Underwriting through a full cycle

Most underwriting is anchored to recent performance because recent performance is the best documented. The problem is that businesses are usually bought near the top of their own operating cycle, when demand, pricing and utilisation are all cooperating at once. A model built on that moment describes an unrepeatable year.

Our approach is to establish what the business earns in ordinary conditions. We look for the mid-point of pricing over the last full cycle, the utilisation level the asset base can hold without extraordinary effort, and the cost structure that persists when volume falls. The resulting figure is usually lower than the trailing number, and it is the one we finance against.

We then test the downside deliberately. What happens to cash generation if volume falls by a quarter and pricing follows it down. Whether the business can fund its maintenance capital expenditure and its obligations in that state. How long it can operate there without needing anything from us that we have not already committed.

A business that survives that test does not need to be rescued at the exact moment rescue is most expensive. That is the entire point. Cyclical downturns are not risks to be avoided, they are conditions to be prepared for, and the companies that are prepared tend to acquire assets from the companies that were not.

Underwriting through a full cycle rarely produces the highest headline return in a model. It produces the return that is still there when the model has been overtaken by events.