Downside Modeling in Loan Offerings

Introduction

What is Downside Modeling?

• The practice of projecting borrower financial performance
• Under stressed or adverse scenarios
• To assess credit risk, loan structure resilience, and potential recovery outcomes

Introduction

What is Downside Modeling?

• While base case projections reflect expected performance
• Downside cases examine how businesses and capital structures perform during:
• Revenue declines, margin compression, operational disruptions, or adverse market conditions

Purpose and Importance

Credit Risk Assessment:

• Downside cases reveal how borrowers perform during challenging periods
• Identifying whether businesses generate sufficient cash flow
• To service debt and maintain operations under stress

Purpose and Importance

Leverage Calibration:

• Stress scenarios determine appropriate maximum leverage levels
• Ensuring capital structures remain sustainable
• Even when performance deteriorates from base case expectations

Purpose and Importance

Covenant Setting:

• Understanding downside performance informs covenant level selection
• Ensuring financial covenants provide early warning of distress
• Without triggering unnecessary technical defaults during normal business volatility

Purpose and Importance

Recovery Analysis:

• Distressed scenarios enable estimation of potential recovery values
• Through asset liquidation, going-concern sales, or restructuring processes
• Informing loss-given-default assumptions

Purpose and Importance

Structural Protections:

• Downside analysis identifies necessary structural features
• Including security packages, amortization schedules
• Cash flow sweeps, or covenant triggers protecting lender interests during stress

Purpose and Importance

Borrower Confidence:

• Demonstrating capital structure resilience under stress cases
• Provides borrowers confidence that financing remains sustainable
• Across business cycles rather than only in optimistic scenarios

Downside Scenario Types

Moderate Downside:

• Scenarios modeling 10-15% revenue declines
• Or modest margin compression
• Representing typical recessionary impacts or competitive pressures affecting most businesses periodically

Downside Scenario Types

Severe Downside:

• More substantial stress with 20-30% revenue declines
• Significant margin deterioration, or major operational disruptions
• Representing severe recessions, industry crises, or company-specific challenges

Downside Scenario Types

Distressed Case:

• Extreme scenarios examining bankruptcy, liquidation, or restructuring outcomes
• To estimate ultimate recovery values
• For loss-given-default calculations

Downside Scenario Types

Operational Disruption:

• Scenarios modeling specific events such as customer loss, supplier failures
• Product recalls, regulatory actions
• Or other discrete adverse occurrences

Downside Scenario Types

Market-Specific Stress:

• Industry-tailored scenarios reflecting sector-specific risks
• Including commodity price collapses, regulatory changes
• Technological disruption, or competitive dynamics

Downside Scenario Types

Permanent Impairment:

• Cases assuming persistent rather than cyclical deterioration
• Modeling situations where business fundamentals erode permanently
• Through market share loss or structural industry decline

Revenue Stress Assumptions

Magnitude Selection:

• Moderate cases typically model 10-15% declines, severe cases 20-30%
• With specific percentages informed by historical volatility, industry cyclicality
• Customer concentration, and competitive dynamics

Revenue Stress Assumptions

Timing and Duration:

• Model whether declines occur suddenly (single quarter shock)
• Or gradually (deterioration over multiple quarters)
• And whether recovery begins after trough quarters or stress persists

Revenue Stress Assumptions

Recovery Trajectory:

• Assumptions about whether revenue recovers to pre-stress levels
• Recovers partially, or stabilizes at permanently lower levels
• Significantly impact long-term credit metrics and sustainability

Revenue Stress Assumptions

Customer Concentration:

• Businesses with concentrated customer bases
• Require scenarios modeling major customer loss
• Often assuming top one or two customers reduce or eliminate purchases

Revenue Stress Assumptions

Geographic or Product Mix:

• Consider whether stress affects all revenue streams uniformly
• Or impacts specific geographies, product lines
• Or customer segments disproportionately

Revenue Stress Assumptions

Competitive Dynamics:

• Model market share loss scenarios
• Where revenue declines exceed market contraction
• Due to competitive pressures, pricing deterioration, or product obsolescence

Margin and Cost Assumptions

Variable Cost Flexibility:

• Assess which costs truly flex with revenue (raw materials, commissions, shipping)
• Versus those remaining fixed
• Despite revenue declines (salaries, rent, insurance)

Margin and Cost Assumptions

Margin Compression:

• Model gross margin deterioration from pricing pressure
• Unfavorable product mix shifts, or input cost increases
• Typically assuming 100-300 basis points of margin erosion

Margin and Cost Assumptions

Fixed Cost Rigidity:

• Recognize that many costs remain fixed short-term despite revenue declines
• Causing EBITDA margins to compress more severely
• Than gross margins during downturns

Margin and Cost Assumptions

Cost Reduction Timing:

• Realistically model management's ability to reduce costs
• Recognizing that headcount reductions, facility closures
• Or contract renegotiations require multiple quarters to implement

Margin and Cost Assumptions

Restructuring Costs:

• Include one-time expenses associated with cost reduction initiatives
• Including severance, lease terminations, or facility closures
• That worsen near-term cash flow

Margin and Cost Assumptions

Operating Leverage:

• Industries with high fixed cost structures (manufacturing, airlines, hotels)
• Experience more severe EBITDA declines than revenue declines
• Requiring aggressive stress assumptions

Working Capital Dynamics

Receivables Collection:

• Stress scenarios often assume slower collections
• Extending days sales outstanding (DSO) by 10-15 days
• As customers delay payments during economic stress

Working Capital Dynamics

Inventory Challenges:

• Model scenarios where inventory turns slow due to demand weakness
• Creating cash consumption
• As companies maintain inventory levels while sales decline

Working Capital Dynamics

Payables Extension:

• Companies may extend days payables outstanding (DPO) during stress
• Providing temporary cash relief
• Though potentially damaging supplier relationships

Working Capital Dynamics

Cash Conversion Deterioration:

• Combined effects of slower collections, excess inventory
• And constrained payables extension
• Often create significant working capital cash drains during revenue declines

Working Capital Dynamics

Seasonal Amplification:

• For seasonal businesses, stress occurring during peak working capital build periods
• Creates compounded challenges
• Requiring larger liquidity resources

Working Capital Dynamics

Permanent Working Capital:

• Distinguish between temporary working capital increases reversing during recovery
• Versus permanent increases in working capital as percentage of revenue
• Requiring ongoing funding

Capital Expenditure Considerations

Maintenance Capex:

• Identify minimum capital expenditures required to maintain operations
• And prevent asset deterioration
• Recognizing this spending cannot be deferred indefinitely without operational consequences

Capital Expenditure Considerations

Growth Capex Elimination:

• Assume discretionary growth investments are eliminated during stress
• Though some contractual commitments or essential investments
• May require continuation

Capital Expenditure Considerations

Deferred Maintenance:

• Model potential for temporarily deferring even maintenance spending during acute stress
• Though recognizing this creates future catch-up requirements
• Or asset degradation

Capital Expenditure Considerations

Industry Requirements:

• Capital-intensive industries (manufacturing, transportation, energy)
• Have higher maintenance requirements
• Limiting capital expenditure flexibility compared to asset-light businesses

Capital Expenditure Considerations

Sale-Leaseback Options:

• Consider whether asset monetization through sale-leaseback transactions
• Provides liquidity alternatives
• During stress periods

Liquidity and Cash Flow Analysis

Free Cash Flow Calculation:

• Project cash from operations minus capital expenditures under stress scenarios
• Determining whether businesses remain cash flow positive
• Or consume cash during downturns

Liquidity and Cash Flow Analysis

Revolver Draws:

• Model when and how much borrowers draw on revolving credit facilities during stress
• Ensuring adequate availability exists
• When needed most

Liquidity and Cash Flow Analysis

Cash Burn Analysis:

• For scenarios where businesses turn cash flow negative
• Calculate quarterly and cumulative cash consumption
• To determine whether liquidity sources suffice

Liquidity and Cash Flow Analysis

Minimum Cash Requirements:

• Ensure projections maintain minimum operating cash balances
• For payroll, vendor payments, and daily operations
• Rather than assuming companies can operate at zero cash

Liquidity and Cash Flow Analysis

Cash Sources:

• Identify potential cash generation through working capital reduction
• Asset sales, expense deferrals
• Or other liquidity measures available during stress

Liquidity and Cash Flow Analysis

Liquidity Duration:

• Calculate how many quarters businesses can sustain operations under stress scenarios
• Before exhausting available liquidity
• From cash, revolver availability, and discretionary cash sources

Covenant Compliance Under Stress

Leverage Ratio Impacts:

• Model how stress scenarios affect leverage ratios
• Typically seeing denominator (EBITDA) decline significantly
• While numerator (debt) may increase through revolver draws

Covenant Compliance Under Stress

Coverage Ratio Pressure:

• Interest coverage ratios deteriorate from both lower EBITDA
• And potentially higher interest expense
• If stress triggers pricing step-ups or causes revolver draws at higher rates

Covenant Compliance Under Stress

Quarterly Phasing:

• Identify specific quarters where covenant breaches occur under stress scenarios
• Recognizing that quarterly testing
• Creates multiple potential failure points

Covenant Compliance Under Stress

Cushion Consumption:

• Calculate how stress scenarios consume covenant headroom
• Determining whether initial cushions prove adequate
• To absorb contemplated downside performance

Covenant Compliance Under Stress

Amendment Likelihood:

• Severe stress scenarios often result in covenant breaches
• Requiring amendments or waivers
• Informing pricing, structure, and lender approval requirements

Covenant Compliance Under Stress

Cure Provisions:

• Assess whether equity cure rights or other contractual mechanisms
• Enable borrowers to remedy covenant breaches
• Without formal amendments

Recovery Analysis

Going-Concern Value:

• Estimate enterprise values under stress scenarios
• Assuming businesses continue operating
• Using stressed EBITDA multiples (typically 30-50% below normalized multiples)

Recovery Analysis

Liquidation Analysis:

• Model orderly liquidation values for assets including:
• Accounts receivable (70-85% recovery), inventory (40-70%)
• Equipment (50-70%), and real estate (60-80% of appraised value)

Recovery Analysis

Time Value Considerations:

• Recognize that liquidations require time—often 6-18 months
• Creating interest accrual, professional fees, and operating losses
• That consume estate value

Recovery Analysis

Priority Waterfall:

• Calculate recovery percentages for each debt tranche
• Based on asset values, liquidation costs, priority claims
• And structural subordination through guarantor structures

Recovery Analysis

Structural Considerations:

• Assess how security packages, guarantees, and intercreditor agreements
• Affect recovery distributions
• Across first lien, second lien, and unsecured creditor classes

Recovery Analysis

Industry-Specific Factors:

• Certain industries (retail, restaurants) have minimal liquidation values
• While others (real estate, equipment-intensive manufacturing)
• Provide substantial asset backing

Stress Testing Best Practices

Multiple Scenarios:

• Develop 2-4 downside cases with varying severity
• Rather than single stress scenarios
• Providing range of outcomes and probability-weighted analysis

Stress Testing Best Practices

Informed Assumptions:

• Base stress assumptions on historical performance during prior downturns
• Industry cyclicality data, and company-specific vulnerabilities
• Rather than arbitrary percentages

Stress Testing Best Practices

Management Input:

• Engage management to understand which cost reductions are feasible
• What working capital flexibility exists
• And how they would respond to specific stress scenarios

Stress Testing Best Practices

Sensitivity Tables:

• Create tables showing covenant compliance and liquidity
• Across ranges of revenue decline percentages
• And margin compression scenarios

Stress Testing Best Practices

Quarterly Granularity:

• Model stress scenarios quarterly rather than annually
• To capture covenant testing points, seasonal effects
• And specific timing of liquidity consumption

Stress Testing Best Practices

Recovery Assumptions:

• Test sensitivity of recovery values to asset value assumptions
• Time to liquidation, and professional fees
• Recognizing significant uncertainty in distressed outcomes

Industry-Specific Considerations

Cyclical Industries:

• Manufacturing, construction, and commodities
• Require more severe stress scenarios reflecting historical volatility
• Modeling 30-40% peak-to-trough revenue declines

Industry-Specific Considerations

Defensive Industries:

• Healthcare, utilities, and consumer staples
• Warrant less severe scenarios (10-20% declines)
• Given historical resilience during recessions

Industry-Specific Considerations

Technology and Growth:

• High-growth technology companies require scenarios modeling both growth deceleration
• And potential rapid obsolescence
• From competitive or technological disruption

Industry-Specific Considerations

Retail and Consumer:

• Customer traffic-dependent businesses model scenarios including:
• E-commerce disruption, consumer spending retrenchment
• And rapid same-store sales deterioration

Industry-Specific Considerations

Energy and Commodities:

• Commodity price-driven businesses require scenarios
• Stressing underlying commodity prices
• With corresponding revenue and margin impacts

Industry-Specific Considerations

Sponsor-Backed:

• Private equity-owned companies may have sponsor support during stress
• Though models should not assume automatic equity contributions
• Without contractual commitments

Common Modeling Errors

Insufficient Severity:

• Overly optimistic stress scenarios that model modest declines
• Businesses could easily absorb
• Provide false confidence and fail to identify true vulnerabilities

Common Modeling Errors

Unrealistic Cost Cuts:

• Assuming immediate or excessive cost reductions
• Without considering contractual commitments, regulatory requirements
• Or practical implementation constraints

Common Modeling Errors

Working Capital Oversimplification:

• Modeling working capital as simple percentage of revenue
• Without considering collection timing, inventory turn dynamics
• Or payables management realities

Common Modeling Errors

Linear Assumptions:

• Applying uniform stress percentages across all revenue streams or cost categories
• Rather than considering differential impacts
• Across business units or products

Common Modeling Errors

Ignoring Timing:

• Failing to model quarterly phasing of stress onset, trough periods, and recovery
• Potentially missing critical liquidity
• Or covenant compliance points

Common Modeling Errors

Recovery Optimism:

