Avoiding Leverage in Rough Times

As a private equity investor by profession, I am acutely aware of the dangers of leverage. Too much debt can limit a company's flexibility, cripple it with interest charges and force management to make short-sighted decisions. Even a good company can be badly damaged by leverage and an average company likely gets ruined by too much debt.

As a result of these dangers, I tend to avoid leverage in my personal portfolio. I am also focused on growth companies and "highly leveraged growth company" is largely an oxymoron.

In troubled times, avoiding highly leveraged companies becomes even more important because the debt is like an anchor dragging the company under the turbulent waves of a difficult economy. While a decline in sales can hurt a stock price at an unleveraged company, that same drop in sales can bankrupt a highly leveraged company because of the fixed nature of the debt costs.

I currently have nine companies in my portfolio and as usually they are conservatively positioned from a debt standpoint. Five of those companies actually have "net cash" on their balance sheet, meaning they have more cash than debt. Two more of my portfolio companies have very little debt (less than 10% of total capital). The final two portfolio companies do have debt, but the leverage ratios are very reasonable; one has debt that is 42% of capital and 1.94X EBITDA, while the second one has debt of 33% of capital and 2.69X EBITDA (near the top end of my range but it is a financial services company so they are more leveraged by their nature).

So how much is too much leverage? In the LBO world, banks will typically lend between 3.0x to 4.0x EBITDA depending upon the lending environment. In general, leverage at or above 4.0X EBITDA becomes a burden to a company. At this point the company is making short term decisions largely guided by debt. I would run from most public companies with debt of more than 4.0X EBITDA - and if their competitors are not also leveraged at the same levels, the leveraged company is at a severe competitive disadvantage.