I’ve used “synthetic leverage” to describe when a company employs someone else’s resources, like capital or operations, to generate additional income. An example is Warren Buffett’s use of insurance float at Berkshire Hathaway – he used the money from insurance policies to invest in stocks and buy businesses. In other words, he borrowed the money instead of using his own resources!
As you know, using borrowing money to make investments, otherwise called using leverage, can be extremely risky. If your investments lose enough value, the bank or brokerage can force you to post margin (put up more collateral) or call the loan at the worst possible time, forcing you to realize a catastrophic loss.
Crucially, Buffett’s insurance float is non-recourse and not marginable. No one can force him to pay back the loan. So while he still has to make suitable investments, he can be much less worried about catastrophic drawdowns, the kind that has happened to many intelligent and sophisticated investors over time. For example Long Term Capital Management in 1998 (which was 2 Nobel laureates no less) and more recently, Archegos Capital that made financial headlines in 2021.
Some analysts published a study on Buffett’s 40-year performance and found that his underlying investments grew at 15% per year. That is a fantastic long-term track record. However, this is the special part: with his NON-RECOURCE leverage, his returns moved up to nearly 25%. Over 40-something years, that can make a massive difference, between making around 250x your money and making 7,500x your money.
There is a reason Warren Buffett is so revered in the investment community.
Most investors can’t access these kinds of situations. And I don’t use any leverage in money that I manage. But I try to fill the portfolio with other large public companies with synthetic leverage. Focusing on companies that can take advantage of synthetic leverage can increase our chances of success and make more money from our portfolio. We don’t need to make Buffett-like returns to still be very happy, as focusing on companies with synthetic leverage can help us get more bang for our buck!
If you’d like to find out more, please don’t hesitate to reach out.
Founder and Chief Investment officer of Alphyn Capital Management, LLC.