-like instruments and obligations. The second calculates leverage on both reported and adjusted EBITDA. The third rebuilds leverage pro forma for the new facility. The fourth tests the plan for bringing leverage down. The fifth compares leverage with the covenant and with recent comparable deals.

Management’s projection usually shows leverage falling quickly after closing, as EBITDA grows and free cash flow pays down debt. A lender rebuilds that path from its own EBITDA and its own free cash flow figure, including the obligations management left out. Where the lender’s path falls more slowly, the difference shows how much of management’s deleveraging depends on growth that has not happened yet rather than on cash the business already produces.

The five probes, and what validates the answer

Counting all the debt

The first probe builds a complete debt schedule. It starts with funded debt: the revolver, term loans, and any seller notes from past acquisitions. It then adds obligations that are not called debt but will be paid in cash ahead of or alongside the lender. The common ones are earnouts on prior acquisitions, deferred purchase price, capital leases on equipment and vehicles, unfunded pension obligations, and letters of credit that could be drawn. The situation lesson on existing capital asked for these at the start of the process. This probe puts a figure on each one.

A lender reconciles the schedule to the balance sheet and the notes to the financial statements, because contingent items such as earnouts usually appear only in the notes. Management’s own leverage figure often uses funded debt alone. Operating leases on warehouses and branches are a judgment call: credit agreements often leave them out of the leverage test, while some lenders include them in their own view of the business, adjusting EBITDA for rent when they do.

Which EBITDA

The second probe calculates leverage on more than one EBITDA figure, and on both a gross and a net basis. Gross leverage uses total debt. Net leverage subtracts cash on the balance sheet. The gap between leverage on reported EBITDA and on adjusted EBITDA shows how much of the headline multiple depends on add-backs. A borrower at three times on adjusted EBITDA and more than four times on reported EBITDA is asking a lender to accept the add-backs as recurring earnings. The lender uses the EBITDA figure it arrived at in its own add-back review.

Pro forma at closing

The third probe rebuilds the capital structure as it will stand on the day the loan closes. Current leverage matters less than pro forma leverage, because the new facility is what the lender is being asked to take on. A lender builds sources and uses for the transaction, confirms that the new facility repays what it is meant to repay, and counts the new facility at its full drawn amount. A revolver sized at $10mm but drawn at $4mm at closing is still counted at the amount the borrower can draw, because the borrower will draw it when cash is short.

An illustrative schedule

The schedule below continues the specialty distributor from the previous lesson. The borrower has $27.0mm of funded debt today. A new $33.0mm senior facility repays the existing revolver and term loan of $24.0mm, pays $1.0mm of fees, and funds $8.0mm for a new branch and its inventory. The $3.0mm seller note from a prior acquisition stays in place. Pro forma funded debt is $36.0mm. The same acquisition also carries a $1.5mm earnout and $1.0mm of deferred purchase price, which management leaves out of its leverage figure.

Management presents leverage of 3.0 times at closing. The lender’s figure on the same debt is 3.4 times, and 3.6 times once the earnout and deferred purchase price are included. On reported EBITDA, before any add-backs, it is 4.3 times. The covenant is tested on funded debt, so the lender’s 3.4 times leaves room for EBITDA to fall to $9.0mm, about 15 percent, before the covenant is breached. The coverage covenant in the previous lesson breaches after a fall of about 11 percent, so for this borrower coverage is the tighter of the two tests.

The path down

The fourth probe looks at which way leverage is moving. It uses the three-year history and management’s projected path. Leverage can fall because debt is repaid or because EBITDA grows, and a lender separates the two. Debt repaid from free cash flow the business already produces is the more reliable source. A path that depends on EBITDA growth depends on the growth assumptions the model and durability work tested.

Management’s path reaches 1.4 times in three years. Most of that fall comes from repaying debt, and about a third from EBITDA growing by $1.2mm a year. The lender’s path uses its own EBITDA, grows it at the rate the durability work supports, and repays debt only from the $2.7mm to $2.9mm of free cash flow a year that its own figures produce. It reaches 2.6 times. Both paths are reasonable starting points for a discussion, and the gap between them shows how much of management’s case rests on growth.

Against the covenant and the market

The fifth probe measures headroom against the leverage covenant, using the covenant’s own definitions of debt and EBITDA. Those definitions set which obligations count and which add-backs are allowed, in the same way as for the coverage test. A lender also runs its downside case through the leverage test. For the distributor, the downside from the previous lesson takes EBITDA to $9.7mm, which puts funded leverage at 3.7 times against the 4.0 times covenant.

A lender then compares the borrower’s leverage with recent comparable deals: credits of a similar size, in a similar industry, closed in the current market. Management sometimes presents a peer group chosen to make its multiple look moderate. A lender uses its own record and what it sees in the market, and a multiple above the range for comparable credits needs a specific reason, such as contracted revenue or strong collateral.

For a borrower that is consuming cash

A leverage multiple has no meaning when EBITDA is negative. A lender sizes the loan against the value of the company instead, using loan-to-value: the loan divided by enterprise value or by the valuation at the last equity round. A $15mm loan to a company valued at $150mm at its last round is a 10 percent loan-to-value. The debt schedule still matters, because earnouts, deferred payments and other obligations rank alongside or ahead of the lender, and the pro forma still counts the new facility at its full drawn amount. The deleveraging path is replaced by the plan to reach breakeven, and the leverage covenant by a minimum cash covenant. The lesson on the cash-consuming borrower covers this case in full.

What the leverage read produces

At the end of this component a lender has a complete debt schedule including debt-like obligations, leverage on reported and adjusted EBITDA on a gross and net basis, current and pro forma leverage at closing, its own projected path for bringing leverage down, and headroom against the covenant in its base and downside cases.

That output is used in three places. The pro forma leverage sets the loan amount the lender is prepared to commit. The debt schedule shows where the new loan ranks against the other obligations, which the repayment layer covers. And the lender’s projected path sets expected leverage at maturity, which is what a refinancing lender will look at.

A borrower can build its own full debt schedule and pro forma leverage before a lender asks for them. Which obligations a particular lender will count, where it will set the covenant, and how much of the growth in management’s path it will accept depend on what they have lent against before.

Next in the series

Liquidity and working capital: how much cash growth ties up

Receivables, inventory and supplier terms, and the lowest point in the cash balance over the next 12 to 24 months.

