The red flags investors should look for in private lending

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The writer is a partner at Silver Point Capital and author of “The Credit Investor’s Handbook.”

Credit markets have had a series of high-profile blowouts in the past three months. These events prompted Jamie Dimon, CEO of JP Morgan, to warn of “cockroaches” lurking in the financial system, pointing to the private credit market in particular.

This has led many investors to question how safe the asset class really is. However, when implemented appropriately, high-quality secured lending in private markets remains a compelling asset class, offering attractive risk-adjusted returns with collateral that provides meaningful downside protection.

The challenge is that we may be late in the credit cycle, as a flood of new capital enters the private market. In this environment, investors have to be more selective about the deals they back. The central question here is how to avoid the next catastrophe similar to the recent collapse of US auto parts group First Brands and subprime auto lender Tricolor Bank in Texas.

As I said in my book Credit Investor GuideThe answer is to systematically identify “red flags” in a borrower’s financial statements, and then pursue rigorous and skeptical due diligence.

Financial statement analysis has become a lost art in today’s era of rapid capital deployment in credit markets. A red flag doesn’t automatically rule out an investment, but for a top-tier manager, it should trigger rigorous due diligence and uncomfortable questions that demand clear answers from the company. The goal is straightforward: either convince yourself that fears are manageable or walk away. There are many practical warning signs, but here are some that vigilant investors should pay attention to:

• A material increase in “days receivable” — the time it takes a company to collect cash from its customers — can be a big red flag. This may indicate that the company is inflating reported sales through tactics such as “dealer dumping,” where excess inventory is pushed to distributors regardless of actual demand in the end market.

• A declining order backlog is a clear warning that the current advertised sales growth may be unsustainable or misleading.

• Significant fluctuations in foreign currency exchange rates can distort financial performance. This can make multinational companies appear to be growing when the business could actually be shrinking if its performance is evaluated using a fixed currency rate over a certain period.

• Aggressive serial acquisitions can be used to mask underlying deterioration in the organic core business.

• Poor inventory management can also hide weakness. A manufacturer may overestimate profits by overproducing inventory to artificially reduce per-unit costs, quietly building up dangerous inventories in the process. Investors should closely monitor “days of inventory” to ensure production stays in line with demand.

• Reducing some operating expenses could be another warning sign. Management teams under pressure to meet short-term goals may reduce research and development or advertising to manage near-term earnings. They may also intentionally understate bad debt expenses or incorrectly capitalize routine operating expenses.

Not all anomalies are fraudulent, but red flags can be identified, provided investors actually look for them.

Beyond the financial statements themselves, there are qualitative and structural warning signs. First Brands is a textbook example. Aside from questions about its debt and acquisition-fueled growth, company founder Patrick James has had a documented history of two legal battles over fraud allegations, including a 2009 lawsuit that alleged he inflated accounts receivable and inventory numbers. James denied the allegations in both cases, which were eventually dismissed after settlements were reached.

First Brands also used special purpose vehicles to keep debt off its balance sheet — a tactic used by Enron that should have set off alarm bells — and relied heavily on a form of financing known as reverse factoring in which lenders speed up payments to the company’s suppliers and recoup the money later. These arrangements may have obscured the true extent of its influence. Any one of these features is worth serious scrutiny.

The lesson from First Brands and other recent failures is that discipline is the key to credit investing success. In an asset class that has grown sevenfold since 2008 to about $1.7 trillion and is growing rapidly, the pressure to put money to work can overwhelm the patience required for proper analysis.

The tools for spotting problematic credits haven’t changed: read financial statements closely; Question business model and capital structure; Investigate the backgrounds of senior executives, and never allow the lure of returns exceeding 10% to overtake healthy skepticism.

Ed Mule, my mentor and co-founder of Silver Point Capital, often reminds our team that the best way to become a great credit investor is to do a post-mortem examination of trades that fail. First Brands offers precisely this type of case study—a reminder that the most costly lesson is the one you refuse to learn.

This article reflects only the personal opinions of the author, and not of Silver Point Capital