Credit Risk Management 101
The job isn’t winning the term sheet; it’s protecting principal and keeping cash flowing. This primer covers covenant design, early-warning indicators, defaults & recoveries, and practical monitoring playbooks you can actually run.
← Back to GuidesRisk Management Overview
Credit risk management is the discipline of preventing loss and maximizing recoveries. It starts at underwriting but lives in monitoring and action: codify expectations in documents, track reality, escalate quickly, and negotiate from leverage.
Covenant Design
- Financial covenants: leverage, interest coverage, FCCR; sensible cushions and step-downs.
- Negative covenants: debt baskets, liens, RPs, investments, asset sales, prepayments.
- Builder baskets: calibrated to FCF; tight definitions to avoid leakage.
- Definitions matter: EBITDA, capex, extraordinary items; MFN and portability guardrails.
- Information rights: monthly/quarterly KPI packs, auditor letters, board/observer rights.
Early-Warning Indicators
- P&L/CF: margin compression, negative mix, cash burn, SBC creep replacing cash comp.
- Working capital: AR aging stretch, inventory weeks rising, AP past due, cash traps.
- Operational: customer churn, backlog slippage, quality issues, key-person risk.
- Covenant headroom: shrinking cushions vs plan; recurring “one-time” add-backs.
- Sponsor behavior: delayed reporting, aggressive add-backs, reluctance to fund DDAs.
Defaults & Recoveries
- Default triggers: payment, covenant, cross-default, MAC, reporting failures.
- Recovery levers: collateral enforcement, equity cures, pay-to-play waivers, DIP options.
- Negotiation posture: milestone-based forbearance; give-gets tied to liquidity and KPIs.
- Waterfall modeling: breakpoints for first/second liens; sensitivity to sale proceeds.
Aim for going-concern outcomes; liquidation is usually worst economics.
Monitoring Playbooks
- Baseline: quarterly compliance certificates, KPI dashboards, variance-to-plan analysis.
- Yellow flag: tighten reporting cadence, add 13-week cash flow, covenant reset planning.
- Orange flag: independent business review, advisor engagement, liquidity bridge, amendment terms.
- Red flag: standstill/forbearance, collateral actions, interim funding with priming protections.
Reporting & Governance
- Cadence: monthly ops packs; quarterly board-level risk reviews.
- Heatmaps: traffic-light borrowers by leverage, coverage, ratings drift, covenant runway.
- Escalation: define thresholds for IC notification and amendment authorization.
- Documentation: decision logs; amendment/waiver history with rationale.
Tools & Automation
- Certificate ingestion: auto-parse covenants, compute headroom, attach source docs.
- Alerting: threshold-based notifications on KPIs, covenants, and liquidity drift.
- Portfolio view: roll-ups by sector, sponsor, risk band, and ratings drift.
- Workflow: ticketing for amendments/waivers with checklists and approvals.
Yes, this is exactly where your Orion modules shine.
Common Mistakes
- Loose definitions that gut covenants over time.
- Ignoring working-capital signals until cash is gone.
- Underestimating sponsor incentives and timing pressure.
- Reporting that tracks too little, too slowly.
- Negotiating amendments without hard milestones and give-gets.
Conclusion
Credit risk management is repeatable process, not art. Codify expectations, measure reality, escalate early, and negotiate from strength. Build the playbooks before you need them.