You can build your own debt schedule and pro forma leverage. Knowing which obligations the lenders in your process will count, and where they will set the covenant, is the part I do at Synthase Capital Partners.

Coverage is the ratio of the cash a business generates to the debt service it owes. It is the first figure a lender looks at, and the one the loan is repaid from. A borrower that reports $10mm of adjusted EBITDA and $4mm of annual debt service shows coverage of 2.5 times. A lender rebuilds both halves of that ratio before accepting it: the EBITDA, by testing each add-back and converting it to cash, and the debt service, by using the definitions in the credit agreement.

Five probes sit in this component. The first strips one-off items out of EBITDA. The second converts what is left into free cash flow. The third calculates coverage on the credit agreement’s definitions. The fourth looks at how much cash flow moves from quarter to quarter. The fifth tests coverage in a downside. Each one takes the reported figure a step closer to the cash that will actually be available to pay the lender.

This component is where a lender’s own projection starts. Management’s forecast begins from its adjusted EBITDA and grows it. A lender begins from the EBITDA left after its own add-back review, converts it to free cash flow using the borrower’s historical conversion rate, and applies the growth assumptions supported by the model layer. The coverage in the lender’s base case is often lower than management’s, and the gap comes from specific add-backs and conversion items that a borrower can see and discuss.

The five probes, and what validates the answer

Testing the add-backs

Adjusted EBITDA is reported EBITDA plus a list of costs management considers one-off. Common add-backs include owner compensation above a market salary, transaction and legal fees, restructuring and severance, costs of a plant move, a lawsuit settlement, and synergies from an acquisition not yet realized. A lender asks for the full list covering the trailing 24 months and reviews each item.

The main test is whether the cost will come back. A severance cost that appears once is non-recurring. A severance cost that appears in each of the last three years is a regular cost of running the business, even if each year’s is described as one-off. The same applies to consulting fees, recruiting costs and inventory write-downs. A lender also checks whether the adjusted EBITDA ties to cash actually collected. An add-back for a cost that was paid in cash still reduced the cash available that year.

Projected add-backs get the most scrutiny. Cost savings from an acquisition or a restructuring that have not yet happened are a forecast, and a lender usually accepts them only in part, or only once they appear in the results. The result of this probe is the EBITDA figure the lender uses for the rest of the numbers layer, including as the denominator for leverage in the next lesson.

From EBITDA to free cash flow

EBITDA leaves out several uses of cash that come before the lender is paid. The second probe subtracts them.

A lender reconciles the walk to the audited cash flow statement, so each line comes from a reported figure rather than an estimate. It runs the walk over several years, because conversion can vary a lot. A distributor growing quickly may convert less than half its EBITDA to free cash flow because receivables and inventory are growing with sales. A specialty contractor’s conversion may swing from year to year with the timing of billing on large jobs. The multi-year view shows a lender which conversion rate to use in its projection, and how much it could vary.

Coverage on the credit agreement’s definitions

The third probe calculates coverage the way the covenant will measure it. Credit agreements define both halves of the ratio. The cash flow definition sets which add-backs are allowed and whether any are capped. The fixed charge definition sets what is included alongside interest and scheduled principal, such as lease payments, capex, taxes or distributions. Two coverage figures for the same business can differ by a wide margin depending on those definitions.

A lender rebuilds the ratio independently on the definitions in its own proposed agreement. Where a borrower has an existing facility, the lender also rebuilds the coverage reported under that facility’s definitions, because a figure calculated on generous definitions can show headroom that disappears on stricter ones.

An illustrative schedule

The schedule below applies the first three probes to an illustrative borrower: a specialty distributor with $140mm of revenue. The same company is used in each lesson in this layer, so the figures carry forward. Management presents $12.0mm of adjusted EBITDA. The lender accepts four of the six add-backs in full or in part and arrives at $10.6mm. On the same capex, taxes and debt service, fixed charge coverage falls from 1.72 times to 1.44 times, against a covenant level of 1.20 times.

Each difference between the two columns comes from a single add-back, so a borrower that prepares the schedule itself can see roughly where a lender will land before the process starts.

Quarter to quarter

The fourth probe looks at cash flow by quarter over the trailing 8 to 12 quarters. An annual figure can hide a weak quarter, and covenants are usually tested quarterly on a trailing twelve-month basis. A lender separates normal seasonality, such as a landscaping contractor’s slow winter or a food manufacturer’s holiday build, from volatility that has no regular pattern. Seasonality is predictable and can be planned for in the covenant levels and the revolver. Irregular volatility is the kind that can cause a covenant breach in a quarter nobody expected.

Coverage in a downside

The fifth probe runs a lender’s downside case through to coverage. The question it answers is how far revenue and margin can fall before coverage drops below the covenant level. The downside is built from the durability findings rather than a flat percentage decline: the price concessions the buyer power work showed are likely at the next renewals, the input cost increase sized in the supplier power lesson, the volume at risk from the rivalry and substitutes work, and the delay in management’s response from the execution lesson.

The output is a figure a lender and a borrower can both discuss. For the distributor in the schedule, coverage reaches the 1.20 times covenant when cash flow falls to $6.0mm, so the lender’s EBITDA of $10.6mm can fall by about $1.2mm, or 11 percent, with capex and taxes held constant. If the downside built from the durability findings takes out $0.9mm, the remaining $0.3mm is the headroom. Headroom is one of the main inputs to the covenant levels and the loan amount, and on these figures it is thin.

For a borrower that is consuming cash

Coverage has no usable figure when EBITDA is negative. A lender replaces it with runway: the number of months the borrower’s cash lasts at the current rate of burn, set against the date of the next funding milestone, such as an equity raise, a product approval or breakeven. The quarterly series becomes a monthly burn trend, which shows whether the cash consumed each month is falling as planned. The downside case tests how long the cash lasts if the milestone slips or the next raise is delayed. The add-back review still applies, because a burn figure with costs excluded understates how fast the cash is being used. The lesson on the cash-consuming borrower covers this case in full.

What the cash flow and coverage read produces

At the end of this component a lender has five builds: an EBITDA bridge with each add-back accepted, reduced or removed, a walk from that EBITDA to free cash flow over several years, coverage on the credit agreement’s definitions, a quarterly cash flow series, and a downside case showing how far results can fall before coverage breaches.

That output is used in three places. The validated EBITDA is the denominator for every leverage ratio in the next lesson. The free cash flow is the primary source of repayment. And the downside case is carried into the repayment layer, where it is used to test whether the business can still be refinanced at maturity.

