A Story about Leverage: Archegos Capital

Dr. Ajibola Awolowo

If you have been following the financial news lately, that name should ring a bell. They were in the news for all the wrong reasons some weeks ago. Archegos Capital was a family office that managed the personal assets of its founder, Bill Hwang. Unfortunately, they made quite a lot of highly leveraged bets in the market that went wrong. This bankrupted the firm and brought huge losses to their creditors. It was reported in the financial press that Bill Hwang lost $20 billion in 2 days.

This is not a forensic enquiry into what went wrong at Archegos Capital. Well, maybe in a sense, it is. This is an article on what leverage or debt is and how to benefit from it while avoiding its downside.

If you sample public opinion, you will probably find that the average Nigerian is debt averse. We all try to avoid personally being in debt unless it is necessary. Businesses, on the other hand, rely on short term or long-term debt to fund growth since growth and capital go hand in glove.

They might need to build a new factory, open a new outlet, hire more staff or develop a new product line. To source the required funds, companies usually have a couple of options. They can either approach their shareholders to raise more equity which can come in the form of a rights offering or a public offering.

The second option available to company management is to borrow the capital from a bank, in the form of loans, or from the investing public through the sale of commercial papers and corporate bonds. These loans from banks or investors constitute debt or leverage.

People or institutions that lend companies the capital they require do so because they earn an income from this transaction. Bank loans and commercial papers earn an interest while bonds pay a coupon.

Whichever option the company chooses, it comes at a cost. With equity, the cost is dilution of ownership and the pressure the company puts on itself to generate returns with the new equity obtained. With an increased equity, the company must now generate more profit to maintain previous return on equity. With debt, the cost is interest which must be paid to creditors in addition to the principal and the need to improve Returns on assets.

The job of company management is to decide which of the two options to utilize in funding corporate growth per time. At times when the interest rates are low, utilizing debt to raise required capital might be the cheaper option while in periods when the share price of the company has been driven up by sentiments, as seen in bull markets, selling equity might be the best option. This is the reason why the Nigerian Exchange saw record numbers of Initial Public offers (IPOs) and public offers (PO) in the bull market of 2007/ 2008.

Debt is an immensely powerful tool in the arsenal of companies. When used correctly, it can be a stitch in time that saves more than nine. If abused, however, it can spell doom to the company as Archegos Capital painfully found out. The key to earning the benefits of debts while avoiding its pitfalls is to only take on the right amount of debt.

Taking on too much debt is unhealthy as money that would otherwise have filtered down into the bottom line ends up leaving the coffers of the company. As companies take on more debt, their bottom line dwindles.

Companies that are overly indebted also expose themselves to risks associated with an increase in interest rate. Their creditors can decide to refinance a loan once interest rates go up leaving the debtor in a precarious situation.

The high level of indebtedness of a company may be because of a few things. The first is that the business requires a lot of capital to remain competitive. Businesses that have remarkably high maintenance capital expenditure requirements will be a good example of this. Investors will be better served by avoiding these companies as most of the profit earned will be spent paying interests on never ending loans.

The second reason why a company might carry high level of debt is if they are chasing too much growth in too little a time. This may make companies undertake leveraged buy-outs of other companies and put themselves in harm’s way in the process.

How then can we assess the level of indebtedness of any company?

Since the funds used to repay debts come out of the company earnings, an ideal place to begin analysing a company’s debt burden is to compare its long-term debt to its earnings. Long term debts are those that must be repaid beyond a one-year time frame. You can find this figure in the non-current liability segment of the balance sheet.

When you divide the long-term debt by the profit after tax, the answer you get would be the number of years that the company will need to pay off all its debts using all its profits every year. For example, if a company, Company A, has long-term debt of N2 million and its profit after tax is N200 thousand, then the long-term debt to Profit after tax ratio is 10. Using all its profits, the company will require 10 years to pay off its debts.

Compare this with company B that earns N1 million as PAT and has a long-term debt of N5 million. Company B would require 5 years to pay off all its debts using its entire profits.

In comparing both companies, it is obvious that company A, despite having lower overall debt, is a more risky business than company B. It carries a greater risk because they will likely carry the debt for a longer period, need a larger percentage of their Profits to pay off the debt and will suffer more from the compound interest that will accrue on the debt due to the longer period it will take them to pay it off.

Another useful metric in assessing the level of indebtedness of companies is the long term debt to free cash flow ratio. Rather than utilizing profit after tax as the denominator in the equation above, free cash flow is used. Free cash flow is the physical cash that can be taken out of a business without compromising present standards and future growth prospects of the company. To derive free cash flow, subtract capital expenditure (which is found in cashflow from investing activities segment of the cash flow statement) from net cash generated from operations, also seen on the cash flow statement.

Personally, I prefer companies I invest in to have long term debt to earnings or free cash flow ratio of between 3 to 5. This reassures me that the company is not paying excessive compound interest on its debts.

Debt to equity ratio is another metric that can be used to assess the debt profile of a company. It is calculated by dividing the company’s total liability by total shareholders’ equity. When the answer is less than 1, it means assets are financed using more of equity than debt which is what I prefer. However, when the answer is greater than 1, the company has more debt than equity which connotes a higher risk profile.

A practical demonstration of this can be seen in the debt-to-equity ratios of MTN Nigeria for the full year 2020 of 10 while that for Airtel Africa is 1.98. Going by this metric alone, it is obvious that MTN Nigeria is very highly leveraged and carries a greater risk as compared to Airtel Africa. This is just an example and does not constitute a buy or sell recommendation.

We should be careful while using the measures of leverage highlighted. They should only be used to compare companies within the same industry. This is because the level of debt required in every industry is different. Also, certain industries thrive on debt and are highly levered. The banking industry is a prime example of this.

Taking on debt is almost an inevitable part of doing business. The amount of debt that companies take on, however, is optional and is at the discretion of company management.

One of the screening criteria I use in deciding which companies are worthy enough to make it into my portfolio is their level of indebtedness. High levels of debt translate to a higher level of risk and I tend to avoid companies like this. Investors will do well to only invest in companies that carry manageable amounts of debt on their books to avoid an Archegos type of implosion.

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