The 4 C's of Credit

I have some friends who are looking at trying to gain positions in Fixed Income so I thought I would have a quick review of the 4 C's of Credit. They are:

1. Character - The management team's record, strategy and internal controls
2. Capacity - Ability to meet debt obligations
3. Collateral - Assets pledged to back the loan
4. Covenants - Restrictions on activities as well as maintenance

Recall that in bankruptcy, there is a hierarchy to how remaining capital, collateral and other assets are distributed relative to tranches. However, in restructuring "everyone gets a haircut".

Also, when building credit ratings, there are various ratios that are looked at, particularly:

• Profitiability Ratios
• Liquidity Ratios (Short Term Solvency)
• Capitalization (Leverage) Ratios (Solvency)

[Operating] Working Capital - What's the Difference?

I was working with a buddy on a financial model recently and this came up as an issue. It's very confusing because Working Capital is defined by operating assets and liabilities (short term or current assets and liabilities) and it *seems* synonymous with Operating Working Capital, which it is not. First, the definitions:

Working Capital is defined as:
WC = CA - CL
CA - Current Assets
CL - Current Liabilities

However, when doing M&A or LBO's we aren't concerned with Working Capital as much as we are with Operating Working Capital. Why?

Cash and Short Term debt instruments are actually financing components and aren't actually included in Operating Working Capital (OWC). In an acquisition, the target firms capital structure is usually zeroed out (unless there is a debt roll over clause) and the capital structure used to purchase the company is plugged in (including good will, recognisable intangible assets etc).

So Operating Working capital has some adjustments:
OWC = CA - CL - Cash + Short Term Debt

It's the same idea as excess cash rather than cash in Enterprise Value.

Commitment - Restrictions for Improved Reward

Wow. What an oxymoron. We had briefly heard about this in game theory in Economics way back in Q1 and now it's coming up again in Q3 in finance.

First in game theory and dominant strategies. Look at the following example of the prisoner's dilemma:

So in the typical fashion, the dominant strategies for both players show that they will end up in the lower right corner with a return of 3 each. This is unfortunate, as there is a potential to get 5 each if they could only credibly commit to Strategy A each. But because of the conditions of the prisoner's dilemma, it's impossible.

To change the parameters of the game, what if it was possible for Player 1 and 2 to commit to impairing their own return matrix? For instance, what if Players 1 and 2 could reduce their returns in the cells AB and BA to 4 instead of 7 (as shown below)? Suddenly, the dominant strategy changes and the end game to a return of 5 each rather than 3.
We achieve a counter intuitive result. By placing restrictions on their own returns, both players can achieve a higher return.

In our finance class today, we talked about a different scenario with similar characteristics. First, an overly simplified example. Because equity holders are only liable for capital at risk (what money they put in), with the effects of leverage, they can increase their upside with a bottom of bankruptcy. This will encourage them to take on projects even if they have a stand-alone negative NPV (but a positive NPV with regards to the equity holder's return and relationship in bankruptcy - equity holders don't lose more money then they put in).

However, the debt holders will require a larger return on their debt to compensate them (make them whole) and offset the risk. This in turn can make projects unattractive and become prohibitive.
However, shareholders can introduce debt covenants in order to restrict the their own flexibility (preventing them from taking on too much risk and inflating their upside) to secure financing and ensure debt holders that they won't have to bear the dead weight loss of projects which fail.
Again, a counter intuitive result: You can do better by restricting your choices.

Looking at BCG's (In)Famous 2x2 Matrix with HHI

Today, we were talking about BCG's 2x2 Matrix (shown above) in our marketing class and our professor proposed to specifically define market share using a benchmark of the industry leader (or if the company was the market leader, the second place leader) as the line between High and Low Market Share. He acknowledged the primary shortcoming that using this definition, there can only be (by definition) one cash cow in the industry. He then introduced the idea of Coke and Pepsi with 52% and 48% relative marketshare (a slight exaggeration to prove a point) where they are both cash cows generating regular cash flows, but failing the definition: Pepsi would then be "dropped" as a project because of poor systematic definition. Or even if you use a given number (say x%) it doesn't account for the number of firms or size of firms.

