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The Global Financial Crisis of 2008 marked a watershed moment in how the modern financial ecosystem perceives the role and reliability of credit rating agencies such as S&P and Moody’s. While it is unrealistic to expect any rating system to predict every default—especially in the face of increasingly complex financial instruments and unforeseeable macroeconomic shocks—what shook investors was the failure to flag seemingly obvious risks, despite access to vast pools of data and analytical resources.

This has catalyzed a deeper conversation: Is a single credit rating sufficient in assessing risk, especially in the growing and highly nuanced world of alternative debt? The answer, increasingly, is no.

Deconstructing risk in alternative credit

In reality, the risk of default—or loss of capital—can be decomposed into three core components:

• Issuer Credit Risk: The traditional metric—this is the risk that the borrower’s business underperforms and fails to generate sufficient cash flow to meet its debt obligations.

• Security Enforcement Risk: This refers to the practical enforceability of the collateral backing the loan. Legal delays, jurisdictional challenges, or poorly structured security arrangements can all erode recovery value, even when collateral exists.

• Fraud Risk: In cases where underlying financial or legal information is intentionally falsified, including the status or validity of the collateral itself, traditional credit models often fail to detect or price this risk appropriately.

Unfortunately, the credit rating ecosystem continues to center its assessments predominantly on issuer creditworthiness, with insufficient weight assigned to the latter two risks. This is particularly problematic in the alternative debt space, where structures are highly bespoke, historical information is sparse—especially for newer companies—and rating agencies often lack the depth or frameworks to fully capture deal-specific nuances.

Rethinking underwriting: A broader risk lens

To build a more complete picture of risk, investors must supplement traditional credit ratings with expert views from legal advisors, auditors, and structuring specialists. Key dimensions to consider include:

• Legal Enforceability of Security: Contracts must be tested for strength under adversarial scenarios. The difference between a prolonged legal battle and swift recovery often lies in the quality of documentation and jurisdictional clarity.
• Security Composition and Liquidity: Not all collateral is equal. Easily monetizable assets like cash, stocks, or gold offer a stronger safety net than hard-to-enforce assets like land under industrial use, which may be encumbered or contextually illiquid.
• Covenant Structures: Protective covenants can shift power back to investors when the borrower’s financial health deteriorates. Clauses enabling early redemption in the event of over-leverage or operational decline are essential tools.
• Governance and Transparency: A review of audit quality, board independence, and access to timely disclosures can offer early signals of management integrity and institutional discipline—critical factors in emerging and private markets.
• Cash Flow Structuring: Tailored repayment plans that prioritize principal recovery and embed cash traps or escrow mechanisms can significantly mitigate downside risk, even if underlying business performance fluctuates.

Toward smarter capital allocation

A more holistic risk framework is not just a defensive strategy—it also helps unlock better capital pricing. When investors can distinguish between borrowers based on enforceability, governance, and cash flow resilience—not just ratings—they can channel capital more efficiently, rewarding higher quality with lower cost of funds.

In a world where capital is increasingly flowing toward private and alternative credit markets, risk must be evaluated with greater granularity. Moving beyond the convenience of a single rating to a more comprehensive, multi-dimensional approach is not just prudent—it is necessary for the health and maturation of the financial system.

(The author of the article is Nikhil Aggarwal, Founder & Group CEO, Grip Invest)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)