Debt: Not (Always) a Four Letter Word

A story in Tuesday's FT quoted heavily from a letter sent by PE firm TPG to its investors:

Last month's letter, obtained by the Financial Times, made the case that the leveraged buy-out was "an investment structure which is useful at some times during the cycle but not at other times".

"When debt is mispriced and inexpensive, as was the case before 2008, it makes sense to replace equity with debt, hence the abundance of LBOs," the letter said. "[Now] it makes sense to replace debt with equity, -leading to restructurings and recapitalisations."

Once upon a time I was young and a total Buffett-worshipper, and being a Buffett-worshipper to me meant YOU DON'T BORROW MONEY EVER. Like a a true Capricorn, however, I've loosened up with age and now look differently at investors who use debt. I now realize that there is debt and there is debt, and evaluting how an investor uses it, both qualitatively and quantitatively, is an important part of manager selection.

The best investors work both sides of the balance sheet, they're in the spread business. A dollar earned from the right side spends the same as a dollar earned from the right. Any stream of cash flows, whether going in or coming out the door, can be cheap, and value investors buy things cheap. If you can buy cheap AND maintain a margin of safety, you're well on your way. So you can scold the Masters of the Universe for what they did in the last few years, but many of them were smart: they recognized a cheap liability and "bought" it, and some of them did so with a margin of safety too.

Once I deprogrammed myself from the no-debt-ever cult, I began to see more clearly that Buffett has never been as strict with himself as his aphorisms imply. His primal urge to use Other People's Money is as strong as the most venal subprime packager, he's just done it more intelligently and always with a margin of safety. Not just insurance float, but also borrowing against utility earnings and to finance mobile home purchases, issuing debt for unspecified later use, even its derivatives bets. Take a look at the right side of Berkshire's balance sheet today--it's loaded with debt.

It's not just Buffett either. Baupost has drifted away from public market bets towards things like real estate, using non-recourse debt when the numbers make sense. Charlie Munger's first fortune came from a heavily leverage real estate development--again, non-recourse. John Malone has waged a decades-long war against the IRS, using levered cash flow growth, backed by what were essentially government-enforced monopolies, to shield earnings. Much of David Swensen's outperformance in the last decade comes from large allocations to real estate and PE funds, both of which took advantage of cheap debt.

It begs the question: Where are the debt arbitrages of today and tomorrow? If you're a creditworthy individual, and if you're worried about inflation to boot, now may be a great time to purchase a house in much of the country--the government is helping you out. I've in the past wondered whether Japan is the next great PE opportunity, as super-low borrowing costs on liabilities are starting to coincide with lower PE ratios (higher earnings yields) on assets. The same may be true for residential real estate too: according to the Economist, the price-to-rent ratio is lower in Japan than in any other OECD country. That implies higher cap rates, which in combination with lower borrowing costs means a fertile ground for dealmakers in the next few years.

So I'm keeping my eye on who is best using the liability side of the balance sheet.

Disclosure: Long Berkshire Hathaway.

Comments

[Gregman2:]

Debt is fine as long as you're not expecting a bail-out if things go south. Again, debt used to be used to generate income producing, high growth opportunities. And it was largely financed by the tax code.
Under Obama this may change.

May 11 10:41 AM

[Fred Voetsch:]

The worst time to take on debt is when you have no choice.

May 11 03:59 PM

[henarl:]

Debt is fine as an investment tool, but not as a lifestyle enhancer.

May 11 06:16 PM