It is no surprise that the word “promise” features prominently within loan documentation. A borrower’s willingness and intent to repay a loan is just as important as his ability, and perhaps more so when conditions become stressful. Cash flows and the value of good collateral can decline during an economic slowdown, but the character of good managers always stays constant. A company’s success may be attributed to its products, technology, or market strategy, but it is ultimately the people that run the company and make the key decisions that determine its future. The character of a borrower’s management team has great significance in our credit analysis.
Assessing and measuring character requires judgment and experience. Prior to the Industrial Revolution, lenders and borrowers were intimately familiar with one another and staked their personal relationships, not just their business motives, behind the credit decision. Today, in an environment when loans are still made to be sold, and transactions are sourced in large volumes from around the world, lenders are challenged in making character determinations. This is further exacerbated inside a troubled company, where management is reluctance to communicate due to fear and denial.
We assess management character by examining two components: competency and integrity. Competency is checked through independent verifications of education, career experience, historical business performance, any criminal convictions and civil litigation, and personal credit scores. Any inconsistency between our checks and management representations are flagged for further investigation. Personal credit scores are an especially useful indicator because they demonstrate management’s attitude toward debt repayment. Our experience shows that credit information for management of a company explains a significant amount of variation in the performance of that company’s credit.
Indicators of management integrity are less easily observed and can take significant time to accumulate. However, the manner in which management communicates information provides important clues into their integrity. Examples include pattern of delays in information reporting, reluctance to provide disclosure, failure to provide specific and complete answers to questions, providing evasive information or being excessively defensive, destroying key documents, and overly complex transactions in the circumstances. We not only need to be able to understand the information we receive from management but should be able to trust it. Consistently failing to meet projections is a quick way to lose our trust. While companies cannot be expected to see into the future, flawed assumptions and unrealistic targets put management integrity into question.
We tend to avoid situations where company leaders have excessive control over the dissemination of information and there is fear (along with high turnover) among finance and accounting staff. Another red flag is if management has less to lose than we do, in relative terms, from a company failure. Any deception, misrepresentation, or lie is a clear and strong warning signal, and usually results in a permanent fracture of our relationship with management. In an ideal world, we can make accurate assessments of management character at the onset of a loan; however, more often, as unexpected crisis occur, or as a company and industry evolve, management’s true competence and integrity gets revealed.
Too many warning signs are an indication of distress. In such circumstances, many lenders simply revise the loan covenants. However, if management character is flawed, then loan covenants, no matter how often they are revised, will inevitably be breached. Liquidation is the only viable solution when management’s “promise” no longer holds meaning.