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The first step in any family succession plan is to choose the appropriate heir for the business. Where there is only one heir, it is necessary to decide whether he or she wishes to, and is capable of, taking over the business. If there is more than one suitable candidate, it is necessary to decide which one will be chosen. The factors to consider include business aptitude and management potential. Potential is more important than experience, because you can groom your heir for the role as owner/manager over an extended period.

In theory, the steps involved and the logic employed in choosing the appropriate heir should be similar to those involved in choosing the best CEO for the business, or the lead manager in a management buy-out: that is, the heir you choose should be the one most capable of running the business successfully when you leave. In practice, however, the choice may be made for various personal and family related reasons, rather than on solid business-based grounds.

Where there is only one heir (or only one heir who is interested in taking over the business), obviously it might still be a mistake, on purely business grounds, to hand over the business to that heir. But, if this is to be the case, your task is to make the best of a dubious decision and to prepare this person as best you can for the role of running the business.

A family succession is different from all other exit options in so far as the emphasis is often not on maximising the owner’s exit price, but rather on ensuring that the business continues successfully under the ownership of the successor. Consequently, the tailoring (or grooming) is concentrated on the successor, rather than on the business. This alters the perspective of the business’s suitability for the exit option chosen and the notion of what purchasers are looking for. This will become clearer from what follows below.

Generally speaking, most types of businesses qualify for a family succession. However, if the successor is required to borrow money against the business’s assets to acquire the business, the business will need to be able to support the borrowings and the successor will need to have a professionally produced business plan demonstrating this ability.

As I have said, the emphasis in family successions is usually more on the suitability of the heir than the suitability of the business, so this question has to be changed to: ‘What are we looking for in the successor?’ This will influence the choice of successor and the way he or she should be groomed for the take over.

We will now look at the steps necessary for grooming (or tailoring) the heir for taking over the business.

The traditional fundamental approach and structural models generally are based on the same set of balance sheet inputs. But while the fundamental approach used by most credit analysts requires thorough company and industry knowledge and is therefore rather costly and time-consuming, equity-based models are an efficient means to screen broad universes of credit issuers. However, structural models allow to incorporate credit analysts’ forecasts to take account of qualitative information that is not yet reflected in the balance sheet. Projections can be used to create more realistic estimates of the default threshold or to generate different scenarios with respect to future liabilities.

The bear market for credit between 1997 and mid-2002 has put a new focus on valuing corporate credit. The debt-financed equity bull market of the second half of the 1990s was accompanied by historically high default rates and investigations of the management and reporting of corporate balance sheets.

Obviously the standard approach of using rating agency credit ratings to gauge credit risk is no longer sufficient. As a consequence, quantitative approaches have recently gained popularity, particularly structural models based on equity-market inputs. Quantitative models can be used as a tool to provide warning signals or to determine whether the spread on a corporate bond adequately compensates the investor for the risk. Due to the current low-yield/low-return environment the number of investors interested in credit products has grown worldwide. Credit models like KMV or CreditGrades have been developed to meet the growing investor demand.

These enhancements of the Merton model are able to incorporate companyspecific details and can include subjective credit analyst views. With respect to the rapidly expanding credit derivatives market, quantitative models provide critical inputs for valuation and hedging. Default correlation, a major driver for the valuation of credit portfolio products, can be modeled in both structural and reduced form models. Finally, quantitative credit models have become indispensable tools for the risk management of financial institutions.

Although various quantitative models are used by credit investors, two approaches for modeling default have gained widespread acceptance: structural models and reduced-form models. Both of these methods provide estimates of default probabilities or fair market spreads.

The performance of most portfolio managers is measured against a benchmark index. Active management exposes investors to beta, which is defined as portfolio volatility relative to the market, and to alpha, the value added by the portfolio manager’s luck or skill. Sharpe (1991) observes that the market as a whole is made up of all market participants, and therefore the average return of all participants equals the return of market, before fees and costs. After fees and costs, however, the average return of all market participants is below market return. Consequently, to beat the market consistently, investors need to have special skills. Interestingly, if one asks market participants what active return they expect to earn, 90 percent of them say they expect an excess return of 1–1.5 percent. Obviously, this contradicts conventional wisdom.