Public Credit (IG & HY) Case Study Interview

Good questions. Let me try to address

1) Yes companies generally draw on their revolver to finance seasonal working capital outflows and repay the facility when those amounts are unwound later in the year. Given an hour available for analysis, I would not really prioritize the revolver other than noting what current availability is and whether you think they'll draw over the next 12 months. When I think of a bad capital structure, I think of a business with high fixed costs that has found itself with a lot of debt and other fixed charges whether interest, capex, or both. What happens there is the negative operating leverage turns a 5-10% decline in top-line to a 30-40% EBITDA hit. 

2) Agreed. If you want extra credit you can supplement your traditional credit ratios with things like Debt / EBITDA - Capex, EBITDA - Capex / Interest, and I think UFCF % of Debt and LFCF % of Debt are underrated metrics that should be discussed more often. Companies with EBITDA - Capex / Interest ratios of 1x or less (or approaching) are zombies because they cannot cover interest expense while adequately reinvesting capital into the business which in turn prevents EBITDA from growing, so on so forth.

3) Using public comps is fine, and you can also use the historical multiples your company has generally traded at. For a quick and dirty, I like to look at 3 to 5 year averages and their standard deviation and see what happens at the mean, -1 SD and -2 SD movements. A quick way to check if your valuation is sane is to tie your output to another valuation method and see if it makes sense. For example, you might use 10x EBITDA to arrive at your enterprise value, but if you then take your estimate for unlevered free cash flow and check against that same enterprise value maybe your valuation is implying a 5% unlevered FCF yield when the company has generally been a 10% unlevered FCF yield business, in which case your EBITDA multiple estimate probably needs to come down. This works vise versa and with all sorts of different approaches. I like it because it keeps me honest and considers multiple different aspects of the business such as cash flow conversion. I think for a 1 hour case study you should just keep in mind what minimum valuation is needed before value breaks at your debt and try to think about what assumptions are required to get there...multiple needs to contract by 50% and that would be a -2 SD move vs. historical, margins need to contract by x% or top-line needs to decline by y%. Something like that, but I don't think you'll have sufficient time to really flesh that out but it should be perfectly fine for the debrief conversation. 

4) Good question, lets try to unpack it. There are a couple ways to think about relative value, but as a starting point its important to separate credit risk from the offered yield by the market. Think about the business risk (FCF going up or down, broadly speaking), refinancing risk (can they refinance maturities as they come due), and restructuring risk (does this capital structure need to restructure, and if so am I covered or not). All of those functions feed into credit risk which can simply be thought of as are you getting par + accrued back. As I mentioned, you want to make sure you are being paid for credit risk, not equity risk. So thats the first thing you should think of when assessing the yield on the credit. For reference, the HY index is yielding 8.5% right now. To your point on comps, yes people generally compare credit yields and ratios of one issuer versus a universe of comparables. You can look at things like gross and net leverage, EBITDA margins, interest coverage ratios, and UFCF/LFCF ratios to get a quick sense for the relative balance sheet health of each. You can also look at things like gross and net LTVs, and another way people try to "fit" comparables is by looking things like Spread per Turn - i.e., how much spread per turn of leverage does the credit offer you. So you generally look for things that suggest you get "paid better" in terms of yield or spread for one issuer versus the comp universe based on the strength of their credit ratios relative to peers. Considering different coupons and maturities turns into a more technical discussion and means we need to think about duration and convexity - i.e., sensitivity to rates - and frankly I think that will be beyond the scope of your discussion at this point. But for a quick and dirty, bonds and loans with low coupons and longer maturities will be more sensitive to rates. A bond with a 5% coupon and 10 year maturity trading at par will decline 7 points with a 100bps increase in rates (whether its the fed or the credit spread on the bond), whereas a bond with a 10% coupon and 5 year maturity trading at par will only decline 4 points with the same rate movement. This is why Google 2% Bonds due 2050 that were issued in August of 2020 trade at 63 cents now, even though Google is a perfectly fine credit. This aspect of credit is really more applicable to investment grade issuers, not high yield, but the dynamic does exist there. In general the shorter your duration is the more insulated you are from rate risk and the focus can be on credit risk, which I personally prefer. 

Hope that was helpful.