A borrower can prepare its own EBITDA bridge and cash flow walk before a lender asks for them. Which add-backs a particular lender will accept, which coverage definitions it will agree to, and how much headroom it will require against its downside case depend on what they have lent against before.

Next in the series

Leverage: the debt multiple before and after the new loan

Current and pro forma leverage at closing, including debt-like instruments and obligations such as leases, seller notes and earnouts.

You can build your own EBITDA bridge and free cash flow walk. Knowing which add-backs the lenders in your process will accept, and negotiating the definitions the covenant uses, is the part I do at Synthase Capital Partners.

The first three layers of the series covered what the borrower is asking for, how the business makes money, and what could change that over the term of the loan. The numbers layer puts those findings into the financial model.

This layer asks whether the business can service the debt. The borrower’s financial statements and projections already show EBITDA, leverage and coverage. A lender rebuilds each figure from the source documents, adjusts it for what the earlier work found, and takes its own figures to credit committee.

A lender also builds its own base case and downside case here, instead of relying on management’s projections. The model layer supplies the base case assumptions, such as how much revenue is contracted and which costs are fixed. The durability layer supplies the downside: which customers could push price down, which input costs could rise, and which competitors could take volume.

Five components, and what each one tests

Cash flow and coverage, leverage, and liquidity get the full treatment for every borrower. Together they show whether the debt can be paid and how much room there is if results fall short. Capital intensity and financial policy get less attention unless something earlier flagged them, such as a plant near the end of its useful life, a sponsor near the end of its hold period, or an owner who has taken distributions ahead of paying down debt.

The lessons publish in the order the builds depend on each other: cash flow and coverage, leverage, liquidity and working capital, capital intensity, financial policy. The EBITDA figure from cash flow and coverage is the denominator for every leverage ratio. Working capital needs from the liquidity work go into the free cash flow calculation, and maintenance capex determines how much of that free cash flow is left for debt service.

Where the inputs come from

Each component draws on findings from earlier lessons.

The durability findings go mainly into the downside case. Instead of assuming a flat twenty percent revenue decline, a lender can model specific events: a price concession at the next rebid with the two largest customers, two quarters of higher input costs before they are passed on, and the volume a competitor’s new plant could take. Each line can be traced to the lesson that produced it.

Borrowers that do not yet generate cash

Most of this layer assumes the borrower has positive EBITDA. Coverage and leverage both use EBITDA, so neither gives a usable figure for a borrower that is still consuming cash, such as a venture-backed company before profitability or a business partway through a large build-out. These borrowers are a minority of deals, and lenders assess them differently.

A loan to a cash-consuming borrower is repaid from cash on the balance sheet, the next equity raise, a sale of the company, or the business reaching breakeven before maturity. A lender measures how many months the cash will last and what event is expected to extend it.

Liquidity and working capital applies to both types of borrower as written, and its monthly sources-and-uses schedule is the main build for a cash-consuming borrower. Each of the five lessons in this layer includes a paragraph on how its component applies to a cash-consuming borrower, and a separate lesson after the five covers that case in full.

What the layer produces

Covenant levels come from this layer. A lender sets leverage and coverage tests with headroom against its own base case, and sizes that headroom using its downside case. Two borrowers reporting the same adjusted EBITDA will be offered different covenant levels if the lender accepts one borrower’s add-backs in full and cuts the other’s by a third.

Which EBITDA figure to present

A borrower that reports adjusted EBITDA has to decide which figure to lead with. The adjusted figure sets the leverage multiple a lender sees first and the loan amount the borrower can ask for. A lender tests every add-back, and if it removes some of them, it becomes more cautious about the rest of the package.

Which approach works better depends on facts outside the business: which lender types are in the process and how each one treats add-backs, how the lenders in the process treated similar add-backs in recent deals, whether the credit agreement definitions of EBITDA are open to negotiation, and what leverage comparable credits have closed at recently.

Next in the series

Cash flow and coverage: how much of the reported EBITDA is cash the debt can be paid from

Testing each add-back, walking EBITDA to free cash flow, and rebuilding coverage on the credit agreement’s own definitions.

You can build your own EBITDA bridge and liquidity schedule. Deciding which EBITDA figure to lead with, and how the lenders in your process will read it, is the part I do at Synthase Capital Partners.

The five forces describe pressure from outside the business. Execution is the sixth component in this layer and the only one inside it. It is not part of Porter’s framework. It is included because a credit rests on a plan, the plan rests on a management team, and the five forces lessons each end with a finding that the team will have to act on at some point during the term.

A lender asks two things of management. The first is whether the team can carry out the specific plan the debt funds: an acquisition, a plant expansion, a new territory, a scale-up in volume. The second is whether the team can respond when one of the forces moves against the business during the term: a large customer rebids, an input price rises, a competitor cuts price, an entrant arrives. The first is about delivering a known plan. The second is about handling events that are not in the plan.

Four probes sit in this component. The first asks whether the team has done this before. The second compares management’s past budgets with actual results. The third identifies what depends on individual people. The fourth assesses whether the organization can carry the specific plan the debt funds. They group together because each tests a different part of the same question: whether the cash flow the projections assume will be produced by the people running the business.

This component bears on the projections more directly than any of the five forces. The forecast is management’s own work, and the budget-against-actuals record shows how close management’s past forecasts came to what happened. A team that has consistently reached its budget earns a base case close to the one it presents. A team that has missed by fifteen percent in each of the last three years has shown a lender how much to discount the next forecast, and in which lines.

The four probes, and what validates the answer

The record against the task

The first probe matches the team’s experience to what the plan now requires. A lender is not assessing whether management is capable in general. A family-owned distributor run well for twenty years by the same team may be making its first acquisition, and running an integration is a different task from running a stable business. A contractor that has grown steadily by adding crews may be proposing to open a second region, which requires managing people it does not see every day. The record that matters is the one that matches the task, and references from lenders, customers or former colleagues are how a lender verifies it.

The same probe covers how the team has handled pressure. The five forces lessons each produced a record of an event the business has already been through: the renewal pricing history in the lesson on what lets customers set the price, the pass-through record in the lesson on what lets suppliers raise the borrower’s costs, the price and volume split in the rivalry lesson. Each of those records also shows what management did. A team that raised prices within a quarter of an input increase, or replaced a lost account within a year, has shown it responds. A team whose margin fell for a year before it acted has shown how long it takes. That timing is what a lender carries into the downside case for the forces the earlier lessons found to be strong.