• Overestimating asset liquidation values
• Underestimating liquidation costs and timeframes
• Or ignoring structural subordination in recovery analysis

Stress Scenario Documentation

Assumption Transparency:

• Clearly document all stress assumptions
• Including revenue declines, margin compression
• Cost reduction timing, and working capital impacts

Stress Scenario Documentation

Historical Context:

• Reference historical company performance, industry precedents
• Or comparable situations
• Supporting stress assumption reasonableness

Stress Scenario Documentation

Sensitivity Analysis:

• Include sensitivity tables varying key assumptions
• To demonstrate how outcome ranges change
• With different stress magnitudes

Stress Scenario Documentation

Management Response:

• Document assumed management actions during stress
• Including cost reductions, working capital improvements
• Capital expenditure deferrals, or asset sales

Stress Scenario Documentation

Comparison to Base:

• Present stress scenarios alongside base cases
• Clearly highlighting differences in assumptions, performance
• Covenant compliance, and liquidity

Stress Scenario Documentation

Recovery Methodologies:

• Explain asset valuation approaches, liquidation assumptions
• And priority waterfall calculations
• Supporting recovery estimates

Use in Credit Decisions

Leverage Determination:

• Downside analysis directly informs maximum leverage recommendations
• With sustainable leverage defined as levels maintaining adequate covenant headroom
• And positive cash flow under moderate stress

Use in Credit Decisions

Covenant Levels:

• Set financial covenant levels providing cushions
• Absorbing moderate stress without triggering breaches
• While severe stress scenarios justify covenant trip points

Use in Credit Decisions

Pricing Adjustments:

• Stress analysis revealing elevated risk under downside scenarios
• Justifies pricing adjustments through higher margins, floors, or fees
• Compensating for increased loss probability

Use in Credit Decisions

Structural Features:

• Downside vulnerability informs requirements for amortization, cash sweeps
• Additional security, guarantees
• Or other structural protections

Use in Credit Decisions

Approval Recommendations:

• Credit committees evaluate whether downside performance remains acceptable
• With unacceptable stress outcomes prompting deal decline
• Structure changes, or exposure reductions

Integration with Credit Memos

Scenario Presentation:

• Credit memoranda typically present base, moderate downside, and severe downside cases
• With clear labeling
• And assumption documentation

Integration with Credit Memos

Key Metrics Summary:

• Highlight critical metrics including minimum EBITDA, maximum leverage
• Trough liquidity
• And covenant compliance across scenarios

Integration with Credit Memos

Risk Identification:

• Use downside scenarios to identify key risks and vulnerabilities
• Explaining what conditions would lead to stress outcomes

Integration with Credit Memos

Mitigants and Protections:

• Connect downside findings to structural protections
• Demonstrating how covenant levels, amortization, or security features
• Address identified vulnerabilities

Integration with Credit Memos

Recovery Estimates:

• Present recovery analysis supporting loss-given-default assumptions
• Used in expected loss calculations
• And risk-adjusted return metrics

Borrower Perspective

Sustainability Assessment:

• Borrowers use downside modeling to ensure proposed leverage levels
• Remain manageable even during challenging periods
• Avoiding over-leveraging that creates distress risk

Borrower Perspective

Covenant Negotiation:

• Understanding stress performance informs covenant level negotiations
• Demonstrating why specific cushions or levels
• Are necessary

Borrower Perspective

Contingency Planning:

• Stress scenarios inform development of contingency plans
• Including cost reduction initiatives, working capital improvements
• Or refinancing strategies

Borrower Perspective

Communication Tool:

• Well-developed downside cases demonstrate sophisticated financial planning to lenders
• Potentially improving terms
• By evidencing risk awareness and mitigation planning

Borrower Perspective

Strategic Decision-Making:

• Downside analysis informs strategic decisions about timing of debt-financed acquisitions
• Dividend policies
• Or growth investments

Conclusion

• Downside modeling constitutes essential discipline in credit underwriting and portfolio management
• Moving beyond optimistic base cases
• To rigorously assess performance under adverse conditions that inevitably occur across business and credit cycles

Conclusion

• Effective stress testing requires realistic assumptions grounded in historical precedent
• Industry dynamics, and company-specific vulnerabilities
• Rather than arbitrary percentage declines

Conclusion

• The analysis directly informs critical credit decisions
• Including appropriate leverage levels, covenant structures, pricing
• And required structural protections

Conclusion

• For lenders, robust downside modeling enables informed risk-taking
• Ensuring credit exposures remain within acceptable loss parameters
• Even when performance deteriorates

Conclusion

• Success requires balancing sufficiently severe stress assumptions to identify genuine vulnerabilities
• Against unrealistically catastrophic scenarios that would never support any lending
• Creating resilient credit cultures protecting both lender and borrower interests