Some companies with advantaged business models can safely leverage alternative third-party sources of capital or operations to generate significant incremental income. I broadly refer to this as “synthetic leverage.” Probably the best-known example is Warren Buffett financing his investments at Berkshire Hathaway with insurance float. While it is standard practice for insurance companies to invest their float in relatively safe fixed income, Buffett excelled at using float to invest in equities and buy whole companies.
Over 70% of our portfolio is invested in companies that have “synthetic leverage.” Leverage is of course the use of borrowed capital to amplify investment returns. Investors can borrow against the value of the assets they are buying, for example with real estate, or use margin loans in the case of public securities. Companies can fund their operations through debt, with the goal of enhancing return on capital while avoiding dilution associated with equity raises. The major drawbacks are the costs to service loans, and the often severe consequences of failing to do so (having debts called, the risk of bankruptcy), as well as the threat of margin calls on public security investors when the value of their investments deteriorates, forcing liquidations often at precisely the wrong time. In contrast, synthetic leverage has fewer of these downsides. |
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