Past budgets against results

The second probe is the most objective of the four. Management’s budgets for the last three to five years are set beside the actual results, line by line. The comparison shows the size of any gap and where it sits.

The last row connects the budget record to the second part of the execution question. A year in which revenue came in under budget because a customer was lost or a price was conceded is also a record of how the team responded to that event. A team that revised the forecast in the second quarter and brought overhead down to protect coverage is a different credit from one that held the plan and reported the miss at year end.

Depth behind the individuals

The third probe identifies the individuals the business depends on and whether anyone stands behind them. In many mid-market businesses, the owner or one senior salesperson holds the largest customer relationships, one engineer holds the knowledge of how a key process runs, and the chief executive makes most decisions. The read on what keeps customers established how much of the customer base sits with individual people. This probe asks what happens to the business if one of them leaves during the term, and whether there is a second person who could step in.

Key-person dependence also affects how the team handles pressure from the other forces. A business where one person negotiates every major renewal and supply contract can respond to a rebid or an input increase only as fast as that person can, and cannot respond at all if that person is unavailable.

Capacity for the specific plan

The fourth probe sets the organization’s capacity against the plan the debt funds. It reuses the scalability assessment from the key activities read, which established whether the operation can produce at the volume the plan requires. This probe adds the people: whether the team has the finance function to integrate an acquired company’s reporting, the supervisors to run a second shift, the sales capacity to open a new territory while serving the existing one. A plan that doubles the business while the management team stays the same size is asking the same people to carry twice the load.

This probe also sets the plan against the rest of the term. A team fully occupied by an integration in the first two years has less capacity to respond to a customer loss or a competitor’s move in the same period. A lender reads the timing of the plan’s demands on management alongside the timing of the pressures the five forces lessons identified.

What the execution read produces

At the end of this component a lender has the team’s record matched to the plan’s task, a record of how management responded to past pressure from customers, suppliers and competitors, the size and direction of past budget misses, the people the business depends on, and an assessment of whether the organization can carry the plan during the term.

That output is used in three places. The budget record sets how far to discount management’s base case. The response timing sets how long the downside case assumes pressure lasts before management acts. And the finding feeds the view on whether the business will be financeable at maturity, since a lender refinancing the borrower then will be lending to the same team, or to whoever replaced it.

This completes the durability layer. Each of the six components produces a finding on pressure the business will face during the term, and each finding feeds an assumption in the downside case. A borrower can produce its budget record and name the people it depends on. Whether a particular lender treats a first-time acquirer as a reason for tighter covenants, a larger equity contribution, or key-person provisions in the credit agreement depends on what they have lent against before.

Next in the series

The numbers layer: turning the model and durability work into coverage and leverage

How the findings from the first three layers become the base case, the downside case and the ratios a lender underwrites to.

You can produce your budget record and name the people your business depends on. Reading how a particular lender will weigh that record against the plan you are asking them to fund is the part I do at Synthase Capital Partners.

Porter’s fifth force is the threat of entry. New entrants bring capacity and a need to win share, which puts pressure on prices, costs and the investment incumbents need to make to compete. Porter’s point is that the threat of entry, rather than entry itself, is what limits an industry’s profitability. Where entry is easy, incumbents have to hold prices low enough, or invest enough, to deter it. The threat depends on two things: the barriers to entry, and the reaction an entrant can expect from the companies already in the market.

This lesson reads the borrower’s market against Porter’s barriers and his conditions for retaliation, then uses four probes to test the finding: which barrier actually protects the borrower, whether it is rising or falling, whether a company in an adjacent market could enter using what it already has, and how quickly capital would fund new entrants if the market’s returns are visibly attractive.

Management’s plan usually holds the current margin, and sometimes expands it. Where barriers are low and the borrower’s margins are above what an entrant would need to earn, Porter’s framework says new capacity will arrive and bring prices down, and a plan that holds margin is assuming no one enters. The new entrants read lets a lender set the margin assumption in the downside case from the height of the barriers and the record of recent entry, rather than from the borrower’s current margin.

The barriers to entry

Porter identified seven sources of barriers to entry. Each is an advantage incumbents hold that an entrant would have to overcome or pay for.

Several of these carry over from earlier work. Switching costs were established in the lesson on what lets customers set the price, and access to distribution in the channels read. The key resources read identified the assets that produce the cash flow, and Porter’s incumbency advantages ask which of those an entrant could not easily acquire. A distributor with a warehouse network sited near its customers, a food manufacturer with shelf space at national retailers, and a contractor holding licenses that take years to obtain each have a barrier that can be named.

The reaction an entrant expects

Porter’s second element is expected retaliation. A potential entrant weighs how the incumbents are likely to respond, and a strong expected response deters entry as effectively as a barrier.

These conditions overlap with the rivalry lesson, and the overlap cuts two ways for a lender. An industry where incumbents retaliate hard deters entry, which protects the borrower. The same retaliation, once an entrant does come in, takes the form of a price response that the borrower is part of. The borrower’s capacity to take part is its own balance sheet, including the facility being underwritten.

Testing the barrier over the term

Four probes establish which barrier protects the borrower and whether it will still hold at maturity.

The first probe asks the borrower to name its barrier in Porter’s terms and then tests it. Many borrowers describe their barrier as relationships or expertise, which are not on Porter’s list and are hard to verify. A lender presses for the specific form: a license that took four years to obtain, a plant an entrant would need $40mm to build, a position on a national retailer’s approved vendor list. The test is whether an entrant would have to spend money or time to get past it, and how much.

The second probe uses the record of recent entry as the evidence. A lender asks who has entered the market in the last several years, what they came in with, and how much share they took. A barrier that several entrants have cleared is lower than described, and one that entrants have tried and failed to clear has been tested. Porter’s barriers can also change over time: a patent expires, a regulation is relaxed, a technology lowers the minimum efficient scale. The direction over the term of the loan matters more than the height today.

The third probe addresses the entrant Porter considered the most dangerous: a company diversifying from another market that can use its existing capabilities and cash flow to enter. A building products distributor adding a product line that the borrower specializes in, a customer’s existing supplier offering the borrower’s service alongside its own, or a larger manufacturer extending into an adjacent category each arrives with some of Porter’s barriers already cleared. In software this threat usually takes the form of a larger product adding the capability as a feature, and that version is specific to software.

The fourth probe asks how quickly entry could happen. Where the borrower’s margins are visibly high and the barrier is low, capital will fund entrants, and the speed depends on the funding available. A sponsor-backed consolidator can enter a fragmented market through acquisitions in a year or two. This probe sets the timing of the margin pressure against the loan’s maturity.

What the new entrants read produces

At the end of this component a lender has the barrier that protects the borrower, named and tested, a view on whether incumbents would retaliate against an entrant, the record of recent entry and the direction the barrier is moving, the adjacent companies best placed to enter, and a view on how quickly entry could be funded.

That output is used in three places. The height and direction of the barrier set the margin assumption in the downside case. The timing of possible entry is compared with the loan’s maturity and amortization. And the finding feeds the view on whether the business will be financeable at maturity, since a lender refinancing the borrower then will ask how much of the current margin an entrant has already taken.

A borrower can name its barrier in Porter’s terms and produce the record of recent entry. Whether a particular lender treats a falling barrier as a reason to price the credit higher, shorten the tenor, or accept it in a market it knows well depends on what they have lent against before.

Next in the series

Execution: whether management can deliver the plan and handle what the other forces bring

The team’s record at the task the loan funds, and at responding when competitors, customers or suppliers move against the business.

You can name the barrier that protects your market and show who has tried to enter it. Reading how a particular lender will weigh that barrier against the term you are asking for is the part I do at Synthase Capital Partners.

Porter’s fourth force is the threat of substitutes. He defined a substitute as a product that performs the same or a similar function as the industry’s product by a different means. Plastic containers substitute for glass, a staffing agency substitutes for a company’s own hiring, and a customer doing the work in-house substitutes for buying it. Substitutes come from outside the borrower’s industry, which is why they are easy to miss: they do not appear on a list of competitors, and the borrower may not track them.

Porter’s central point is that substitutes place a ceiling on the price an industry can charge. If the industry raises its price too far above what the substitute costs for the same result, customers move. The threat is high when two conditions hold: the substitute offers an attractive trade-off between price and performance, and the customer’s cost of switching to it is low. This lesson establishes where that ceiling sits for the borrower, then uses four probes to test whether it is moving: what need the customer is paying to meet, what alternatives could meet it, whether a change in technology is making those alternatives better, and whether the borrower’s switching costs hold substitution off until the loan matures.

Management’s plan usually carries price increases and stable or growing volume in the borrower’s category. Where a substitute is improving in price or performance, the ceiling is falling, and the plan’s price increases are limited by it regardless of how the borrower compares with its direct competitors. The substitutes read lets a lender test the price assumption in the plan against the ceiling, and size the volume that could move to the substitute over the term in the downside case.

What counts as a substitute

Porter noted that substitutes take more forms than a competing product. Each of the forms below meets the customer’s need without buying from the borrower’s industry.

The forms apply differently across businesses. A specialty contractor’s substitute is often the customer’s own maintenance crew. An equipment distributor’s is the customer running existing machines longer or buying used. A packaged-goods supplier’s is a different format or a store brand that meets the same need. A fabricator’s is a change in the customer’s design that uses a different material or removes the part. In each case the borrower may be the strongest company in its own industry and still lose volume, because the customer has left the industry rather than changed supplier within it.

Porter also noted that substitutes can change because of developments in unrelated industries. A cost reduction in a different material, a new process at a customer, or a regulatory change affecting an alternative can move the price ceiling without anything changing in the borrower’s industry. That is why the substitutes read looks outside the borrower’s competitive set.

Testing the threat over the term

Four probes establish which substitutes apply to the borrower and whether they could take volume or cap price before the loan matures.

The first probe sets the terms for the rest. It reuses the value proposition read and restates what the product does for the customer in terms of the function rather than the product. A borrower that makes steel fuel tanks for agricultural equipment is meeting the need to store fuel on a machine; stated that way, a plastic tank is a substitute, and the question becomes whether equipment makers are moving to it. Where the need is defined as narrowly as the product, no substitutes appear.

The second probe maps the alternatives against the defined need, using the forms Porter described. For each one, a lender wants its price and performance relative to the borrower’s product, because Porter’s first condition is that trade-off. A substitute that is cheaper but worse sets a floor under what customers will tolerate; one that is cheaper and comparable sets the ceiling. In-house production deserves particular attention for any customer large enough to do it, and it overlaps with the in-house threat covered in the lesson on what lets customers set the price.

The third probe asks whether that trade-off is moving within the term. This is where Porter’s point about unrelated industries applies. A lender is looking for developments that would make a substitute cheaper or better before the loan matures: a new material reaching cost parity, a process change at customers, a regulation that favors one alternative. A substitute improving steadily can reduce a category’s volume while the borrower keeps its share of what remains.

The fourth probe compares the pace of substitution with the loan’s maturity. Porter’s second condition is the customer’s cost of switching to the substitute, and the switching costs established in the buyer power lesson apply here as well: a part qualified into a customer’s product, or equipment built around a particular input, slows the move. The question for a lender is whether the switching cost delays substitution past maturity or only slows it within the term. A switching cost that holds customers for three years supports a three-year loan and does less for a seven-year one.

What the substitutes read produces

At the end of this component a lender has the customer’s need stated as a function, a map of the alternatives that could meet it with their price and performance against the borrower’s, a view on whether any of them is improving within the term, and a comparison of the switching costs with the loan’s maturity.

That output is used in three places. The price and performance of the closest substitute tests the price increases in the plan. The pace of substitution sets the category volume assumption in the downside case. And the comparison with maturity feeds the view on whether the business will be financeable at that date, since a lender refinancing the borrower then will look at the same substitutes after several more years of improvement.

A borrower can define the need its product meets and map the alternatives. Whether a particular lender treats an improving substitute as a reason to shorten the tenor, increase amortization, or accept it as a slow change in a category it knows depends on what they have lent against before.

Next in the series

New entrants: what keeps other companies out of the borrower’s market

The barriers that protect the borrower, who has entered recently, and how far they got.

You can define the need your product meets and map what else could meet it. Reading how a particular lender will weigh a substitute against the term you are asking for is the part I do at Synthase Capital Partners.

Porter’s third force is the bargaining power of suppliers. It is the mirror of buyer power: suppliers with leverage can charge higher prices, limit quality or service, or shift costs onto the companies that buy from them. Porter’s analysis asks what gives a group of suppliers that leverage over an industry. He included labor in the definition, so a workforce with skills that are hard to replace, or one that bargains collectively, is a supplier in the same sense as a raw material vendor.

