Private market investments have grown increasingly popular due to perceived benefits such as greater portfolio diversification and reduced volatility. However, it is essential to thoroughly understand all the characteristics and risks associated with private market investments before making any decisions.
In this article, we will dive into one of the largest components of private investing: financial leverage.
What is financial leverage?
Leverage is another way of saying debt. In addition to investor equity, many private investment funds borrow money to acquire a portfolio investment, and many borrow as much as they can. When a fund borrows money in addition to investor equity, it is considered “leveraged”. If you hear the term leveraged, it is typically in reference to financial leverage, not operational leverage, which we may discuss in a future blog post.
Why use leverage?
The goal of leverage is for the acquired investment (be it a property or company) to generate a return that exceeds the interest rate on the borrowed money. If this is the case it is considered positive leverage and will amplify the return that the contributed equity earns. However, if the investment does not outpace the interest rate, it is considered negative leverage, subsequently amplifying losses. This is where the significant risk of using leverage arises. The table below reflects the potential good and bad of debt.
What are some of the risks?
- The primary risk of leverage is the required monthly debt service that comes with borrowing money. Debt service is the obligation of a borrower to pay back monthly principal plus interest. If the fund cannot service its debt, the fund is at risk of defaulting on the loan and conceding control of its assets to the creditors. Often the creditors will sell the assets of the private investment fund at a significant discount in an attempt to recoup the outstanding principal as quickly as possible. This can easily leave equity holders with little to nothing to show for their investment.
In more severe cases, the private investment fund collateralizes the loan with other portfolio companies. If the fund is unable to make the required payments on the debt, the lender could take recourse on the other portfolio investments, significantly affecting overall fund performance.
This risk escalates in times of economic downturn. For example, in 2008 many highly leveraged private investment funds struggled as cash flows plummeted while debt service obligations remained fixed. The funds were forced to burn capital or concede control of the investment to creditors. Unleveraged funds may have the added flexibility of waiting out longer periods of macroeconomic downturn. While other holding costs are still present, there can be a significant increase in an unleveraged fund’s ability to “ride out the storm” due the absence of any debt servicing. - Another risk stems from holding debt in a rising interest rate environment, which has become increasingly relevant in recent years. Leverage is often structured as floating-rate debt, meaning that as rates rise, so does the cost of borrowing. As stated above, for leverage to be beneficial, the return on the portfolio investment must exceed the debt service of the loan. Accordingly, the higher the interest rate, the more difficult it becomes for the leverage to be positive. If a fund made a leveraged acquisition in a period of low interest rates, like that of 2020, a sudden spike in interest rates can erode profit margins and diminish returns.
- One final risk worth mentioning is the prioritization of meeting debt obligations over quality operational improvements and long-term growth. If a fund deployed a large amount of leverage, it could easily shift the management team’s focus from important operational decisions to making decisions that satisfy short-term performance covenants. The primary covenant assigned to debt is the debt service coverage ratio or “DSCR”. This is a ratio (NOI ÷ Debt Service) lenders use to ensure the net operating income of the portfolio investment is large enough to fulfill the debt service. If the ratio (usually between 1.2 and 2.0) falls below the required level, the lender may be entitled to default the fund and seize control of the asset.
Given the importance of the DSCR and consequences if violated, it is understandable why a fund’s management team could be encouraged to make decisions to satisfy the covenants, the quickest way being cutting costs on long-term strategic initiatives. Cost-cutting to meet short-term financial measures, similar to earnings per share in public markets, has proven to affect long-term profitability and sustainability.
How do I know how much leverage a fund uses?
When considering a private investment fund, the easiest spot to find how much debt a fund uses is within the offering documents, specifically the Private Placement Memorandum (PPM). The summary section may outline whether debt is utilized, or it is likely there is a capital table somewhere in the PPM that outlines the amount of equity and debt compared to the total fund size. “Highly leveraged” traditionally refers to a fund that has more debt than equity. Another way is to ask your point of contact directly. While past performance is not indicative of future results, it may be worth asking about their performance history to ensure that equity holders are being appropriately rewarded for the amount of debt deployed.
Key Takeaways:
- Leverage means debt. If a fund uses long term debt, it is considered “leveraged”.
- If a fund cannot satisfy the required payments of principal and interest, the creditor can default the fund and may be able to seize control and liquidate the assets of the investment fund, quicky erasing investor contributions.
- Interest rate increases can lead to diminished returns.
- Debt could cause management decisions to align with meeting covenants vs. long-term investments and growth.
- Higher leverage = higher risk. Leverage can just as easily amplify losses as it can amplify returns. Investors should be rewarded appropriately for the amount of debt used.
All investing involves risk, including the potential loss of principal. This content is for informational purposes only and does not constitute investment advice. Past performance is not indicative of future results.