The following was excerpted from Third Eye Capital
Management Inc.'s Q1 2012 Investor Letter.
"I Promise to Pay…"
It is no surprise that the word "promise" features prominently
within loan documentation. A borrower's willingness and intent to
repay a loan is just as important as his ability, and perhaps more
so when conditions become stressful. Cash flows and the value of
good collateral can decline during an economic slowdown, but the
character of good managers always stays constant. A company's
success may be attributed to its products, technology, or market
strategy, but it is ultimately the people that run the company and
make the key decisions that determine its future. The character of
a borrower's management team has great significance in our credit
Assessing and measuring character requires
judgment and experience. Prior to the Industrial Revolution,
lenders and borrowers were intimately familiar with one another and
staked their personal relationships, not just their business
motives, behind the credit decision. Today, in an environment when
loans are still made to be sold, and transactions are sourced in
large volumes from around the world, lenders are challenged in
making character determinations. This is further exacerbated inside
a troubled company, where management is reluctance to communicate
due to fear and denial.
We assess management character by examining two
components: competency and integrity. Competency is checked through
independent verifications of education, career experience,
historical business performance, any criminal convictions and civil
litigation, and personal credit scores. Any inconsistency between
our checks and management representations are flagged for further
investigation. Personal credit scores are an especially useful
indicator because they demonstrate management's attitude toward
debt repayment. Our experience shows that credit information for
management of a company explains a significant amount of variation
in the performance of that company's credit.
Indicators of management integrity are less
easily observed and can take significant time to accumulate.
However, the manner in which management communicates information
provides important clues into their integrity. Examples include
pattern of delays in information reporting, reluctance to provide
disclosure, failure to provide specific and complete answers to
questions, providing evasive information or being excessively
defensive, destroying key documents, and overly complex
transactions in the circumstances. We not only need to be able to
understand the information we receive from management but should be
able to trust it. Consistently failing to meet projections is a
quick way to lose our trust. While companies cannot be expected to
see into the future, flawed assumptions and unrealistic targets put
management integrity into question.
We tend to avoid situations where company
leaders have excessive control over the dissemination of
information and there is fear (along with high turnover) among
finance and accounting staff. Another red flag is if management has
less to lose than we do, in relative terms, from a company failure.
Any deception, misrepresentation, or lie is a clear and strong
warning signal, and usually results in a permanent fracture of our
relationship with management. In an ideal world, we can make
accurate assessments of management character at the onset of a
loan; however, more often, as unexpected crisis occur, or as a
company and industry evolve, management's true competence and
integrity gets revealed.
Too many warning signs are an indication of
distress. In such circumstances, many lenders simply
revise the loan covenants. However, if management character is
flawed, then loan covenants, no matter how often they are revised,
will inevitably be breached. Liquidation is the only viable
solution when management's "promise" no longer holds meaning.
Third Eye Capital Management Inc.