Additional Benefits of LeverageBy Scott Dickes
In our previous post we outlined how using debt in a transaction is often maligned by the media and gave one benefit of leverage. Here we finish off the topic with 3 additional benefits we see with using debt in a transaction.
Benefit #2: Less Equity At Risk – So Equity Returns Can Be Higher
This is just simple math. Let’s assume you buy a company for $2 and sell it for $3 in 5 years. (To make this problem simpler, let’s also assume there are no distributions at all during the 5 year period and that the debt is not amortized.) If you financed this transaction with 100% equity, you generated a 50% return over five years, or an annualized return of about 8.5%.
Now, let’s assume that when you buy the company for $2, you borrow $1.50 from a bank and invest $0.50 in equity. When you sell the company in 5 years for $3, you take $1.50 of the proceeds and pay back the bank, leaving $1.50 for the equity owners. Since you invested $0.50 and the equity is now worth $1.50, this is a 200% return over 5 years, or an annualized return of about 24.5%.
Obviously a 24.5% annual rate of return is significantly better than an 8.5% annual rate of return.
Benefit #3: Debt Reduces Bad Decisions by Management / Governor on Cash
While Hadley Capital provides active oversight of its portfolio companies, it does not manage any of its companies on a day to day basis. Day to day management of each business is the responsibility of each company’s management team.
We implicitly trust our management teams and we believe we have some of the best operators out there running our companies. However, we also believe that the obligation to meet a defined principal amortization schedule is an excellent motivational tool and helps management teams prioritize uses of capital. Projects with a potentially low rate of return are not funded – only the best uses of capital receive funding.
Benefit #4: Portfolio Company Lenders Are Our Partners – Deal Confirmation
Hadley Capital has established many excellent and long-term relationships with debt financing partners. We view these organizations as our partners in each transaction. If we are excited about a deal, 9 times out of 10, so are our debt partners. However, occasionally our lending partners balk at a transaction we find attractive. We trust our financing partners and we know they have good judgment. If they don’t like a deal it makes us ask what they see that we don’t. While we can still complete the transaction without them (either by finding other lenders or putting in more equity) we have learned over the years that supportive lenders usually signal a good transaction.