Opening Credit

A practitioner's guide to credit investment

Justin McGowan, Duncan Sankey

• Publisher: Harriman House
• Year: 2015
• eBook ISBN: 9780857194688
• Edition: 1

As a result of prevailing monetary conditions since the global financial crisis, the world has witnessed unprecedented growth in global corporate credit markets. Yet, despite the trillions of dollars put to work in the debt capital markets, corporate credit is still an unfamiliar concept to most investors compared to other asset classes, such as equities and commodities. Every red-top newspaper and 24-hour news service is happy to report the latest twitch in the Dow, FTSE or Stoxx indices but momentous moves in the iBoxx or iTraxx go unmentioned. And whereas many a talking head is happy to pose as an equity analyst, few feel comfortable venturing into the arcana of credit. Yet the corporate credit market, as the authors of this new book show, is both materially larger than its equity peer and has shown more attractive risk/ reward characteristics over the last 90-odd years.In Opening Credit, career credit professionals, Justin McGowan and Duncan Sankey, aim to redress this by drawing on their more than 50 years' collective experience in the field to elucidate a practitioner's approach to corporate credit investment. Whilst explaining the basics of traditional credit analysis and affirming its value, McGowan and Sankey also caution against its shortcomings. They demonstrate the need both to penetrate the veil of accounting to get to the economic reality behind the annuals and interim numbers and to analyse the individuals that drive them - the key executives and board members. They employ a range of cogent and easy-to-follow case studies to illustrate the value of their executive- and governance-led approach, which places management front and centre in understanding corporate credit. Opening Credit will appeal to all those seeking a better understanding of corporate credit, including analysts looking to develop their skills, fund managers (especially those with an eye to SRI), bankers, IFAs, financial journalists, academics and students of finance.

1. Management and Governance: A Qualitative Overlay to Investment Decisions

Introduction

Why does all this matter?

In this chapter we hope to address the more qualitative area of our approach to analysis, corporate governance, and the examination of overlapping groups within corporate executive and non-executive teams. We give examples of how this approach can be a valuable tool in assessing the likely actions of management teams – actions which can, in our view, be the deciding factor in the long-term credit standing of the corporation concerned. We explore the nature of a corporation and the blurring of its identity with that of those who run it. We argue that the actions of these individuals can be more important in determining the trajectory of a corporation’s credit standing than those of its owners.

We also examine a range of ownership structures with the aim of ascertaining whether one form or another is better aligned to the interests of the credit investor. We look at the response of regulators to the more egregious abuses of agency that have come to light in the past two decades and examine their effectiveness to date. We then tie these themes together from a credit perspective and give four case studies from corporate life that illustrate some of the more important aspects.

From the outset our perspective is that a grasp of these interconnected factors is the key to understanding credit transition early – which is where the investor will make or avoid losing money – yet this more narrative-based, qualitative side of credit assessment is often demoted to a distant second place by mathematical modelling and number-crunching, methods far better at inspiring confidence in investment committees. This is a serious omission. How meaningful can a numerical projection be if it is not viewed from a perspective that is also informed by management’s motivations?

1. The nature of the corporation

“Neither bodies to be punished nor souls to be condemned”7

Consider the following headlines:

‘Adidas seeks criminal probe into Reebok India irregularities’

‘J.P. Morgan and taking responsibility’

‘Centrica warns of higher gas costs’

‘Eurostar eyes expansion across Europe’

‘3i set to appoint ex-City banker as chief’

Do you notice anything? In each of these headlines, one could substitute the company’s name with that of a human being without compromising meaning:

‘Inspector Morse seeks criminal probe into Reebok India irregularities’

‘William Murdoch warns of higher gas costs’

‘George Osborne set to appoint ex-City banker as chief’

We are accustomed to talking and thinking of corporations as people. For example, beverages multinational Diageo, in the ‘Sustainability and Responsibility’ section of its website, states that it is “[a]cting with integrity in everything we do”8– something to which most individuals would aspire. US auto behemoth Ford “has supported thousands of programs that strengthen communities and improve quality of life” and in 2012/13 gave $30m to US-based nonprofit organisations.9 Just like an individual giving money to United Way or working for his or her local Rotary Club; indeed, “Ford believe commitment to community is an important part of who and what we are.”10 (Note the use of the pronoun “we”.)