This lesson reads the borrower’s suppliers against Porter’s conditions, then uses four probes to establish what that means for the borrower: which inputs are large enough to move the margin, how much power the suppliers of those inputs hold, whether the borrower has passed past cost increases through to its own customers, and what an input price increase does to debt service coverage.

Management’s plan usually carries input costs at current levels or rising with general inflation, and holds gross margin steady. Where the suppliers of a major input are concentrated, hard to replace and not dependent on the borrower’s industry for their revenue, Porter’s framework says they will raise prices when they can, and a plan that holds input costs flat is assuming they will not. The supplier power read lets a lender set the input cost assumption in the downside case from the suppliers’ position, and the share of any increase the borrower recovers from its own record of passing costs through.

What gives suppliers leverage

Porter set out the conditions under which a group of suppliers is powerful. Each can be established from the borrower’s purchasing records and the structure of the supplying industry.

Dependence is the condition borrowers most often overlook. A specialty chemical supplier selling a small share of its output to a coatings manufacturer will allocate supply to its larger customers when capacity is tight, and the coatings manufacturer has no leverage to prevent it. The same supplier selling half its output to the coatings industry has a reason to keep that industry supplied and priced competitively.

Switching costs on the supply side often come from the borrower’s own customers. A fabricator whose customer has approved a specific steel mill or resin grade cannot change suppliers without the customer’s requalification, and that approval sits outside the borrower’s control. The partnerships read identified these dependencies; Porter’s conditions establish how much pricing leverage each one gives the supplier.

Testing the finding against the borrower’s costs

Four probes take the suppliers’ position and establish what it means for the borrower’s margin and its debt service.

The first probe narrows the analysis to the inputs that matter. It reuses the cost classification from the cost structure read and isolates the inputs whose price, if it moved, would change gross margin by an amount a lender would notice. For a food manufacturer that is usually one or two commodities and packaging; for a specialty contractor it is often skilled labor and one or two materials. Porter’s conditions are then applied only to those inputs.

The second probe applies Porter’s conditions to the suppliers of each major input. It reuses the dependency map from the partnerships read. The distinction a lender draws is between an input bought from many suppliers at a market price, an input bought from a few suppliers who can coordinate price, and an input with one qualified source. Each carries a different degree of leverage, and the last carries the most.

The third probe links supplier power to buyer power. A borrower facing a powerful supplier is protected if it can pass the increase on to its own customers, and the ability to do that depends on the leverage those customers hold, which was the subject of the lesson on what lets customers set the price. The evidence is the record: input cost and selling price over the last period in which the input rose sharply. A distributor that raised its prices within a quarter of its supplier’s increase has shown it can pass costs through. A manufacturer whose margin fell for a year before prices caught up has shown it absorbs them first.

The fourth probe turns the finding into a number. It runs an input price increase through the financial model to margin and to debt service coverage.

The value of the stress is that it converts Porter’s qualitative conditions into the measure a lender is actually underwriting. A single-sourced input that is two percent of cost of sales is a supply risk, and the partnerships read covers it as one. A concentrated input that is thirty percent of cost of sales, bought by a borrower that absorbs increases for a year, is a coverage risk.

What the supplier power read produces

At the end of this component a lender has the inputs the margin depends on, a finding on how much leverage the suppliers of each one hold, the borrower’s record of passing cost increases through, and a coverage figure after an input price increase.

That output is used in three places. The input price increase and the recovery share set the cost assumptions in the downside case. The pass-through record tests the gross margin in the plan. And the finding on supplier leverage feeds the view on whether the business will be financeable at maturity, since supply agreements that expire before that date will be renegotiated with the same suppliers.

A borrower can map its major inputs against Porter’s conditions and produce its pass-through record. Whether a particular lender sizes the input price increase from the last cycle or a worse one, and whether it treats the result as a covenant level, a reserve or a pricing point, depends on what they have lent against before.

Next in the series

Substitutes: what else the customer could use instead

Products outside the borrower’s industry that meet the same need, and whether their price and performance are improving over the term of the loan.

You can map your major inputs against Porter’s conditions and produce your pass-through record. Reading how a particular lender will size the input stress, and what it does to the covenants you are offered, is the part I do at Synthase Capital Partners.

Porter’s second force is the bargaining power of buyers: the ability of customers to force prices down, demand more quality or service for the same price, and play sellers against each other. As with rivalry, his analysis is of the industry. It asks what gives a group of buyers leverage over the companies that sell to them, and what makes those buyers care about price. A lender applies that to the borrower’s customers to set the price the borrower can expect to hold at renewals and rebids over the term of the loan.

Porter separated two conditions. Bargaining leverage is whether buyers are in a position to negotiate price down. Price sensitivity is whether they want to. A customer with leverage may not use it if the purchase is a small part of its costs or affects the quality of its own product. This lesson reads the borrower’s customers against both conditions, then uses five probes to test the finding against what has happened with the borrower’s accounts: what the switching cost is, what the contracts commit, what happened to price at renewals, why past customers left, and whether customers would keep buying in their own downturn.

Management’s plan usually carries price increases at renewal and stable volume from existing customers. Where buyers are concentrated, face low switching costs and spend a large share of their own costs on the borrower’s product, Porter’s framework says they will resist those increases, and a plan that assumes otherwise is assuming the borrower’s customers behave differently from the rest of the industry’s. The buyer power read lets a lender set the renewal price assumption from the borrower’s actual renewal history, and the volume assumption in the downside case from whether customers keep or cut the purchase when their own business slows.

What gives buyers leverage

Porter set out the conditions under which a group of buyers holds bargaining leverage. Each can be established from the customer list, the product and the way customers buy.

Concentration is the condition most lenders check first, and it carries over from the read on who pays. Porter’s framing adds the seller’s side of the same fact: a customer that takes a large share of the borrower’s output has leverage in proportion to how much the borrower needs that volume to cover its fixed costs. A food manufacturer selling forty percent of its volume to two national retailers, running plants that need that volume, is in that position at every category review.

Porter also noted that intermediate buyers, such as distributors and retailers, gain leverage when they can influence what the end customer buys. A retailer that controls shelf placement or a distributor that recommends one brand over another holds power that a direct customer of the same size would not. The channels read established who holds the customer; this condition establishes what that position is worth in a price negotiation.

What makes buyers care about price

Leverage alone does not set the price. Porter’s second set of conditions describes when buyers are sensitive to price and will use the leverage they have.

