Learning to (un)Love Leverage

It was literally on my first day of business school that a classmate asked me, "What's the most expensive form of capital?"

It was bizarre sort of pop quiz; he had come out of private equity, while I had been building servers for the last four years.  I floundered.

"Equity," he solemnly informed me, after a few minutes of bewildered guessing.  "Debt payments are capped.  Equity has unlimited upside, while debt payments are capped.

This is conventional wisdom at America's business schools, and over the next few years, I definitely lived it.  We borrowed money for school, for living expenses, for books.  I bought a car, went skiing, went to Mexico on spring break.  Why shouldn't we?  We were "consumption smoothing"; in a few years, we'd be making more than $100K, so why not spend a little of that now?

Then we were unleashed on the world to tell companies about the astonishing benefits of leverage.  Leverage let you turn a small investment into a huge profit.  Leverage means you get all that juicy corporate upside for yourself.  You should never use equity finance if you can use debt.

That logic is alive and well, as Joe Weisenthal reports:

We remarked after Goldman Sachs (GS) came out with earnings, that analysts were already pestering the company about its mere 14x leverage ratio, wondering when they might start to get more aggressive -- this after the financial system nearly collapsed due to too much leverage.

Nobody's learned anything.

He goes on to quote an HBS blog lamenting Google's lack of leverage.  To which one of his commenters retorts:

Joe - have you ever looked at a finance textbook? If you can borrow long-term funds at a cheap rate to acquire/fund businesses that will grow/earn CFs at a faster rate, then that is value-creating, bottom line. It's a better strategy than using equity (or not buying back equity) due to the higher cost of capital (opportunity cost) of that equity.

In short - if someone will lend you money at 6% to invest in a business that returns 10%, then you have a positive economic return.

The trouble is NOT in taking on debt, per se, but in terms of taking on debt to fund projects/do LBOs that don't earn cash at a rate ABOVE the cost of that debt.

What's missing from that picture?  Risk.  I didn't get that $100,000+ job I was expecting; I ended up in journalism, making less than half that.  My loan payments ate up something like 45% of my take-home, which made it extremely difficult to live.  Loan payments have limited upside for the investor. But they have unlimited downside for the borrower:  if you can't make your loan payments, you're bankrupt, and out of business, or at the very least, forced through an awful restructuring.

The problem is, in an expected value calculation, going bust shows up as a zero.  But in fact, it's an extremely negative-utility event.  Oh, some people can merrily declare bankruptcy and walk away.  But most people, and firms, find it deeply traumatic.  That isn't captured when you blithely declare that equity is more expensive than debt.  Or talk about investing in a business that returns 10%, as if there were some kind of textbook world where you could actually get a guaranteed return.

American debt levels are hugely out of line with other countries.  I'm a big fan of American exceptionalism, but in this case, I'll say that we're at least partially in error.  We need to take the downside of leverage much more seriously, starting with our nation's business schools.  OF course, I don't expect people taking on $100,000 worth of debt to be too easy to persuade of the dangers of leverage.