But who or what are they? Do these corporations have a right to make assertions that could plausibly come from a human individual?

A fundamental ambiguity

Companies do bear some similarities to people in the manner in which they operate in the legal and economic sphere. Individuals pay taxes; so (for the most part) do corporations. Individuals can enter into contracts (including credit contracts) and end up before the court if they renege on them; so can corporations. Individuals can own and trade in property; so can corporations. Individuals may commit manslaughter and murder; so, in some jurisdictions, may corporations be charged with crimes of corporate manslaughter or homicide although, in reality, convictions under such legislation are few and far between.11 Individuals in most liberal democracies can express political views through campaign contributions to political parties; indeed, in many societies, such a right is held inalienable and enshrined in constitutional law. And, in the US at least, following the US Supreme Court’s ruling in 2010 in the case of Citizens United vs. Federal Election Commission, corporations can do the same through contributions to “electioneering communications”.12

Can it be right to think of corporations as persons? In a word, no. The sine qua non of personhood is sentience and, with a few basic tests, we can dismiss the idea that a corporation is a sentient agent. Can a corporation feel? No. Can it perceive? No. Is it conscious? No. Does it experience subjective conscious experiences? Again, no. To cite Ben Cohen and Jerry Greenfield of the eponymous ice cream: “I’m Ben, I’m a person. I’m Jerry, I’m a person. Ben & Jerry’s Ice Cream? Not a person.”13

The relationship between senior management and corporate identity

But go back to the beginning of this chapter. If, as a corporation, J.P. Morgan lacks intentionality, how can it take responsibility? How can 3i make any appointments? How can Adidas seek a criminal probe or Centrica warn about anything?

Herein lies the true nature of corporate personhood. The corporation itself has no intentionality but the individuals who run it – the senior-most executives frequently identified as the ‘C-suite’ (chief executive officer, chief financial officer, chief operating officer) and, to a limited extent, the corporation’s board of directors (more about them later) most definitely do.

It is these individuals who steer the company’s strategic direction. They commit resources to expand in some areas, while withdrawing them to contract in others they deem less profitable. They decide what markets to be active in and where to locate facilities. They hire their immediate reports, determine their remuneration and establish their performance criteria; in so doing, they determine the working environment and set the ethical tone of the organisation, since their appointees will, most likely, share some of the values of management (which presumably attracted them to this employer as opposed to another) and will, in turn, hire and set performance criteria which enable them to meet the goals set for them by the C-suite, and so on down the chain. The C-suite will also hire lobbyists to persuade politicians (or, as we have seen in some cases, do a bit of persuasion themselves). They forge, or at least approve, the company’s standard operating practices. Of particular interest to credit investors, they decide the company’s policies on capital allocation and funding, its appetite for leverage, its willingness to engage in mergers and acquisitions, and its generosity towards shareholders.

Good credit analysis examines the C-suite

These individuals make or approve all the decisions that affect a corporation and its interaction with all other stakeholders. Thus, when we analyse corporations as credit investor...

Table of contents

• Contents
• About the Authors
• Preface
• Introduction
• 1. Management and Governance: A Qualitative Overlay to Investment Decisions
• 2. Management and Governance: Case Studies
• 3. Traditional Credit Analysis: A Necessary Skill Set
• 4. How Managements Present Reality
• 5. Behind the Numbers: Adjusted Debt and Liquidity
• 6. How Non-Credit Factors Drive Credit
• 7. How Market Considerations Affect Credit
• Concluding Thoughts
• Publishing details