By Mark Hergenroeder, Centrifuge Credit Group Facilitator
The Centrifuge Credit Group is a team of credit professionals that provides independent risk analysis on pools before they launch on Centrifuge. Our last blog post introduced the Credit Group, its members, and the vital purpose it serves for the Centrifuge ecosystem. In this post, we’ll explore the steps and methodologies that the Group performs as they analyze a pool.
Navigating the strengths and concerns of investing in real assets via credit can be complex.
The bespoke nature of many credit transactions warrants the need for industry specific expertise. For this reason, the Group provides quality credit analysis in a concise and digestible format for a wide range of audiences, with the aim to reduce information asymmetry.
Credit analysis highlights a range of quantitative and qualitative characteristics that affect an issuer’s ability to service its debt obligations. Identifying the key elements of risk in a transaction helps to inform the probability of default and loss on one’s principal. A healthy mix of optimism, pessimism and realism is important for most forms of investment analysis.
However, since the majority of return on lending comes from fixed interest payments with limited upside, protection from unexpected downside risk is paramount when looking for quality risk adjusted returns in credit markets.
The Group leverages its experience to develop pointed information requests not covered in the issuer’s data room. These questions identify the key legal projections in a transaction and help with understanding historical and projected drivers of both asset and cash flow performance. This tends to be a back and forth process involving multiple conversations with a particular issuer.
Risk factors that lenders focus on can vary significantly depending on the industry that the issuer operates in.
An aggressive leverage ratio for an issuer in one industry could be well below the average in others. The importance of an issuer’s market share may be emphasized more depending on the concentration of the market it operates in. Certain business models may be more exposed to regulatory risk than others. The volatility of underlying assets serving as collateral may be a crucial determinant of credit risk in one industry while, in others, it can be an ancillary consideration.
Moody’s alone has developed over 150 distinct credit rating methodologies that weight different quantitative and qualitative metrics specific to the issuer’s industry and asset class. This underscores the importance of having a diverse group of professionals in the Credit Group in order to effectively understand risk when reviewing new pools. These risk factors ultimately all relate back to the issuer's ability to service debt obligations.
A generic framework of risk metrics applicable to a wide range of credit transactions may include:
Structural Integrity ‒ ensuring the legal structure governing the transaction is sound and investors’ rights are adequately protected (e.g. triggers events for defaults, recourse, remedies, prepayment, and termination provisions)
Collateral Quality ‒ the type (e.g. industry, sector, region) and quality (e.g. historical and expected volatility of fair value, liquidity, default and recovery rates) of the underlying secured assets
Cash Flow Analysis ‒ evaluating the expected cash flows from the underlying assets and assessing their adequacy to meet debt service obligations, incorporating both micro and macro risk factors over varying projections periods
Stress Testing/Scenario Analysis ‒ applying extreme but plausible adverse changes to variables that affect cash flows or collateral value to understand principal recovery in potential worst-case scenarios
Tranche Structure/Cash Flow Waterfall ‒ priority of payments between different classes/tranches of debt
Counterparty Risk ‒ the risk that the counterparties involved in the transaction (e.g. admin agents, custodians, ancillary capital partners providers etc.) may not meet their contractual obligations
Currency/Token/Coin Risk ‒ if underlying assets are denominated in different currencies/tokens/coins, the risk of fluctuating exchange rates needs to be considered
Regulatory Environment ‒ the impact of current and potential future regulatory changes
Organization and Management ‒ assessing the quality and character of key decision makers involved in operating activities related to the transaction
Interpreting this information helps to inform what asset and interest coverage will be in downside scenarios — major considerations for lenders in search for quality yields. Summarizing this information in short form credit reviews will help users of the Centrifuge platform better assess strengths and concerns associated with a particular pool and will facilitate the growth of on-chain lending.
Learn more about the Credit Group — and the world of credit as a whole — with these resources below: