Four Ways to Spot Cockroaches

JP Morgan's Jamie Dimon warning about “cockroaches” in private credit wasn’t a comment on the industry's hygiene. Rather, it was a potent image of one visible problem usually pointing to many more hidden ones, potentially spooking investors attracted to the asset class. However, the problems with First Brands were not inevitable and here are four of the key safeguards that could have caught them earlier. 

We approach this as middle-market lenders working primarily with sponsored companies. First Brands was not even a private credit borrower as much of its debt was issued via the bank syndication channel. However, the principles around earnings quality, covenants, governance and structural transparency apply right across private credit lending.

1. The risks of founder-owned businesses

First Brands was a founder-owned business that pursued aggressive debt-funded growth without the governance structures that typically come with sponsor backing such as that from responsible private equity owner. Here’s why:

• Aligned incentives: Sponsors have significant equity capital at risk and reputational considerations that discourage aggressive accounting or structural complexity
• Governance oversight: Professional board oversight and regular reporting requirements translate into better transparency
• Track record: Established sponsors have relationships they want to maintain with lenders for future transactions

2. Earnings quality matters

The quality of EBITDA can vary dramatically, and First Brands exemplifies the risks of inadequately scrutinised earnings adjustments. Reports indicate the company's EBITDA was historically heavily adjusted with significant cost savings and synergies related to acquisitions. Perhaps more concerning, First Brands allegedly allocated significant costs of factoring arrangements as interest expense rather than operating expenses, thereby overstating operating margins by approximately 300-400 basis points.

Rigorous earnings quality assessment must include:

• Independent verification: Comprehensive quality of earnings (QoE) studies performed by independent accounting firms, alongside third-party market reports and customer/vendor diligence
• Sponsor collaboration: Working with established sponsors means benefiting from their diligence work, including detailed QoE analyses that have become standard practice in sponsor-backed transactions
• Risk acceptance criteria: Explicit guardrails around the types and levels of acceptable EBITDA adjustments, ensuring that underwriting is based on sustainable, cash-generative earnings

3. Covenant-lite documentation eliminates critical early warning systems

First Brands' debt was structured as covenant-lite, meaning it lacked financial maintenance covenants that would have required the company to maintain minimum financial performance thresholds. This structure, common in the broadly syndicated loan market, meant lenders had no contractual trigger to intervene as the company's financial condition deteriorated. By the time the problems became apparent, the situation had progressed from manageable stress to catastrophic failure.

Covenant-lite structures only provide incurrence covenants (restrictions tested only when the company takes specific actions like incurring additional debt or making acquisitions). They do not provide ongoing monitoring of financial health. In First Brands' case, this meant lenders had no formal mechanism to:

• Detect deterioration early: Without quarterly or monthly testing of leverage or coverage ratios, warning signs went unaddressed
• Engage proactively: Maintenance covenants create natural touchpoints for lender-borrower dialogue before problems escalate
• Negotiate amendments: Covenant discussions often lead to operational improvements, additional reporting, or structural modifications that can prevent defaults

Best practice requires at least one financial maintenance covenant in every transaction:

• Ongoing performance monitoring: Financial maintenance covenants (typically including maximum total leverage ratios and minimum interest coverage or fixed charge coverage ratios) are tested quarterly, providing regular checkpoints on business performance
• Early intervention rights: When a company approaches covenant levels, it creates an opportunity for constructive dialogue with management and sponsors to address issues before they become critical
• Negotiating leverage: Covenant discussions give lenders the ability to require additional equity contributions, operational changes, restrictions on distributions, or enhanced reporting to stabilise the situation
• Alignment with sponsors: Maintenance covenants ensure sponsors remain engaged and incentivised to support portfolio companies through challenging periods rather than walking away

The difference between covenant-lite and covenant-heavy documentation became starkly apparent in First Brands: lenders had their debt marked in the 90s at 30 June, only to see it collapse to the 30s by 30 September. With proper maintenance covenants, deteriorating leverage ratios or coverage metrics would have triggered lender engagement months earlier, potentially preventing or mitigating the ultimate outcome.

4. Documentation and structural controls are your first line of defence

Perhaps the most alarming aspect of First Brands was the structural complexity that obscured the true financial picture. The company financed operations through multiple mechanisms that were opaque and not visible to all lenders: accounts receivable factoring (both third-party and reverse factoring), debt in bankruptcy-remote Special Purpose Vehicles (SPVs) secured by raw materials and inventory, and various other off-balance-sheet arrangements totalling US$2.3 billion. Collateral tracking and disclosure were clearly inadequate, leading to commingling and potential double-pledging of assets. This house of cards could not withstand market volatility from tariff impacts.

Lenders need to structure transactions with robust protections:

• Comprehensive documentation: Loan agreements should include detailed reporting requirements, covenant packages (including financial maintenance covenants), and restrictions on additional indebtedness and off-balance-sheet financing
• Collateral controls: Rigorous collateral monitoring, including field examinations and third-party appraisals, with clear perfection of security interests
• Structural simplicity: Avoid unnecessarily complex structures and maintain transparency across the capital structure, ensuring full understanding of all sources of financing and potential claims on assets
• Ongoing monitoring: Regular financial reporting, compliance certificates, and direct communication with management and sponsors allow early identification of issues

You don't spot cockroaches by waiting for them to scurry across the kitchen floor; you look in dark corners, check for telltale signs, and inspect regularly. First Brands' collapse revealed that too many lenders were doing the equivalent of admiring the gleaming countertops whilst ignoring what was happening behind the walls.

Authors: Putri Pascualy, Client Portfolio Manager for private credit at Man Group, Matt Giller, Managing Director, Direct Lending at Man Group and Andrew Kurtz, Vice President, Direct Lending at Man Group.

Bill Gates hasn’t backed down on climate, he’s widened the frame

Bill Gates chose an interesting time to release a note detailing his latest views on climate change. It comes on the eve of COP30, the annual event that brings together world leaders and scientists to discuss and negotiate climate action, held in Brazil’s Amazon and on the 10-year anniversary of the Paris Accord negotiated at COP21. Gates lays out his Three tough truths about climate change:

1. Climate change is a serious problem, but it will not be the end of civilization
2. Temperature is not the best way to measure our progress on climate
3. Health and prosperity are the best defence against climate change

It didn’t go down well with the climate advocacy world to have one of their main champions seemingly  “quiet quitting” on the cause. However, while some see this as retreat, for investors it represents an expansion of the climate investment thesis. Climate action isn't just about temperature reduction but about innovation in hard-to-abate sectors and building resilience in vulnerable populations.

Gates correctly points out that we have made tremendous progress on climate change in the last 10 years and while the earth is currently hotter than the Paris Accord goal, life will go on. We have reduced projected emissions by 40% since 2015 and have shaved 1.3°C off temperature projections

Figure 1. We have made progress on projected greenhouse gas emissions

Source: International Energy Agency World Energy Outlook 2014 and 2024, as at 11 November 2014 and 16 October 2024.

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Electric vehicle sales have increased tenfold over the last decade and now account for over 20% of global sales. Technological improvements have dramatically reduced solar, wind and battery costs and they are now cost competitive with fossil fuels.

While technological innovation has eliminated those green premiums (the cost difference between clean and dirty ways of doing something), Gates correctly argues that more innovation is needed in the hard-to-abate sectors – particularly construction materials (steel, cement, chemicals) and transport (marine, aviation).

The emergence of China as a clean energy force

Capital flows clearly support this thesis (Figure 2). Clean energy investments have increased dramatically while those in fossil fuels have either declined (US, China, SE Asia) or increased moderately (EU, India). China is clearly leading the way, both in terms of total capital invested and growth over the last five years.

Figure 2. China is now leading the way

Source: International Energy Agency as of 31 December 2024.

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Investors have started to take note. Despite the political headwinds in the US, the Clean Energy ETF (ICLN), a global basket of clean energy stocks, is up 52.5% this year (as of 5 Nov), well ahead of the broad markets.

Investment implications

Besides reducing the Green Premium in hard-to-abate sectors, Gates urges investors to focus on adaptation (A/C, drought-resistant seeds…) for the inevitably hotter world. This is particularly urgent for the most vulnerable populations to increase their health and prosperity (Truth 3). Evidence from the University of Chicago’s Climate Impact Lab says that deaths from climate change can fall by more than 50% if we account for unexpected growth of low-income countries.

While some see Gates' note as throwing in the towel on climate, he's asking a different question. Not whether we'll hit Paris targets, but whether we're building the resilience and prosperity needed to thrive through the transition¹.

All data sourced from Bloomberg unless otherwise stated.

Author: Rob Furdak, Chief Investment Officer for Responsible Investment at Man Group.

¹ From Bill Gates - Three tough truths about climate.

This inequity is the reason our climate strategies need to prioritize human welfare. This may seem obvious - who could be against improving people’s lives? - but sometimes human welfare takes a backseat to lowering emissions, with bad consequences.

For example, a few years ago, the government of one low-income country set out to cut emissions by banning synthetic fertilizers. Farmers’ yields plummeted, there was much less food available, and prices skyrocketed. The country was hit by a crisis because the government valued reducing emissions above other important things.