Downside-First Credit Underwriting
Underwrite the path to repayment before considering potential return.
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 5
- Confidence
- 94%
Downside-First Credit Underwriting begins with a defensive question: what specific mechanism will return the lender's principal at maturity? The analyst maps contractual obligations to cash flows, collateral, operating resilience, and structural protections before considering yield. The process then stress-tests the borrower against adverse conditions such as rising rates, slowing demand, higher input costs, and compressed margins. Inflation is evaluated at the company level by determining whether costs can be passed to customers or absorbed without undermining earnings and debt service. A credit qualifies only when repayment remains credible under realistic downside scenarios. This reverses the temptation to start with an attractive coupon and instead treats yield as compensation for risks that have been explicitly identified, measured, and mitigated.
Origin
Mark Jenkins developed a defensive orientation through bankruptcy investigations, credit analysis at Goldman Sachs, and more than three decades in global credit markets.
Core principles
- 01Prioritize return of capital before return on capital.
- 02Treat every loan as a contractual path to repayment.
- 03Evaluate operating resilience rather than relying on market forecasts.
- 04Test whether borrowers can absorb or pass through rising costs.
- 05Use structure, collateral, and cash flow to reduce downside risk.
How to run it
- 1
Define the repayment contract
Document the amount advanced, payment schedule, maturity, covenants, and exact sources expected to repay principal. Make the path from present cash generation to final repayment explicit.
Pro tip Summarize the repayment thesis in one sentence before reviewing the offered yield.
Watch out Do not treat refinancing as an assured source of repayment.
- 2
Map operating cash flows
Identify the business activities that generate debt-service cash and determine how stable they are across economic conditions. Separate recurring cash flow from temporary or accounting-driven earnings.
Pro tip Reconcile management's adjusted earnings with actual cash conversion.
Watch out Strong reported EBITDA can conceal weak cash generation.
- 3
Stress the microeconomics
Model the effects of higher rates, input inflation, weaker volumes, and margin compression on repayment capacity. Focus on the borrower's economics rather than making the loan depend on a broad macro forecast.
Pro tip Test several interacting stresses instead of changing only one variable.
Watch out A floating-rate asset protects the lender from duration risk but may increase the borrower's interest burden.
- 4
Test pricing power
Determine whether the borrower can pass higher costs to customers, absorb them operationally, or neither. Verify this using contracts, customer behavior, and historical margin performance.
Pro tip Look for evidence of completed price increases rather than management's stated intention to raise prices.
Watch out Assuming universal pricing power can materially overstate resilience.
- 5
Build downside protection
Evaluate collateral, seniority, covenants, excess coverage, and other structural cushions. Approve the credit only if these protections support a credible recovery or repayment outcome.
Pro tip Calculate both going-concern and liquidation recoveries.
Watch out Collateral may lose value precisely when the borrower defaults.
In the wild
A white-label staple-food provider experiences sharply higher ingredient costs. Rather than rejecting the loan solely because inflation is rising, the lender verifies that the company has successfully passed those costs to large distributors and reruns debt-service coverage using the new margins.
→ The lender distinguishes a resilient borrower with demonstrated pricing power from one whose margins would collapse under inflation.
A lender considers a floating-rate loan to a mature software company. The analyst benefits from lower duration exposure but also models whether higher base rates could push the borrower's interest coverage below covenant levels. The loan proceeds only after leverage is reduced and a minimum-liquidity covenant is added.
→ Rate protection for the lender is balanced against repayment pressure on the borrower.
Common mistakes
Starting with the yield
An attractive coupon can distract from an uncertain repayment path. Establish the downside case before deciding whether the return is adequate.
Using macro views as underwriting
A correct forecast does not guarantee that an individual borrower can survive. Translate inflation, rates, and growth assumptions into company-specific cash-flow effects.
Overvaluing collateral
Hard assets are not sufficient by themselves when their value depends on contracts, utilization, or distressed-market demand.
Is it for you?
Best for
It is best for credit analysts, private lenders, and portfolio managers evaluating loans through uncertain economic conditions.
Not ideal for
It is not ideal for early-stage equity investments whose value depends primarily on uncapped growth rather than contractual repayment.
From the transcript
“what you're looking to do is there's a contract between me and you, and I give you some money, and at the end of that…”
“I think the other thing that Goldman really taught me was how to mitigate risk and downside and really focus on the downside and a…”
“What we're trying to do is look at portfolios were that ability to pass on costs or absorb costs is greater than things that are…”
From the episode
Mark Jenkins on Leveraged Finance and Pension Plans
Mark Jenkins