These conditions explain why two customers of the same size behave differently. A contractor buying fasteners that are a small part of the project cost and that could delay the project if they fail will pay for reliability. A packaged-goods company buying corrugated boxes that are a meaningful share of its cost of goods, have no effect on the product and are made to a common specification will rebid them regularly. The first customer has leverage and does not use it; the second has leverage and uses it at every contract.

Thin margins at the customer are the condition most likely to change within the term of a loan. A customer industry going into its own downturn becomes more price-sensitive at the same time its volumes fall, so the borrower sees pressure on price and volume together.

Testing the finding against the borrower’s accounts

Five probes test whether the leverage and sensitivity the industry read predicts are showing up in how the borrower’s customers have actually behaved.

The switching cost probe tests Porter’s third leverage condition with evidence. Most borrowers can describe a switching cost; fewer can show that customers who left paid it. A fabricator whose part is qualified into a customer’s assembly can point to the requalification a competitor’s part would need. If customers have moved to competitors without going through that requalification, the switching cost is lower than described. The customers who left are the best evidence a lender has of what leaving costs.

The contract probe reuses the contract read from the lesson on what keeps customers. The question here is narrower: whether the contracts limit the buyer’s leverage during the term. A supply agreement with committed volumes and a fixed price schedule limits it until expiry. A master agreement with no minimum volume sets terms without committing the customer to buy, and leaves the customer’s leverage intact. The expiry dates of the largest contracts are compared with the loan’s maturity.

The renewal pricing probe is the direct test of whether buyers are using their leverage. It uses the same transaction data as the price and volume split in the rivalry lesson, grouped by account and renewal date. Prices held or raised at renewal with the largest customers are evidence that leverage is limited in practice. Prices conceded at renewal, or volume moved to a second supplier after a rebid, show where the power sits regardless of what the concentration figures suggest.

The departure probe asks what caused customers to leave in the past. Porter’s conditions describe a standing position; the departures show what changes it. In most businesses the causes are specific: a new purchasing manager who rebids the category, a customer acquired by a company with its own supplier, a competitor offering a lower price, a change in the customer’s product that removes the borrower’s part. Knowing which of these has caused departures before tells a lender what to watch for over the term.

The downturn probe connects to Porter’s price sensitivity conditions and to the value proposition read. A product that is essential to the customer’s operation, or whose failure would be costly, tends to keep its volume when the customer cuts spending. A discretionary purchase is among the first to go. The evidence is volume by customer through the last period when the customer’s own industry was weak.

What the buyer power read produces

At the end of this component a lender has a finding on how much leverage the borrower’s customers hold and how sensitive they are to price, a named switching cost tested against past departures, the contract commitments set against the loan’s maturity, the renewal price history for the largest accounts, and a view on how customer volume behaves in a downturn.

That output is used in three places. The renewal price history sets the price assumption for existing customers in the base and downside cases. The downturn finding sets the volume assumption in the downside case. And the verdict on how much leverage customers hold feeds the view on whether the business will be financeable at maturity, since the largest contracts that expire before that date will be renegotiated with the same buyers.

A borrower can describe its customers against Porter’s conditions and produce the renewal history by account. Whether a particular lender treats concentrated buyers as a concentration limit in the borrowing base, a covenant on the largest customers, or a normal feature of an industry they lend into depends on what they have lent against before.

Next in the series

Supplier power: what lets suppliers raise the borrower’s costs

How concentrated the suppliers are, what it costs to switch, and whether the borrower can pass cost increases on.

You can read your customers against Porter’s conditions and produce your renewal history by account. Reading how a particular lender will treat what that shows, and what it does to the advance rate and covenants you are offered, is the part I do at Synthase Capital Partners.

Porter defined rivalry as competition among existing firms in an industry, and his analysis is about the industry’s structure rather than any one company’s position in it. Some industries push their participants toward cutting price whenever volume softens; others let them compete on service, specification or delivery and hold margin. A lender needs to know which kind of industry the borrower is in before reading the borrower’s own numbers, because the structure sets how much pressure will be applied over the term of the loan.

This lesson works in two steps. The first reads the industry against Porter’s conditions for intense rivalry. The second uses the borrower’s data to establish whether that rivalry is reaching its revenue: how the growth rate compares with the market, how much of it was acquired, how much came from price versus volume, what the largest competitors can afford to do, and what the leading indicators show.

Management’s plan usually holds realized price and gross margin roughly flat while volume grows. In an industry with high fixed costs, slow growth and little differentiation, Porter’s framework says the participants will trade price for volume when demand softens, and a plan that assumes otherwise is assuming the borrower is the exception. The rivalry read lets a lender set the price assumption in the base and downside cases from the industry’s structure and the borrower’s own price history, rather than from management’s target margin.

What makes rivalry intense

Porter set out the conditions under which rivalry is most intense. Each is a fact about the industry that a lender can establish without the borrower’s internal data.

Porter also distinguished rivalry on price from rivalry on other dimensions. Price competition transfers margin directly to customers and is easy for a competitor to match, so it tends to lower returns for the whole industry. Competition on features, service, delivery time or brand is harder to copy and can leave margins intact. He noted that price competition is most likely when products are close to identical, switching costs are low, fixed costs are high relative to marginal costs, capacity comes in large increments, and the product is perishable. For a lender, the useful output of this step is a plain finding on which kind of competition the borrower’s industry runs on.

Two of the conditions connect to earlier work. High fixed costs are the same fixed-cost floor established in the [cost structure read](https://www.thecreditbubble.com/p/cost-structure-how-much-of-the-cost), applied now to competitors as well as the borrower. Exit barriers matter in a downturn: competitors that cannot sell their assets or walk away from their commitments keep producing and pricing to cover cash costs, which extends the period of weak pricing.

Whether it is reaching the borrower

Five probes establish how much of the pressure the industry read predicts is already showing up in the borrower’s numbers.

The market comparison uses the same industry growth figure as the structural read, applied to the borrower. A distributor growing nine percent in a market growing twelve percent is losing share while reporting growth. This is also where management’s own market sizing is replaced with a third-party number, because a borrower that defines its market narrowly enough can show share gains in any conditions.

The organic split applies to borrowers that have been acquiring. A fabricator that bought two competitors over three years reports the combined revenue, and the growth rate contains both the acquired revenue and whatever the original business did. A lender needs the two separated by year. In a slow-growth industry, acquisition is a common way to report growth while the underlying business is flat, and growth that depends on further acquisitions depends on further capital.

