Understanding Financial Leverage

"Leverage" is one of the more interesting and difficult concepts to fully grasp in all of finance, but it's important for anyone that borrows or plans to borrow money to understand. Much of the confusion stems from the contrasting meanings embedded in the same word. Merriam-Webster's dictionary includes two very different definitions. The first suggests strength: "power, effectiveness." The other, on face value, has little to do with control: "the use of credit to enhance one's speculative capacity." Combining the two suggests that the party which borrows has the leverage — they have the power and advantage over others. Does that mean that the borrower is dominant over the lender? Somehow, that flies in the face of what many of us learned at an early age. The gambler who can't pay his bookie ends up with a right hook to the gut. Yet many people jump into risky financial situations without considering the potential consequences.

The most intimate relationship most of us have with leverage is our home mortgage. In the vast majority of cases, over many decades, this structure has been positive and transformative to the buyer. However, there are two conditions necessary for financial leverage to actually become power. The first is that the borrower must be able to make his payments, or he risks repossession. The second is that the asset underlying the leverage holds its value. As leverage accentuates the profit when asset values rise, it decimates return when values fall. Without these conditions, the music stops, and the benefit of leverage becomes a huge liability.

Leverage went through a gilded period in the mid- to late-1980s when buyout king Mike Milken heralded the use of debt for companies trying to grow quickly. The interest rates were attractive to investors — well in the high single digits and even above that level — and company managements were anxious to access capital for expansion and acquisitions. As the manager of the Leisure & Entertainment Fund at Fidelity Investments in the mid-1980s, I witnessed up close and personal many deals funded with substantial leverage.

One example was Orion Pictures, a small studio created by well-regarded, disgruntled United Artists executives in the late 1970s. They raised money for a slate of films and, remarkably, produced four Oscar winners for Best Picture between 1978 and 1992: Amadeus, Platoon, Dances with Wolves, and The Silence of the Lambs. Despite that critical success, Orion was ultimately undone by the combination of movie misses that far outnumbered the hits and debt that ballooned to over $500M. Unable to meet its interest payments, the company filed for bankruptcy in 1991. Orion wasn't the only one. Overzealous borrowing habits contributed to the rise and fall of many other entertainment companies during the 1980s and 1990s, such as New World Pictures, Carolco, Cannon Group, De Laurentis Films, and Live Entertainment.

What could have saved these companies? Orion and other film studios needed level-headed projections about projects before jumping in with both feet. Debt comes with payments that don't stop even if a film tanks. They needed reasonable budgets with spending caps per movie and an honest appreciation of the overwhelming odds against producing a hit in Hollywood. These same tenets apply to every leverage decision, far beyond the movie world.

Most of us have an optimistic bias and prefer to think that leverage will expand our existing abilities rather than saddle us with a persistent burden of heavy cash outflows. No one buys a house or invests in a business thinking that it will go down in value. During periods of strong asset growth, the common association of "leverage" becomes too one-sidedly positive (although the fallout from the recent recession may have moved popular bias too far in the other direction). The key to using leverage successfully is common sense, realistic assumptions, and a clear-eyed understanding of the risks.

Consider a new business: I recently spoke to a young woman who showed me her proposal for opening an exercise studio, specializing in biking or "spinning" classes. She had carefully prepared a business plan based on expected participants per class, price, available classes per week, and all her anticipated costs. She also needed money, either from investors or a loan.

New businesses either have strong openings, such as new restaurants, which then trail off as the next hot spot grabs the limelight, or slow starts, when, hopefully, word spreads and revenues build. Regardless, a financing component adds another fixed cost. The key to borrowing effectively is to have a keen understanding of what might go wrong. How long will her business survive if members sign up at half the pace? What if a competitor slashes membership prices by 25%? I urged her to prepare for the likely deviation from the outline in front of me. A loan might turn her dream into a reality, but it would also raise the break-even level, something all borrowers must remember.

Leverage can be positive, thanks to the countless individuals and businesses in existence who have relied on a loan to get started. Leverage can and does work under the right circumstances. Lending would not still be in existence after thousands of years if it wasn't a useful tool in careful hands. But careful analysis and preparation by the borrower of several possible scenarios — good and bad — for the business, project, or investment are necessary to really know what you're getting into. Otherwise, debt will be your worst enemy.

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