The red flags investors should look for in private lending

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a partner at Silver Point Capital and author of ‘The Credit Investor’s Handbook’

Credit markets have been hit by a series of high-profile blow‑ups in the past three months. The episodes prompted Jamie Dimon, the chief executive of JPMorgan, to warn of “cockroaches” lurking in the financial system, pointing to the private credit market in particular.

This has led many investors to question how safe the asset class really is. Yet when appropriately executed, senior secured lending in private markets remains a compelling asset class, offering attractive risk-adjusted returns with collateral providing meaningful downside protection.

The challenge is that we may be late in the credit cycle, with a flood of new capital entering the private market. In this environment, investors should be far more selective about which deals they back. The central question is how to avoid the next disaster akin to the recent collapse of US auto parts group First Brands and Texas subprime auto lender Tricolor.

As I argued in my book, The Credit Investor’s Handbookthe answer lies in systematically identifying “red flags” in a borrower’s financial statements and then pursuing rigorous, sceptical due diligence.

Financial statement analysis has become something of a lost art in today’s era of rapid capital deployment in the credit markets. A red flag does not automatically disqualify an investment, but, for a top-tier manager, it should trigger rigorous due diligence and uncomfortable questions that demand clear answers from the company. The objective is straightforward: either satisfy yourself that the concerns are manageable or walk away. There are numerous practical warning signs, but here are a few that vigilant investors should look out for:

• A material increase in “receivable days” — the time it takes for a company to collect cash from its customers — can be a major red flag. It may indicate that the company is inflating reported sales through tactics such as “dealer dumping”, where excess inventory is pushed on to distributors regardless of actual end-market demand.

• A declining order backlog is a clear warning that current reported sales growth may be unsustainable or misleading.

• Significant fluctuations in foreign exchange rates can distort financial performance. This can make multinationals appear to be growing when the business could actually be shrinking if its performance was assessed using a constant currency rate over a period.

• Aggressive serial acquisitions can be used to mask underlying deterioration in the organic core business.

• Inventory mismanagement can also hide weakness. A manufacturer might overstate profits by overproducing inventory to artificially reduce per-unit costs, quietly building dangerous stockpiles in the process. Investors should closely monitor “inventory days” to ensure production remains aligned with demand.

• A reduction of certain operating expenses can be another warning sign. Management teams under pressure to hit short‑term targets can cut research and development or advertising to manage near‑term earnings. They can also intentionally understate bad debt expense or improperly capitalise routine operating expenses.

Not every anomaly is fraudulent, but red flags are identifiable, provided investors are actually looking for them.

Beyond the financial statements themselves, there are qualitative and structural warning signs. First Brands is a textbook example. Apart from questions over its debt and acquisition-fuelled growth, the company’s founder Patrick James had a documented history of two legal battles over fraud allegations, including a 2009 lawsuit that claimed he inflated accounts receivable and inventory figures. James has denied the allegations in the two cases, which were both ultimately dismissed after settlements were reached.

First Brands also used special-purpose vehicles to keep debt off its balance sheet — a tactic used by Enron that should have set off alarm bells — and relied heavily on a form of financing known as reverse‑factoring where lenders accelerate payments to a company’s suppliers and recoup the money later. These arrangements may have obscured the true extent of its leverage. Any one of these features warranted serious scrutiny.

The lesson from First Brands and the other recent failures is that discipline is key to successful credit investing. In an asset class that has grown by seven times since 2008 to about $1.7tn and is growing rapidly, the pressure to put money to work can overwhelm the patience required for proper analysis.

The tools for spotting problematic credits have not changed: read the financial statements closely; interrogate the business model and capital structure; investigate the backgrounds of key executives and never allow the lure of double‑digit yields to override healthy scepticism.

Ed Mule, my mentor and the co‑founder of Silver Point Capital, frequently reminds our team that the best way to become a great credit investor is to conduct postmortems on deals that went wrong. First Brands offers precisely that kind of case study — a reminder that the most expensive lesson is the one you refuse to learn.

This article solely reflects the personal opinions of the author, not Silver Point Capital