The price and volume decomposition is the direct test of whether price competition is reaching the borrower. It comes from transaction data: units and realized price per unit, by product line and period.

A specialty contractor bidding at progressively thinner margins to keep the crews busy shows revenue growth and a falling realized price. That is the pattern Porter describes in a high-fixed-cost industry, visible in one company’s numbers. The share gained this way is easy to reverse, because a competitor that wants the work back only has to match the price.

The competitor assessment applies Porter’s point about diverse rivals with high stakes to named companies. A lender is looking for which competitors have the balance sheet, the ownership or the strategic reason to sustain below-margin pricing: a sponsor-backed consolidator in a fragmented market, a public company defending a segment, a larger supplier moving downstream. Recent moves are read the same way: a new plant, a territory expansion, a recapitalization. The assessment is about capability over the term rather than current behavior.

The leading indicators address flat revenue. Flat revenue in a mature industry with stable share is a different credit from flat revenue that is the first year of a decline, and the reported number does not distinguish them. Win rate on bids and rebids, pipeline coverage against the plan’s new-business target, and reorder rates by customer vintage move one or two periods ahead of revenue. These reuse the data assembled for [the read on what keeps customers](https://www.thecreditbubble.com/p/customer-relationships-what-keeps). Win rate is the one most borrowers cannot produce, because it requires tracking losses as well as wins.

What the rivalry read produces

At the end of this component a lender has a finding on how intense rivalry is in the borrower’s industry and whether it runs on price, the reported growth rate broken into market, acquired, volume and price, a named list of competitors with an assessment of what each can afford to do, and a direction of travel from the leading indicators.

That output is used in three places. The industry finding and the price history set the price assumption in the downside case, and give the decline in that case a cause. The price and volume work tests the margin assumptions in the plan. And the combined verdict feeds the view on whether the business will be financeable at maturity, since a lender refinancing the borrower at that date will run the same read on the industry as it stands then.

A borrower can describe its industry against Porter’s conditions and run the decomposition on its own transaction data. Whether a particular lender treats price-based rivalry as a margin risk to be covenanted, a known feature of an industry they lend into regularly, or a reason to shorten the tenor depends on what they have lent against before.

Next in the series

Buyer power: what lets customers set the price

How concentrated the customers are, what it costs them to switch, and how much the purchase matters to their own costs.

You can read your industry against Porter’s conditions and decompose your own growth rate. Reading how a particular lender will treat what that shows, and what it does to the terms you are offered, is the part I do at Synthase Capital Partners.

The nine blocks describe the business as it operates now. A loan is serviced over a term and repaid or refinanced at the end of it, so a lender needs a view on which parts of that description are likely to still hold when the facility matures. This layer takes the blocks already read and asks how much pressure each one is under, and from where.

The tool for the external side is the five forces framework, published by Michael Porter in 1980: rivalry among existing competitors, the bargaining power of buyers, the bargaining power of suppliers, the threat of substitutes, and the threat of new entrants. Porter wrote it to explain why some industries earn better returns than others, and his analysis is of the industry rather than any one company in it. A lender applies it to one borrower over the term of one loan. Each force is a mechanism by which cash flow currently available for debt service could be taken, and the questions are who would take it, how much, and how quickly.

Those five forces sit outside the business. A sixth component in this layer sits inside it: execution. The credit rests on a plan, the plan rests on a management team, and a plan that requires the operation to scale, integrate an acquisition or hold price through a cost increase depends on that team being able to do it. Execution is assessed the same way the external forces are, as something that could reduce the cash flow the projections assume.

Six components, and what each one tests

Porter’s point is that the forces are not equally strong, and which one dominates differs by industry. Buyer power dominates for a food manufacturer selling to a few national retailers; supplier power dominates for a fabricator dependent on one scarce input. A lender reads all five and gives the full treatment to the ones that are strong in the borrower’s industry. Rivalry and buyer power are most often in that position, because they act directly on the revenue a lender is being repaid from. Execution is read more heavily when the plan requires the business to run at a size the management team has not run before.

The term sets how far the read has to hold

A revolver renewed annually and a five-year term loan do not carry the same durability question. The facility’s tenor sets how far out the read has to reach, and its amortization profile sets which years matter most. Where the loan amortizes, the early years carry more of the repayment and a decline late in the term is absorbed by a smaller balance. Where it is interest-only with the principal due at maturity, the full balance depends on the business being financeable at that date, and the durability work is carrying most of the credit.

This is also what separates the durability read from a general assessment of competitive position. A barrier to entry eroding over ten years is a strategic issue for the owner and not a credit issue on a three-year facility. A supplier contract expiring in eighteen months on the same facility is both. Each force is assessed against the term, not in the abstract.

Most of the facts are already on the table

This layer runs on the model work rather than on a fresh diligence list. Each component draws its inputs from blocks a credit team has already read, and adds a stress to them.

One consequence of that structure is that a weak answer in the model layer costs a borrower twice. The criticality finding is the clearest case: whether customers treat the spend as mission-critical or discretionary is the root input to both buyer power and substitutes, so a thin answer there weakens two durability components at once. That is why lenders return to a block a borrower considers settled.

What the layer produces

The downside case in the financial model is where this layer becomes a number. A twenty percent revenue decline is an assumption until something explains why it would happen, and the rivalry, buyer power and supplier power findings are what supply that explanation. Two borrowers can be stressed at the same revenue decline and have different probabilities attached to it, and the difference comes out of this layer rather than out of the statements.

How much term to ask for

Most borrowers know where their own durability answer is weakest before a lender finds it: a customer whose contract is at will, an input with one qualified supplier, a plan that requires the business to run at a scale the team has not run before. Because the tenor sets how far the read has to hold, the term requested is one of the few things a borrower controls that changes how heavily that weakness is examined.

The determining facts sit outside the business: which lender types are in the process and what tenors they write, where pricing sits for each term at the time of the raise, whether any of them has lent into the sector recently enough to hold its own view of how durable it is, and what the existing maturities already force.

Next in the series

Rivalry: whether the growth is taking share or being bought with price

Separating share gains from discounting, organic revenue from acquired, and reading win rates and pipeline for the direction of travel.

You can name the pressure on your own model and the component where the answer is weakest. Which tenor to ask for, and how a particular lender will read that weakness against it, is the part I do at Synthase Capital Partners.