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The Double Edge Sword: Leverage

Updated: Apr 1, 2021

As we spoke with our investors about our upcoming fund and investment strategy, a question came up – why not use leverage to juice up the return and use less capital? There is no right or wrong answer: every choice comes down to your needs and your judgment about the current and future market conditions. I am here to offer you different perspectives to help you make informed decision. Mini-debate: leverage vs. no leverage? Everyone knows leverage is a double-edge sword: it may magnify the return, but at the cost of increasing risk. So how do we quantitatively decide what’s the optimal leverage level? First of all, we need to understand how leverage can increase return. Return of equity is calculated as the ratio between net income and equity, where net income is pre-tax income minus tax. Since interest expense is deducted before tax, the higher the leverage, the higher the after-tax income, thanks to the “tax shield” effect. The hypothetical example shows how leverage can boost return on equity.

However, using leverage gives the lender the claim on the asset in case of insolvency. In a bull market, insolvency is unlikely; when market is volatile, you need to assess the probability of insolvency by calculating metrics like debt coverage ratio, which is the ratio of net operating income and debt service. When debt coverage ratio is low, you are vulnerable to the volatile market. In the hypothetical example below, the 80% levered portfolio gets completely wiped out in economy downturn. In case of an unleveraged portfolio, investors have claims on the asset without a forced sale. It gives the investors a longer runway to turn the project around, install better operators, and sell the asset in a better market.

You can build a sensitivity analysis matrix with various leverage levels and various gross incomes. You will see how sensitive the return on equity is to different parameters. Now you have to ask yourself four questions:

  1. What’s my return given current leverage?

  2. What additional return I pick up by increasing leverage?

  3. How volatile is the current and the future market? How much margin of safety I have to survive different market conditions? What additional risk is imposed by increasing leverage?

  4. Is the additional return worth taking the additional risk?

As you can see, your preference for leverage to a large extent depends on your prediction about the future. If you are certain, congratulations, your decision is easy. If you are not sure which scenario will play out, you should come up with different scenarios and assign them with probabilities. At Sharpe Investor Group, we believe low teens return without leverage already outperforms a lot of levered deals, it’s not worthy picking up nickels in front of a steam roller.

We are working diligently to launch our fund in early March. It is expected to deliver ~20% preferred return WITHOUT using any leverage, which is very rare in an uncertain market like the current one. Of course, this opportunity may not be a good fit for you, unless it matches with your investment goals and your risk tolerance.

That’s why I want to schedule a 30-min call with you to learn more about your investment return target and risk tolerance. It will help me decide whether to send this opportunity to you. This opportunity is open to accredited investors only. If it is not a good fit, what kind of opportunities are you interested in?

You can schedule a 30-min call with me by selecting the time here:

Invest with Confidence.

Yan Yan

Sharpe Investor Group

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