Understanding the connection between business and structural risks is one of the keys to successful credit investing. “Good company, bad balance sheet” is how opportunistic credit managers describe troubled but attractive situations in which to invest. It’s helpful to examine these transactions for clues as to how the borrower got a bad balance sheet to begin with.

Determining the appropriate amount of debt or leverage to put on the company is a good place to start. This is based on a number of factors, some obvious, some less so. How much cash flow will the business throw off under a variety of stressed “hypos”? Can it afford to pay interest and principal in a downside scenario? Underwriters often look at portfolio companies in similar sectors for insights into new transactions.

Sponsors always have a plan to grow their businesses. Is that plan fully supported by whatever financing structure (e.g. delayed draw term loan) is being proposed? Particularly crucial in the current environment is what are the rate and capex assumptions, and the resulting debt service ratios?