In thinking about this, I also started to think about how we might be able to use the Herfindahl-Hirschman Index (HHI)to help correct for this problem. The current problem in the above standard proposed model is the definition of "market share" doesn't include competitiveness of the market (or lack thereof) when defining a cash cow. However, by definition the HHI looks at both the market share of the leaders as well as the effect on competitiveness from their relative size to each other.

Having said that, I would change "Market Share" in the horizontal axis to "Competitive Market Share" or mathematically:

Competitive Market Share = Competitive Market Capture / HHI

Where,

Competitive Market Capture = [% Market Share * 100]^2

Using this formula, we can tell that in the extremes, it works. For instance in a monopoly, Competitive Market Capture = HHI, so Competitive Market Share = 1.0 or 100%

In "perfect" competition (infinite number of firms with infinitesimal or marginal / trivial /zero market share), Competitive Market Capture = 0, Competitive Market Share = 0.0 or 0%.(Actually, to try to use "layman's" calculus terms, the Competitive Market Capture would be by definition a "smaller" zero than the HHI).

Also, because of the effect of squaring the market share (as is the case in HHI) we account for the effect of size in terms of competitiveness.

Having said that, the finance perspective is different then the marketing perspective. The only thing that really matters: Positive NPV.

Past Behaviour Predicting Future Performance

Often we've heard the phrase "Past behaviour is [not] a good predictor of future performance".

The above sentence includes the word [not] in finance, but excludes the word [not] when dealing with people (I think most psychologists would suggest). In short, history predicts people, but not companies or markets.

It kind of bothers me when I see maxims which are essentially identical in one case (individuals), but don't apply en mass (for groups). However, it reminds me of an interesting result I noticed relating to random motion.

If you have a dot in space, and you define it's movement as being "random", over time, the dot will essentially remain in the same spot (the expected value of random movement for one dot is zero change over time).

However, if you have multiple dots on a page, each who's movement is individually defined as "random", over time, you will actually experience diffusion. This is a bit counter intuitive as you would expect that since each individual's dot is random and because of the above result (where individual dots with random movement are expected not to stray to far from their original position) that individual dots won't move. If I'm not mistaken, the diffusion should actually take a normal distribution.

Latin America International Study Tour (LAIST) - Class Begins

Today, we had our first class for the Latin America International Study Tour (LAIST) with our professor Anil Verma. His style is certainly different from Walid, but you can tell straight away that it will be a unique experience of a different flavour (given we are also going to Latin America versus the Middle East). It suddenly occurs to me that the feel of the tour will greatly influenced by the professor who is running the tour (I'll have to confirm this hunch with people going on other tours: China, India and Europe).

We have four assignments to accomplish and I've taken advantage of my previous "experience" and have already found a partner to work with and a room mate.

Our first class was a good warm up getting us familiar with the major exports, businesses, history and cultural aspects in Brazil. We'll have plenty more work to do shortly as we will have a similar task as in the Middle East tour of researching the companies we will be going to visit.

We'll be having classes almost every week between now and when we leave. We are all excited already and talking about events and places we want to see.

Role Playing in Leadership

Yesterday, we were in our leadership discussing a case about an aggressive investment banker, "Rob Parson", who was being abbrasive but accomplishing the job by increasing the firms revenue and market share. However, the issue was his attitude and fit into the culture of his firm, Morgan Stanley.

Our professor asked two of us to role play, one to be the manager and one to be the banker. She asked the class: "Who can channel Rob Parson?" and there was a humming of my name in the class. A friend sitting next to me kept poking me to raise my hand up so I finally did. The professor looked over to me and asked me if I wanted to play the role of Rob, the investment banker, as long as I didn't use "inappropriate language" (even though that is what happened in the actual case).

My classmate, Sid, played the role of the manager and was sitting a few seats to my left. The chalk board was covered with notes from our discussion and we immediately began to draw down arguements in defending our positions:

"You don't fit into our culture, we want you to be more like us to work better with us."
"If you want me to be more like you, then you want a market share of 2%!"
"You don't treat people well and they don't want to work with you! I can't promote you!"
"The industry has expectations and we need to move faster! You need to decide if you want an investment banking division!"

By the end, our discussion got really heated and we lost ourselves in the moment as we really had at each other. The teacher halted the conversation and took over to show us what actually happened in the case: Rob walked out of the room.

Our classmates were generous with their applause, but it was an intense exercise. Sid and I shook hands over a great debating challenge where tempers rose and it was a lot of fun.