Leverage

Leverage refers to the use of debt to finance an activity and increase profits and return on equity.  Leverage can be used to expand operations and lower unit cost, or it can be used for acquisitions. The term itself denotes power. The benefits that can be derived through the use of leverage is particularly tempting in times of low interest rates and profits further magnified as a result.

The risk of using leverage, however, is significant. Certain lenders will offer to provide capital in amounts that far exceed reasonable levels for a particular business because they are willing to foreclose on the business if payment or covenant defaults occur. In fact, some lenders, particularly distress investors, employ “loan to own” strategies.

Management will often times be overly optimistic in preparing projections and fail to account for increased interest rates and lender fees. When utilizing leverage, it is critical that all adverse events be considered and plans developed to deal with such events. Market risk and competitive threats must be thoroughly examined.

Well thought out contingency plans should be considered in the event the refinancing of debt at the end of the term is not achievable. Asset sales, equity raises or a combination thereof should be planned well in advance of expiration of the term. Values can erode rapidly if Lenders are exerting pressure. High leverage ratios alone can signal a distressed sale process. Lenders will often times extract costly extension fees and increase rates while a payoff strategy is being implemented. Lenders will also require that the Borrower engage advisors approved by the Lender to assist the Borrower in developing costly restructuring plans or debt payoff strategies acceptable to the Lender. Such advisors often have a conflict of interest in that they are motivated to achieve the Lender’s goal at the expense of the Borrower’s owners.

Determine the optimal capital structure for the business and understand the risks. Assess the opportunities for growth conservatively and the reasonableness of payoff strategies before employing financial leverage.