Showing posts with label overleveraged. Show all posts
Showing posts with label overleveraged. Show all posts

Friday 26 October 2012

Leverage and Risk


The most obvious risk of leverage is that it multiplies losses. 
  • A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. 
  • An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.
There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one.
  • If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.  
  • Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside.

So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.

Popular risks

There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up badly. But the issue here is those people are not leveraging anything, they're borrowing money for consumption.

In finance, the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. That at least might work out. People who consistently spend more than they make have a problem, but it's overspending (or underearning), not leverage. The same point is more controversial for governments.

People sometimes borrow money out of desperation rather than calculation. That also is not leverage. But it is true that leverage sometimes increases involuntarily. When Long-Term Capital Management collapsed with over 100 to 1 leverage, it wasn't that the principals tried to run the firm at 100 to 1 leverage, it was that as equity eroded and they were unable to liquidate positions, the leverage level was beyond their control. One hundred to one leverage was a symptom of their problems, not the cause (although, of course, part of the cause was the 27 to 1 leverage the firm was running before it got into trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the real troubles started).  But the point is the fact that collapsing entities often have a lot of leverage does not mean that leverage causes collapses.

Involuntary leverage is a risk.  It means that as things get bad, leverage goes up, multiplying losses as things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.  The risk can be mitigated by negotiating the terms of leverage, and by leveraging only liquid assets.




Forced position reductions

A common misconception is that levered entities are forced to reduce positions as they lose money. This is only true if the entity is run at maximum leverage.

The point is that it is using maximum leverage that can force position reductions, not simply using leverage. It often surprises people to learn that hedge funds running at 10 to 1 or higher notional leverage ratios hold 80 percent or 90 percent cash.


Model risk

Another risk of leverage is model risk. Economic leverage depends on model assumptions.  If that assumption is incorrect, the fund may have much more economic leverage than it thinks. For example, if refinery capacity is shut down by a hurricane, the price of oil may fall (less demand from refineries) while the price of gasoline might rise (less supply from refineries). A 5% fall in the price of oil and a 5% rise in the price of gasoline could wipe out the fund.

Counterparty risk

Leverage may involve a counterparty, either a creditor or a derivative counterparty. It doesn't always do that, for example a company levering by acquiring a fixed asset has no further reliance on a counterparty.

In the case of a creditor, most of the risk is usually on the creditor's side, but there can be risks to the borrower, such as demand repayment clauses or rights to seize collateral.  If a derivative counterparty fails, unrealized gains on the contract may be jeopardized. These risks can be mitigated by negotiating terms, including mark-to-market collateral.

http://en.wikipedia.org/wiki/Leverage_(finance)

Leverage

Using OPM (other people's money) to make money is smart business as long as the company doesn't go over its head in debt.

From the perspective of a shareholder, the more revenue-producing assets a company can put into play without requiring more money from the shareholders, the better.

The downside, of course, is the vulnerability issue and what creditors might do if the income dries up enough to make servicing the debt difficult or impossible.

Common ratios to evaluate leverage are:

1.  Debt to Assets (Total Debt / Total Assets)
2.  Assets to Equity (Total Assets / Shareholder Equity)
3.  Debt to Equity (Total Debt / Shareholder Equity)
4.  Debt to Capital (Long-term Debt / Total Capitalization)


Don't base an investment solely on any of the ratios above.  Their most useful purpose could be to call your attention to possible upcoming changes in your quality criteria and might lead you to be more vigilant about them as you manage your portfolio.



Debt Service


For those companies with high leverage, you should also look at their ability to service their debts.  For this, look at these ratios:

1.  Interest Coverage (EBIT / Interest)
2.  Interest and Principal Coverage  [EBIT / (Interest + Adjusted Principal Repayments)]




Definition of 'Leverage Ratio'

Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.


Investopedia explains 'Leverage Ratio'

The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

Read more: http://www.investopedia.com/terms/l/leverageratio.asp#ixzz2ALwlASAr

Sunday 24 June 2012

Corporate Finance - Business and Financial Risk



To further examine risk in the capital structure, two additional measures of risk found in capital budgeting:

1.Business risk
2.Financial risk

1.Business RiskA company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:
  • Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.
  • Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.


2.Financial RiskA company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Let's use the troubled airline industry as an example. The average leverage for the industry is quite high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face an imminent bankruptcy.


Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/business-financial-risk.asp#ixzz1yewzbr6X

Wednesday 25 April 2012

Investor concerns about the use of leverage in the Bakrie Group

Deadline looms for Bakries covenant breach

Mon Apr 23, 2012 7:11pm EDT


By Prakash Chakravarti and Janeman Latul

(Reuters) - Indonesian group Bakrie has until Friday to resolve a covenant breach on a $437 million loan following a drop in the price of its London-listed coal miner Bumi Plc last week, sources familiar with the loan said on Monday.

The breach was the latest in a series of debt problems for Bakrie Group, one of Indonesia's largest conglomerates and which avoided a debt crisis last year by selling a stake in Bumi Plc to an Indonesian investor for $1 billion.

Credit Suisse sent a notice on behalf of lenders to the borrower following the covenant breach, after Bumi Plc shares - pledged as collateral against the borrowing - slid 3.8 percent over the course of last week, according to the sources, who declined to be identified because the matter was not public.

Bumi Plc declined to comment. A director at the Bakrie Group's Jakarta-listed coal miner Bumi Resources said he was not aware of any default notice.

Bumi Resources shares dropped 7.4 percent on Monday, while Bumi Plc shares were down a further 7.6 percent on the day by 1150 GMT.

The sources said the notice required Bakrie Group to bring back the collateral coverage on the loan to a level that would require depositing cash of around $100 million with lenders.

Failure to do so by the deadline of April 27 would constitute a default that could lead to lenders demanding prepayment of the full $437 million loan.

The Financial Times first reported on Saturday that creditors issued a default notice on the $437 million loan.

One of the sources told Reuters that Bakrie family arm Long Haul, which took a $247 million portion of the loan, could either top up the loan or pay it and then refinance it.

Either way, a majority of creditors were backing the Bakrie Group so a default requiring full prepayment was seen as unlikely, meaning this was unlikely to become a new crisis, the source said.

A director at Bakrie Group holding firm Bakrie & Bros , which took the other $190 million of the loan that does not require a top-up, said: "We are not in any default situation with our loan at the moment."

Shares in Bakrie & Bros were unchanged on Monday.

Even so, the new debt issue is likely to add to investor concerns about the use of leverage in the Bakrie Group and its subsidiary companies and corporate governance, both issues that have weighed on its stocks in the past year.

Bumi Plc's stock has fallen 43 percent so far this year.

Bumi Plc sought to draw a line under discord between its main stakeholders last month, announcing a board shake-up that saw new major shareholder Samin Tan installed as chairman and that left a role for co-founder Nat Rothschild.

Saturday 25 April 2009

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.