The Value of Leverage

Leverage: oft misunderstood, intensely mistrusted, publicly reviled, privately coveted.

Leverage: creator of wealth, cancer of markets, destroyer of nations.

Or is it?

Saying that leverage is bad is akin to saying that speed is bad. It is true in both cases that too much of either is dangerous. What is misunderstood is that too little of either is dangerous as well.

A simple example is driving at 30 kph on a highway. If the rest of the cars are driving close to the speed limit, e.g. 100 kph, then the car driving at 30 kph is a threat to their own safety as well as the safety of others. That is why there is a minimum speed limit on highways.

Analogies have their uses and their limits. There is only so far one can stretch the speed as leverage metaphor, especially since leverage has a much greater value. To get a better understanding of the value of leverage one must first get a better understanding of leverage.

Moving on to leverage. Leverage is simply a measure of the ratio of debt to equity. This link between debt and equity is critical. Debt is an absolute number, saying that a company has USD 1 million of debt does not really give any insight on whether this is a lot or a little. If the company had USD 100 million of equity then the debt does not seem to be a big deal. On the other hand, if the company only had USD 10,000 of equity then the debt level would be alarming.

Before getting into technical details, an easy gut check is useful. Imagine that you never took any debt. No student loans for university. No credit card debt shopping for professional clothes for your job. No loans to buy furniture for your home. No car loan to buy your car. No mortgage to buy a house. No loans to pay large lump sum school fees for your children. Your financial risk might decrease but your quality of life would plummet.

This begins to give us an insight into the value of leverage.

For most people every single expense mentioned previously is considered essential and must be funded. The only problem is that there is a mismatch in cash outflows and cash inflows.

Consider the professional clothes issues. This can cost several thousand dollars, a large sum for a new graduate but easily covered out of savings from the first three or four pay checks. A clear win.

As always, life is not about minimising any one risk, but about managing it and ensuring that you benefit appropriately for the risks taken.

Moving to the corporate world, does the personal analogy cross over?

We go back to the foundation of leverage: managing cash flow mismatch. The cash conversion cycle is rarely 0 days and the gap between cash outflows to suppliers to produce the product / service to cash inflows from customers needs to be funded. This is working capital financing. Without it no company can function.

The real value of leverage comes in the form of growth funding. To fulfill their potential, companies need growth capital. The classic company needs to acquire physical assets and service companies need to hire and train talent and then pay their expensive compensation before they can acquire clients and generate cash inflows.

The mistake many companies make is to fund 100% of this using equity. The thinking is that equity is far less risky, in that there is no maturity date when it needs to be repaid. The assumption is that there is no cost to the equity, when in reality there is a high cost to the equity, due to its illiquidity and junior position in terms of claims on the company’s future cash flows.

So how does the cost of equity manifest itself? The first method is shareholder demands for dividends. If shareholders want to get paid dividends then they will get paid dividends because as owners it is their right. A board that disagrees with them get fired.

The second method is via the share price. You see, a return is composed of a payout by the company, e.g. the dividends, divided by the rise in price of the shares. If the company refuses or is unable to increase dividends, then the market will adjust by dropping the price of the shares.

In efficient markets the lack of a market equity return will get the board and management fired. Markets that remain inefficient through a faulty understanding of the cost of capital,will have companies whose capital structure is viewed as inefficient by foreign investors. Relatively low equity returns will put off foreign investment and no amount of changes in regulation will help attract it.

What can be done to improve the situation?

First is to make it more palatable for companies to borrow, not least by banning the use of security cheques by lenders. The threat of getting fired for low equity returns pales in comparison to the threat of prison.

Second is to encourage alternative lenders into the market. Bankruptcy regulation is just as important to higher yield lenders as it is to borrowers. Alternative lenders with the skill and appetite to fill the massive gap left in the capital structure of companies by equity shareholders at one end and commercial banks at the other will do more to attract foreign investment than any other avenue.

The supply of credit more in line with the needs of the market will allow companies to build a more competitive capital structure, one that not only attracts foreign capital but also allows companies to more easily expand regionally and internationally.

This article was originally published in The National.