Investing in Levered Businesses
Leverage is a two-edged sword. The history is replete with examples of high levered businesses that have generated significant wealth for its shareholders, while on the other hand, with enough examples of other such businesses gone bankrupt.
Hence, investing in such businesses demand extreme caution and significant margins of safety, while always being mindful of downside extremities.
Let me illustrate two major categories of such businesses-
Banking and Insurance
This is one of the most difficult areas to assess. There are numerous examples of so-called quality banks and insurance companies who have done wonderfully well for many decades and suddenly collapsed. Examples abound including CITI Bank, UBS, etc.
As Nassim Taleb says, ‘to a turkey every day, his caretaker seems like a nice guy until the day he finally kills him’. I am always skeptical of Financial Institutions turning out to be the same as there are very few and rare robust or antifragile financial institutions worthy of taking care of our long-term capital. A wrongly incentivized CEO in a non-founder led financial institution can potentially create devastating effects for its shareholders.
Other high Levered businesses
Only a very few businesses can support high leverage. They are primarily meant to be businesses which have very strong and predictable cash flows.
In today's world, every business encounters constant challenges in operating and regulatory environments. On top of it, the majority of business models are ripe to disruption. A business needs significant financial flexibility and strength to navigate such territories.
Managing operating, and technological challenges are itself a difficult task that if you add high leverage on top of it, only a sliver of such businesses could survive or be resilient for the long run. Besides this, the capital allocation becomes key as they need very strong, ideally founder-led management (with skin in the game) to navigate these challenges.
One has to be very sure of predictability and durability of such cash flows and ensure that these businesses are -
able to handle extreme economic downturns and be free-cash flow positive in all environments
not facing significant secular headwinds- secular headwinds always find one or the other reason to surprise a business with much faster decline in cash flow than anticipated.
How to invest in such Businesses
One can avoid investing in such businesses altogether, but I firmly believe that being dogmatic about rules restricts one’s ability to see things differently and be opportunistic in extreme times.
Investing in such businesses must be avoided in normal times (as the downside risks are higher compared to the upside). But, in extreme scenarios, they should be looked at and can be opportunistically invested in with the right strategy and risk mitigation.
We prefer levered businesses that are -
Founder led institution whose family wealth is dependent on running the franchise effectively for a generation and beyond
A collection of multiple unrelated assets to protect extreme downside
Bought at a very low price
In addition, we focus a lot on the position size in line with the downside risks.
Reflections in Our Portfolio
In our portfolio, we own a healthy dose of levered businesses structured on above principles.
A couple of our bigger holdings are a collection of relatively stable cash generating levered broadband assets in multiple geographies of Europe and Latin America respectively. Each business is independent, and leverage is structured to reside in individual geographies with no recourse to others or the parent company. Similarly, we own a diversified financial services business in India which has a lending business along with other independent capital light businesses.
Hence, we are not betting on the success of a 100% levered asset. We primarily own these assets along with other optionalities or unlevered assets inside a company .
We only own one pure-play lending business in our portfolio, but it is owned by a family with track record of >25% in 3 decades and we were able to buy it at around 1/3rd of the book value minimizing downside risks. We also own a couple of media businesses in the US which carry substantial leverage and are facing headwinds in their core linear business, but we believe its very low valuation, shareholder focussed family owners, essentially covers severe downside for its declining linear businesses, while other cash generating assets including studios and licencing businesses provide additional upside which is not currently recognized by the market. In addition, it is slowly creating a streaming asset (via its investments) which can provide substantial optionality. In these highly levered assets, we also mitigate risk by using a small position size (no more than 5% of the portfolio).
Akhil D.